26.6 So, that's it.

That’s it. The whole class has really been just one big model. Here it is in a nutshell.

The only things that truly matter in the world are real. They’re the planet we’re on, its people, its natural resources.

We have ways of transforming our resources (human and natural) into goods and services that make our lives better: food and clothing, phones and computers, fish and coconuts. Because the same resources can be used to produce different goods, and because resources are scarce, this means we face tradeoffs.

If there were only one person in the whole world, that person could make decisions however he or she wanted; but they would still face a tradeoff, and they would choose to produce the combination of goods such that their own willingness to trade one good for another (their MRS) reflected the opportunity cost they faced, based on the resources and technology available to them (their MRT). Put another way, they produce and consume goods such that the marginal benefit from consuming the last unit of each good exactly reflected the marginal cost of the resources used to produce it: \(MRS = MRT\) In a complex economy with billions of people and millions of firms, there is no one decision-maker. Instead, consumers have income and decide what to buy with it, and profit-maximizing firms decide what and how much to produce. Both consumers and producers base their decisions on the market prices they observe. Consumers set the price ratio between any two goods equal to their MRS, while firms set their price equal to their marginal cost; and since the ratio of marginal costs is one expression for the MRT, we have \(MRS = {p_1 \over p_2} = {MC_1 \over MC_2} = MRT\) In other words, under the stringent assumption that everyone is a price taker, prices act as a true signal of value in the marketplace, and organize productive behavior in exactly the same way a single omniscient social planner would.

Limitations and Extensions of the Model

The simple model presented in this course is a benchmark, but it’s not particularly realistic. Within the framework of competitive markets, there can be edge cases and complications like corner solutions: a consumer may decide to spend all their money on one good, or a firm may go out of business, so the notion that the MRS is equal to the price ratio may not always hold. If we had another ten weeks, we could delve more into the ways in which those edge cases play out in both partial and general equilibrium.

But more importantly, the model is limited in the scope of real-world phenomena that it can analyze. As you proceed through the Econ major, you’ll encounter a number of courses which extend and refine the model we’ve seen here:

Game Theory: Beyond perfect competition (Econ 160)

First, not all markets are competitive; many of the most important in any economy, from railroads to AI chip makers, are characterized by market power. Industries with a lot of those firms, in which each firm reacts strategically to other firms, aren’t well described by a model that assumes all firms are price takers. The field of game theory tries to come up with a parallel set of equilibrium notions to the model of competitive markets for situations like these.

Mechanism Design: Asymmetric information (Econ 136)

Second, the goods we have been talking about here are known quantities, and we assumed that all consumers and producers knew all the relevant market prices. In the real world, there are lots of cases in which agents make decisions under uncertainty, not knowing exactly what they’re getting or even what their other options might be. When the price mechanism doesn’t cause people to reveal their private information, other mechanisms can. The field of mechanism design, much of which has been developed at Stanford, is dedicated to an “engineering approach” to solving economic problems via the design of such mechanisms.

Environmental and Public Economics: Externalities and Public Goods (Econ 155, 177, etc.)

Third, this model we’ve assumed that all goods are private goods: my enjoyment of a fish doesn’t affect your enjoyment of a coconut, and vice versa. In the real world, the economic activities of one agent might dramatically affect the welfare of another. And some goods, like fireworks shows, have a benefit to many people simultaneously; while others, like a polluting factory, might harm others. Markets on their own will not solve these kinds of problems, which leads to them sometimes being called “market failures.” The field of environmental economics is one way of using mechanism design to try to improve welfare by correcting for these failures; likewise, the field of public economics strives to understand how public goods can be optimally provided, and funded.

Behavioral Economics: Bounded rationality (Econ 178)

Fourth, at the very core of the models in this course has been an assumption that people know the problem they’re facing and…well, solve it. Perfectly. Every time. This clearly isn’t the case, and economists have sought to extend the models of choice to include a wider array of decision-making processes. The field of behavioral economics uses insights from psychology and other disciplines to create a more nuanced approach to the model of decision-making presented in this class.

Econ 51 presents a sampling of all of these…I hope to see you there to continue to the journey!

Beyond specifics: the most important takeaway

Beyond the specifics and limitations of this model, though, there is an even more fundamental takeaway, which is the nature of an economic model itself.

The model we derived has some fundamental properties common to most, if not all, microeconomic models:

• It specifies the agents making decisions, and the decisions they are making.
• It specifies the payoffs each agent receives, as a function of its own decisions and the decisions of other people
• It uses those decisions and payoffs to characterize an optimization problem for each of the agents
• It defines what an equilibrium of the model is, and why the forces within the model draw it toward that equilibrium (or not)

Finally, having defined the model, we can perform two types of analysis:

• Comparative statics: how do changes in exogenous parameters affect the equilibrium in the model, and the kinds of optimal decisions made by agents?
• Welfare analysis: is the outcome of the model “good” or “bad,” and what makes it so?

No matter what problem you are facing, this approach to modeling the situation can help you analyze it more rigorously…which, to be honest, is the real value of the course. You may never take a Lagrangian again…but you will face tradeoffs. Hopefully this course will have helped you navigate those tradeoffs a little better…at least marginally so. :)