Models in Economics: Some Important Examples

A model is a simplified representation of a real situation that is used to better understand real-life situations.

A model is any simplified representation of reality that is used to better understand real-life situations. But how do we create a simplified representation of an economic situation?

One possibility—an economist’s equivalent of a wind tunnel—is to find or create a real but simplified economy. For example, economists interested in the economic role of money have studied the system of exchange that developed in World War II prison camps, in which cigarettes became a universally accepted form of payment even among prisoners who didn’t smoke.

Another possibility is to simulate the workings of the economy on a computer. For example, when changes in tax law are proposed, government officials use tax models—large mathematical computer programs—to assess how the proposed changes would affect different types of people.

The other things equal assumption means that all other relevant factors remain unchanged.

Models are important because their simplicity allows economists to focus on the effects of only one change at a time. That is, they allow us to hold everything else constant and study how one change affects the overall economic outcome. So an important assumption when building economic models is the other things equal assumption, which means that all other relevant factors remain unchanged.

!worldview! FOR INQUIRING MINDS: The Model That Ate the Economy

A model is just a model, right? So how much damage can it do? Economists probably would have answered that question quite differently before the financial meltdown of 2008-2009 than after it. The financial crisis continues to reverberate today—a testament to why economic models are so important. For an economic model—a bad economic model, it turns out—played a significant role in the origins of the crisis.

A model that underestimated the risks of investing in MBSs had dire consequences for financial firms on Wall Street and for the global economy.
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“The model that ate the economy” originated in finance theory, the branch of economics that seeks to understand what assets like stocks and bonds are worth. Financial theorists often get hired (at very high salaries, mind you) to devise complex mathematical models to help investment companies decide what assets to buy and sell and at what price.

The trouble began with an asset known as an MBS, which is short for mortgage-backed security. The owner of an MBS is entitled to a stream of earnings based on the payments made by thousands of people on their home loans. But an MBS carries with it a potential problem: those homeowners can stop paying their mortgages, inflicting losses on the owner of the MBS. So investors wanted to know how risky an MBS was—that is, how likely it was to lose money.

In 2000, a Wall Street financial theorist announced that he had solved the problem by adopting a huge mathematical simplification. With it, he devised a simple model for estimating the risk of an MBS. Financial firms loved the model because it opened up a huge and extraordinarily profitable market for them in the selling of MBSs to investors. Using the model, financial firms were able to package and sell billions of dollars in MBSs, generating billions in profits for themselves.

Or investors thought they had calculated the risk of losing money on an MBS. Some financial experts—particularly Darrell Duffie, a Stanford University finance professor—warned from the sidelines that the estimates of risk calculated by this simple model were just plain wrong. He, and other critics, said that in the search for simplicity, the model seriously underestimated the risk of losing money on an MBS.

The warnings fell on deaf ears—no doubt because financial firms were making so much money. Billions of dollars worth of MBSs were sold to investors in the United States and abroad. In 2008–2009, the problems critics warned about exploded in catastrophic fashion.

Over the previous decade, American home prices had risen too high, and mortgages had been extended to many who were unable to pay. As home prices fell to earth, millions of homeowners didn’t pay their mortgages. With losses mounting for MBS investors, it became all too clear that the model had indeed underestimated the risks.

When investors and financial institutions around the world realized the extent of their losses, the worldwide economy ground to an abrupt halt.

People lost their homes, companies went bankrupt, and unemployment surged. The recovery over the past six years has been achingly slow, and it wasn’t until 2014 that the number of employed Americans returned to pre-recession levels.

But you can’t always find or create a small-scale version of the whole economy, and a computer program is only as good as the data it uses. (Programmers have a saying: “garbage in, garbage out.”) For many purposes, the most effective form of economic modeling is the construction of “thought experiments”: simplified, hypothetical versions of real-life situations.

In Chapter 1 we illustrated the concept of equilibrium with the example of how customers at a supermarket would rearrange themselves when a new cash register opens. Though we didn’t say it, this was an example of a simple model—an imaginary supermarket, in which many details were ignored. (What were customers buying? Never mind.) This simple model can be used to answer a “what if” question: what if another cash register were opened?

As the cash register story showed, it is often possible to describe and analyze a useful economic model in plain English. However, because much of economics involves changes in quantities—in the price of a product, the number of units produced, or the number of workers employed in its production—economists often find that using some mathematics helps clarify an issue. In particular, a numerical example, a simple equation, or—especially—a graph can be key to understanding an economic concept.

Whatever form it takes, a good economic model can be a tremendous aid to understanding. The best way to grasp this point is to consider some simple but important economic models and what they tell us.

In discussing these models, we make considerable use of graphs to represent mathematical relationships. Graphs play an important role throughout this book. If you are already familiar with how graphs are used, you can skip the appendix to this chapter, which provides a brief introduction to the use of graphs in economics. If not, this would be a good time to turn to it.