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Handout-Comparative Static Analysis

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Comparative Static Analysis An economic system can be modeled by using a system of equations. Comparative static analysis is a tool that can be used to analyze a system of equations. The use of comparative static analysis on an economic model can provide valuable information about how an economic system works. 1 Modeling a System A general approach for considering a system is diagrammed in Figure B. below. There are inputs to the system and outputs from the system. The system itself can be thought of as machine that transforms inputs into outputs. !hen the inputs and outputs of a system can be quantified" variables can be assigned to each input and output. #sing variables to represent the levels of the inputs and outputs is useful because the levels tend to change over time. An endogenous variable is an output variable of the system. The level of each endogenous variable is determined by the system. An exogenous variable is an input variable to the system. The level of an e$ogenous variable is not determined by the system" but rather is determined outside the system. Figure 1: Modeling a System

Endogenous Variable Exogenous Variable

Inputs Exo g e n o us Va ria b le s

The system itself is represented by a system of equations. %ach equation captures a relationship that is thought to e$ist between the endogenous and e$ogenous variables. A basic rule of thumb is that the number of endogenous variables that can be determined by a system is equal to the number of independent equations in the system. For e$ample" if you desire to e$plain the behavior of & economic variables" then you must construct a model with & independent equations. !hen e$amining models constructed by others" it is not always obvious which variables are endogenous and which variables are e$ogenous. Typically" the model builder has in mind what variable is 'being endogenized( each time an equation is added to a model. To be clear in presenting your model" it is good to e$plicitly state which variables are endogenous and which are e$ogenous. 2 Comparative Statics A solution to a system of equations is a set of values for the endogenous variables such that all of the equations of the system are simultaneously satisfied. Considering Figure " it is evident that the solution values for the endogenous variables will change if the e$ogenous variables change. A comparative static analysis e$amines how the solution values for the endogenous variables" or output variables" of a system change when the e$ogenous variables" or input variables" change. A ma)or difficulty in analyzing a complicated system is identifying cause and effect. !ith many endogenous and e$ogenous variables changing simultaneously" it is difficult to uncover how a change in a single input variable affects the outputs of the system. For this reason" it is standard

Syst e m Sys t e m of Eq u a t io n s

Outpu t s En d o g e n o us Va ria b le s

System

Solution Comparative Static Analysis

1 -

. • Take the derivative of the solution for the endogenous variable with respect to the e$ogenous variable of interest. The number of endogenous variables should be equal to the number of independent +or nonequivalent. 6owever" many comparative static results can be obtained using graphical tools. Classify the variables in model.Appen dix B: Comp a r a tiv e Static Analysis practice when performing comparative static analyses to e$amine the changes in the solutions for the endogenous variables that occur when one e$ogenous variable is increased by one unit." a good or service. &. Finally" develop an equation to describe the interaction of buyers and sellers..& comparative static multipliers can be calculated. Thus" if there are & endogenous variables and * e$ogenous variables in a model" then +&. 3econd" develop an equation to describe the behavior of sellers. !e need only know that the market is for an output of a production process +i. • /dentify the endogenous variables in model.+*.. A model of a market for a specific product can be developed using a system of equations as follows. /n this book" the comparative static multiplier for an endogenous variable y given a one unit increase in an e$ogenous variable x is written ∂y0∂x" mathematically recognizing that the multiplier is the partial derivative of the endogenous variable take with respect to the e$ogenous variable. !hen the system of equations being analyzed can be solved" the following five step approach can used to perform a comparative static analysis1 . 5. • Choose an endogenous variable of interest." labor. • Classify the remaining variables as e$ogenous variables. A comparative static multiplier gives the change in a chosen endogenous variable when a chosen e$ogenous variable increases by one unit. Those who are not very familiar with calculus may find the mathematics of comparative static analysis overwhelming. A market always involves an interaction between buyers and sellers. . Comparative Static Multiplier 2 . +A good first step would be to carefully study the mathematical appendi$ of this book. First" develop an equation to describe the behavior of buyers. For those in this situation" the preferable course of action would be to learn the mathematics since some results can only be obtained using the mathematics. /nterpret each comparative static multiplier calculated as the change in the endogenous variable of interest that occurs when the e$ogenous variable of interest increases by one unit. 3olve the model1 Find the solution for each endogenous variable as a function of the model4s e$ogenous variables. Thus" even those who cannot calculate derivatives can do comparative static analyses. Calculate the comparative static multipliers. The e$ample in the ne$t section will help make the general ideas discussed in this section and the last section more concrete. 3 An Example: A Mar et !or a "roduct 3uppose you want to develop a model of a market for a product.. 2. • #se different endogenous and e$ogenous variable combinations until all the desired comparative static multipliers have been found.e. equations in the model.. as opposed to an input +e. !rite down the model as a system of equations.g. • Choose an e$ogenous variable of interest. !e do not have to specify the product.

The supply curve is graphed in Figure . The supply curve is linear. The demand curve is graphed in Figure 2" with : being treated as the independent variable and 8 being treated as the dependent variable." :" a" and b.." the amount of the product which buyers wish to buy. The demand curve is linear.e.. As the sensitivity parameter b gets larger" demand becomes more responsive to a change in price. then 8 increases by a . then 8 decreases by b . The variable a measures the sensitivity of demand to a change in income" while the variable b measures the sensitivity of demand to a change in price.&.9 let : denote the price of the product9 and let .2 +from 55 to 52. =iven these numbers" 8 . /f the sensitivity parameter a were equal to zero" then demand would be totally insensitive to a change in income." and let : denote the price of the product as before." while if : increases by +from .+.. 7et the variable 8 denote the demand for the product +i. and is found by setting independent variable : equal to zero. . To understand why these variables measure sensitivity" substitute in numbers for the variables . ?ow" note that if . Typically" an increase in price leads to an increase in supply. The intercept of the demand curve is equal to a. The intercept of the supply 3 - . /f the sensitivity parameter b were equal to zero" then demand would be totally insensitive to a change in price. > +2.e. + <<. As the sensitivity parameter a gets larger" demand becomes more responsive to a change in income. .Appen dix B: Comp a r a tiv e Static Analysis Although many factors may affect the willingness of buyers to buy a product" let4s only consider two here1 price and income. denote the income of buyers." the amount of the product which sellers wish to sell.&" and b .<<" : . These assumptions are captured by the following linear equation1 D = aY − bP " a > < " b > < . to 5.2." a ..&.. & +from 55 to 55. This e$ample illustrates that the parameter a gives the change in demand that occurs when income increases by one unit" while the parameter b gives the change in demand that occurs when the product price increases by one unit.55. This assumption is captured by the equation1 S = cP " c > < . 7et the variable 3 denote the supply of the product +i.+. increases by +from << to < . The slope of the demand curve is >b" equal to the coefficient on the independent variable :." with : being treated as the independent variable and 3 being treated as the dependent variable. The variables a and b are called sensitivity parameters. Figure 2: #$e %emand Curve Sensitivity "arameter D aY 3lope = −b E&uilibrium Condition P D = aY − bP P Considering the willingness of sellers to produce and sell a product" assume that only the product price is important. Typically" an increase in price leads to a decrease in demand" while an increase in income leads to an increase in demand. 7et .

The slope of the supply curve is c" equal to the coefficient on the independent variable :. The supply and demand curves are each plotted with the price variable : as the independent variable.Appen dix B: Comp a r a tiv e Static Analysis curve is equal to zero" found by setting independent variable : equal to zero. Figure 3: #$e Supply Curve S S = cP 3lope = c E&uilibrium "rice P The market is represented in Figure B. /f there was a surplus" we might e$pect the price to decrease. Alternatively" if there was a shortage" we might e$pect the price to increase. %$amining the figure" note that supply e$ceeds demand when the price is above the price P@" meaning there is a surplus of the product. Alternatively" demand e$ceeds supply when the price is below the price P@" meaning there is a shortage of the product. Figure ': #$e Mar et S" D aY S = cP P S @ = D@ D = aY − bP P@ P 4 . The variable c is a sensitivity parameter" giving the change in supply that occurs when the price increases by one unit. This notion can be captured by our model by adding the equilibrium condition S = D.5" where the supply and demand curves are each plotted in the same space. Consequently" we would e$pect the price to gravitate toward the price P@ where supply equals demand.

6aving found the solution for :" the solutions for 8 can now be found by substitution as follows1 D = aY − bP " =iven + . Those who have had some practice solving systems of equations know that it is quite possible to 'go around in circles( and never reach a solution. b+c a D = aY − b Y" b+c b+c a D=a Y −b Y" b+c b+c 5 - . S = D . a" b" c %ndogenous Aariables +.. 3T" +B. AT 8istributive 7aw BT ?otice that the solution for P was found by applying the substitution theorem first" the addition theorem second" and the multiplication theorem last.2. As a general rule" applying the theorems in the order used here is best in terms of making progress toward a solution.. Thus" the variables S and D are also endogenous variables. The following presentation of the model is useful in that it is brief and complete once the definitions of the variables are understood1 +B. S. D %$ogenous Aariables +5." +B. Classification of Aariables +*. D. The remaining variables . /t is generally easiest to solve models representing markets by starting with the equilibrium condition.. . /n this case" by starting with the equilibrium condition" the solution for P can be found1 Cb + cD P = aY " P= S=D cP = aY − bP " bP + cP = aY " a Y" b+c =iven +B.Appen dix B: Comp a r a tiv e Static Analysis %$amining Figure 5" notice that the equilibrium condition" together with demand equation and supply equation" determines the price P. S = cP " c > < 9 +B. To solve the model" remember that the goal is to isolate each endogenous variable on one side of an equation and have only e$ogenous variables on the other side.. Y.5" the equilibrium quantity supplied S@ and the equilibrium quantity demanded D@ are also determined by the three equations of the model. The mathematical appendi$ also contains an e$ample of how to apply these theorems to solve a system of equations.1 a" b" c" .1 P. . These theorems are e$plained in Appendi$ A>>>the mathematical appendi$. D = aY − bP " a > < " b > < 9 +B... 3T" 3olution for : Bultiply a." a" b" and c are e$ogenous.. S.. Thus" P is an endogenous variable.1 P. As shown on the vertical a$is in Figure 2. The abbreviations 3T" AT" and BT used in the solutions below stand for the substitution theorem" the addition theorem" and the multiplication theorem. term by b+c = . That is" there is only one price such that supply equals demand>>>the equilibrium price P@. To summarize" the model consists of the three equations that determine the three endogenous variables S" D" and P.

" c .2. b +c 3T" 3olution for : Constant Coefficient Fule :ower Fule The result ∂P 0 ∂Y = a 0 Cb + cD indicates that a one unit increase in Y leads to an increase in P of a0Cb+cD. shows the effect that the e$ogenous variable Y has on the endogenous variable P through the system." +B. Aalues for the e$ogenous variables must be given before the model can generate the predictions for the endogenous variables.--Appe n dix A---for an expl a n a ti o n of how to calculat e com p a r a t iv e static multipliers using the rules of differe n ti a tio n. b+c . Again" only these solutions are consistent with equations +B.+ 2 Thus" given these particular values for the parameters a" b" and c" 2< units would be bought and sold at a price of < +dollars." +B..G2D .. See the mat h e m a t i c a l app e n di x. /f" for e$ample" it was known that a .5. This multiplier can be calculated as follows1 ∂P ∂ a = Y " ∂Y ∂Y b + c a ∂ = [ Y] " b + c ∂Y = a .2. 6owever" if the e$ogenous variables change" then the predicted values of the endogenous variables will change. Thus" this model can predict the product price and the quantity of product bought and sold.. The solutions for 3 and 8 are associated with 3@ and 8@ on the vertical a$is of Figure B. 3T" 3olution for 8 ac Y b+c The solution for : is associated with P@ on the horizontal a$is of Figure B.. /f a . Y= << = 2< .. The solution is the modelEs predicted value of the endogenous variable.Appen dix B: Comp a r a tiv e Static Analysis D= ac Y b+c Combine terms The solution for 3 can then be easily found1 S = D" S= =iven +.+ 2 and S=D= ac +..2" and Y . simultaneously." and +B..2" the result would indicate that a one dollar increase in income would lead to increase in the product4s price of a0CbGcD . ?ote" however" that each solution depends upon the e$ogenous variables of the model..&" b .&0C. per unit. /t is the only price that satisfies equations +B.. 1 6 ." and +B.& Y= << = < b+c . <" or < cents.+ 2 . holding simultaneously." and c . .&" b . . The comparative static multiplier ∂:0∂...<<" then we can obtain our model4s predictions for the variables P" S" and D from the solutions above1 P= a .5.&.

?otice in the figure that the equilibrium quantity bought and sold also increases.Appen dix B: Comp a r a tiv e Static Analysis To show this comparative static result graphically" note that when . Figure *: #$e E!!ect o! an increase in c S" D S = c2 P 7 - . To show this comparative static result graphically" note that when c increases the slope of the supply curve in figure 2. As Y increases from Y to Y2" the equilibrium price level increases from P to P2. The reader should be able to confirm this by showing that the comparative static multipliers ∂D 0 ∂Y and ∂S 0 ∂Y are positive. increases the intercept of the demand curve in Figure 5 increases.5 increases. ?otice in the figure that the equilibrium quantity bought and sold increases. This multiplier can be calculated as follows1 ∂P ∂ a = Y " ∂c ∂c b + c ∂ = aY " ∂c b + c ∂ − = aY b + c] " [ ∂c 3T" 3olution for : Constant Coefficient Fule Algebra :ower Fule Algebra [ ] = aY [ − = [ b + c] 2 − aY ][ b + c] −2 " < <. The result ∂P 0 ∂c = −aY 0 Cb + cD2 indicates that a one unit increase in c leads to a decrease in : of aY 0 Cb + cD2 . Thus" as is shown in Figure &" an increase in Y makes the demand curve shift upward. The reader should be able to confirm this by showing that the comparative static multipliers ∂D 0 ∂c and ∂S 0 ∂c are positive. Figure (: #$e E!!ect o! an increase in ) S" D aY2 P aY PD2 S2 = S =D S = cP D = aY2 − bP D = aY − bP P P 2 P The comparative static multiplier ∂P 0 ∂c shows the effect that the e$ogenous variable c has on the endogenous variable : through the system. As c increases from c to c2" the equilibrium price level decreases from : to :2. Thus" as is shown in Figure H" an increase in c makes the supply curve rotate upward.

.. For practice" the reader might calculate and interpret these results. +5. :erforming a comparative static analysis. $ s = $ " +. $ d 0 P = #Y − "i " +2. +equation 2. %$ogenous Aariable 3olution Comparative 3tatic Bultiplier %quilibrium Condition .. +2. /n addition" the reader should be able to show each of the comparative static results diagrammatically. For the capital market model presented in question " plot consumption C as it depends upon output . $ d = $ s . C = C + cY " C > < " I = I − bi " I > < " i AD = C + I Y = C+ S AS = A << c< > <" b > < A = AD 2.. The following equations can be used to represent a model of a 'money market. /dentify the intercept and slope for each curve you draw. +H. +&.. The following equations can be used to represent a model of a 'capital market. + . +ey .( 3olve this system of equations" assuming the endogenous variables are Bd" Bs" and i! + .( 3olve this system of equations" assuming the endogenous variables are A8" C" /" A3" 3" .Appen dix B: Comp a r a tiv e Static Analysis S =c P S 2 = D2 S =D D = aY − bP P 2 P P A total of 2 comparative static multipliers can be calculated. # > <" $ >< " > <" Y > <9 . +. =ive an economic interpretation of the intercept and slope for each curve you have drawn." and graph investment / as it depends upon the real interest rate level I +equation . 8 ..evie/ 0uestions: Appendix .ords: Appendix %ndogenous Aariable 3ystem Comparative 3tatic Analysis 3ensitivity :arameter %quilibrium :rice +ey Concepts: Appendix • • Bodeling an economic system using a system of equations.

Appen dix B: Comp a r a tiv e Static Analysis 5. 9 - . Find and give economic interpretations of the multipliers ∂ Y 0∂ C and ∂C 0 ∂c for the capital market model presented in question . H. coordinate plane1 C =C " C = C + cY " C = C + c[Y −% ] −α i. &. Assuming C > < " < < c < " α > < " i > < " and % > < " plot the following equations in a single C = C + c[Y −% ] " +Y. Find and give economic interpretations of the multipliers ∂ i 0 ∂$ and ∂i 0 ∂" for the money market model presented in question .C.

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