Causal explanation - To explain a specific economic event is to cite its causes - To explain a general economic phenomenon is to describe the causal mechanism responsible for it - Causal explanations cannot be successful unless they are true o Cheap money in the early 00s doesn't explain the financial crisis of the late 00s unless money was cheap - w/o cheap money, there would not have been a crisis " Cheap = interest rates were lower than the rate that would have been adequate given the economic conditions o The monetary transmission mechanism doesn't explain the aggregate relationship between money, the interest rate and real variables unless changes in the real variables are brought about by the transmission mechanism Economic models Hotelling's law [Harold Hotelling's principle of minimal differentiation] - Starting point: if one of a number of sellers of a good increases his price slightly, he will not immediately lose all his business to competitors o Various reasons why: his store is nearer than others, he sells goods which his competitors don't, prefer his quality - Law of one price is at best a ceteris paribus law o LooP - in one market, the same goods must sell at the same price - if not, customers would flock to the cheapest seller, forcing more expensive sellers to lower prices " Assumes that goods are identical in every respect inc. distance and quality . Never true of actual goods - Hotelling's model describes what happens when one of the conditions in the ceteris paribus clause is relaxed - namely when goods differ in their spatial distance to the buyer along a single dimension Buyers of a commodity are uniformly distributed along a line segment of length / - Two vendors A and B are at distances a and b respectively from each end of the line segment - Cost of production for the good to A and B is assumed to be 0 - Demand is perfectly inelastic - each customer purchases one unit of the item no matter what - Each buyer transports his purchase to the place he consumes it at cost c per unit distance - B's price can exceed that of A without B losing all his customers to A o He must not let his price exceed A's by more than the transportation cost from A to B o B can attract some surplus biz and a portion of that between A and B o The lower A's price compared to B's, the more business he can attract - Assumption thus far: A and B have fixed locations o Relax assumption: A will want to make their profit as big as possible, as will B o A and B cannot occupy the same price point because they would enter into a price war, reducing profits for both o A and B will move as close as possible to each other without becoming identical - Too much alike - profit-maximising equilibrium differs from the