Have you ever thought about the need for the usage of graphs, equations, and diagrams by economists to illustrate such concepts as inflation, price, unemployment, economic growth? Then you have come across the core of the economic model.
When I first came across the term economic model, it sounded complex and intimidating. But it’s actually much simpler than it sounds. At its core, an economic model is just a simplified way of looking at complex economic reality to understand how different factors relate to each other.
An economic model is a simplified description of reality that economists use to understand economic relationships, market behavior, and decision-making, as well as to make forecasts and analyze potential outcomes.
Models may have various forms: graphs, diagrams, mathematical equation, simulation in computers, statistical relationship. The International Monetary Fund describes economic model as the simplified description of reality that is created to produce hypotheses about the economic behavior and test them.
The important point of the definition is “simplified“. Economic model is not aimed at covering all the details of reality, but at analyzing the factors of importance for answering the research question.
In this guide, we will learn what is an economic model, including how it works and built, the different types and examples, their advantages and disadvantages, and how to evaluate their relevance.
What Is an Economic Model?
An economic model is a simplified version of an economic situation, relationship, or process.
Models allow economists to study how different variables relate to each other. A simple supply-demand model, for instance, could demonstrate how any change in the level of supply or demand will impact the product’s price and quantity.
An economic model could be presented in the form of:
- A graph
- A diagram
- Mathematical equation
- Statistical model
- Computer simulation
- Set of assumptions and relations
According to authorities, economists rely on theoretical models to strip away the complexity of real-world problems to its bare minimum in order to be able to analyze them.
Imagine a map. A map does not display every tree, person, window or piece of furniture in a city. It would be hard to use such a map. Instead, it only shows roads, places and other important information.
Economic model is just like that. It excludes some aspects in order to concentrate on the relations.
Why Do Economists Build Models?
The economy is huge and complex. People decide things all the time. Firms set their prices, consumers buy products, governments implement policies, banks alter the lending environment, and global affairs impact trade and investments. An attempt to study all these at once would overwhelm us.
Models help out here.
1. In order to Simplify Complex Economic Issues
Models help economists simplify complex problems by considering only the essentials.
Consider, for instance, that an economist wishes to understand why the price of coffee went up.
There can be numerous factors contributing to this increase:
- Climate conditions
- Cost of transportation
- Labor cost
- Demand from consumers
- Exchange rates
- Coffee production
- Energy prices
- Government policies
Models consider just supply and demand initially. This is simpler to analyze.
2. To Explain Relationships
Models aid economists in explaining the relationships between different variables.
For instance:
Price Increase → Demand Decrease
This is a simplified way of expressing the inverse relationship between price and demand, holding everything else constant.
3. To Make Predictions
Models can also help in making predictions or forecasting outcomes.
In this case, economists may use models to predict what the effect of increasing the interest rate will be on borrowing, investments, consumption, or economic performance. Predictions made using such models are not always accurate since models rely on some assumptions and information.
However, they are important pieces of evidence that one can use when making decisions.
For example, the Federal Reserve makes use of economic models to forecast future economic events and analyze the possible effects of their policies.
Why Do Economists Need an Economic Model?
The aim of the economic model is to make the economic reality simple enough for economists to study relationships, test hypotheses, make forecasts, and analyze outcomes.
Economic models help in answering questions like:
- What occurs in case of price changes?
- What effect will there be on consumption when there is a change in income?
- What will happen if demand increases?
- How may a tax affect production?
- How might interest rates affect investment?
- What causes economic growth?
Models can also help to examine hypothetical situations. For instance, economists can consider the impacts of applying a tax or a policy.
This is one of the reasons why economic models are useful for the government, organizations, researchers, and financial institutions.
How does an economic model function?
Even though each model functions differently, the process is generally as follows:
Step 1: Economic Question
To begin, economists decide on what they need to know.
Examples include:
What is the effect of changes in price on consumer demand?
Step 2: Variables to Consider
After that, they decide on variables to consider.
For a basic demand model, they could include:
- Price of the product
- Quantity of demand
- Income of consumers
- Preferences of consumers
Step 3: Make Assumptions
Many models tend to make assumptions in order to simplify their analysis.
This is because an economist may assume all other important factors to be constant in analyzing the relationship of price.
This is typically referred to as ceteris paribus, which means “all else being equal.”
Step 4: Create Relationship
The relationship between the variables is stated by the model.
In the case of a demand model, an increase in price results in a decrease in quantity demanded.
Step 5: Model Representation
This can be done through:
- Graphs
- Equations
- Diagrams
- Statistical relations
- Computer models
Step 6: Analysis of the Results
At last, the model helps the economists analyze the results and compare the predictions with evidence.
It is the point when the model actually starts being useful, not just a theoretical construction.
What are the main features of an economic model?
Even though economic models vary greatly, there are some elements that are common among them.
Variables
Variables are elements that can vary. Some examples are:
- Price
- Income
- Labor
- Output
- Consumption
- Interest
Assumptions
Assumptions set conditions under which the model is constructed.
They help to make reality more manageable.
Parameters
Parameters are elements that define how variables relate to each other within a model.
Relationships
It describes how a variable changes in response to another variable.
Equations or Diagrams
Mathematical formulas and graphs represent relationships between variables.
Example of an Economic Model
The simplest way of comprehending an economic model would be to consider an example.
Supply and Demand Model
Supply and demand model can be considered as one of the simplest economic models.
It analyzes:
- Price
- Quantity supplied
- Quantity demanded
Consider a case of a popular coffee shop that becomes even more popular. The demand for coffee in this shop goes up. As a result, if the supply of coffee remains the same, there will be an upward pressure on the prices due to the increase in demand.
Simple supply and demand model enables economists to understand the relationship between price and quantity in order to determine equilibrium price and quantity.
The IMF suggests standard supply and demand approach as an economic model. It is simple that is why it is good.
Examples of Economic Models
There are many types of economic models.
Circular Flow Model
The circular flow model shows how households and firms interact using markets.
Households supply labor and other factors of production to firms, and firms supply goods and services to households. There is a flow of money and factors of production between these two.
The OpenStax employs the circular flow model as an introductory model that explains interaction between households, firms, goods and services market, and labor market.
Production Possibility Frontier
The production possibility frontier (PPF) shows the trade-off an economy faces in using its scarce resources in order to produce various combinations of goods or services.
This concept can be useful for explaining:
- Scarcity
- Opportunity Cost
- Efficiency
- Trade-off
Aggregate Demand and Aggregate Supply Model
AD/AS model is used in macroeconomics for analyzing relationships concerning the overall price level and the aggregate output in the economy.
Some of the topics that may be analyzed using this model include:
- Economic Growth
- Inflation
- Unemployment
- Recession
According to authorities, AD/AS model is a model that allows for examining several macroeconomic relationships together.
Econometric Models
Econometric models employ statistical tools and economic information to find the relationship among variables. For instance, a researcher may utilize previous information to study the correlation between income and consumer expenditure.
According to the IMF, there is a distinction between theoretical and empirical models in that theoretical models derive predictions from economic theory while empirical models test those predictions using data.
Theoretical vs. Empirical Economic Models
Economic models can be generally classified into various groups.
Theoretical Models
Theoretical models try to explain economic behavior by way of assumptions and logical connections.
They could try to answer:
What should happen to Y if X changes, under the aforementioned conditions?
For instance, a theoretical model may argue that a rise in the price of a good would decrease the quantity demanded for the good, all else being equal.
Empirical Models
Empirical models use data from the real world to see if the predicted connections hold true.
For instance:
A theoretical model may hypothesize that income affects consumer spending.
An empirical model could use data to measure how spending responds to a change in income.
It is crucial to know the difference between the two types because an economic theory cannot be accepted just because it sounds reasonable on paper.
What is the Best Test of an Economic Model?
One of the frequently asked questions is what is the best test of an economic model? It is obvious that the best test for a model is whether the results or the implications of the model are supported by the corresponding real-life evidence and whether the model contributes to the explanation/prediction of outcomes in respect of the problem it aims to solve.
In other words, do not evaluate an economic model in terms of how realistically it looks like.
Rather, assess it in terms of its usefulness for its specific purpose and whether its predictions can be supported by the corresponding evidence.
So, for instance, the simplest model of supply and demand does not aim at explaining all aspects which influence the price of coffee. However, it can be useful in the explanation of how changes in supply or demand influence the equilibrium price and quantity.
Thus, a model can be simplified without becoming useless.
Why Not Everything Is Included in Economic Models
It may well be the most critical idea to learn by beginners. The model isn’t expected to perfectly duplicate reality. Just picture the map including all objects from a city. It will be too detailed for any navigation use.
Economic models are like this. Economists deliberately omit certain details to highlight specific relations. The IMF states that economic models inevitably oversimplify reality and emphasize judgments on what should be included.
Thus, when encountering economic models with apparently ridiculous assumptions, you shouldn’t consider such models as useless.
Rather than doing so, you should try asking yourself:
What does this model seek to explain?
This is the right question to ask.
Advantages of Using Economic Models
There are a number of reasons for using economic models.
- They Clarify Complex Relationships
An economic model may be able to depict something which would take many pages to describe.
- They Assist in Testing Economic Hypotheses
The predictions derived from models may then be tested against real life.
- They Facilitate Economic Policy Evaluation
Economic models may be employed by the government to evaluate the likely impacts of policy decisions.
- They Aid Decision-Making in Business
Companies can employ economic forecasting and models while deciding on prices, investments, demand and market conditions.
- They Facilitate Structured Thinking
Economic models make one consider the important variables and assumptions.
Limitations of Economic Models
Economic models are quite effective, but they are not magical tools.
- Economical models are based on assumptions
In case of wrong assumptions, conclusions drawn from these models may be biased.
- Models Cannot Account for All Human Actions
It is obvious that humans do not always act in accordance with simplified economic models.
- Predictions Are Subject to Unexpected Events
Any unexpected event may ruin even the most complicated model.
- Importance of the Data Used
Empirical economic models rely on the data used.
- Differences in Economists Views May Lead to Differing Models
Two economists may have different assumptions or variables and thus come up with two different results. This fact does not mean that one of the two models is incorrect.
Economic Model and Economic Theory
These concepts are often used interchangeably, particularly in beginning economics. There is, however, a difference between them. Economic theory usually refers to a broader explanation of economic relations or behavior, whereas economic model refers to a particular representation of it which can be used for analysis.
Theory can be seen as an abstract representation of economic relations whereas models can be applied or empirical.
A quick way to distinguish them:
- Theory = broader explanation
- Model = particular representation to analyze it
Economic Models in Everyday Situations
Not everybody who uses economic models is an economist. Economic models play a role in many decisions that surround us.
For instance, corporations can employ models for predicting the demand before putting out their product into the market. Banks can employ models when determining financial risks.
Want to see how entrepreneurs fuel the economy? Explore why entrepreneurs are important for the economy.
Governments can use economic models when deciding on policy alternatives. Central banks make use of economic analysis and models when assessing economic events and monetary policy. Even a business person thinking about increasing the price of his or her product is applying an informal model:
What if I increase the price? How many consumers will I lose?
That’s how economic reasoning works.
Conclusion
So economic model is a simplified view of economic reality which allows economists to establish connections, test hypotheses, predict and study possible consequences.
First of all, economic models can appear scary since they tend to use graphs, equations, and specific vocabulary. However, when you look at them as tools of simplification, it becomes easy to comprehend them. What you should remember is that a model does not have to include everything to be valuable. A useful economic model will concentrate only on the elements that matter in this particular case.
For instance, a supply and demand model does not cover every single factor which can affect a decision to buy some coffee. Nevertheless, it is able to explain how price, demand, and supply impact the market situation. This is the true value of economic models they allow us to take a complex reality and turn it into a simplified way of thinking.
And when you understand this idea, economics stops appearing to be a subject full of complicated graphs and turns into something much more tangible and useful.
FAQs
Q. Who creates economic models?
Economic models are developed by economists, researchers, governments, central banks, financial institutions, and other analysts. Different models are designed for different questions and purposes.
Q. Can economic models be used for small businesses?
Yes. Businesses can use economic reasoning and quantitative models to forecast demand, estimate pricing effects, evaluate investments, and analyze market conditions.
Q. Are all economic models mathematical?
No. Economic models can be represented through graphs, diagrams, verbal descriptions, equations, statistical methods, and computer simulations. Some models are highly mathematical, while others are quite simple.
Q. Why can two economic models give different answers?
Different models may use different assumptions, variables, data, or methods. Because economic reality is complex, analysts may choose different ways to represent the same problem.
Q. Can an economic model be changed?
Yes. Models are often revised when new evidence, better data, technological changes, or new economic insights become available. Models are tools, so they can be improved when their limitations become apparent.
