Economic Models

 

Economists often study politically charged issues, but they try to address these issues with a scientist’s objectivity. Like any science, economics has its own set of tools — terminology, data, and a way of thinking. The best way to become familiar with these tools is to practice using them. By using economic models, we can understand economic phenomenon.

Model Building

Teachers of biology teach basic anatomy with plastic replicas of the human body. These models have all the major organs—the heart, the liver, the kidneys, and so on—which allow teachers to show their students very simply how the important parts of the body fit together. Although these plastic models are artificial, show many details, and even omit many other details about the human body, no one would mistake one of them for a real person.

Economists also use models to understand the world, but unlike plastic manikins; an economist’s model is more likely to be made of symbols, diagrams and equations. Economists build models to explain economic variables, such as GDP, inflation, unemployment, and the relationships among the variables as well as economic phenomenon.

Just as the biology teacher’s model does not include all the body’s details, an economist’s model does not include every feature of the economy. All models—in biology, economics, etc—simplify reality to improve our understanding of it.

Economic models have two kinds of variables: endogenous variables and exogenous variables. Endogenous variables are those variables that a model explains, are determined within the model and are the model’s output. Exogenous variables are those variables that a model takes as given, come from outside the model and serve as the model’s input. Models show how the exogenous variables influence the endogenous variables.

To make these ideas clearer, let’s review the model of supply and demand. Imagine that an economist wants to figure out what factors influence the price of pizza and the quantity of pizza sold. She would develop a model to describe the behavior of pizza buyers, the behavior of pizza sellers, and their interaction in the pizza market.

Qd=D(P, Y),      the quantity of pizza demanded by consumers (Qd) depends on the price of pizza (P) and on aggregate income (Y).

Qs= S(P, Pm),     the quantity of pizza supplied by pizzerias (Qs) depends on the price of pizza (P) and on the price of materials (Pm), such as cheese, tomatoes, flour, and anchovies.

Qs = Qd = Q,  Finally, the economist assumes that the price of pizza adjusts to bring the quantity supplied and quantity demanded into balance.

These three equations compose a model of the market for pizza.

This model of the pizza market has two exogenous variables (the aggregate income [Y] and the price of materials [Pm]). The model does not explain them but instead takes them as given (they may be explained by another model). The model has also two endogenous variables (the price of pizza [P] and the quantity of pizza exchanged [Q], these are the variables that the model explains. The model can be used to show how a change in any exogenous variable affects both endogenous variables.

The Use of Multiple Models

Economists study many facets of the economy. For example, they examine the role of saving in economic growth, the impact of minimum-wage laws on unemployment, the effect of inflation on interest rates, and the influence of trade policy on the trade balance and exchange rate.

Economists use models to address all of these issues, but no single model can answer every question. Instead, there are many models, each for a particular facet of the economy. But remember that a model is only as good as its assumptions and that an assumption that is useful for some purposes may be misleading for others. When using a model, the economist must keep in mind the underlying assumptions and judge whether they are reasonable for studying the matter at hand.