Economic Models

Read this section on the reasoning behind economic models, which are just representations of reality or theoretical thinking for understanding something. Pay attention to the explanation about the Circular Flow Diagram (Figure 2), which represents how the economy and its actors are related to one another. Make sure to answer the quiz questions.

Learning Objectives

  • Explain the characteristics and purpose of economic models

An economic model is a simplified version of reality that allows us to observe, understand, and make predictions about economic behavior. The purpose of a model is to take a complex, real-world situation and pare it down to the essentials. If designed well, a model can give the analyst a better understanding of the situation and any related problems.

A good model is simple enough to be understood while complex enough to capture key information. Sometimes economists use the term theory instead of model. Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation. Often, models are used to test theories. In this course, however, we will use the terms interchangeably.