Question

Standard economic models treat the economy as a stable system in equilibrium. Discuss how the concepts of feedback loops and thresholds introduce nonlinearity in economic systems, and how this contrasts with the implications of standard economic models with respect to equilibrium. Will two very similar economies necessarily react in a similar way to a shock?

Answer 1

First, let's understand the concepts of standard economic models, feedback loops and thresholds.

Standard economic models rests on various assumptions which may not be true such as buyers are rational which means that they have perfect information and they can rank their options with their preferences and will always choose the option they like the best and markets are clear of friction.

Threshold loops can be referred to as a system structure where everythig is connected in a loop for example the output a population produces increases the goods and services available to them which in return increases the life expectancy which will increase the population and which will result in increase in output and the loop will start again.

Threshold refers to a parameter which serves as a benchmark for comparison and take any corrective action in case of any breach which will result in complete review and redesign of these parameters.It is basically the opportunity cost in economics.

Now, let's discuss how the two concepts introduce nonlinearity in economic syatem as most economic models are not entirely realistic as it often excludes factors such as pollution which in result excludes the real social cost of these externalities as the market is connected and with increase in market demand and supply,pollution increases and climate change occurs which will give rise to a new set of systems and variables not known or experienced before.

Also, considering when the gains from the loop are very large, it will result in exponential growth and with threshold, people will look at their opportunity cost and which will create a chaotic behaviour and other divergences which are far away from the standard economic model of a stable syatem in equilibrium.Example,with any news of market collapse or war or any such extreme variables, people rush to banks and we see share markets crash.

The standard economic model puts a lot of faith in the market which simply doesn't work as the economy is a network because any action in an economy or a finite world here will lead to a chain of effects which are connected to one another.Every day economy is increasing and new factors come into play which gives rise to other factors which may result in formation of new businesses,customers,competition and will lead to government regulation.

The two very similar economies will not necesaarily react in a similar way to a shock as witnessed by the recent european sovereign debt crisis where some countries like italy,ireland,greece,italy were far more affected than others such as germany which has now strengthen it's position.