Question

1. Comment on the role of economic models. What are the strengths and weaknesses of said models?

Answer 1

Economic Models

Economic models are used by economists to analyse the real world scenarios. It provides a logical, abstract template to learners and analysts. Economic models are most often composed of diagrams and equations. In order to simplify the analysis and concentrate on the truly important things economist model does not use every feature of the economy.

Economic models are useful for presenting visually the essence of economic arguments. The visual appeal of a model simplify reality to improve our understanding of it.

Types of models

There are mainly four types of models used in economic analysis.

Visual models – Represents an abstract economy; graphs with lines and curves that tell an economic story. Most visual models are visual extensions of mathematical models underlying.

Mathematical Models - These are systems of simultaneous equations with an equal or greater number of economic variables analysed through algebra and calculus.

Empirical Models - Empirical models are models based on mathematical equations designed to be used with data collected. Model values are derived from the data analysis done through accepted statistical techniques.

Simulation Models - Simulation models embody the features of mathematical models without requiring that the user be proficient in mathematics. (for eg programming language like C++).

Economic models

The basic understanding of economic models can be developed through these 2 economic models

1. Circular flow diagram

The economy consists of millions of people engaged in activities like selling, buying, manufacturing etc. In order to understand the economy we use circular flow diagram model which analyse how the economy is organised and how the participants in the economy interact with each other.

The diagram is a schematic representation of the organization of the economy. Households and firms make decisions. Households and firms interact in the market for goods and services (households are buyers and firms are sellers) and in the market for the factors of production (where forms are buyers and households are sellers). The outer set of arrows show the flow of dollars, and the inner set shows the flow of inputs and outputs.

2. Production Possibility Frontier (PPF)

PPF is a graph that shows the combination of output that an economy can produce given the factors of production and the available technology. In order to simplify the analysis economic model assume that economy produces only two goods – cars and computers.

The PPF shows the combinations of output that the economy can possibly produce. The economy can produce any combinations on or inside the frontier.

However, points outside the frontier are not feasible given the economy’s resources.

Strengths and weaknesses

Economic models provides a picture of behaviour of economic agents. So they just merely represent a type of consistent economic behaviour either visually or mathematically. These models are not applied models. In reality the weaknesses of economic models are more than its strengths.

Improper assumptions: Models have high integrity conform to the rigorous standards of logic inherent in mathematics. However, mathematical models must begin with precise assumptions about economic activity. The conclusions and insights offered by the model are restricted or even determined by the initial assumptions. Therefore, if the initial assumptions are wrong or misleading, despite the logical integrity of the model, its conclusions will be as much in error as the initial assumptions. A model can be logically consistent internally but may yield bad results

Oversimplification: Economic models try to simplify the situations for the ease of analysts. To make some sense from the model, the analyst will pull out those key variables which seem to have the most importance and fit only them into a logical scheme, omitting the others. However, the omitted variables do matter in the real economy. Therefore some generalizations end up being too crude to produce accurate results.

Mathematical Intractability: Macroeconomic models, usually have a large number of equations and variables. All of these must be reduced to a solution if the model is to be of any value. For the ease of doing, sometimes the underlying equations assumed to be either linear, or easily converted to linear, such as exponential or log-linear. But real economic behaviour doesn't necessarily exhibit patterns that are "linear", or even represented well by orderly equations that are non-linear and that can still be used in a large model. The "math of reality" is remarkably complex, and cannot be duplicated in abstract model of human design.

The other limitations are its assumed tendency towards equilibrium and its incompatibility to use as an applied model. So we can conclude that economic model gives a better understanding of economic situations. However they have a lot of limitations which makes it incompatible with the real economic scenarios.