An economic model is a theoretical representation of an actual or real economic situation. It explains what happens in the real world by relying on certain assumptions. There are many variables in real life that make events complex to understand. A model simplifies the situation by reducing the complexities, thereby making the phenomenon easy to comprehend. Modelling enables economic researchers to concentrate on the investigation at hand without having to worry about too many complications that can affect the outcomes in reality. Economic relationships are established and conclusions are drawn about a region, a country or the world by means of models. For example, a model can be used to forecast consumption apart from establishing the relationship between consumption and income.
A model is often expressed in form of mathematical equations due to the fact that they have high accuracy and consistency. It can also be stated in words or shown graphically. A dynamic model has time as one of its variables while a static model does not have time as a variable.
Components of a model
A variable is a quantity that can change because it can assume any of a set of values. The variable that a model attempts to explain is the dependent variable while the independent variable helps to determine the behaviour of the dependent variable. This means that the size of the dependent variable is related to the independent variable. In the model, D= 12 + 3P, P is the independent variable while D, whose value is determined by P, is the dependent variable. If the value of P is changed, D will change as well. A model has one dependent variable and one or more independent variables.
If a variable can be measured at a particular point in time, it is referred to as a stock variable. But if the researcher has to measure a variable over a period of time, that variable is called a flow variable.
The size of a constant is fixed and not subject to change. It may stand on its own or be placed together with a variable. In the model C=a+bY, a and b are constants.
Assumptions help us to understand the connection between a dependent variable and an independent variable. They simplify reality by reducing the complexities of the real world. A common assumption that is made in economic research is the “Ceteris Paribus” assumption. Ceteris Paribus is a Latin phrase that means “other things being equal”, “other things being held constant”, “all else unchanged”, or “all other things being equal”. This assumption enables the researcher to concentrate on the variables at hand and neglect other variables that could influence the outcome in a real situation. For instance, when investigating the effect of price on quantity demanded of a product, the researcher focuses on price and quantity demanded and neglects other factors that can possibly influence demand such as income, taste, advertising, etc.
Stages involved in constructing and testing economic models
Building the model
The economic phenomenon to be explored will require that variables be identified and the relationship between them be stated in mathematical terms, for instance. The underlying assumptions are also stated at this stage. In formulating variables and assumptions, the researchers need a deep understanding of economic theories and the knowledge of published works on the problem being investigated.
Estimating the parameters of the model
The researcher has to gather relevant statistical data or observations to estimate the coefficients of the model. The relationship among variables and the assumptions are also studied at this stage.
Ascertaining the reliability of the model
The conclusions drawn from models should be applicable to real-life situations. Consistency with actual data helps to ascertain whether the model can be used to forecast future events. The estimates from the model should be evaluated in order to determine their reliability. The results obtained are assessed for statistical correctness and conformity with economic theories. Some parameters have to be positive while others have to be negative based on economic theories. This is why the estimates obtained must be compared with what the relevant economic theory says. This is not to say that there are no exceptions.
Deviations of estimates could be determined statistically to expose errors which can make the collected data unrepresentative of the actual phenomenon been studied.
Acceptance, rejection or modification of the model
The evaluation of the model could lead to acceptance if reliable or rejection if inconsistent with empirical facts. The model may also be modified especially when there is a change in the actual situation which renders the model obsolete.