Economy

An economy consists of the economic systems of a country or other area; the labor, capital
and land resources; and the manufacturing, production, trade, distribution, and consumption
of goods and services of that area.
A given economy is the result of a process that involves its technological evolution, history
and social organization, as well as its geography, natural resource endowment, and ecology,
as main factors. These factors give context, content, and set the conditions and parameters in
which an economy functions.
A market based economy may be described as a spatially limited social network where goods
and services are freely produced and exchanged according to demand and supply between
participants (economic agents) by barter or a medium of exchange with a credit or debit value
accepted within the network. Capital and labor can move freely across places, industries and
firms in search of higher profits, dividens, interests, and compensations and benefits. Rent on
land allocates this generally fixed resource among competing users.
Contemporary Capitalism is a market economy in which most of the production capacity is
owned and directed by the private sector. Government role is limited to provide for defense
and internal security; administer justice and prisons; make laws and regulations; enforce
contracts, laws and regulations; correct market imperfections and failures; ensure full
employment without inflation; promote balance economic growth and development; provide
for the poor, children, and elderly; protect and assist in emergencies and natural disasters;
provide basic opportunities to all members of society; prevent future calamities and disasters;
and, pursue national goals established by society at large such as protection of the
environment and natural resources.
On the other hand, traditional socialism is a command-based economy in which markets and
the free exchange of goods and services, as well as manufacturing, production, trade and
distribution are replaced or done by government central planning and state owned enterprises.
In this economy all private owners of capital (called capitalist) and of land (called
landowners) are not allowed or banned; and the only permitted private ownership is of
consumption goods. Capital and land are assigned by the state and movement of labor is
severely restricted. There are no profits, dividends, interest or rent. Labor compensation and
benefits are decided by central planners.
Finally, a mixed economy contains elements of both capitalism and socialism which means a
market based economy with a varied degree of government central planning and state owned
enterprises.
Contents
1 Range
2 Etymology
3 History
o 3.1 Ancient times
o 3.2 Middle ages
o 3.3 Early modern times
o 3.4 The industrial revolution
o 3.5 After World War II
4 Economic phases of precedence
5 Economic measures
o 5.1 GDP
6 Informal economy
7 Largest economies by GDP in 2012
8 Economies with the largest contribution to global economic growth from 1996 to 2011
9 See also
10 Notes
11 References
12 Further reading
Range
Today the range of fields of study examining the economy revolve around the social science
of economics, but may include sociology (economic sociology), history (economic history),
anthropology (economic anthropology), and geography (economic geography). Practical
fields directly related to the human activities involving production, distribution, exchange,
and consumption of goods and services as a whole, are engineering, management, business
administration, applied science, and finance.
All professions, occupations, economic agents or economic activities, contribute to the
economy. Consumption, saving, and investment are variable components in the economy that
determine macroeconomic equilibrium. There are three main sectors of economic activity:
primary, secondary, and tertiary.
Due to the growing importance of the financial sector in modern times,
[1]
the term real
economy is used by analysts
[2][3]
as well as politicians
[4]
to denote the part of the economy that
is concerned with actually producing goods and services,
[5]
as ostensibly contrasted with the
paper economy, or the financial side of the economy,
[6]
which is concerned with buying and
selling on the financial markets. Alternate and long-standing terminology distinguishes
measures of an economy expressed in real values (adjusted for inflation), such as real GDP, or
in nominal values (unadjusted for inflation).
[7]

Etymology
The English words "economy" and "economics" can be traced back to the Greek words
(i.e. "one who manages a household", a composite word derived from
("house") and ("manage; distribute")) and ("household management").
The first recorded sense of the word "conomy" is in the phrase "the management of
conomic affairs", found in a work possibly composed in a monastery in 1440. "Economy" is
later recorded in more general senses, including "thrift" and "administration".
The most frequently used current sense, denoting "the economic system of a country or an
area", seems not to have developed until the 19th or 20th century.
[8]

History
Ancient times
See also: Palace economy
As long as someone has been making, supplying and distributing goods or services, there has
been some sort of economy; economies grew larger as societies grew and became more
complex. Sumer developed a large scale economy based on commodity money, while the
Babylonians and their neighboring city states later developed the earliest system of economics
as we think of, in terms of rules/laws on debt, legal contracts and law codes relating to
business practices, and private property.
[9]

The Babylonians and their city state neighbors developed forms of economics comparable to
currently used civil society (law) concepts.
[10]
They developed the first known codified legal
and administrative systems, complete with courts, jails, and government records.
Several centuries after the invention of cuneiform, the use of writing expanded beyond
debt/payment certificates and inventory lists to be applied for the first time, about 2600 BC, to
messages and mail delivery, history, legend, mathematics, astronomical records and other
pursuits. Ways to divide private property, when it is contended... amounts of interest on debt...
rules as to property and monetary compensation concerning property damage or physical
damage to a person... fines for 'wrong doing'... and compensation in money for various
infractions of formalized law were standardized for the first time in history.
[9]



Greek drachm of Aegina. Obverse: Land turtle / Reverse: (INA) and dolphin. The oldest turtle coin
dates 700 BC
The ancient economy was mainly based on subsistence farming. The Shekel referred to an
ancient unit of weight and currency. The first usage of the term came from Mesopotamia circa
3000 BC. and referred to a specific mass of barley which related other values in a metric such
as silver, bronze, copper etc. A barley/shekel was originally both a unit of currency and a unit
of weight... just as the British Pound was originally a unit denominating a one pound mass of
silver.
For most people the exchange of goods occurred through social relationships. There were also
traders who bartered in the marketplaces. In Ancient Greece, where the present English word
'economy' originated, many people were bond slaves of the freeholders. Economic discussion
was driven by scarcity.
Middle ages
In Medieval times, what we now call economy was not far from the subsistence level. Most
exchange occurred within social groups. On top of this, the great conquerors raised venture
capital (from ventura, ital.; risk) to finance their captures. The capital should be refunded by
the goods they would bring up in the New World. Merchants such as Jakob Fugger (1459
1525) and Giovanni di Bicci de' Medici (13601428) founded the first banks.
[citation needed]
The
discoveries of Marco Polo (12541324),
[dubious discuss]
Christopher Columbus (14511506) and
Vasco da Gama (14691524) led to a first global economy. The first enterprises were trading
establishments. In 1513 the first stock exchange was founded in Antwerpen. Economy at the
time meant primarily trade.
Early modern times
The European captures became branches of the European states, the so-called colonies. The
rising nation-states Spain, Portugal, France, Great Britain and the Netherlands tried to control
the trade through custom duties and taxes in order to protect their national economy. The so-
called mercantilism (from mercator, lat.: merchant) was a first approach to intermediate
between private wealth and public interest. The secularization in Europe allowed states to use
the immense property of the church for the development of towns. The influence of the nobles
decreased. The first Secretaries of State for economy started their work. Bankers like Amschel
Mayer Rothschild (17731855) started to finance national projects such as wars and
infrastructure. Economy from then on meant national economy as a topic for the economic
activities of the citizens of a state.
The industrial revolution
The first economist in the true meaning of the word was the Scotsman Adam Smith (1723
1790). He defined the elements of a national economy: products are offered at a natural price
generated by the use of competition - supply and demand - and the division of labour. He
maintained that the basic motive for free trade is human self interest. The so-called self
interest hypothesis became the anthropological basis for economics. Thomas Malthus (1766
1834) transferred the idea of supply and demand to the problem of overpopulation. The
United States of America became the place where millions of expatriates from all European
countries were searching for free economic evolvement.
The Industrial Revolution was a period from the 18th to the 19th century where major
changes in agriculture, manufacturing, mining, and transport had a profound effect on the
socioeconomic and cultural conditions starting in the United Kingdom, then subsequently
spreading throughout Europe, North America, and eventually the world. The onset of the
Industrial Revolution marked a major turning point in human history; almost every aspect of
daily life was eventually influenced in some way. In Europe wild capitalism started to replace
the system of mercantilism (today: protectionism) and led to economic growth. The period
today is called industrial revolution because the system of Production, production and division
of labour enabled the mass production of goods.
After World War II
After the chaos of two World Wars and the devastating Great Depression, policymakers
searched for new ways of controlling the course of the economy. This was explored and
discussed by Friedrich August von Hayek (18991992) and Milton Friedman (19122006)
who pleaded for a global free trade and are supposed to be the fathers of the so called
neoliberalism. However, the prevailing view was that held by John Maynard Keynes (1883
1946), who argued for a stronger control of the markets by the state. The theory that the state
can alleviate economic problems and instigate economic growth through state manipulation of
aggregate demand is called Keynesianism in his honor. In the late 1950s the economic growth
in America and Europeoften called Wirtschaftswunder (ger: economic miracle) brought
up a new form of economy: mass consumption economy. In 1958 John Kenneth Galbraith
(19082006) was the first to speak of an affluent society. In most of the countries the
economic system is called a social market economy.
Economic phases of precedence
The economy may be considered as having developed through the following Phases or
Degrees of Precedence.
The ancient economy was mainly based on subsistence farming.
The industrial revolution phase lessened the role of subsistence farming, converting it to
more extensive and mono-cultural forms of agriculture in the last three centuries. The
economic growth took place mostly in mining, construction and manufacturing industries.
Commerce became more significant due to the need for improved exchange and distribution
of produce throughout the community.
In the economies of modern consumer societies phase there is a growing part played by
services, finance, and technologythe (knowledge economy).
In modern economies, these phase precedences are somewhat differently expressed by
degrees of activity.
[citation needed]

Primary stage/degree of the economy: Involves the extraction and production of raw
materials, such as corn, coal, wood and iron. (A coal miner and a fisherman would be workers
in the primary degree.)
Secondary stage/degree of the economy: Involves the transformation of raw or
intermediate materials into goods e.g. manufacturing steel into cars, or textiles into clothing.
(A builder and a dressmaker would be workers in the secondary degree.) At this stage the
associated industrial economy is also sub-divided into several economic sectors (also called
industries). Their separate evolution during the Industrial Revolution phase is dealt with
elsewhere.
Tertiary stage/degree of the economy: Involves the provision of services to consumers and
businesses, such as baby-sitting, cinema and banking. (A shopkeeper and an accountant
would be workers in the tertiary degree.)
Quaternary stage/degree of the economy: Involves the research and development needed
to produce products from natural resources and their subsequent by-products. (A logging
company might research ways to use partially burnt wood to be processed so that the
undamaged portions of it can be made into pulp for paper.) Note that education is
sometimes included in this sector.
Other sectors of the developed community include :
the Public Sector or state sector (which usually includes: parliament, law-courts and
government centers, various emergency services, public health, shelters for empoverished
and threatened people, transport facilities, air/sea ports, post-natal care, hospitals, schools,
libraries, museums, preserved historical buildings, parks/gardens, nature-reserves, some
universities, national sports grounds/stadiums, national arts/concert-halls or theaters and
centers for various religions).
the Private Sector or privately-run businesses.
the Social sector or Voluntary sector.
Economic measures
There are a number of ways to measure economic activity of a nation. These methods of
measuring economic activity include:
Consumer spending
Exchange Rate
Gross domestic product
GDP per capita
GNP
Stock Market
Interest Rate
National Debt
Rate of Inflation
Unemployment
Balance of Trade
GDP
The GDP - Gross domestic product of a country is a measure of the size of its economy. The
most conventional economic analysis of a country relies heavily on economic indicators like
the GDP and GDP per capita. While often useful, it should be noted that GDP only includes
economic activity for which money is exchanged.
Informal economy
Main article: Informal economy
An informal economy is economic activity that is neither taxed nor monitored by a
government, contrasted with a formal economy. The informal economy is thus not included in
that government's Gross National Product (GNP). Although the informal economy is often
associated with developing countries, all economic systems contain an informal economy in
some proportion.
Informal economic activity is a dynamic process which includes many aspects of economic
and social theory including exchange, regulation, and enforcement. By its nature, it is
necessarily difficult to observe, study, define, and measure. No single source readily or
authoritatively defines informal economy as a unit of study.
The terms "under the table" and "off the books" typically refer to this type of economy. The
term black market refers to a specific subset of the informal economy. The term "informal
sector" was used in many earlier studies, and has been mostly replaced in more recent studies
which use the newer term.
Micro economics are focused on an individual person in a given economic society and Macro
economics is looking at an economy as a whole. (town, city, region)



Capitalism
Econometrics
Economic history (includes list by country)
Economic system
Economic equilibrium
Ecological economics
History of money
Non-market economics
Macroeconomics
Microeconomics
Supply and demand
Thermoeconomics
World Economy

Economic system
An economic system is the combination of the various agencies, entities (or even sectors as
described by some authors) that provide the economic structure that defines the social
community. These agencies are joined by lines of trade and exchange along which goods,
money etc. are continuously flowing. An example of such a system for a closed economy is
shown in the flow-diagram. The economics system involves production, allocation of
economic inputs, distribution of economic outputs, landlords and land availability, households
(earnings and expenditure consumption of goods and services in an economy), capitalists,
banks (finance institutions) and government. It is a set of institutions and their various social
relations.
Alternatively, it is the set of principles by which problems of economics are addressed, such
as the economic problem of scarcity through allocation of finite productive resources.
[1]
An
economic system is composed of people, institutions, rules, and relationships. For example,
the convention of property, the institution of government, or the employee-employer
relationship. Examples of contemporary economic systems include capitalist systems,
socialist systems, and mixed economies. Today the world largely operates under a global
economic system based on the capitalist mode of production.
"Economic systems" is the economics category that includes the study of such systems.
Decision-making structures
The decision-making structures of an economy determine the use of economic inputs (the
means of production), distribution of output, the level of centralization in decision-making,
and who makes these decisions. Decisions might be carried out by industrial councils, by a
government agency, or by private owners. Some aspects of these structures include:
Coordination mechanism: How information is obtained and used to coordinate economic
activity. The two dominant forms of coordination include planning and the market; planning
can be either centralized or de-centralized, and the two mechanisms are not mutually
exclusive.
Productive property rights: This refers to ownership (rights to the proceeds of output
generated) and control over the use of the means of production. They may be owned
privately, by the state, by those who use it, or held in common by society.
Incentive system: A mechanism for inducing certain economic agents to engage in productive
activity; it can be based on either material reward (compensation) or moral reward (social
prestige).
[2]

Types


Marxist-Leninist Communist states (red) and formerly Communist-run (orange) countries of the
world.
There are several basic questions that must be answered in order for an economy to run
satisfactorily. The scarcity problem, for example, requires answers to basic questions, such as:
what to produce, how to produce it, and who gets what is produced. An economic system is a
way of answering these basic questions, and different economic systems answer them
differently. Many different objectives may be seen as desirable for an economy, like
efficiency, growth, liberty, and equality.
[3]

Economic systems can be divided by the way they allocate economic inputs (the means of
production) and how they make decisions regarding the use of inputs. A common distinction
of great importance is that between capitalism (a market economy) and socialism (economic
planning).
In a capitalist economic system, production is carried out to maximize private profit, decisions
regarding investment and the use of the means of production are determined by competing
business owners in the marketplace; production takes place within the process of capital
accumulation. The means of production are owned primarily by private enterprises and
decisions regarding production and investment determined by private owners in capital
markets. Capitalist systems range from laissez-faire, with minimal government regulation and
state enterprise, to regulated and social market systems, with the stated aim of ensuring social
justice and a more equitable distribution of wealth (see welfare state) or ameliorating market
failures (see economic intervention).
In a socialist economic system, production is carried out to directly satisfy economic demand
by producing goods and services for use; decisions regarding the use of the means of
production are adjusted to satisfy economic demand, investment (control over the surplus
value) is carried out through a mechanism of inclusive collective decision-making. The means
of production are either publicly owned, or are owned by the workers cooperatively. A
socialist economic system that is based on the process of capital accumulation, but seeks to
control or direct that process through state ownership or cooperative control to ensure
stability, equality or expand decision-making power, are market socialist systems.
The basic and general economic systems are:
Market economy ("hands off" systems, such as Laissez-faire capitalism)
Mixed economy (a hybrid that blends some aspects of both market and planned economies)
Planned economy ("hands on" systems, such as state socialism)
Traditional economy (a generic term for older economic systems)
Command (Centrally Planned or Socialist) Economic Systems: (a generic term for older
economic systems)
Participatory economics (a system where the production and distribution of goods is guided
by public participation)
Gift economy (where an exchange is made without any explicit agreement for immediate or
future rewards)
Barter economy (where goods and services are directly exchanged for other goods or
services)
Types of socialist systems
Economic systems can be subdivided by their coordinating mechanism (planning and
markets) into planned socialist market socialist systems. Additionally, socialism can be
divided based on the ownership of the means of production into those that are based on public
ownership, worker or consumer cooperatives and common ownership (i.e., non-ownership).
Communism is a hypothetical stage of Socialist development articulated by Marx as "second
stage Socialism" in Critique of the Gotha Program, whereby economic output is distributed
based on need and not simply on the basis of labor contribution.
The primary concern for socialist planned economies is to coordinate production to directly
satisfy human needs/economic demand (as opposed to generate profit and satisfy needs as a
byproduct of pursuing profit), to advance the productive forces of the economy while being
immune to the systemic inefficiencies (cyclical processes) and crisis of overproduction that
plagues capitalism so that production would be subject to the needs of society as opposed to
being ordered around capital accumulation.
[4][5]

In orthodox Marxism, the mode of production is tantamount to the subject of this article,
determining with a superstructure of relations the entirety of a given culture or stage of human
development.
Planned systems
Calculation in kind
Indicative planning
Planned economy
State socialism
Market systems
Market socialism
Socialist market economy
Mutualism (economic theory)
Types of mixed economies
Economic systems that contain substantial state, private and sometimes cooperative
ownership and operated in mixed economies - i.e., ones that contain substantial amounts of
both market activity and economic planning.
Distributism - Catholic ideal of a "third way" economy, featuring more distributed ownership
Georgism - socialized rents on land
Mixed economy
o American School
o Dirigisme
o Nordic model
o Japanese system
o Mercantilism
o Social market economy also known as Soziale Marktwirtschaft
o Social corporatism
o Socialist-oriented market economy
o Progressive utilization theory
o Indicative planning also known as a planned market economy
Evolutionary economics
See also: Evolutionary economics
Karl Marx's theory of economic development was based on the premise of evolving economic
systems; specifically, over the course of history superior economic systems would replace
inferior ones. Inferior systems were beset by internal contradictions and inefficiencies that
make them impossible to survive over the long term. In Marx's scheme, feudalism was
replaced by capitalism, which would eventually be superseded by socialism.
[2]
Joseph
Schumpeter had an evolutionary conception of economic development, but unlike Marx, he
de-emphasized the role of class struggle in contributing to qualitative change in the economic
mode of production. In subsequent world history, Communist states run according to Marxist-
Leninist ideologies have either collapsed or gradually reformed their centrally-planned
economies toward market-based economies, for example with perestroika and the dissolution
of the Soviet Union, Chinese economic reform, and i Mi in Vietnam.
Mainstream evolutionary economics continues to study economic change in modern times.
There has also been renewed interest in understanding economic systems as evolutionary
systems in the emerging field of Complexity economics.
Context in society
An economic system can be considered a part of the social system and hierarchically equal to
the law system, political system, cultural, etc. There is often a strong correlation between
certain ideologies, political systems and certain economic systems (for example, consider the
meanings of the term "communism"). Many economic systems overlap each other in various
areas (for example, the term "mixed economy" can be argued to include elements from
various systems). There are also various mutually exclusive hierarchical categorizations.
List of economic systems
This list attempts to sort all possible economic systems in alphabetical order, without any
division or hierarchization.
American School
Anarchism
Anarcho-capitalism
Anarcho-communism
Autarky
Barter economy
Buddhist economy
Capitalism
Colonialism
Communism
Corporatism
Corporate capitalism
Digital economy
Distributism
Dirigisme
Fascist socialization
Feudalism
Georgism
Green economy
Hydraulic despotism
Inclusive democracy
Information economy
Internet economy
Islamic economics
Japanese System
Knowledge economy
Libertarian communism
Libertarian socialism
Market economy
Market socialism
Marxian economics
Mercantilism
Mixed economy
Mutualism
National Socialism
Natural economy
Neo-colonialism
Network economy
Nordic model
Non-property system
Parecon
Participatory economy
Planned economy
PROUTist economy
Self-management
Social Credit
Social market economy
Socialism
Socialist market economy
Syndicalism
Subsistence economy
Traditional economy
Virtual economy
See also
Economy
History of economic thought
Political economy
Economic ideology
Holmes System
Further reading
Richard Bonney (1995), Economic Systems and State Finance, 680 pp.
David W. Conklin (1991), Comparative Economic Systems, Cambridge University Press, 427
pp.
George Sylvester Counts (1970), Bolshevism, Fascism, and Capitalism: An Account of the
Three Economic Systems.
Robert L. Heilbroner and Peter J. Boettke (2007). "Economic Systems". The New
Encyclopdia Britannica, v. 17, pp. 90815.
Harold Glenn Moulton, Financial Organization and the Economic System, 515 pp.
Jacques Jacobus Polak (2003), An International Economic System, 179 pp.
Frederic L. Pryor (1996), Economic Evolution and Structure: 384 pp.
Frederic L. Pryor (2005), Economic Systems of Foraging, Agricultural, and Industrial Societies,
332 pp.
Graeme Snooks (1999), Global Transition: A General Theory, PalgraveMacmillan, 395 pp.
References
1. ^ NA (2007). "economic systems," The New Encyclopdia Britannica, v. 4, p. 357.
2. ^
a

b
Comparing Economic Systems in the Twenty-First Century, 2003, by Gregory and Stuart.
ISBN 0-618-26181-8.
3. ^ David W. Conklin (1991), Comparative Economic Systems, University of Calgary Press, p.1.
4. ^ Socialism: Still Impossible After All These Years, on Mises.org. Retrieved February 15, 2010,
from Mises.org http://mises.org/journals/scholar/Boettke.pdf, What Socialism means: " The
ultimate end of socialism was the 'end of history', in which perfect social harmony would
permanently be established. Social harmony was to be achieved by the abolition of
exploitation, the transcendence of alienation, and above all, the transformation of society
from the 'kingdom of necessity' to the 'kingdom of freedom.' How would such a world be
achieved? The socialists informed us that by rationalizing production and thus advancing
material production beyond the bounds reachable under capitalism, socialism would usher
mankind into a post-scarcity world."
5. ^ Socialism and Calculation, on worldsocialism.org. Retrieved February 15, 2010, from
worldsocialism.org: http://www.worldsocialism.org/spgb/overview/calculation.pdf:
"Although money, and so monetary calculation, will disappear in socialism this does not
mean that there will no longer be any need to make choices, evaluations and
calculations...Wealth will be produced and distributed in its natural form of useful things, of
objects that can serve to satisfy some human need or other. Not being produced for sale on a
market, items of wealth will not acquire an exchange-value in addition to their use-value. In
socialism their value, in the normal non-economic sense of the word, will not be their selling
price nor the time needed to produce them but their usefulness. It is for this that they will be
appreciated, evaluated, wanted. . . and produced."
External links
Video Overview of Economic Systems by Thinkwell
Social Studies VSC Glossary
Glossary-Cultural Anthropology
ECONOMIC SYSTEMS, a refereed journal for the analysis of market and non-market solution,
by Elsevier since 2001.
Economic Systems by WebEc, 2007.
World Economic Systems
Workers' self-management
Worker self-management (sometimes called workers' control or autogestion) is a form of
workplace decision-making in which the workers themselves agree on choices (for issues
such as customer care, general production methods, scheduling, division of labour) instead of
an owner or traditional supervisor telling workers what to do, how to do it and where to do it.
Examples of such self-management allegedly include the Paris Commune, the Russian
Revolution, the German Revolution, the Spanish Revolution, Titoist Yugoslavia, Algeria
under Ahmed Ben Bella, the fbricas recuperadas movement in Argentina, the LIP factory in
France in the 1970s, the Mondragn Cooperative Corporation which is the Basque Country's
largest corporation, AK Press
[1]
in the United States, etc.
Argentina's fbricas recuperadas movement, which emerged in response to Argentine's 2001
economic crisis,
[2]
is the current most significant workers' self-management phenomenon in
the world.
English-language discussions of this phenomenon may employ several different translations
of the original Spanish expression other than recovered factory. For example, recuperated
factory/business, reclaimed factory, and worker-run factory have been noted. The
phenomenon is also known as "autogestion," which comes from the French word for self-
management (applied to factories, popular education systems, and other uses). Worker self-
management may coincide with employee ownership.
Workers' self-management is often the decision-making model used in co-operative economic
arrangements such as worker cooperatives, workers' councils, participatory economics, and
similar arrangements where the workplace operates without a boss. This model of decision
making does not involve consulting all employees for every tiny issue in a time-consuming,
inefficient and ineffective manner. Real-world examples show that only large-scale decisions
are made by all employees during council meetings and small decisions are made by those
implementing them while coordinating with the rest and following more general agreements.
Theory

This section does not cite any references or sources.
Autogestion was first theorized by Pierre-Joseph Proudhon during the first part of the 19th
century.
[3]
It then became a primary component of some trade union organizations, in
particular revolutionary syndicalism which was introduced in late 19th century France and
guild socialism in early 20th century Britain, although both movements collapsed in the early
1920s. French trade-union CFDT ("Confdration Franaise Dmocratique du Travail")
included worker self-management in its 1970 program, before later abandoning it. The
philosophy of workers' self-management has been promoted by the Industrial Workers of the
World (IWW) since its founding in the United States in 1905.
Critics of workers' self-management from the left, such as Gilles Dauv and Jacques Camatte,
do not admonish the model as reactionary but simply as not progressive in the context of
developed capitalism. Such critics suggest that capitalism is more than a relationship of
management. Rather, they suggest capitalism should be considered as a social totality which
workers' self-management in and of itself only perpetuates and does not challenge - despite its
seemingly radical content and activity. This theory is used to explain why self-management in
Yugoslavia never advanced beyond the confines of the larger state monopoly economy, or
why many modern worker-owned facilities tend to return to hiring managers and accountants
after only a few years of operation.
History
One significant experiment with workers' self-management took place during the Spanish
Revolution (19361939).
[4]

In the 1950s, at the height of the Cold War, Titoist Yugoslavia advocated a socialist version
of autogestion, leading to a break with Moscow, which practiced central planning and state
ownership of industry. The economy of Yugoslavia was organized according to the theories
of Tito and more directly Edvard Kardelj. Croatian scientist Branko Horvat also made a
significant contribution to the theory of socialism (radniko samoupravljanje) as practiced in
Yugoslavia. With the exception of a recession in the mid-1960s, the country's economy
prospered under Titoist Socialism. Unemployment was low, the education level of the work
force steadily increased. The life expectancy (which was about 72 years) and living standards
of Yugoslav citizens was nearly equal to the life expectancy and living standards of citizens of
western capitalist countries such as Portugal. Due to Yugoslavia's neutrality and its leading
role in the Non-Aligned Movement, Yugoslav companies exported to both Western and
Eastern markets. Yugoslav companies carried out construction of numerous major
infrastructural and industrial projects in Africa, Europe and Asia.
[5][6]

After May 68 in France, LIP factory, a clockwork factory based in Besanon, became self-
managed starting in 1973, after the management's decision to liquidate it. The LIP experience
was an emblematic social conflict of post-68 in France. CFDT (the CCT as it was referred to
in Northern Spain), trade-unionist Charles Piaget led the strike in which workers claimed the
means of production. The Unified Socialist Party (PSU), which included former Radical
Pierre Mends-France, was in favour of autogestion or self-management.
[7]

South America
In October 2005 the first Encuentro Latinoamericano de Empresas Recuperadas ("Latin
American Encounter of Recovered Companies") took place in Caracas, Venezuela, with
representatives of 263 such companies from different countries living through similar
economical and social situations. The meeting had, as its main outcome, the Compromiso de
Caracas (Caracas' Commitment); a vindicating text of the movement.
The Hotel Bauen in Buenos Aires, occupied and self-managed since 2003.
The fbricas recuperadas movement (Argentina)
Argentina's fbricas recuperadas movement, which emerged in response to Argentine's 2001
economic crisis,
[2]
is the current most significant workers' self-management phenomenon in
the world. Workers took over control of the factories in which they had worked, commonly
after bankruptcy, or after a factory occupation to circumvent a lockout.
Fbricas recuperadas means "reclaimed/recovered factories." The Spanish verb recuperar
means not only "to get back", "to take back" or "to reclaim" but also "to put back into good
condition". Although initially referring to industrial facilities, the term may also apply to
businesses other than factories (e.g. Hotel Bauen in Buenos Aires).
Throughout the 1990s in Argentina's southern province of Neuqun, drastic economic and
political events occurred where the citizens ultimately rose up. Although the first shift
occurred in a single factory, bosses were progressively fired throughout the province so that
by 2005 the workers of the province controlled most of the factories.
The movement emerged as a response to Argentine's 2001 economic crisis,
[2]
and about 200
Argentine companies were "recovered" by their workers and turned into co-operatives.
Prominent examples include the Brukman factory, the Hotel Bauen and FaSinPat (formerly
known as Zanon). As of 2005, about 15,000 Argentine workers run recovered factories.
The phenomenon of fabricas recuperadas ("recovered factories") is not new in Argentina.
Rather, such social movements were completely dismantled during the so-called "Dirty War"
in the 1970s. Thus, during Hctor Cmpora's first months of government (MayJuly 1973), a
rather moderate and left-wing Peronist, approximately 600 social conflicts, strikes and factory
occupations had taken place.
[8]

Many recovered factories are run co-operatively and all workers receive the same wage.
Important management decisions are taken democratically by an assembly of all workers,
rather than by professional managers.
The proliferation of these "recoveries" has led to the formation of a recovered factory
movement, which has ties to a diverse political network including socialists, Peronists,
anarchists and communists. Organizationally, this includes two major federations of
recovered factories, the larger Movimiento Nacional de Empresas Recuperadas (or National
Movement of Recuperated Businesses, or MNER) on the left and the smaller National
Movement of Recuperated Factories (MNFR)
[9]
on the right.
[10]
Some labor unions,
unemployed protestors (known as piqueteros), traditional worker cooperatives and a range of
political groups have also provided support for these take-overs. In March 2003, with the help
of the MNER, former employees of the luxury Hotel Bauen occupied the building and took
control of it.
One of the highest difficulties such a movement faces is its relation towards the classic
economic system, as most classically managed firms refused,
[verification needed]
for various
reasons (among which ideological hostility to the very principle of autogestion) to work and
deal with recovered factories. Thus, isolated recovered factories find it easier to work together
in building an alternative, more democratic economic system and thus manage to reach a
critical size and power which enables it to negotiate with the ordinary capitalistic firms.
The movement led in 2011 to a new bankruptcy law that facilitates take over by the
workers.
[11]
The legislation was signed into law by President Cristina Kirchner on June 29,
2011.
[12]

See also
Anarcho-syndicalism
Austromarxism
Ceylon Transport Board
Collectivism
Consensus decision-making
Co-operatives
Council communism
Direct democracy
Distributism
Edvard Kardelj, a Yugoslavian
Communist Party leader
Employee ownership
Inclusive Democracy
Industrial democracy
Orpheus Chamber Orchestra
Paris Commune of 1871
Participatory economics
Popular Education
The Take (2004 film), documentary about
reclaimed factories and worker co-
operatives in Argentina
Unified Socialist Party (France)
United States Federation of Worker
Cooperatives
Worker cooperative
Workers' control
Workers' council
Workplace democracy
Mutualism (economic theory)
Mondragn Corporation, probably the
world's largest self-managed enterprise
1971 Harco work-in (a four-week "work-in"
by Australian steelworkers)
Notes
1. ^ AKPress.org
2. ^
a

b

c
Guido Galafassi, Paula Lenguita, Robinson Salazar Perez (2004) Nuevas Practicas
Politicas Insumisas En Argentina pp.222, 238
3. ^ Proudhon, Pierre-Joseph (1866-1876). 'Oeuvres Compltes', volume 17. Paris: Lacroix.
pp. 1889.
4. ^ Dolgoff, S. (1974), The Anarchist Collectives: Workers' Self-Management in the Spanish
Revolution, ISBN 978-0-914156-03-1
5. ^ Liotta, P.H.. "Paradigm Lost :Yugoslav Self-Management and the Economics of Disaster".
Retrieved 18 August 2010.
6. ^ "Yugoslavia: Introduction of Socialist Self-Management". Country Data. December 1990.
Retrieved 18 August 2010.
7. ^ LIP, l'imagination au pouvoir, article by Serge Halimi in Le Monde diplomatique, 20 March
2007 (French)
8. ^ Hugo Moreno, Le dsastre argentin. Pronisme, politique et violence sociale (1930-2001),
Editions Syllepses, Paris, 2005, p.109 (French)
9. ^ Movimiento Nacional de Fabricas Recuperadas
10. ^ Marie Trigona, Recuperated Enterprises in Argentina - Reversing the Logic of Capitalism,
Znet, March 27, 2006 (English)
11. ^ Pagina12: Nueva Ley de Quiebras (April 2011), Fbricas recuperadas y tambin legales
(June 2nd 2011)
12. ^ CFK promulg la reforma de la Ley de Quiebras in Pgina/12, June 29th 2011
References
Bolloten, Burnett (1991). The Spanish Civil War: Revolution and Counterrevolution. Chapel
Hill: University of North Carolina. ISBN 0-8078-1906-9.

Economic model


A diagram of the IS/LM model
In economics, a model is a theoretical construct that represents economic
processes by a set of variables and a set of logical and/or quantitative
relationships between them. The economic model is a simplified framework
designed to illustrate complex processes, often but not always using
mathematical techniques. Frequently, economic models posit structural
parameters. Structural parameters are underlying parameters in a model
or class of models.
[1]
A model may have various parameters and those
parameters may change to create various properties. Methodological uses
of models include investigation, theorizing, fitting theories to the
world.
[2]
Contents
1 Overview
2 Types of models
o 2.1 Quantitative vs. Qualitative models
3 Pitfalls
o 3.1 Restrictive, unrealistic assumptions
o 3.2 Omitted details
o 3.3 Are economic models falsifiable?
4 History
5 Tests of macroeconomic predictions
o 5.1 Comparison with models in other sciences
o 5.2 The effects of deterministic chaos on economic models
o 5.3 The critique of hubris in planning
6 Examples of economic models
7 See also
8 Notes
9 References
10 External links
Overview
In general terms, economic models have two functions: first as a simplification of and
abstraction from observed data, and second as a means of selection of data based on a
paradigm of econometric study.
Simplification is particularly important for economics given the enormous complexity of
economic processes. This complexity can be attributed to the diversity of factors that
determine economic activity; these factors include: individual and cooperative decision
processes, resource limitations, environmental and geographical constraints, institutional and
legal requirements and purely random fluctuations. Economists therefore must make a
reasoned choice of which variables and which relationships between these variables are
relevant and which ways of analyzing and presenting this information are useful.
Selection is important because the nature of an economic model will often determine what
facts will be looked at, and how they will be compiled. For example inflation is a general
economic concept, but to measure inflation requires a model of behavior, so that an economist
can differentiate between real changes in price, and changes in price which are to be attributed
to inflation.
In addition to their professional academic interest, the use of models include:
Forecasting economic activity in a way in which conclusions are logically related to
assumptions;
Proposing economic policy to modify future economic activity;
Presenting reasoned arguments to politically justify economic policy at the national level, to
explain and influence company strategy at the level of the firm, or to provide intelligent
advice for household economic decisions at the level of households.
Planning and allocation, in the case of centrally planned economies, and on a smaller scale in
logistics and management of businesses.
In finance predictive models have been used since the 1980s for trading (investment, and
speculation), for example emerging market bonds were often traded based on economic
models predicting the growth of the developing nation issuing them. Since the 1990s many
long-term risk management models have incorporated economic relationships between
simulated variables in an attempt to detect high-exposure future scenarios (often through a
Monte Carlo method).
A model establishes an argumentative framework for applying logic and mathematics that can
be independently discussed and tested and that can be applied in various instances. Policies
and arguments that rely on economic models have a clear basis for soundness, namely the
validity of the supporting model.
Economic models in current use do not pretend to be theories of everything economic; any
such pretensions would immediately be thwarted by computational infeasibility and the
paucity of theories for most types of economic behavior. Therefore conclusions drawn from
models will be approximate representations of economic facts. However, properly constructed
models can remove extraneous information and isolate useful approximations of key
relationships. In this way more can be understood about the relationships in question than by
trying to understand the entire economic process.
The details of model construction vary with type of model and its application, but a generic
process can be identified. Generally any modelling process has two steps: generating a model,
then checking the model for accuracy (sometimes called diagnostics). The diagnostic step is
important because a model is only useful to the extent that it accurately mirrors the
relationships that it purports to describe. Creating and diagnosing a model is frequently an
iterative process in which the model is modified (and hopefully improved) with each iteration
of diagnosis and respecification. Once a satisfactory model is found, it should be double
checked by applying it to a different data set.
Types of models
According to whether all the model variables are deterministic, economic models can be
classified as stochastic or non-stochastic models; according to whether all the variables are
quantitative, economic models are classified as discrete or continuous choice model;
according to the model's intended purpose/function, it can be classified as quantitative or
qualitative; according to the model's ambit, it can be classified as a general equilibrium
model, a partial equilibrium model, or even a non-equilibrium model; according to the
economic agent's characteristics, models can be classified as rational agent models,
representative agent models etc.
Stochastic models are formulated using stochastic processes. They model economically
observable values over time. Most of econometrics is based on statistics to formulate and
test hypotheses about these processes or estimate parameters for them. A widely used class
of econometric models popularized by Tinbergen and later Wold are autoregressive models,
in which the stochastic process satisfies some relation between current and past values.
Examples of these are autoregressive moving average models and related ones such as
autoregressive conditional heteroskedasticity (ARCH) and GARCH models for the modelling
of heteroskedasticity.
Non-stochastic mathematical models may be purely qualitative (for example, models
involved in some aspect of social choice theory) or quantitative (involving rationalization of
financial variables, for example with hyperbolic coordinates, and/or specific forms of
functional relationships between variables). In some cases economic predictions of a model
merely assert the direction of movement of economic variables, and so the functional
relationships are used only in a qualitative sense: for example, if the price of an item
increases, then the demand for that item will decrease. For such models, economists often
use two-dimensional graphs instead of functions.
Qualitative models Although almost all economic models involve some form of
mathematical or quantitative analysis, qualitative models are occasionally used. One
example is qualitative scenario planning in which possible future events are played out.
Another example is non-numerical decision tree analysis. Qualitative models often suffer
from lack of precision.
At a more practical level, quantitative modelling is applied to many areas of economics and
several methodologies have evolved more or less independently of each other. As a result, no
overall model taxonomy is naturally available. We can nonetheless provide a few examples
which illustrate some particularly relevant points of model construction.
An accounting model is one based on the premise that for every credit there is a debit. More
symbolically, an accounting model expresses some principle of conservation in the form
algebraic sum of inflows = sinks sources
This principle is certainly true for money and it is the basis for national income accounting.
Accounting models are true by convention, that is any experimental failure to confirm them,
would be attributed to fraud, arithmetic error or an extraneous injection (or destruction) of
cash which we would interpret as showing the experiment was conducted improperly.
Optimality and constrained optimization models Other examples of quantitative models
are based on principles such as profit or utility maximization. An example of such a model is
given by the comparative statics of taxation on the profit-maximizing firm. The profit of a
firm is given by

where is the price that a product commands in the market if it is supplied at the rate
, is the revenue obtained from selling the product, is the cost of bringing
the product to market at the rate , and is the tax that the firm must pay per unit of the
product sold.
The profit maximization assumption states that a firm will produce at the output rate x if that
rate maximizes the firm's profit. Using differential calculus we can obtain conditions on x
under which this holds. The first order maximization condition for x is

Regarding x is an implicitly defined function of t by this equation (see implicit function
theorem), one concludes that the derivative of x with respect to t has the same sign as

which is negative if the second order conditions for a local maximum are satisfied.
Thus the profit maximization model predicts something about the effect of taxation on
output, namely that output decreases with increased taxation. If the predictions of the
model fail, we conclude that the profit maximization hypothesis was false; this should lead to
alternate theories of the firm, for example based on bounded rationality.
Borrowing a notion apparently first used in economics by Paul Samuelson, this model of
taxation and the predicted dependency of output on the tax rate, illustrates an operationally
meaningful theorem; that is one which requires some economically meaningful assumption
which is falsifiable under certain conditions.
Aggregate models. Macroeconomics needs to deal with aggregate quantities such as output,
the price level, the interest rate and so on. Now real output is actually a vector of goods and
services, such as cars, passenger airplanes, computers, food items, secretarial services, home
repair services etc. Similarly price is the vector of individual prices of goods and services.
Models in which the vector nature of the quantities is maintained are used in practice, for
example Leontief input-output models are of this kind. However, for the most part, these
models are computationally much harder to deal with and harder to use as tools for
qualitative analysis. For this reason, macroeconomic models usually lump together different
variables into a single quantity such as output or price. Moreover, quantitative relationships
between these aggregate variables are often parts of important macroeconomic theories.
This process of aggregation and functional dependency between various aggregates usually is
interpreted statistically and validated by econometrics. For instance, one ingredient of the
Keynesian model is a functional relationship between consumption and national income: C =
C(Y). This relationship plays an important role in Keynesian analysis.elow
Quantitative vs. Qualitative models
A quantitative model is designed to produce accurate predictions, without elucidating the
underlying dynamics. On the other hand, a qualitative model aims to explain these dynamics
without necessarily fitting empirical data or informing accurate predictions. Interest rate
parity can be deemed a qualitative model in this sense: though it generally fails to fit
exchange rate data as well as higher-powered statistical forecasting models, it offers an
intuitive interpretation of the exchange rate and its relation to foreign and domestic interest
and inflation rates. Views on the relative merits of qualitative and quantitative models vary
across the profession: Milton Friedman can be viewed as having advocated a qualitative
approach, while Ronald Coase worried that "if you torture the data long enough, it will
confess;" Prospect theory as proposed by Daniel Kahneman(a Nobel prize winner) is more
quantiative, while rational agent models are more qualitative.
Pitfalls
Restrictive, unrealistic assumptions
Provably unrealistic assumptions are pervasive in neoclassical economic theory (also called
the "standard theory" or "neoclassical paradigm"), and those assumptions are inherited by
simplified models for that theory. (Any model based on a flawed theory, cannot transcend the
limitations of that theory.) Joseph Stiglitz' 2001 Nobel Prize lecture
[3]
reviews his work on
Information Asymmetries, which contrasts with the assumption, in standard models, of
"Perfect Information". Stiglitz surveys many aspects of these faulty standard models, and the
faulty policy implications and recommendations that arise from their unrealistic assumptions.
Stiglitz writes: (p. 519520)
"I only varied one assumption the assumption concerning perfect information and in ways
which seemed highly plausible. ... We succeeded in showing not only that the standard theory
was not robust changing only one assumption in ways which were totally plausible had
drastic consequences, but also that an alternative robust paradigm with great explanatory
power could be constructed. There were other deficiencies in the theory, some of which were
closely connected. The standard theory assumed that technology and preferences were fixed.
But changes in technology, R & D, are at the heart of capitalism. ... I similarly became
increasingly convinced of the inappropriateness of the assumption of fixed preferences.
(Footnote: In addition, much of recent economic theory has assumed that beliefs are, in some
sense, rational. As noted earlier, there are many aspects of economic behavior that seem hard
to reconcile with this hypothesis.)"
Economic models can be such powerful tools in understanding some economic relationships,
that it is easy to ignore their limitations. One tangible example where the limits of Economic
Models collided with reality, but were nevertheless accepted as "evidence" in public policy
debates, involved models to simulate the effects of NAFTA, the North American Free Trade
Agreement. James Stanford published his examination of 10 of these models.
[4]

[5]

The fundamental issue is circularity: embedding one's assumptions as foundational "input"
axioms in a model, then proceeding to "prove" that, indeed, the model's "output" supports the
validity of those assumptions. Such a model is consistent with similar models that have
adopted those same assumptions. But is it consistent with reality? As with any scientific
theory, empirical validation is needed, if we are to have any confidence in its predictive
ability.
If those assumptions are, in fact, fundamental aspects of empirical reality, then the model's
output will correctly describe reality (if it is properly "tuned", and if it is not missing any
crucial assumptions). But if those assumptions are not valid for the particular aspect of reality
one attempts to simulate, then it becomes a case of "GIGO" Garbage In, Garbage Out".
James Stanford outlines this issue for the specific Computable General Equilibrium ("CGE")
models that were introduced as evidence into the public policy debate, by advocates for
NAFTA:
[6]

"..CGE models are circular: if trade theory holds that free trade is mutually beneficial, then a
quantitative simulation model based on that theoretical structure will automatically show that
free trade is mutually beneficial...if the economy actually behaves in the manner supposed by
the modeler, and the model itself sheds no light on this question, then a properly calibrated
model may provide a rough empirical estimate of the effects of a policy change. But the
validity of the model hangs entirely on the prior, nontested specification of its structural
relationships ... [Hence, the apparent consensus of pro-NAFTA modelers] reflects more a
consensus of prior theoretical views than a consensus of quantitative evidence."
Commenting on Stanford's analysis, one computer scientist wrote,
"When simulating the impact of a trade agreement on labor, it seems absurd to assume a priori
that capital is immobile, that full employment will prevail, that unit labor costs are identical in
the U.S. and Mexico, that American consumers will prefer products made in America (even if
they are more expensive), and that trade flows between the U.S. and Mexico will exactly
balance. Yet a recent examination of ten prominent CGE models showed that nine of them
include at least one of those unrealistic assumptions, and two of the CGE models included all
the above assumptions.
This situation bears a disturbing resemblance to computer-assisted intellectual dishonesty.
Human beings have always been masters of self-deception, and hiding the essential basis of
one's deception by embedding it in a computer program surely helps reduce what might
otherwise become an intolerable burden of cognitive dissonance."
[7]

In commenting on the general phenomenon of embedding unrealistic "GIGO" assumptions in
neoclassical economic models, Nobel prizewinner Joseph Stiglitz is only slightly more
diplomatic: (p. 507-8)
"But the ... model, by construction, ruled out the information asymmetries which are at the
heart of macro-economic problems. Only if an individual has a severe case of schizophrenia is
it possible for such problems to arise. If one begins with a model that assumes that markets
clear, it is hard to see how one can get much insight into unemployment (the failure of the
labor market to clear)."
[3]

Despite the prominence of Stiglitz' 2001 Nobel prize lecture, the use of misleading (perhaps
intentionally) neoclassical models persisted in 2007, according to these authors:
[8]

" ... projected welfare gains from trade liberalization are derived from global computable
general equilibrium (CGE) models, which are based on highly unrealistic assumptions. CGE
models have become the main tool for economic analysis of the benefits of multilateral trade
liberalization; therefore, it is essential that these models be scrutinized for their realism and
relevance. ... we analyze the foundation of CGE models and argue that their predictions are
often misleading. ... We appeal for more honest simulation strategies that produce a variety of
plausible outcomes."
The working paper, "Debunking the Myths of Computable General Equilibrium Models",
[9]

provides both a history, and a readable theoretical analysis of what CGE models are, and are
not. In particular, despite their name, CGE models use neither the Walrass general
equilibrium, nor the Arrow-Debreus General Equilibrium frameworks. Thus, CGE models are
highly distorted simplifications of theoretical frameworkscollectively called "the
neoclassical economic paradigm" whichthemselveswere largely discredited by Joseph
Stiglitz.
In the "Concluding Remarks" (p. 524) of his 2001 Nobel Prize lecture, Stiglitz examined why
the neoclassical paradigmand models based on itpersists, despite his publication, over a
decade earlier, of some of his seminal results showing that Information Asymmetries
invalidated core Assumptions of that paradigm and its models:
"One might ask, how can we explain the persistence of the paradigm for so long? Partly, it
must be because, in spite of its deficiencies, it did provide insights into many economic
phenomena. ... But one cannot ignore the possibility that the survival of the [neoclassical]
paradigm was partly because the belief in that paradigm, and the policy prescriptions, has
served certain interests."
[3]

In the aftermath of the 20072009 global economic meltdown, the profession's attachment to
unrealistic models is increasingly being questioned and criticized. After a weeklong
workshop, one group of economists released a paper highly critical of their own profession's
unethical use of unrealistic models. Their Abstract offers an indictment of fundamental
practices:
"The economics profession appears to have been unaware of the long build-up to the current
worldwide financial crisis and to have significantly underestimated its dimensions once it
started to unfold. In our view, this lack of understanding is due to a misallocation of research
efforts in economics. We trace the deeper roots of this failure to the professions focus on
models that, by design, disregard key elements driving outcomes in real-world markets. The
economics profession has failed in communicating the limitations, weaknesses, and even
dangers of its preferred models to the public. This state of affairs makes clear the need for a
major reorientation of focus in the research economists undertake, as well as for the
establishment of an ethical code that would ask economists to understand and communicate
the limitations and potential misuses of their models."
[10]

Omitted details
A great danger inherent in the simplification required to fit the entire economy into a model is
omitting critical elements. Some economists believe that making the model as simple as
possible is an art form, but the details left out are often contentious. For instance:
Market models often exclude externalities such as unpunished pollution. Such models are
the basis for many environmentalist attacks on mainstream economists. It is said that if the
social costs of externalities were included in the models their conclusions would be very
different, and models are often accused of leaving out these terms because of economist's
pro-free market bias.
In turn, environmental economics has been accused of omitting key financial considerations
from its models. For example the returns to solar power investments are sometimes
modelled without a discount factor, so that the present utility of solar energy delivered in a
century's time is precisely equal to gas-power station energy today.
Financial models can be oversimplified by relying on historically unprecedented arbitrage-
free markets, probably underestimating the chance of crises, and under-pricing or under-
planning for risk.
Models of consumption either assume that humans are immortal or that teenagers plan their
life around an optimal retirement supported by the next generation. (These conclusions are
probably harmless, except possibly to the credibility of the modelling profession.)
All Models share the same problem of the butterfly effect. Because they represent large
complex nonlinear systems, it is possible that any missing variable as well as errors in value
of included variables can lead to erroneous results.
Are economic models falsifiable?
The sharp distinction between falsifiable economic models and those that are not is by no
means a universally accepted one. Indeed one can argue that the ceteris paribus (all else being
equal) qualification that accompanies any claim in economics is nothing more than an all-
purpose escape clause (See N. de Marchi and M. Blaug.) The all else being equal claim allows
holding all variables constant except the few that the model is attempting to reason about.
This allows the separation and clarification of the specific relationship. However, in reality all
else is never equal, so economic models are guaranteed to not be perfect. The goal of the
model is that the isolated and simplified relationship has some predictive power that can be
tested, mainly that it is a theory capable of being applied to reality. To qualify as a theory, a
model should arguably answer three questions: Theory of what?, Why should we care?, What
merit is in your explanation? If the model fails to do so, it is probably too detached from
reality and meaningful societal issues to qualify as theory. Research conducted according to
this three-question test finds that in the 2004 edition of the Journal of Economic Theory, only
12% of the articles satisfy the three requirements.
[11]
Ignoring the fact that the ceteris
paribus assumption is being made is another big failure often made when a model is applied.
At the minimum an attempt must be made to look at the various factors that may not be equal
and take those into account.
History
One of the major problems addressed by economic models has been understanding economic
growth. An early attempt to provide a technique to approach this came from the French
physiocratic school in the Eighteenth century. Among these economists, Franois Quesnay
should be noted, particularly for his development and use of tables he called Tableaux
conomiques. These tables have in fact been interpreted in more modern terminology as a
Leontiev model, see the Phillips reference below.
All through the 18th century (that is, well before the founding of modern political economy,
conventionally marked by Adam Smith's 1776 Wealth of Nations) simple probabilistic
models were used to understand the economics of insurance. This was a natural extrapolation
of the theory of gambling, and played an important role both in the development of
probability theory itself and in the development of actuarial science. Many of the giants of
18th century mathematics contributed to this field. Around 1730, De Moivre addressed some
of these problems in the 3rd edition of the Doctrine of Chances. Even earlier (1709), Nicolas
Bernoulli studies problems related to savings and interest in the Ars Conjectandi. In 1730,
Daniel Bernoulli studied "moral probability" in his book Mensura Sortis, where he introduced
what would today be called "logarithmic utility of money" and applied it to gambling and
insurance problems, including a solution of the paradoxical Saint Petersburg problem. All of
these developments were summarized by Laplace in his Analytical Theory of Probabilities
(1812). Clearly, by the time David Ricardo came along he had a lot of well-established math
to draw from.
Tests of macroeconomic predictions
In the late 1980s a research institute compared twelve leading macroeconomic models
available at the time. They compared the models' predictions for how the economy would
respond to specific economic shocks (allowing the models to control for all the variability in
the real world; this was a test of model vs. model, not a test against the actual outcome).
Although the models simplified the world and started from a stable, known common
parameters the various models gave significantly different answers. For instance, in
calculating the impact of a monetary loosening on output some models estimated a 3% change
in GDP after one year, and one gave almost no change, with the rest spread between.
[12]

Partly as a result of such experiments, modern central bankers no longer have as much
confidence that it is possible to 'fine-tune' the economy as they had in the 1960s and early
1970s. Modern policy makers tend to use a less activist approach, explicitly because they lack
confidence that their models will actually predict where the economy is going, or the effect of
any shock upon it. The new, more humble, approach sees danger in dramatic policy changes
based on model predictions, because of several practical and theoretical limitations in current
macroeconomic models; in addition to the theoretical pitfalls, (listed above) some problems
specific to aggregate modelling are:
Limitations in model construction caused by difficulties in understanding the underlying
mechanisms of the real economy. (Hence the profusion of separate models.)
The law of Unintended consequences, on elements of the real economy not yet included in
the model.
The time lag in both receiving data and the reaction of economic variables to policy makers
attempts to 'steer' them (mostly through monetary policy) in the direction that central
bankers want them to move. Milton Friedman has vigorously argued that these lags are so
long and unpredictably variable that effective management of the macroeconomy is
impossible.
The difficulty in correctly specifying all of the parameters (through econometric
measurements) even if the structural model and data were perfect.
The fact that all the model's relationships and coefficients are stochastic, so that the error
term becomes very large quickly, and the available snapshot of the input parameters is
already out of date.
Modern economic models incorporate the reaction of the public & market to the policy
maker's actions (through game theory), and this feedback is included in modern models
(following the rational expectations revolution and Robert Lucas, Jr.'s critique of the optimal
control concept of precise macroeconomic management). If the response to the decision
maker's actions (and their credibility) must be included in the model then it becomes much
harder to influence some of the variables simulated.
Comparison with models in other sciences
Complex systems specialist and mathematician David Orrell wrote on this issue and explained
that the weather, human health and economics use similar methods of prediction
(mathematical models). Their systems the atmosphere, the human body and the economy
also have similar levels of complexity. He found that forecasts fail because the models suffer
from two problems : i- they cannot capture the full detail of the underlying system, so rely on
approximate equations; ii- they are sensitive to small changes in the exact form of these
equations. This is because complex systems like the economy or the climate consist of a
delicate balance of opposing forces, so a slight imbalance in their representation has big
effects. Thus, predictions of things like economic recessions are still highly inaccurate,
despite the use of enormous models running on fast computers. [2]
The effects of deterministic chaos on economic models
Economic and meteorological simulations may share a fundamental limit to their predictive
powers: chaos. Although the modern mathematical work on chaotic systems began in the
1970s the danger of chaos had been identified and defined in Econometrica as early as 1958:
"Good theorising consists to a large extent in avoiding assumptions....(with the property
that)....a small change in what is posited will seriously affect the conclusions."
(William Baumol, Econometrica, 26 see: Economics on the Edge of Chaos).
It is straightforward to design economic models susceptible to butterfly effects of initial-
condition sensitivity.
[13][14]

However, the econometric research program to identify which variables are chaotic (if any)
has largely concluded that aggregate macroeconomic variables probably do not behave
chaotically. This would mean that refinements to the models could ultimately produce reliable
long-term forecasts. However the validity of this conclusion has generated two challenges:
In 2004 Philip Mirowski challenged this view and those who hold it, saying that chaos in
economics is suffering from a biased "crusade" against it by neo-classical economics in order
to preserve their mathematical models.
The variables in finance may well be subject to chaos. Also in 2004, the University of
Canterbury study Economics on the Edge of Chaos concludes that after noise is removed
from S&P 500 returns, evidence of deterministic chaos is found.
More recently, chaos (or the butterfly effect) has been identified as less significant than
previously thought to explain prediction errors. Rather, the predictive power of economics
and meteorology would mostly be limited by the models themselves and the nature of their
underlying systems (see Comparison with models in other sciences above).
The critique of hubris in planning
A key strand of free market economic thinking is that the market's "invisible hand" guides an
economy to prosperity more efficiently than central planning using an economic model. One
reason, emphasized by Friedrich Hayek, is the claim that many of the true forces shaping the
economy can never be captured in a single plan. This is an argument which cannot be made
through a conventional (mathematical) economic model, because it says that there are critical
systemic-elements that will always be omitted from any top-down analysis of the economy.
[15]

Examples of economic models
BlackScholes option pricing model
Heckscher-Ohlin model
International Futures
IS/LM model
Participatory Economics
Keynesian cross
Leontief's input-output model
World3
Wonderland
See also
Economic methodology
Computational Economics
Agent-based computational economics
Macroeconomic model
Financial modeling