What is an Economic Model?

An economic model is a simplified representation of a real-world economic situation or phenomenon that is used to analyse and understand the underlying economic principles at work.

Economic models are built on assumptions about how people, firms, and markets behave, and they use mathematical and statistical techniques to make predictions and test hypotheses about economic phenomena.

The importance of assumptions

An economic assumption is a simplified statement about how people, firms, or markets are expected to behave in a given situation.

For example, an economic model might assume that people always act in their own self-interest or that firms always maximise profits.

It is important to note that economic assumptions are simplifications of reality and that they may not always hold true in all situations.

The ceteris paribus assumption

The ceteris paribus assumption is a Latin phrase that means "other things being equal." It is used in economics to refer to the assumption that all other factors are held constant in order to isolate the effect of a single variable on an economic outcome.

The ceteris paribus assumption is often used when building and analyzing economic models. For example, an economist might build a model to analyze the effect of a change in taxes on consumer spending. In order to isolate the effect of the tax change, the economist would hold all other factors constant, such as income, prices, and consumer confidence. This would allow the economist to focus on the specific effect of the tax change on consumer spending, without the influence of other variables.

The use of economic models

Economic models are used to understand and explain micro and macro economic phenomena, to make predictions about future economic events, and to evaluate the effects of different economic policies.

Examples of different economic models

There are many different types of economic models that are used to analyze and understand economic phenomena. Some examples of different economic models include:

1. Supply and demand model: This model is used to understand the relationship between the quantity of a good or service that is available and the price at which it is offered. The model assumes that as the price of a good increases, the quantity demanded by consumers will decrease, while the quantity supplied by producers will increase. Click here for resources on the price mechanism
2. Production function model: This model is used to understand the relationship between the inputs used in the production process (such as labor and capital) and the output of a good or service. The model assumes that as the inputs are increased, the output will also increase, but at a diminishing rate. Click here for resources on the law of diminishing returns.
3. Utility maximization model: This model is used to understand how consumers make decisions about what goods and services to purchase. The model assumes that consumers aim to maximise their utility (or satisfaction) from their purchases and will choose the combination of goods and services that provides the greatest utility for their given budget. Click here for study resources on utility theory
4. Game theory model: This model is used to analyze strategic interactions between two or more individuals or firms. The model assumes that each participant will make decisions based on their own self-interest and on the expectations of the other participants. Click here for study resources on game theory