Economics, Models and Reality

Economic Models

Have you ever observed children playing together when they make a small mud or wooden house? If you watch them closely they would take roles of some elders. they will pretend to go to office, they pretend to cook and have some tea together in mini cups. But if you closely hear them their stories are all built on assumption which are continuously made as the story progresses. you will constantly hear them make suppositions, like "suppose Ali comes to my house" or " Suppose Ali and Aleena are brother and sister" and all such assumptions
goes on. and you know that none of these assumptions are true but they just pretend it to be. Then under these assumptions they progress with their stories. They might come up to a stage where Ali and Aleena will marry. And then one of the kids most probably an elder one would correct them, that based on your assumptions brothers and sisters cannot marry. So there goes a lesson of real life for them.

Children learn from playing. They do not build real houses but models of real houses. They apply assumptions and get intuition about the real life. Economist learn about the real economy in the same fashion. They make Models, Apply their assumptions and play with the variables to derive intuition about the economy. Economic Models needs not necessarily to be exactly true, but it should provide some meaningful insight about the real world. Many people criticize economic models for being unrealistic and based on assumption, but the only real model is the world itself. The purpose of assumptions is to simplify models so that a given connection between variables is established. Once we know a relationship exist we may relax some assumptions to move towards reality.

Economic Models are generally expressed as Graphs or a set of Mathematical Equations. Models consists of two types of variables known as endogenous or exogenous variables. 

Endogenous and Exogenous variables

Exogenous variables are input variables of the model. Exo means external or which comes from outside. So the value of exogenous variables are not determined by the model but comes from outside of the model. these values are what we feed into the model. The resultant variables are called endogenous, meaning that their values are determined inside the model. So they are output or result of the model. In order to understand these variable lets take a very simple model relating to law of demand. We will discuss Law of demand in detail latter but for the time being we can get an idea

Q = 50 - 2P

Here Q is quantity demanded of lets say Banana and P is price of one Banana. In this model Q is endogenous because its value is determined by the Right hand side of the equation. P on the other hand is exogenous since its value is not determined here. If suppose price per unit of banana is 10. Putting its value in the above equation will give us Quantity demand equal to 30. If we put price equal to 20 the Quantity demand will equal to 10. so the value of Q will always be determined from the model whereas P can have any value. We can also call endogenous variables as dependent variables and exogenous variables as independent variables, since the value of Q depends on P.

We can also represent a Model in its functional form as

Q = f (P)

meaning Quantity demand is function of Price but now only we know they are related but cannot calculate the exact values.

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