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How to Build an Economic Model

Consider an architect who is looking to build a major office building somewhere in a city. To get the right plan and follow to the latter, they may consider building a physical model that sits on top of the table to show how the entire block will appear at the end of the project. This model is drawn to scale and can be opened up to show both the interior and the exterior. Apart from this, companies often build models of their new products, which are generally rougher and less finished to demonstrate how the new product will look like and work once out on the market. These models are important because they help people visualize what a product or a building will look like once complete. It works better in finding the right aspects of the projects than it would without them.

This is the same way economic models work. They let economists and policymakers get a complete view or picture of economic phenomena. Models show how different factors fit together, affecting the entire system. As you may have already learned in the previous courses, consumers and manufacturers are the main players in an economy. Firms produce goods, which households acquire by paying set amounts of money for them. One the other hand, households define the labor market, which they sell to firms to gain wages, salaries, and benefits. These mutual relationships must happen for economic growth, development, and stability.

The Circular Flow Diagram

A good economic model begins with the researcher drawing what is known as a circular flow diagram.

This diagram shows that an economy is comprised of two groups: on one side is the household group, and on the other is firms. They interact within two general markets that make up an economy: the goods-and-services market, also the product market, and the labor market. Firms produce products and sell them to households. In this case, the households are on the demand side, whereas the firms are on the supply. Firms gain profit through revenues generated from a completed sales process. If they set the prices right, it becomes very easy to grow and make more profits. Households, on the other hand, benefit by using the product.

Households or on the labor market side where they sell labor to companies and other employees. In this case, households shift to the supply side while firms fall under demand. Firms but labor by paying households with wages and other benefits, and in return, ensure the supply-and-demand market gets the wheels it needs to run.

There are many different markets for goods and labor in the real-world. You can add within the simplified circular flow diagram as many as you want. It is the best way of simplifying these differences, making it easy to grasp. For instance, the figure above simply shows that firms give products to households in exchange for payments. The outer ring carries two sides of the product market, whereby households demand and firms supply. Households are also seen as worked who carry their services to the firms and receive the aforementioned benefits. As you can see in the inner circle representing the two sides of the labor market, households are supplying, whereas firms are demanding. The circular flow model in this example has been broken down to bare essentials. However, it has enough features to explain how relations in the markets work.

This is one of the most basic things you need to understand to create a verifiable economic model. It will help you easily create what you want to fill in the necessary. An analyst can add as many details as they want to introduce more real-world elements. For instance, one can add in financial markets, governments, or interactions with the whole globe through imports and exports. Economists have a set of theories in their heads, which are more like a carpenter's toolbox. Whenever something comes up, and they have to explain, they just refer to their toolbox until they get the most suitable theory to explain the occurrence. Consider the 2008 Great Recession, for instance. It let to the fall, and near fall of many markets, economies collapsed, and many people were affected. In such a case, economic analysts can come up with theories that explain their probable cause and offer appropriate advice to policymakers.

If you are going to continue with economic studies, you will face different situations that require the creation of specific m models. At sometimes, especially at the entry-level, you may not need a model to figure out the right answer, it just comes. But as you continue deeper, you will face challenges that can only be explained through these models. Supply-and-demand and Keynesian theory of consumption are among the most common approaches used in modern economies.

Note that, a fundamental aspect of economic models is linearity, or whether the variable under study constantly changes with another variable it is being compared to. In other words, economic models exhibit a linear relationship. Also, it is crucial to note where the change in the variable is not constantly proportional; rather, it fluctuates with the study's related variable. In this case, they have a non-linear co-relation.

Economists think very differently from people in other fields. This is mostly because they deal with human psychology and try to determine what rational decision they may make in relation to a specific situation in an economy. Besides, it is clear the world depends on economic development for sustainability. With the technological developments witnessed over the past few decades, it is apparent that proper research is necessary when it comes to making any economic decisions.

How to build and economic model

Most of your work as an economist will involve coming up with theoretical and verifiable models. Luckily, it is not very hard. In this section, we shall share a few ideas on how to create these models. These steps may be changed according to your requirements and personal preferences as you see fit. Besides, it all depends on what you are working on. As you grow, you will discover that there are some ideas that work better than others.

1. Come up with ideas

This is the first and most important step in the process. It may not be a problem to come up with an idea, but coming up with a good idea can be the hardest task. The best way would be to come up with lots of ideas, the sieve out the ones you are not sure about.

Where do you get the ideas from? Most graduate students only look at journal articles for ideas. It may give you something, but it is not the best source of ideas. Yes, there are lots of things, including techniques, insight, and sometimes the truth. However, best, you will only end up with something that someone else has already done. You could find a few loose ends, but the author may have already thought about them and found them unworthy, you did want to waste your time and find yourself in the same situation.

There are very many other sources of ideas, which are very simple. Consider newspapers, magazines, conversations, and TV and radio programs. You will always get ideas about economic processes in these places. Conversations, mostly with business people, can be very fruitful. Ideas can also come from your daily life and experiences. You could be in the market buying something and based on how the traders are handling you, and an idea hit you that there is something strange happening that could have a major impact on the general economy.

Once you have the idea at hand, think about its worthiness. How good is it in the current situation you are working on. Hence, begin by breaking down the idea into a statement anyone can understand, even a non-economist. Failing to do this may create problems for you, forcing a start-over. You may phrase it down but still, notice it is a lousy idea. At least there is hope in what you are doing. It important that you establish whether it is interesting, which should take care of its correctness.

2. Avoid unmatured literature review

Many graduate students rush into a literature review looking for those who may have already working on the idea. It almost sounds like the best idea at the moment, but it is not. You may want to consider waiting a bit before doing this. You will have to look at the literature review eventually, but that does not mean our rush to it. Give yourself the idea that you can do better work with your idea that what anyone else may have done.

You need to practice making a model first. There are chances you will end up producing the exact thing you need, which is goo still because you will have already learned a lot. The first section of this article introduced you to the basics of creating an economic model of why it is important, and it should be enough to get you on the right path. Going slow on the literature review can also introduce you to new approaches that are not in the literature.

3. Build and generalize

Having said that, forget the literature review for a while and get into your model. The good thing is, all economic models look fairly the same. They begin with making choices for that they can advance the objectives later. And you must ensure that choices satisfy different constraints so that there is a variable that can be changed to make everything consistent.

Come up with a plan of attack by, for instance, identifying the individual or firms making the decisions, the constraints they face, their interaction with others, and what may adjust if there is no manual consistence. These issues can be very helpful in putting together pieces of your model. And once you are sure everything is in place, move on to the next stage, which it work an example. Work on as many examples as possible until you get the best idea of what is going on. Just keep it simple and stupid at first, because you don't want to feel too strained at the start.

Once you have made the model as simple as possible, it may not be of much interest. But the most important thing is simplicity. Now it is easy to identify the best approach for generalization since you already have the right pieces to make it work. Consider using some of the things you learned in school. Remind yourself or on various canonical models like consumer choices, producer choices, general equilibrium, the game theory, and many others. There are many general models that can fit in a lot of special cases.

4. Mistakes and literature

In this case, try to simplify to get the best results. Complexify to see its general appearance. This is called a back-and-forth process, which is like sculpting. You will be making mistakes and correcting them and making again and correcting until everything is polished.

Now go for your literature review. Talk to your professors about your work, and most will tell you to look in differing places. They are right mostly, but you will discover your work is better. Research is never easy, but you will have learned something important.

5. Give a seminar and plan and structure your paper

Talking to your friends, families, and f riends get very boring. You should consider giving a seminar about the final work. A talk will help you build the idea much better. Listen to all the ideas, even the stupid ones, and keep your seminar simple.

After the talk, everything should now be clear. Use your computer to make your work more appealing. There is some great software that makes planning and structuring academic papers easy. There are three parts of an academic work, the first can be understood by everyone, the second by a few, and the last is the most serious part. Consider using all these parts.

6. Where to stop

You can always tell when your work is nearly done and getting ready for publications from the seminars. There are no more questions from people, and you have followed everything. Now you can stop and publish your work.


All your work must always have a summery. HenceBuild an Economic Model, the takeaway points are:

- Come up with and organize your ideas

- Create a simple version of the model and put your literature aside first.

- Hold seminars and stop only when there are no more questions.

Now you are ready to try your first model.

Author: James Hamilton

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