Economic Model
Economic analysis relies on building models that simplify complex socio-economic phenomena. In an economic model, unnecessary details are stripped away to focus on the essential elements and processes. Much like a map, an economic model doesn’t need to show every tiny detail, but rather serve as a practical guide to help us interpret the real world. This simplification is what makes economic models effective.
An economic model is a mathematical framework composed of exogenous and endogenous variables, designed to represent a particular social phenomenon from a specific perspective, based on certain assumptions about the behavior of economic agents. Each model makes predictions about how people behave.
For example, one common idea in economic analysis is the principle of optimization, which assumes that individuals always choose the best possible option to maximize their well-being or utility. If someone can rationally evaluate all possible choices and has full information, they will (presumably) select the one that brings them the greatest benefit. Another key assumption in economic models is the principle of equilibrium.
These two principles form the basis of many economic models throughout the history of economic thought. However, they don’t always reflect real-world behavior. For instance, people rarely have access to all the information they need, and they often act irrationally. Otherwise, we wouldn’t see phenomena like speculative bubbles. More sophisticated economic models treat optimization and equilibrium as guiding principles—goals that individuals strive for, even if they can’t perfectly achieve them.
Example
A clear example of simplification in an economic model is the model of perfect competition. In this model, it’s assumed that there are countless firms and consumers, all with perfect and complete information about the market. It also assumes that the goods are homogeneous, meaning they’re identical, and that there are no barriers to entering or leaving the market. In reality, though, firms often differentiate their products, information is far from perfect, and the number of firms is finite. There are also often significant barriers to entry, such as high startup costs. Despite these simplifications, the model of perfect competition provides a theoretical framework to understand how an ideal market would function.
