Economic Modelling

Introduction to Economic Modelling

• Economists use models to understand (and predict) how agents
make choices.
– Model is a simplified representation of reality e.g., world map, diagram
of an electrical circuit or organization chart.
• Economists often use the terms “model” and “theory” interchangeably.
– Economic models are utilized to make predictions about the real-world,
which are subsequently evaluated against observed data.
• Economists refer to their model’s predictions as “hypotheses”.
– Testing models with data enables economists to separate good models,
those that approximately match real-world data, from bad models.
• Economists do not expect this process to reveal “true” model of the world,
since our world is vastly complex, but to identify models that are useful in
understanding our surroundings.
 Principles of Economic Modelling
• All economic models are based on two underlying principles:
– Optimization Principle: Economic agents choose the best alternative
within their budget set, i.e., intuitively think of as “greedy”.
– Equilibrium: A balance (equilibrium) is usually achieved when different
agents are trying to optimize in a given institutional environment.
• The power of an economic model stems from the elimination
of irrelevant detail, in order to focus on the essential features
of economic agents’ choices in a given setting.
– Parsimony is a virtue in modelling e.g., think about the level of detail in
LUMS map.
– “Useful” models are simplified, not perfect, replicas of reality.
• Like models in other sciences, economic models also begin with
precise assumptions about economic agents and their settings.
 Principles of Economic Modelling
– the purpose of assumptions is to focus on the fundamental aspects of
a decision problem.
• Who are the key economic agents? What is the primary objective of each
economic agent? What are the key constraints of economic agents?
– For a model to be useful, it is more important for a model to be simple
than it is for the model to be precisely accurate!
• Is a model as complex as reality really useful? Recall LUMS map example.
– Simplified models can make powerful, often correct, predictions about
our world e.g. consumer and producer behavior, market outcomes etc.
• Nevertheless, a lot of thought goes into framing assumptions,
as a model's conclusions are influenced by initial assumptions.
– Try to make as few assumptions as possible. Is it really necessary?
– Assumptions should be easily justifiable. Does it pass the STINK test?
 Criticisms of Economic Modelling
• But, we don’t use models to make choices/decisions!
– The As-if Principle: Famed pool player’s shots consistent with complex
mathematical models of mechanics.
• Do players solve these complex models before playing their shots?
• No! But (with experience) they act as if they have solved these models!
• Upshot: Even if people don’t utilize economic models to make
choices, but their choices are consistent with the solutions of
these complex mathematical problems!
– Models can help us understand behavior of economic agents!
• Human behavior is not universal like that of protons, electrons.
– Behavioral economics, or economic psychology, studies how behavior
of agents systematically deviates from classical economic models.
– Still, models based on rationality can be used to improve decisions!