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Suttinee Kaewsuwan

BBA 2 SS 2002

Introduction

There are many tools that help people perform a task or an activity in everyday life easier; map is used

for telling the direction and helping people choose the right way; microwave is an important kitchen

tool in the modern life-style that reduces time to warm and to cook food; or electronic mail is an

important information technological innovation that allow people to keep in contact with the people

who live far away from them. In the same way, biologists use human body models as their tools to

explain how internal organs work; engineers build models to see how the system works; also,

economists use models as their tools to help them in dealing with problems or historical data in the

economy.

Economics is one branch of social sciences that is concerned with money flows, trade activities, and

industrial systems in the society. Economists use the scientific approach for developing economic

theories. Considering the way to test a theory, in economics it is not easy as it is in the scientific

world; scientists can make an experiment under the controlled environment or the given conditions to

test their theories. How do economists make a real experiment in economic system which is concerned

with the real society? In this case they need specific tools, i.e. models and historical data, to fulfill

their approach.

What are models in economics? How do they differ from each other? Where and when do economists

use them? And the most important question, why do they need models in economics?

Answers to all these questions will give more understanding about the role and the importance of

models in economics. In the following parts these issues will be discussed in more detail .

-1-

Suttinee Kaewsuwan

BBA 2 SS 2002

What is a Model?

Firstly, it is better to start with the meaning of a model. In Oxford Advanced Learners dictionary by

Hornby (2000) there is one meaning of a model as the following paragraph:

A model is a simple description of a system which used for explaining how something

works or calculating what might happen, etc: a mathematical model for determining

the safe level of pesticides in food, a realistic model of evolution

This definition of a model shows the general way of thinking about it; a model can be used for many

purposes such as an explanation of the system or a calculating process. Many economists have their

own specific definitions of a model in economics. The following definitions are taken from some

economic textbooks.

Samuelson and Nordhaus (1998) gave the definition of a model as a formal framework

for representing the basic features of a complex system by a few central relationships.

Models take the form of graphs, mathematical equation, and computer programs.

Begg, Fischer, and Dornbusch (2000) found that a model or theory makes a series of

simplification from which it deduces how people will behave. It is a deliberate

simplification of reality.

Scientists and mathematicians use their models in problem-solving and problem-analyzing process. In

the same way economists also use a model in economics to analyze and visualize the economic

problem. One branch of mathematics concerning the problem-solving process is called mathematical

modeling, in this field mathematicians try to construct and simplify a model (a set of mathematical

equations) to explain how the whole system works and use the model to calculate and predict what

might happen in case that the system continues working in the same given conditions. Like

mathematical modeling, econometrics is one branch of economics that uses the methods of statistics to

measure and estimate quantitative economic relationships. Samuelson and Nordhaus (1998) gave the

definition of an econometric model as the following:

An econometric model is a set of equations, representing the behavior of the economy,

that has been estimated using historical data.

Nowadays there is an entire industry of econometricians estimating macroeconomic models and

forecasting the future of the economy. Many of them developed computer programs in order to

calculate the complicated system of mathematical equations. We will discuss more about the different

types of models in economics in the following section.

-2-

Suttinee Kaewsuwan

BBA 2 SS 2002

From the definition of a model, it has been said that models in economics have the wide range of

forms including graphs, diagrams, and mathematical models. Economists use these models in different

purposes; it depends on many factors such as what type of raw data they have, how they can represent

the data, and what they want from the model they use. In this section it will be more explanation about

what is the main role of these different models and also some important examples in economics.

Flow Chart

Flow chart is a diagram that shows the connections between the different stages of a process or parts

of a system. Economists use a flow chart to explain how the economy is organized and how

participants in the economy interact with one another. If people follow the right connections in the

flow chart diagram It will be easier for them to understand the relationship between participants in the

economy.

One of the important flow chart using in economics is called the circular-flow diagram, presented in

Figure 1. Circular-flow diagram is a visual model of the economy that shows how dollars flow

through market among households and firms.

FIGURE 1 Circular-flow diagram

Revenue

Goods

and services

sold

Firms sell

Households buy

FIRMS

Wages, rent,

and profit

Goods and

services

bought

goods and services

Hire and use factors

of production

Inputs for

production

Spending

MARKETS

FOR

GOODS AND SERVICES

HOUSEHOLDS

goods and services

Own and sell factors

of production

Labor, land,

and capital

MARKETS

FOR

FACTORS OF PRODUCTION

Households sell

Firms buy

Income

= Flow of goods

and services

= Flow of dollars

-3-

Suttinee Kaewsuwan

BBA 2 SS 2002

Graph

Graph is a planned drawing, consisting of a line or lines, showing how two or more sets of numbers

are related to each other. In general the different types of graphs can be separated by using the number

of variables represented in the graph, i.e. graphs of a single variable such as pie graphs, bar graphs, or

time-series graphs; graphs of two variables (these variables are represented by the x- and y-coordinate)

such as scatter diagrams; and graphs of more than two variables (these graphs are represented by more

than 2 coordinates). In economics many kinds of graphs are used: some graphs show how variables

change over time; other graphs show the relationship between different variables. So it is important to

know what is the difference between these graphs and how to choose the right one to represent

observed or interested data.

While there are so many different kinds of graph in general meaning, it is better to focus on only the

important types of graphs using in economics. The following part is provided more explanation about

the main types of graphs in economics including production possibilities frontier (PPF), time-series

graph, scatter diagrams, and multicurve diagrams.

Production possibilities frontier or PPF is a graph that shows the combinations of output that the

economy can possibly produce given the available factors of production and the available production

technology.

A

150

Machines

Frontier

120

of food-machines production levels.

A smooth curve fills in between the

plots pairs of points, creating the

production possibilities frontier.

90

60

30

F

0

0

10

20

30

40

50

Food

Time-series graphs show how a particular variable moves over time. Time-series graphs have time on

the horizontal axis and variables of interest on the vertical axis. Some example of time-series graphs

using in economics is the debt-GDP ratio.

8000

Sales

6000

companys sales from 1988 to

2000

4000

2000

0

1988

1990

1992

1994

1996

1998

2000

year

-4-

Suttinee Kaewsuwan

BBA 2 SS 2002

Scatter diagrams show observations on a pair of variables. In some cases only individual pairs of

points will be plotted; in many cases it is normal to find scatter diagrams plotted as the combination of

variables for different periods of time (month, year, etc.). An important example of a scatter diagram

in macroeconomics is the consumption function.

June

sales revenue

4000

May

between the monthly advertising

expenditure and the monthly sales

revenue of a company during 6 months.

The line in the scatter diagram shows the

trend of the data.

April

3000

2000

March

January

February

1000

0

0

100

200

300

advertising expenditure

Multicurve diagrams show two or more relationships in a single graph. In many cases only one curve

in a graph is not enough to analyze the complicated system of economic problem. Therefore it will be

useful to present more than one curve in the single graph in order to see the relationship between these

curves. The most important example of the multicurve diagrams is the supply-and-demand diagram,

shown in figure 5.

6

Supply

5

FIGURE 5 Supply-and-demand

diagram

between the quantity of hamburgers

and the price of the hamburger, and

the relationship between the supply

curve and the demand curve.

4

3

2

1

Demand

0

1

Quantity of Hamburgers

-5-

Suttinee Kaewsuwan

BBA 2 SS 2002

Mathematical Model

A mathematical model can be broadly defined as a formulation or equation that expresses the essential

features of a physical system or process in mathematical terms. In a very general sense, it can be

represented as a functional relationship of the form

Dependent variable = f (independent variables, parameters, forcing functions)

(1)

Where the dependent variable is a characteristic that usually reflects the behavior or state of the

system; the independent variables are usually dimensions, such as time and space, along which the

systems behavior is being determined; the parameters are reflective of the systems properties or

composition; and the forcing functions are external influences acting upon it.

The actual mathematical expression of equation (1) can range from a simple algebraic relationship to

large complicated sets of differential equations. Economists use a mathematical model as a theory to

determine the particular problem. Many proven mathematical models are used in economics as the

formulas to help economists calculate and analyze the numerical issues easier, e.g. the rule of 70.

Econometricians use the scientific way of thinking to develop a new econometric model or a theory to

explain the economic system.

When a model is built up, it is a safe way to writing down all the factors that is related to the studied

economic issue, otherwise it might have been forgotten some influenced factors that can make the

trouble inside the model. More detail about how economists develop a model will be discussed later.

Some example of econometric model is the model using for forecasting the GDP.

-6-

Suttinee Kaewsuwan

BBA 2 SS 2002

To answer this question, it is better to understand the way economists use to analyze, solve and foresee

a particular economic issue. As it is mentioned before that economists use the scientific approach to

deal with economic problems, the scientific approach starts from scientific observation (it can be the

environment or other fields of interest), after that they will build up a hypothesis, then they will use the

scientific experiment or existing theories to prove their hypothesis and they will reach a conclusion

that can be true of false (it depends on the results from their experiment). Economists use this way

when they think about a particular issue in the economy; they try to simplify an economic issue in the

way that everyone will understand and be able to follow their thought; they try to find a formula that

can help them calculate the numerical issue; they try to develop a new economic theory to explain the

economic behavior in the real world. What do they need to fulfill these approaches? Absolutely, they

need a tool to help them and in this case it is called a model. The ways that economists use models

can be classified into three purposes: explaining an economic process, examining an economic issue,

and developing a new economic theory.

From Chinese proverb A picture is worth a thousand words, it is true that a picture can express idea

better than words or equations. Graphics help economists in many specific purposes: some shows the

relationship of observed data; some shows how the economic process runs; some shows the trend from

historical data. Graphs and flow charts play the main role in this purpose of using models. There are

some examples from the previous part: the production possibilities frontier shows the relationship

between the available factors of production and the available production technology; the circular-flow

diagram shows how dollars flow through market among households and firms; and the famous supplyand-demand diagram shows the relationship of demand and supply curves in the same frame.

These types of models help them see the picture of the process, know how data relate to each others,

and clarify the idea about the problem. These types of models will be used as a combination with

mathematical models and applied in the other purposes.

What do economists want to know from observed data? Not only do they want to see how the system

looks like or the relationship in the graphic way, but they also want to see the trend or changes from

observed data. Economists use the wide range of mathematical models to examine the economic

issues: some simple formulas are used to calculate a new value from given data or analyze it; some

mathematical models are used in the problem-solving process; some equations are used to estimate

and forecast the change in the economy.

Firstly, it is the best way to start with a simple mathematical equation that is used to calculate and

measure the change in the economy such as the percentage change and the growth rate.

The percentage change is the absolute change divided by the original number,

then multiplied by 100.

It is quite often to see economic data in the report presented as the percentage. When data is studied

over the period of time it will defined as the growth rate that is the percentage change per period

(typically per year). Economists usually use economic growth (the percentage annual change in the

national income of a country a group of countries) in order to see, analyze and forecast the trend and

the economic situation of the observed country.

Secondly, a model is required in the problem-solving process. This process (shown in figure 6) can be

divided into 4 steps: problem definition, mathematical model, numerical or graphic result, and

implementation. Not only a mathematical model is used in the problem-solving process, but also the

graphics, statistics, etc. are used as the problem-solving tools.

-7-

Suttinee Kaewsuwan

BBA 2 SS 2002

Problem

definition

Mathematical

model

THEORY

DATA

Problem-solving tools:

computers, statistics,

graphics, etc.

Numeric or

graphic result

Societal interfaces:

optimization, public

interaction, etc.

Implementation

And the last point, some models are used to estimate and forecast the future trend. Economists have

developed forecasting tools to help them foresee changes in the economy. Forecasting models are built

up by the combination of mathematical models and historical data, as the system of equations.

Nowadays large systems forecast from a few hundred to 10,000 variables. This is the main purpose of

econometrics and it is not easy to deal with forecasting. An example of the important forecasting is

GDP forecasting. The forecasting result can not 100% true some error can be occurred, it depends on

how good the system of equations they set up and how many variables they put into their model.

The good theories help economists measure the changes, see the new trend, and predict the future

result in the economy. How do they develop a new economic theory? They have to combine the

scientific approach, the mathematical knowledge, and historical economic data together. Then they

will use the problem-solving process to find the suitable model for the particular problem, after that

they have to test their model and if it is true they can use it as a new theory. It sounds like an easy

process but it is not easy to simplify reality to a model. Most of economic theories are developed by

based on or related to the existing theories (or models).

Some simple formulas that use in economics , like the rule of 70, comes from the complex

mathematical method. The rule of 70 or the doubling time is derived from the exponential growth

model. The following part shows the way the rule of 70 is developed.

-8-

Suttinee Kaewsuwan

BBA 2 SS 2002

The equation (2) is called the exponential growth model. A quantity is said to have an exponential

growth model if at each instant of time its rate of increase is proportional to the amount of the quality

present.

If we are given a quantity y with an exponential growth, and if we know the amount present at some

initial time, then we can calculate the amount present at any time t by using the following equation

y(t) = y0 ekt

(2)

where y(t) is the amount present at any time t; y0 is the amount present at some initial time t = 0; and

the constant k (k > 0) is the growth rate.

Exponential growth models have proved useful in studies of population growth (for forecasting

purpose). One useful application of the exponential growth model is the doubling time.

If a quantity y has an exponential growth model, then the time required for it to double in size is called

the doubling time. Doubling times depend only on the growth rate and not on the amount present

initially. By using the mathematical method, we can derive the equation (3) from assuming the amount

y has an exponential growth model.

T = 1/k ln 2

(3)

Where T is the amount of time required for y to double in size; the constant k (k > 0) is the growth rate;

and ln 2 0.6931. In economics, we use this applied method and called it as the rule of 70. While the

approximate value of ln 2 is 70, if 70 is divided by the percentage change it will be a required period

that the initial amount will be double in size. From this origin of the rule of 70, it has been shown that

it is not simple to develop a formula, though the formula itself looks very simple.

-9-

Suttinee Kaewsuwan

BBA 2 SS 2002

Conclusion

From the previous parts, it has been discussed about what is a model?, types of models in

economics, and why do economists need a model?. These topics give the better and clearer view

about the role of models in economics. If economists didnt have models, how could they express their

ideas in order to make other people follow and understand their ideas? It is not easy to explain any

economic issues without using graphs, diagrams, or equations.

These Models are the essential tools for economists. The main purpose of using them is to simplify

reality. It is easier to understand economic issues when they are represented data by models. In

economics models have important roles in calculating numerical issues, showing the visualized

version of data, and explaining how the process runs.

Econometrics is a supporting branch of economics for forecasting changes in economics and

developing new economic theories. Econometricians apply a high level of mathematical knowledge to

explain and foresee economic issues.

There are some criticisms about models in economics; for example, a contrast between models and the

purpose of using models, models are used to simplify reality but most of them are not easy to

understand and always explain by using complicated systems of equations. In this point there is no

true or false agreement for it; not only is it true that models should be simple and easy to understand

but it is also important to include all influenced factors in models in order to reduce errors.

Models are used widely in economic reports and researches. Importance of models in economics is not

only tools for economists, but also how they use these tools; how to choose the right one. They

separated econometrics as a branch of economics for further studies about models. From these

discussions it can be concluded that models are very important in economics.

- 10 -

Suttinee Kaewsuwan

BBA 2 SS 2002

Bibliography

1. Anton, H.(1995). Calculus with Analytic Geometry, 5th ed., John Wiley & Sons, Inc.

2. Begg, D., Fischer, S., & Dornbusch, R. (2000). Economics, 6th ed., McGraw-Hill.

3. Hornby, A. S. (2000). Oxford Advanced Learners Dictionary, 6th ed., Oxford University Press.

4. Mankiw, N. G. (2001). Principles of Economics, 2nd ed., Harcourt College Publishers.

5. McClave, J. T., Benson, P. G., & Sincich, T. (1998). A First Course in Business Statistics, 7th ed.,

Prentice Hall.

6. Samuelson, P. A., & Nordhaus, W. D. (1998). Economics, 16th ed., Irwin/McGraw-Hill.

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