Transcript for:
Understanding Economic Models and Simplification

"An economic model or theory is a simplification of reality that allows us to observe, understand, and make predictions about economic behavior." OK, what does this MEAN? How does it apply to us? Why do we need to "simplify reality"? When I ask the question, "How much realism do we want in a model?" most students will respond, "As much as possible," or "100%." But is this true? Is MORE realism always preferred? Let me give you an example: Suppose that it's the end of the semester, and to celebrate, I'll be having a big party at my house! You're invited, but how will you get there? You'll need some kind of directions -- probably a map, right? Well, how much realism do you want your map to have? 100%? Stop for a moment and think about what 100% realism would mean -- in your map, one mile equals one mile!! Where would you put it? OK, so maybe not full scale, but surely we want as much realism as possible, right? Again, think about what this means -- your map would show every rock, every pothole, every blade of grass -- you get the picture. Well, OK, we probably don't need (or want) 100% realism; not only is it cumbersome, but the minor details tend to get in the way, distracting us from our end goal (was that the 17th cow, or the 19th cow?). So if you want to focus on the end goal -- getting to the party -- what level of detail do you really need? If you are like me, you are probably interested in the major cross streets closest to your destination, and perhaps some general directions and major landmarks along the way. Perhaps, as you near your destination/end goal, you would want a bit more detail (the third cross street, fourth house on the right, that sort of thing), but again, 100% detail or realism is neither necessary, nor desired. So, back to the question: How much realism do you want in your model? The answer to this question is rather non-specific: we want enough realism to allow us to achieve our end goal; to reach our destination. How do I know if there is enough? How do I determine if my model is good? Well, if my model -- my simplified version of reality -- is a good one, then it helps me to "observe, understand, and make predictions about" my topic. In the case of the map? The map was good if I successfully achieved my end goal -- if I reached the party! At various points this semester, you may ask me, "but in the REAL world, isn't it the case that... [fill in the blank]?" Often, my response to you will be to bear in mind that we are dealing with a MODEL -- a simplified version of reality. Is it perfectly realistic? No. Does it allow us to observe, understand, and make predictions about economic behavior? You bet!! The models we will use this semester may be in the form of verbal statements, or tables of data, or graphs, or mathematical equations. In Episode#6, I'll give a brief review of graphs, before we move on to setting up a Model that will help us look at scarcity and choice. NEXT TIME: Graphs.