Aggregation problem

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An aggregate in economics is a summary measure describing a market or economy. The aggregation problem is the difficult problem of finding a valid way to treat an empirical or theoretical aggregate as if it reacted like a less-aggregated measure, say, about behavior of an individual agent as described in general microeconomic theory. [1] Examples of aggregates in micro- and macroeconomics relative to less aggregated counterparts are:

Economics Social science that analyzes the production, distribution, and consumption of goods and services

Economics is the social science that studies the production, distribution, and consumption of goods and services.

In economics, an agent is an actor and more specifically a decision maker in a model of some aspect of the economy. Typically, every agent makes decisions by solving a well- or ill-defined optimization or choice problem.

Macroeconomics branch of economics that studies aggregated indicators

Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies.

Contents

The general price level is a hypothetical daily measure of overall prices for some set of goods and services, in an economy or monetary union during a given interval, normalized relative to some base set. Typically, the general price level is approximated with a daily price index, normally the Daily CPI. The general price level can change more than once per day during hyperinflation.

Steam shovel steam-powered excavation machine

A steam shovel is a large steam-powered excavating machine designed for lifting and moving material such as rock and soil. It is the earliest type of power shovel or excavator. Steam shovels played a major role in public works in the 19th and early 20th century, being key to the construction of railroads and the Panama Canal. The development of simpler, cheaper diesel-powered shovels caused steam shovels to fall out of favor in the 1930s.

Money supply total amount of monetary assets available in an economy at a specific time

The money supply is the total value of money available in an economy at a point of time. There are several ways to define "money", but standard measures usually include currency in circulation and demand deposits. Each country’s central bank may use its own definitions of what constitutes money for its purposes.

Standard theory uses simple assumptions to derive general, and commonly accepted, results such as the law of demand to explain market behavior. An example is the abstraction of a composite good. It considers the price of one good changing proportionately to the composite good, that is, all other goods. If this assumption is violated and the agents are subject to aggregated utility functions, restrictions on the latter are necessary to yield the law of demand. The aggregation problem emphasizes:

Law of demand economics theorem

In microeconomics, the law of demand states that, "conditional on all else being equal, as the price of a good increases (↑), quantity demanded decreases (↓); conversely, as the price of a good decreases (↓), quantity demanded (↑)". In other words, the law of demand describes an inverse relationship between price and quantity demanded of a good. Alternatively, other things being constant, quantity demanded of a commodity is inversely related to the price of the commodity. For example, a consumer may demand 2 kilograms of apples at $70 per kg; he may, however, demand 1 kg if the price rises to $80 per kg. This has been the general human behaviour on relationship between the price of the commodity and the quantity demanded. The factors held constant refer to other determinants of demand, such as the prices of other goods and the consumer's income. There are, however, some possible exceptions to the law of demand, such as Giffen goods and Veblen goods.

In economics, a composite good is an abstraction that represents all but one of the goods in the relevant budget.

Franklin Fisher notes that this has not dissuaded macroeconomists from continuing to use such concepts. [2]

Aggregate consumer demand curve

The aggregate consumer demand curve is the summation of the individual consumer demand curves. The aggregation process preserves only two characteristics of individual consumer preference theory—continuity and homogeneity. Aggregation introduces three additional non-price determinants of demand:

Demand curve graph depicting the relationship between the price of a certain commodity and the amount of it that consumers are willing and able to purchase at that given price

In economics, a demand curve is a graph depicting the relationship between the price of a certain commodity and the quantity of that commodity that is demanded at that price. Demand curves may be used to model the price-quantity relationship for an individual consumer, or more commonly for all consumers in a particular market. It is generally assumed that demand curves are downward-sloping, as shown in the adjacent image. This is because of the law of demand: for most goods, the quantity demanded will decrease in response to an increase in price, and will increase in response to a decrease in price.

The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption as measured by their preferences subject to limitations on their expenditures, by maximizing utility subject to a consumer budget constraint.

Thus if the population of consumers increases, ceteris paribus the demand curve will shift out; if the proportion of consumers with a strong preference for a good increases, ceteris paribus the demand for that good will change. Finally, if the distribution of income changes in favor of consumers who prefer the good in question, the demand will shift out. It is important to remember that factors that affect individual demand can also affect aggregate demand. However, net effects must be considered.

Ceteris paribus or caeteris paribus is a Latin phrase meaning "other things equal"; English translations of the phrase include "all other things being equal" or "other things held constant" or "all else unchanged". A prediction or a statement about a causal, empirical, or logical relation between two states of affairs is ceteris paribus if it is acknowledged that the prediction, although usually accurate in expected conditions, can fail or the relation can be abolished by intervening factors.

Difficulties with aggregation

Independence assumption

First, to sum the demand functions without other strong assumptions it must be assumed that they are independent – that is, that one consumer's demand decisions are not influenced by the decisions of another consumer. [3] For example, A is asked how many pairs of shoes he would buy at a certain price. A says at that price I would be willing and able to buy two pairs of shoes. B is asked the same question and says four pairs. Questioner goes back to A and says B is willing to buy four pairs of shoes, what do you think about that? A says if B has any interest in those shoes then I have none. Or A, not to be outdone by B, says "then I'll buy five pairs". And on and on. This problem can be eliminated by assuming that the consumers' tastes are fixed in the short run. This assumption can be expressed as assuming that each consumer is an independent idiosyncratic decision maker.

No interesting properties

This second problem is more serious. As David M. Kreps notes, “total demand will shift about as a function of how individual incomes are distributed even holding total (societal) income fixed. So it makes no sense to speak of aggregate demand as a function of price and societal income". [4] Since any change in relative price brings about a redistribution of real income, there is a separate demand curve for every relative price. Kreps continues, "So what can we say about aggregate demand based on the hypothesis that individuals are preference/utility maximizers? Unless we are able to make strong assumptions about the distribution of preferences or income throughout the economy (everyone has the same homothetic preferences for example) there is little we can say”. [5] The strong assumptions are that everyone has the same tastes and that each person's tastes remain the same as income changes so additional income is spent in exactly the same way as previously.

Microeconomist Hal Varian reached a more muted conclusion: "The aggregate demand function will in general possess no interesting properties". [6] However, Varian continued: "the neoclassical theory of the consumer places no restriction on aggregate behavior in general". [7] This means the preference conditions (with the possible exception of continuity) simply do not apply to the aggregate function.

See also

Notes

  1. Franklin M. Fisher (1987). "aggregation problem," The New Palgrave: A Dictionary of Economics , v. 1, p. 54. [Pp. 53-55.]
  2. Franklin M. Fisher (1987). "aggregation problem," The New Palgrave: A Dictionary of Economics , v. 1, p. 55.
  3. Besanko and Braeutigam, (2005) p. 169.
  4. Kreps (1990) p. 63.
  5. Kreps (1990) p. 63.
  6. Varian (1992) p. 153.
  7. Varian (1992) p. 153.

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