In economics, the model is defined as a theoretical construct that represents the economic relationship between different sets of variables with help of definite assumptions, and a set of logical equations or functions relating to a particular well-defined problem. Thus the model is a description of the relationship between two or more economic variables. For instance, a model may explain how an individual and firms allocate resources and how market prices or input prices are determined. There are different types of the economic model in economics.
Economists use models for two main purposes as analysis of the existing relationship between selected variables and prediction or estimate the future values of the variables within the set of assumptions. Thus, a model is a simplified representation of an actual system or process of human life.
The realistic behavior or phenomenons are represented by the models to explain it, analyze it, to predict it, and to control it. There may be verities of models that can represent the realistic phenomenon of life in different ways. In economics economic (theoretical) and econometric (empirical) models are two widely-used models. Types of the economic model or models in economics can explain as below;
Every economy includes millions of people engaged in several economic activities like buying, selling, working, hiring, manufacturing, distribution, marketing, and so on. They are while performing these sorts of activities linked to each other. To understand how they linked to one another and how an entire system is operating economists have developed different economic models with a given set of assumptions.
An economic model makes statements or hypothesis that is mostly qualitative. For example, the microeconomic theory states that other things remaining unchanged a reduction in the price of a commodity is expected to the increase in quantity demanded of a commodity. But a model or theory itself does not provide any numerical measures of the relationship between two variables. It means the economic theory or model does not able to tell by how much the quantity will go up or down as a result of a certain change in the price of a commodity.
According to Gardener Ackley, “An economic model consists simply of a group or a set of economic relationships, each one of which involves at least one variable which also appears in at least one other relationship which is part of the model.”
The law of demand and the law of supply is considered as very commonly used types of the economic model. They are the classical economic model. The economic model can be constructed at different levels with different sophisticated purposes. The least level of construction of the model is the level of firms. It is the simplest method using or without using mathematical and other functional methodologies to show the simplest representation of complex reality.
A good model should be simple enough to understand and should capture enough key information. Sometimes the economic model is termed economic theory. But fundamentally economic theory is different from the economic model. Economic theory is more abstract representation but the economic model is a more applied or empirical representation. Models are used to test theories.
The model helps to express the complex relationship of economic variables in the simplest possible form. Therefore, it can be said that economic models are the relationship between the variables in the set of equations to describe the theory of economic behavior.
The model is expressed in the form of graphs, mathematical equations, and computer programs. An econometric model is a set of equation/s that represents the behavior of the economy that has been estimated using historical data. The model should be the simplest and able enough to explain the attributes of complex relationships. While forming or building a model sometimes there may be the possibility of the oversimplification of the variables and sometimes the possibility maybe the construction of the model with a set of unrealistic assumptions.
The good model includes all the essential variables related to a particular economic relationship. The variables which are excluded from the model are called disturbances and represented by disturbance term or error term in the econometric model. Econometric models thus attempt to work as a bridge between the exact relationship of economic theory and the disturbing relationships of economic reality. They examine the quantitative aspects of the economic phenomenon.
The field of knowledge which helps us to evaluate economic theories in numerical terms is econometrics. Econometrics integrates economics, mathematics, and statistics to provide numerical values for the parameters of economic relationships and verifies economic theories.
Econometric models show the statistical relationship that is believed to be seized between the several economic quantities relating to a particular economic trend or event under a study. The econometric model has always two parts as one is an economic theory and the second is measurement/magnitude/forecast.
The statements or theories stated by different economists or schools of thoughts are specified into a mathematical form and here stating into a mathematical form signifies the exact relationship between the considered variables (as mathematical models express the relationship in the exact form).
But in reality, some other factors or variables are also responsible for affecting the model that we are developing-called disturbances or error terms. Thus the econometric model ensures all these disturbances inside the model with the presence of error term and fills the gap between the behavior of economic variables (economic model) and disturbances.
For example, we have one of the popular macroeconomic theories stated by J.M Keynes as consumers increase consumption as their income increases, but not as much as the increase in the income. It means the value of MPC lies between 0 to 1. This is the economic relation stated by economic theory.
The econometric model requires the mathematical specification of such a statement stated by the economic model. Here we can express the relationship between income and consumption into a mathematical specification as;
Mathematical Model; Y=B1+B2X
Where B2 is less than one but greater than one Y is consumption, B1 is intercept or autonomous consumption, B2 is slope or MPC and X is income, and B2X is induced consumption.
Here the given mathematical model shows the exact relationship between variables under a study. It means this model tells us that consumption is only the function of income or consumption is only determined by income. But in reality, the amount of consumption may be affected by other factors as well.
Now the econometric model represents these all missing variables that could affect the values of the model by the name disturbance term/error term/residual variable. So the econometric model ensures that there is not the possibility of exact measurement of the phenomenon and so we have to include the residual variable to make our model complete and more generalized.
An error term or residual variable or disturbance term is thus produced by the econometric model when the model does not fully represent the actual relationship between the explanatory and explained variables. So in our example, the econometric model can be expressed as;
Econometric Model; Y=B1+B2X+ U
Where U is disturbance or error term or residual variable
So the econometric model assumes every economic model/relation as stochastic one i.e. it assumes the presence of disturbances in the exact behavioral patterns as suggested by economic models or mathematical models. Additionally, econometric methods or models provide mathematical values to all the coefficient of the relationships under investigation. These values have greater importance in policymaking and further planning. Econometric models are so essential and foundation for future forecasting and policy prescription. Thus these are the major types of the economic model.
Ahuja, H.L. (2017). Advanced Economic Theory. New Delhi: S. Chand and Company.
Jhingan, M.L (2012). Advanced Economic Theory. New Delhi: Vrinda Publications (P) LTD.