An economic model is a simplified representation of an economic process or phenomenon.
An economic model is a simplified representation of the relationship between different variables that explain how the economy or a particular phenomenon in it operates. For example, the variation in the price of a product in a specific market.
Use of economic models
Economic models allow to study complex phenomena and make predictions about the future behavior of variables. Since reality is very complex, the model focuses on capturing only the most relevant variables of the phenomenon studied. Allowing, in this way, a greater understanding and simplicity.
In other words, if we tried to study a phenomenon including all the variables involved, the study would become unmanageable. Reality is complex and our understanding of it limited.
Economic models are based on simplifying assumptions about the relationship of the variables. Its main uses are:
- Understand the relationship between economic variables (formulate and test hypotheses).
- Diagnosis of a particular situation or phenomenon.
- Forecast of the future behavior of the variables.
- Design of economic policies.
Limitations of economic models
At the same time that economic models help us to simplify reality, they have the weakness that many times they do not capture all the relevant variables and therefore their conclusions are wrong. To determine the quality of a model, the quality of the selection of the relevant variables and the appropriateness of the assumptions used must be determined.
Economic model example
Take for example a simple model on determining the salary level of workers in the software programming market.In this model, the basic assumption is that the salary will be determined by the interaction between the supply and demand of labor in this sector. It is then assumed that there is a free market.
Supply and demand are thus determined in turn by other variables. The demand for labor, for example, is determined mainly by: the demand for the product (the price it reaches in the market), the price of labor and other production costs.
The job offer, meanwhile, is determined mainly by: the salary offered and the number of qualified workers (or with the necessary skills for the position).
Then, the interaction of supply and demand will bring us to an equilibrium point that will tell us what the wage level is.
As we can see, the conclusions that we can draw from the model depend on the appropriateness of our assumptions and the selection of the determining variables. In our case, we have chosen the assumptions of the free market and the interaction between supply and demand.
Type of economic models
Economic models can be grouped into two broad categories: microeconomic and macroeconomic.
- Macroeconomic: They determine phenomena at the general or macro level of the economy. For example: the level of production, inflation, etc.
- Microeconomic: They refer to the study of specific markets and / or the behavior of agents at the individual level or in a market. For example, the determination of the price of bread in Spain.
Economic models or systems
Another way to understand the concept of an economic model is when we refer to economic systems or the way the economy is organized. In general there are three types of economic systems:
- Capitalist model: That uses the market as a resource allocation mechanism.
- Socialist or planned model: The economy is planned or intervened to achieve certain objectives.
- Mixed economy: a combination of the above.