Economic models

Meaning and importance

The most striking feature of any Economic system is its overall complexity. To abstract from
the vast complexities of real world economies, economists develop rather simple models that
capture the essentials of the economic process.

Generally, a Model is a simplified representation of a real situation; or

A model is a simplified description of economic reality used to understand and predict the
relationship between variables (Tucker).

Economic theory aims at the construction of models which describe economic behaviour of
individual units such as consumers, firms (producers) and government agencies and
interaction between them. These individual units and their interaction help create the
economic system of a region, a country or the whole world.

Economic models are developed to aid in understanding economic issues e.g. models that
seek to explain the way individuals seek to make ideal decisions (e.g. on Consumption), the
way firms behave and the way in which these two groups interact to establish markets.

Though an abstraction, a model does not contain falsehood; it includes the main features of
the real situation which it represents. Abstraction from reality is achieved by a set of
meaningful and consistent assumptions which aim at the simplification of the phenomenon or
behavioural pattern that the model is designed to study.

The degree of abstraction from reality depends on the purpose for which the model is
constructed.

The series of assumptions in any particular case are chosen carefully so as to be consistent, to
retain as much information as possible, and attain a reasonable degree of generality.

Abstraction is necessary given that the real economic world is extremely complex and any
attempt to study it in its true form would lead to an analysis of unmanageable dimensions.

Models do generally omit some details yet they are still useful – just like a road map. For just
as a road map proves to be useful even though it doesn’t record every small detail e.g. blade

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of grass, economic models say on banana market will not record every minute detail relating
to the banana market or economy.

Abstraction in economic modelling does not imply unrealism but (is) rather a simplification
of reality. It’s thus the beginning of understanding the great complexity of the real economic
world.

A model’s power stems from the elimination of irrelevant details which allows the economist
to focus on the essential features of the real economic reality he/she is attempting to
understand.

In the task of constructing economic models economists are guided by two principles namely:

i. Optimization principle- It states that people typically try to choose what’s best for
them.

ii. Equilibrium principle- Economic forces tend to move to a state of balance. More
specifically, it states that prices will adjust until demand and supply are equal.

Importance or purposes for which models are constructed

There are two main purposes for which a model is built- Analysis and prediction.

 Analysis - This has to do with the explanation of economic behaviour. Using a set of
assumptions we derive certain “laws” which describe and explain with an adequate
degree of generality the behaviour of consumers and producers.

 Prediction: This relates to the effects of forecasting the changes in some magnitudes
in the economy e.g. a model of demand might be used to predict the effect of
increasing consumer’s income. Or supply model might be used to predict the effects
of imposition of tax. NB:

An economic model can be constructed at different levels of aggregation, detail and

sophistication depending on its purpose.

Criteria for judging the validity of a model (Desirable properties of a model)

1. Prediction power/ Forecasting ability- The model should produce satisfactory

predictions of future Values of the dependent (endogenous) Variables. To Milton
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 Friedman, predictive performance of a model is the most important criteria for testing
the validity of a model.

2. Theoretical Plausibility- The model should be compatible with postulates of economic

theory. It must describe adequately the economic phenomena to which it relates.

3. Explanatory Ability - The model should be able to explain the observations of the
actual world. It must be consistent with the observed behaviour of economic variables
whose relationship it determines ⇒power of the model in explaining the behaviour of
economic agents. This criterion is supported by Paul Samuelson.

4. Realism of assumptions- a good model should be based on realistic assumptions.

5. Generality- this relates to a range of cases to which the model applies.

6. Simplicity- A good model should be kept simple and easy to understand. The model
should represent economic relationships with maximum simplicity. The fewer the
equations and the simpler their mathematical form, the better the model is considered,
ceteris Paribus (that is to say provided that other desirable properties are not affected
by simplification of the model).

7. Testability- A model should be built in such a way so that its testable - i.e. should be
capable of being verified or refuted when confronted or compared with the true
economic facts.

8. Accuracy of estimates of parameters - For mathematical models (Econometric) the

estimates of coefficients should be accurate in the sense that they should approximate
as best as possible the true parameters of the structural model.

9. The extent of information the model provides.

- There’s no general agreement regarding which of the above criteria for judging the
validity of a model are more important. However, the more of the above properties a
model possesses the better it is considered for any practical purpose.

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An economic model can be presented verbally, in tables, in graphs, or mathematically.

Application of models – Equilibrium Principle

Marshallian supply – Demand model

Suppose we wished to study the market for mangoes and on the basis of statistical analysis of
historical data concluded that the quantity of mangoes demanded each week depended on the
prices of the same such that.

Qd = 1000-100p ---------------------- (1)

Since this equation contains only one independent variable P, we are implicitly holding
constant all other factors that might affect the demand for managers.

To complete this simple model of pricing suppose that the quantity supplied of mangoes also
depends on price such that,

Qs = -125 + 125p -------------------- (2)

From these 2- equations model, it is possible to get equilibrium quantity and price. An
equilibrium price can be found by setting Qd= Qs i.e. in equilibrium there should be equality
between supply and demand.

Qd = Qs

→ 1000-100p = -125 + 125p

225p = 1125

↔p=5

Suppose DD Function in the case above changes to;

(i) Qd₁ = 775 -100p

(ii) Qd₂ = 1450 -100p

Obtain the new equilibrium graphically and analytically. Explain your findings.

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Although the Marshallian model is an extremely useful and versatile tool, it is only a partial
equilibrium model looking at only one market at a time. This affords analytical simplicity
though it may prevent discovery of important analysis. At this point, general equilibrium
models come in handy.

Q2 Clearly explain what production possibility frontier is. (10marks)

Suppose the production possibility frontier for two goods (X and Y) is given by the equation:

X² + Y² = 100

What is the opportunity cost of producing one more unit of X in terms of Y at the point where
X = 6? (10marks)

Additional information on economic models

An economic model typically consists of several functional relationships, conditions, or

constraints on one or all of these functions, and one or more equilibrium conditions.

Generally, economic models are used to demonstrate an economic principle, to explain an

economic phenomenon, or to predict the economic implication of some change affecting one
or more of the functional relationships. (Peterson Creig & W.C Lewis, 1999, 42).

FUNCTIONAL RELATIONSHIPS: TOTAL AVERAGE AND MARGINAL

A functional relationship of the form

Y = f(x₁, x₂ --------, Xn),

means that there is a systematic relationship between the dependent variable Y and the
independent variables X₁, X₂ --------, Xn and that there is a unique value of Y for any set of
values of the independent variables.

For any total function (e.g. total product, Total cost, Total revenue, e.t.c.) there is an
associated Marginal function and average function.

The Key relationships among the total, average and marginal functions are:

1. The value of the average function at any point is the slope of any ray drawn from the
origin to the total function at that point.
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 2. The value of marginal function at any point is the slope of a line drawn tangent to the
total function at that point.

3. The marginal function will intersect the average function at either a minimum or a
maximum point of the average function.

4. If the marginal function is positive, the total function will be increasing. If the
marginal function is negative the total function will be decreasing.

5. The total function reaches a maximum or minimum when the marginal function
equals zero.

(Q) Suppose the PPF for two goods X and Y is given by the function

2x² + y² =225

Required:

Represent this function graphically

What is the opportunity cost of producing 1 more unit of X in terms of Y at the point where
x= 10.