In economics, a model is defined as a theoretical construct that represents economic processes through a set of variables and a set of logical or quantitative relationships between the two. A model is simply a framework that is designed to show complex economic processes. Most models use mathematical techniques in order to investigate, theorize, and fit theories into economic situations. An economic model presents the economic variables and the complex relationship between them in a simplified mathematical form. For instance, the Law of Demand states that “when the price of a good rise, the quantity demanded of that good falls and vice-versa”. This is an economic theory. The economic model for this theory is
Q = f (P) —— (1), where Q = quantity demanded and P = Price of a good
In Linear form, the functional relationship of (1) can be expressed as:
Q = a – bP —- (2), where a = intercept and b = price elasticity of demand
Equation (2) is the economic model of the Law of Demand. In this model, every increase in price will decrease the quantity demanded. Hence, the application of mathematics in economics makes it easier to present the economic theory in a more understandable form.
Importance of an Economic Model
Economists use models in order to study and portray situations. The focus of a model is to gain a better understanding of how things work, to observe patterns, and to predict the results of stimuli. Models are based on theory and follow the rules of deductive logic.
The economic theory aims at the construction of models which describe the economic behavior of economic agents and their interaction which creates the economic system of a region or a country or the world as a whole.
Economic models have two functions: 1) to simplify and abstract from observed data, and 2) to serve as a means of selection of data based on a paradigm of econometric study. Economic processes are known to be enormously complex, so simplification to gain a clearer understanding is critical. Selecting the correct data is also very important because the nature of the model will determine what economic facts are studied and how they will be compiled.
The five major uses of economic models are:
- To forecast economic activities, but is based on assumptions
- To provide economic recommendations on the predicted future economic behaviors
- To provide a logical justification to support economic policies.
- To give a basic framework for planning and allocating resources
- To assist economic agents in making prudent speculation on trading and investment
Examples of the uses of economic models include professional academic interest, forecasting economic activity, proposing economic policy, presenting reasoned arguments to politically justify the economic policy, as well as economic planning and allocation.
Limitations of a Model
Due to the complexity of economic models, there are obvious limitations that come into account. Some of the major limitations of an economic model are as follows:
- Data accuracy
First, all of the data provided must be complete and accurate in order for the analysis to be successful. Also, once the data is entered, it must be analyzed correctly. In most cases, economic models use mathematical or quantitative analysis. Within this realm of observation, accuracy is very important. During the construction of a model, the information will be checked and updated as needed to ensure accuracy. Some economic models also use qualitative analysis. However, this kind of analysis is known for lacking precision.
The economic model is primarily based on assumptions. The economic model will hold true until the assumptions are valid. Models are fundamentally only as good as their founding assumptions. The models developed by classical economists are undoubtedly the best, but they were based on wrong assumptions.
- The behavior of economic agents
An economic model presents the behavior of economic agents in the mathematical expression. Behavior modeling is one of the most complicated tasks. The behavior of economic agents are ever-changing and bringing such ever-changing behavior in the realm of the economic model is a daunting task. The unpredictability of the behavior of economic agents might challenge the validity and reliability of an economic model.
Hence, no model is perfect. Every model is based on certain assumptions and violation of assumptions vanishes its validity. For example, Say’s Law of Market was valid until 1930, but the validity of the law vanished as it’s one of the major assumptions, that is “Supply creates its own demand”, crumbled.
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