The world is complex... let's use a model to figure it all out!

Economic models are widely used to forecast economic activity, for planning and resource allocation, risk management, policy formation, and many other applications.

It may seem obvious to some, but it is important to always keep in mind the reason for modeling: the real world is complex and we want to make it easier to understand. When modeling, there are always many factors to take into account, many circumstances to consider, and many unknown pieces. The modeler has to constantly balance between simplicity of the model and its applicability. And so, modeling is an art that uses scientific tools.

In economics and business, the term model may refer to a theoretical model, an empirical model, and sometimes to a combination of the two.

A theoretical model is a simplified framework that can be used to illustrate a complex process. Typically, the model describes a set of economic agents, the process that links them, and the environment in which they operate. The most basic theoretical model in economics is that of perfect competition: consumers’ behavior under different circumstance (e.g., different income levels) is described by a demand curve and producers’ behavior under different circumstances (e.g., different material costs) is described by a supply curve. When consumers and producers interact (i.e., when the two curves intersect), equilibrium price and quantity are determined.

Economists use mathematical functions to represent the demand and supply curves capturing the essence of consumers’ and producers’ behavior. This representation enables economists to develop a basic understanding of how equilibrium price and quantity are determined in different circumstances, and to understand how different markets operate. Examples are numerous: fruits and vegetables, electronic products, hotel rooms, soft drinks, automobiles, bank loans, books, and the list goes on and on and on.

But, while many different markets are similar qualitatively, they are very different quantitatively. Developing quantitative understanding of a market requires the usage of economic data and the application of econometric modeling techniques.

Econometrics is a branch of economics that applies statistics to data generated by economic processes, seeking to test hypotheses about these processes or to estimate parameters that describe these processes. Using these parameters, it is possible to quantitatively compare different scenarios across products, industries, countries, and over time, and it is possible to generate forecasts.

More about econometric modeling in our next post.