Using Models in Economics

Introduction

Models are simplified representations of complicated ideas that allow economists to analyze the complex economy.

In economics, we use different types of models to understand complexities:

  • Diagram models show how different economic sectors or actors interact.
  • Graphical models show how two or more economic variables are related to each other in spatial form.
  • Equations that show relationships between variables in mathematical form.

How do we use models in economics?

Step 1: Identify the key variables that will be used

Step 2: Identify variables that will not be included. This is a concept called ceteris paribus.

Step 3: Find out how the variables interact. This will help us select an appropriate model.

  • Which variables are related which other variables?
  • How do they relate to each other?

(Learn more about variables and parameters)

Where are models used in Macroeconomics?

  • The Circular Flow Model is a diagrammatic model that shows how resources in an economy move between households, businesses and government.


  • The Production Possibilities Model is a graphical model that shows different combinations of two goods that can be produced in an economy with the available resources and technology.


  • The Aggregate Supply/Aggregate Demand Model (AS/AD) is a graphical model representing the relationship between buyers and sellers in an economy.


  • A Production Function is a mathematical model that shows how output is related to capital and labor.


  • A Consumption Function is a mathematical model that shows how purchases of goods and services depend on income, wealth, expectations and prices.


Where are models used in Microeconomics?

  • The Supply and Demand Model is a graphical and/or mathematical model of the relationship between the price of a good or service and the quantities buyers demand and sellers supply.

    This is arguably the most important model in economics!




  • The Model of Perfect Competition is a set of assumptions and graphical models that shows how firms will behave under highly competitive conditions.


  • The Monopoly Firm Model is a graphical model that shows price and output behavior of firms that dominate a market.


  • The Budget Line Model is a graphical model that shows combinations of two goods that are affordable to a consumer given the consumer's income and the prices of the two goods.

✓ Final thoughts on economic modeling

Good models don't have to be "realistic". In fact, realistic models may be too complex to be useful. Instead, models should be plausible, informative and lead to good predictions.

  • The benefit of using economic models is that they allow us to simplify complex situations. Indeed, without models, understanding relationships between economic variables would be difficult.
  • The downside of using models is that the conclusions we draw may not hold true when the simplifying assumptions around which the model is built do not hold up in reality.

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