What are economic models?

Economics is a complicated subject. Economic models are used as a type of framework to demonstrate in a simplified fashion how complex economic processes function. An economic model will include a set of variables, together with a set of relationships among them, whether these may be logical or quantitative. Where structural parameters are posited, these parameters are subject to change.

Necessarily subjective since no purely objective measures of economic outcomes exist, an economic model has as its purpose a logical, abstract template which will yield up verifiable theories in regard to economic behavior. There are two main classes of economic model in use – the theoretical and the empirical.

Theoretical economic models
The role of theoretical economic models is to provide in depth answers to important economic questions. This is facilitated by clearly defining certain economic constraints in the model, such as a specific budget limit. Within these constraints, it is assumed in the theoretical economic model that agents will maximize particular objectives, and implications will be borne out that can be tested regarding economic behavior.

Empirical economic models
By contrast, empirical economic models focus on numbers rather than qualitative answers. These models are used first to authenticate the qualitative predictions which have been made by theoretical models and then to translate them into specific numerical conclusions, in the form of mathematical equations. Empirical models include exogenous variables, or inputs (which the model is not required to account for), and dependent variables, or outputs (once one or several inputs are in effect, the model will attempt to provide an explanation for the outputs).

Economists tend to disagree about the correct way to derive the equations from an empirical economic model. Some operate on the assumption of maximizing behavior, while others among them base their equations on their experience of observing data.

Evaluation of economic models
A good economic model will provide precise, confirmable implications to explain a given set of economic data. Evaluation of the model’s’ results comes in the form of testing its major implications, using such tools as case studies, statistics and the results of laboratory experiments. If the economic model results in systematic forecasting errors, this is an objective indication that the model is somehow flawed and requires revision.

While economic models allow us to form and test hypotheses regarding interactive economic relationships, it is difficult to rely solely on models to make long term predictions, due to their inherent errors and the fact that is unrealistic to assume that key factors are predetermined. They can, however, provide some valuable insights.