L11 Exo & Endo

The purpose of this is to show how economists define exogenous and endogenous variables, why this is wrong and misleading, and the massive confusions created in minds of students and teachers thereby, AND the centrality of this confusion in the standard supply and demand theory.

Economists tend to use different names for these two types of factors (or, in mathematical terms, variables). Variables that are outside of a decision-maker’s control are called exogenous variables. Such variables are inputs into economic models. For example, in consumer theory we will usually treat individuals as price-takers. The prices of goods are determined outside of our models of consumer behaviour, and we wish to study how consumers adjust to them. The results of such decisions (e.g., the quantities of each good that a consumer buys) are endogenous variables. These variables are determined within our models. This distinction is pictured schematically in Figure 1.1.

A CENTRAL problem which is ignored by economists is: What happens if the endogenous variables FEED BACK into the exogenous variables. Then variables which are taken as being determined OUTSIDE the system are actually being determined by the system. This often happens in complex systems. In particular, all agents in S&D models take prices as exogenous, but the S&D model determines price, making it endogenous.

Although the actual models developed by economists may be complicated, they all have this basic structure. A good way to start studying a particular model is to identify precisely how it fits into this framework. This distinction between exogenous and endogenous variables will become clearer as we explore a variety of economic models. Keeping straight which variables are determined outside a particular model and which variables are determined within a model can be confusing; therefore, we will try to remind you about this as we go along. The distinction between exogenous and endogenous variables is also helpful in understanding the way in which the ceteris paribus assumption is incorporated into economic models. In most cases we will want to study how the results of our models change when one of the exogenous variables changes. It is possible,

even likely, that the change in such a single variable will change all the results calculated from the model. For example, as we will see, it is likely that the change in the price of a single good will cause an individual to change the quantities of practically every good he or she buys. Examining all such responses is precisely why economists build models. The ceteris paribus assumption is enforced by changing only one exogenous variable, holding all others constant. If we wish to study the effects of a change in the price of petrol on a household’s purchases, we change that price in our model, but we do not change the prices of other goods (and in some cases we do not change the individual’s income either). Holding the other prices constant is what is meant by studying

the ceteris paribus effect of an increase in the price of petrol.

Sleight of Hand: Prices treated as exogenous, but actually endogenous. WHO FORMS PRICES? Key un-answered question -- see relevant article