Understanding Economic Models

Complexity of Economics

• Economics deals with millions/billions of actors (human beings and organizations)
• Each actor is complex (e.g. human brain unpredictability)
• Understanding collective behavior of these actors is daunting

Analogies from Other Fields

Chemistry: Ideal Gas Law

• Chemists simplify complex interactions of gas molecules
• Use simplifying assumptions:
  • Ideal gas law: relates pressure, volume, number of particles, and temperature
• Simplification helps understand complex systems

Biology: Model Organisms

• Human experimentation is complex and often unethical
• Biologists use simpler organisms (e.g. cells, fruit flies, mice)
• Mouse models help in predicting human behavior
• Drug trials often start with mice for safety before human trials

Simplifying Assumptions in Economics

• Economists also use simplifying assumptions:
  • Actors are rational (not always true)
  • Equal access to information (not true in reality)
• Aim to break down complexity into simple equations, lines, charts

Examples of Economic Models

Production Possibility Frontier (PPF)

• Simplification: trade-off between two goods all else equal
• Real world: multiple variables influence decisions

Price Equilibria (Supply and Demand)

• Assumptions: rational actors, perfect information
• Helps in understanding equilibrium prices and quantities

Caution with Economic Models

• Models are useful but not an absolute description of reality
• Important to understand assumptions behind models
• New models arise by revisiting and revising assumptions

Challenges in Testing Economic Models

• Testing in economics is harder than in chemistry, physics, or biology
• Real-world experiments on economies are not feasible
• Clinical trials in medicine are possible; not so in economics
• Economics straddles between social sciences and hard sciences
• Simplifying assumptions are necessary but not always accurate