Introduction to Economic Models and Application
Economics is one of the widest studies subjects in the world. And since the world revolves around economic growth and development, it becomes apparent that the subjects her dipper roots with humanity are more than just the markets. Without economic studies, it is hard to imagine where the world be in terms of general human living standards. There would be no control over markets, and consumers would be left in the mercies of firms. Economics is the missing link between people, economies, governments, and the whole world. It is through economics that we have global systems of operations. In other words, the world has become a small global village because of this.
John Maynard Keynes (1883 – 1946) is considered one of the greatest economists of the modern world. His contributions have been appreciated and accepted across the globe, with theories like the Keynesian theory helping people understand the values of economic studies more. Keynes pointed out that economics is more than just a subject area; it is a way of thinking. His famous writing in the introduction of a book by a fellow economist has always been a major point of reference. He economics is a method more than doctrine… “an apparatus of the mind, a technique of thinking, which helps its possessor to draw the correct conclusion.” This means economic teaches you how to thinks and not what you should think. Those who have economic knowledge make the best decisions in their lives since it gives them the knowledge to understand what is happening around them.
Economists and economic models
Economists have a way of looking at the world and approaching different issues in a different lens than any other discipline. If a biologist looks at new bird species, they can describe it easily using what they see. But for an economist, analysis of the issues and problems is key to finding the right name for anything. They use to come up with economic theories that are founded on specific assumptions about how humanity behaves. In other words, economists rely to a large extent on human psychology. They have to try and understand what the rational person would do in a specific condition, helping them draw more concrete conclusions.
A theory is a critical approach to economic studies and research. We can describe a theory as a simplified representation of how two or more variables related to another and work together. A theory seeks to take a complicated, real-world issue and break it down to its simplest form. If done correctly and succeeds, it can enable the analyst to comprehend what they are trying to resolve and other problems around it. A good theory is characterized by simplicity, it is easy to understand, and anyone can use it to make decisions or come to a conclusion about any issues they may interest in. But there are other complex theories that carry the key features of the object under study as well as the situation under which it is being studied.
On many occasions, economists use the term model, instead of a theory. If you follow the strict rules of application, a theory is a more abstract representation of the issues. A model, on the other hand, is a more applied of empirical representation. In other words, models are used when the economist is trying to test a theory. In this article, we shall be using the terms interchangeably. They are both used for the same case; hence, a model also becomes a theory.
Consider an architect looking at planning for a major office building. They will create a physical model of the building, which sits on the tabletop showing how the entire project will appear once finished. A model reveals a true representation of the project to the scale. It even shows how it will settle with other buildings within the environment. It also happens when companies are looking to introduce a new product, they build models of the products first, which are rough and unfurnished, compared to the final product, but it still has to demonstrate how the real product will look and operate.
A good model always begins with a circular flow diagram.
As seen in the diagram above, the circular flow diagram consists of two groups of items, the households and another for firms. These two variables interact in two markets; goods and services markets where the company sells household items and the labor market where the firm sells labor to business firms. The company also has other employees, which is important because its all-around relationship revolves around developing an economy.
This representation shows the mutual relation between households and firms in the two markets. This relationship flows in a specific direction, as shown by the direction go the arrows. In simple terms, the goods and service market is comprised of the households who receive the products and pays money to the company, which the producer for them. On the other hand, it is the labor market, where households offering labor and receive payment from the firm through wages, salaries, and benefits. Without this relationship, there would be no firms, not consumers, hence not markets. Economic growth and development are dependent on verifiable relations. This is what the model seeks to prove.
In the real world, there are different markets providing goods and services as well as various labor markets. The circular flow diagram becomes the simplification that makes it for one to understand this relation. As you can see, firms produce goods and services, which are sold to households, earning companies some revenues. In this case, the firm has to ensure they have put in place proper pricing and business models according to the situation within their markets. This aspect is represented by the outer circle, and it represents two sides of the product market. Household sells their labor as working to firms and get wages, salaries, and other benefits. This is shown through the inner circle, showing the two aspects of the labor market, where now households are the supplier and firms are in demand.
This is a simple version of a circular flow motion. All the flesh has been removed to the skeleton, but it still has enough to explain the relationship between the labor and product market. It is very easy to add details to this basic representation in case one wants to use real-life elements. The most important thing is to know how different elements interact, then we can add elements like financial markets, governments, and how they interact with the rest of the world through exports and imports.
Consider how a carpenter carries a toolkit around. This is the same way economist carry a set of theories in their heads. When they discover or anticipate an economic problem, you will see them quickly go theories to pick on that most fits the current situation. The theory may not be the solution to the problem, but they use it to derive insights about the issue at hand. Theories, in this case, are expressed as diagrams, graphs, or mathematical equations. And economists don’t automatically figure out the answer to the problem; hence, they draw a diagram of the theory, fills in the necessary variables, and use it to find the best solution. Note, however, that at the start, one can figure out the answer without applying the model – that is, if the problem is clear. As long as you are studying economics, you are going to run into problems that call for a graph to resolved. Besides, the best way to express both micro and macroeconomics is through theories and models. One of the best and most popular theories is those applied for supply and demand, but many others make discovering solutions to problems easier and more fun.
Economic Models and Math
As discussed above, economic models are essential in explaining or making decisions about issues and problems that are or may arise in an economy. As you may have studied in an earlier unit, economies are described by fluctuations that come bubbles and recessions. And when it hits the peak above or the trough under, economists try to understand their causes and suggest the best ways to reverse it to equilibrium. A good example is the 2008 Great Recession that saw the fall of many markets. Economists may attempt to explain the most probable cause of such issues, hence, try to predict how personal income tax cut would impact direct purchases, of say, automobiles.
Economic models can either be in words or appear as mathematical equations. But in this case, we can explain the most critical aspects without using math. We all know that math is a tool that has been used for generations to explore economic concepts. It is the same as the famous analogy that ‘a single picture is worth a thousand words.’ In the same way, economists use graphs as the most effective way to convey information visually without writing too many words. A graph is a picture, as well as a math-based model.
Algebra is a specific way that helps economists explore and express economic models. Sometimes graphs may compel you to ‘eyeball’ a model, in which case, algebra offers more precise answers to the questions. For instance, a firm may put up their product on sale for 10% discount, how much more will consumption increase? Answering this question may require a clear model, which could be a mathematical representation. The use of the algebraic formula for a line enables economists to discover the exact points on the graphs that could be key to interpreting how much of the product is sold.
Some people may wonder why economists would use mathematics when there are many other ways of representing models, like text and narrative. Applying mathematics and be liked to using a fist to bang a nail when you have a hammer. However, math has great advantages over text. First, it disciplines the analyst to think by focusing specifically on what they think. When using text, it is very easy to get away with fuzzy thinking and vague approximations in your mind. But once you reduce the model to algebraic equations, it becomes essential that every figure you come up with is necessary. Secondly, math ensures that stick on the right track. It reminds you that everything you do must be related to what you are researching and that your approaches should be to the point.
But that does not mean that mathematics is all clear. There are times when it becomes very disadvantageous. Well, math is one tool for approaching economic models and using them in a different situation. However, it is not the only one too, or the best tool one can use with models.
The use of mathematical models in development economics has become far too common, particularly ‘computable general equilibrium’ (CGE). These models are being applied on a large scale to determine issues in economic development and find the best solutions to any problem. Governments are often faced with economic issues that call for a more in-depth approach to solutions. In this case, CGE models can be used as a powerful tool for making predictions based on behaviors of complicated national economies in response to some shocks. Whenever policymakers come with various policy interventions, they need first to understand the most probable economic consequences, apart from identifying the macroeconomic properties of the general economy.
The models have become essential tools for economists to run simulations of various macroeconomic scenarios. As such, they are a representation of the opportunity to conduct ‘experiments’ within economies. They give the most important basis for policy advice that consultants and agencies give to governments. In other words, economies are dependent on the predictions offered by economic experts. In order to avoid a situation like the 2008 Great Recession, there must be a way to predict future economic behavior. It is through economic models that these solutions are discovered and help shield economies from serious problems. They also help firms make more informed economic decisions at every level of their investments.
Author: James Hamilton