Functions and Types of Economic Models
– Economic models simplify and abstract observed data.
– They select relevant variables and relationships.
– Economic models are used to forecast economic activity and propose economic policy.
– They justify economic policy at different levels (national, firm, household).
– Economic models aid in planning and allocation in centrally planned economies and logistics.
– They assist in trading and risk management in finance.
– Economic models establish an argumentative framework for logic and mathematics.
– They provide approximate representations of economic facts.
– Economic models remove extraneous information and isolate key relationships.
– Types of economic models include stochastic models, autoregressive models, non-stochastic models, qualitative models, quantitative models, accounting models, and optimization models.
Stochastic and Non-Stochastic Models
– Stochastic models are formulated using stochastic processes and model economically observable values over time.
– Econometrics is used in stochastic models to test hypotheses and estimate parameters.
– Autoregressive models, such as autoregressive moving average and ARCH/GARCH models, are popular in econometric analysis.
– Non-stochastic models can be purely qualitative or quantitative.
– Qualitative models lack precision but predict the direction of movement of economic variables.
– Non-stochastic models often use graphs instead of functions and rationalize financial variables with hyperbolic coordinates.
Profit Maximization Model
– The profit maximization model assumes that a firm produces at the output rate that maximizes its profit.
– Differential calculus is used to obtain conditions for profit maximization.
– The first-order maximization condition states that the derivative of profit with respect to output is equal to zero.
– The second-order conditions for a local maximum state that the derivative of profit with respect to output squared is negative.
– The prediction of the profit maximization model is that output decreases with increased taxation.
Aggregate Models in Macroeconomics
– Macroeconomics deals with aggregate quantities such as output and price level.
– Real output is a vector of goods and services, while price is the vector of individual prices of goods and services.
– Models in macroeconomics often lump variables into single quantities like output and price.
– Quantitative relationships between aggregate variables are important in macroeconomic theories.
Problems with Economic Models and Comparison with Other Sciences
– Economic models rest on assumptions that may not be entirely realistic, such as perfect information and frictionless markets.
– Important issues like externalities may be omitted in economic models, compromising their results.
– There are practical and theoretical limitations in current macroeconomic models, including time lags and difficulty in specifying parameters.
– Economic models are compared to models in other sciences, such as weather prediction and human health.
– The complexity of systems like the economy or climate and the sensitivity to small changes in equations can lead to inaccurate forecasts.
– Deterministic chaos may limit the predictive powers of economic models, but research suggests that aggregate macroeconomic variables do not behave chaotically.
– Free market economic thinking argues that the invisible hand of the market guides the economy more efficiently than central planning using economic models.
– Friedrich Hayek emphasized the limitations of top-down analysis of the economy and the inability of mathematical economic models to capture critical systemic elements. Source: https://en.wikipedia.org/wiki/Economic_model
An economic model is a theoretical construct representing economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified, often mathematical, framework designed to illustrate complex processes. Frequently, economic models posit structural parameters. A model may have various exogenous variables, and those variables may change to create various responses by economic variables. Methodological uses of models include investigation, theorizing, and fitting theories to the world.
