An economic model seeks to explain economic reality, for example why markets behave the way they do. What's more, an economic model seeks to test an assumption or theory about economic behavior. However, how this is tested depends on the model used.

Sam Ouliaris, a senior economist at the IMF Institute, suggests that economists will use either a theoretical economic model or an empirical economic model to test their theories.

Let's explore those ideas in depth.

What is an Economic Model?

In the aftermath of September 11th, 2001, American president Bush urged citizens to go shopping.

For many, his declaration that people should practise materialism and plan trips to Disneyland at a time of national mourning struck a callous, discordant note… but it made good economic sense.

For weeks after that terrible event, people were afraid to leave their homes, to plan for the future or even think that their future could hold anything like amusement parks ever again. Within weeks, the US experienced a dramatic economic slowdown.

The country’s economic equilibrium had been disrupted. There was a lot to spend money on but nobody was spending.

An economic model is an overly-simple description of reality.

Models allow economists to suggest trends in economic behaviour that can be proven – or, in some cases, disproved.

Post-9/11, Americans’ economic behaviour proved the shock and devastation seen real-time.

As mentioned above, economic models generally fall into one of two categories: empirical – based on actual numbers and experience, and theoretical, meaning what might, could or has happened based on a variety of factors.

Economists can predict behaviour simply though shopping analysis
Analysis of shopping trends helps economists predict people's behavior Image by https://500px.com/ michael-gaida from Pixabay

Theoretical Models

Let’s say that females in their 50s tend to buy quality goods from reputable brands regardless of cost while males of the same age trend more towards buying the cheapest product needed, regardless of quality.

Based on these data alone, economists can project those demographics’ needs and desires, how their spending might change as they age (and shop less), and the impact of their spending habits on the country’s overall economy.

They can go further to predict how often replacement goods will be purchased and the cost of disposing of the goods being replaced, how much stock stores should carry to ensure replacement and even the cost of getting the goods to the store.

In short, there is no end to the different interpretations to be had from this simple data set. Now, imagine an unending variety of data to model and the possible results to be found.

Theoretical models provide measured answers to exact questions, allowing economists and policymakers to base decisions for maintaining the economic health and stability of… anything from countries to corporations.

It is vital to remember that economists interpreting modelling data always look for validation of their ‘reality’.

That practice renders all theoretical models subjective, meaning that model interpretation is influenced by the economist’s intuition and/or opinion – and, in no small part, the desires of their clients.

Thus, personal feelings may come into play when analysing modelled data.

Empirical Models

Where theoretical economic models are subjective – open to a desired interpretation, empirical models convert theoretical predictions into actual numbers.

Let’s look again at our data set from above: males and females in their 50s.

Females don’t mind spending more which could mean that they have more money to spend. Such an interpretation posits a positive correlation between the level of income and spending.

In our example, the empirical model seeks to assign, in actual numbers, how much more females are willing to spend in proportion to their rise in income.

It would be more difficult to draw the same empirical model for males’ behaviour because, based on available data, there is no apparent correlation between how much they spend and how much they earn.

Both theoretical and empirical modelling are math-heavy; as an economist, you will frequently be called on to create such models and extrapolate any number of conclusions, depending on the focus of the entity requiring the model.

What Are The Main Economic Theories?

You might study scatterplots to understand economic growth
Scatterplots are used to study and develop economic theories Source: Wikipedia Credit: Marius Xplore

Interpretation of economic models is predicated on economic theory and can yield different conclusions about economic reality.  As an Economics student, you should become familiar with principal economic schools of thought.

You should also learn about a few core economists.

Classical Economics

Classical economics principles derive from pioneering thinkers such as John Locke and Adam Smith - a most controversial figure in his day.

In essence, classical economists believe in a number of things, including:

  • The “invisible hand
  • The division of labour
  • Free trade
  • laissez-faire economics

One reason for the derision heaped on Adam Smith's writings was that the economic model he proposed was so contrary to the political machine of his day.

It just so happened that Adam Smith was alive in a time of great change in his country.

He was a boy when Scotland signed the Treaty of Union, freeing his country from tariffs levied by England and opening lucrative trade routes with the American colonies.

He was not aware of these events, young as he was but they must have played a role in his theorising of economic matters.

When he was in his teens, the Bank of Scotland suffered accusations of being Jacobite sympathisers. In 1727, that bank’s rival received its Royal Charter.

The two institutions attempted to drive each other out of business. These ‘bank wars’ ended in 1751 – coincidentally, only a few years before our Mr Smith published his Theory of Moral Sentiments.

The overarching belief is that markets should always strive for equilibrium. For example, over time, any change to supply should be equalled by a corresponding move in demand.

Mr Smith alludes to ‘the invisible hand’, that the rich are compelled by a moral imperative to distribute onto the poor the necessities of life – presumably wages and/or goods.

Mr Smith was more of an enlightened thinker than an economist. His theories were grounded in morality rather than any fiscal sense or even actual observation. Essentially, he expounded on wishful/hopeful economics - but his ideas still have merit today.

My economics teacher London is a classical economist!

Laissez-Faire Capitalism

Laissez-faire capitalism is closely linked to classical economics.

Far from the lackadaisical impression this term suggests, this economic theory rests on five fundamentals:

  1. The basic unit of any society is the individual
  2. The natural right to freedom mustn’t be denied to any individual
  3. Nature herself is a harmonious and self-regulating system
  4. Individuals must closely watch corporations and other entities of the State because of their inclination to disrupt (the Smithian) spontaneous order.

In today's world, shareholders have the right to review company balance sheets and governments institute oversight committees and submit to external audits. These are both functions of Laisser-Faire capitalism.

The fifth, most important tenet is that markets should always be competitive.

Here is where 'Laisser Faire' runs into trouble.

Governments routinely adjust interest rates to stimulate their economies, meet target inflation rates and add value to their currency.

Governments often fall under scrutiny for potential currency manipulation but these tactics are generally accepted as a legitimate means of maintaining an economy.

However, a company that artificially inflates its stock forms an economic bubble with nothing to sustain it. Such pump and dump schemes are illegal and the perpetrators are usually caught before they can damage the local or global economy.

Advocates for Laisser-Faire argue that economic markets regulate themselves; that government interference is harmful, and to obtain the most benefit for all, capitalism should be free to run its own course.

An economic model.
There are different types of economic modelling. (Source: CC BY-SA 3.0, Jarry1250, Wikimedia Commons)

Marxism

Karl Marx may be better remembered as a philosopher but he contributed much to the field of economics.

His two major works in economics and economic history were:

Title (English)Title (German)First PublishedAuthors
The Communist ManifestoManifest der Kommunistischen Partei1848Karl Marx and Friedrich Engels
CapitalDas Kapital1867Karl Marx

Marx was not a fan of capitalism because he saw too much inherent conflict and instability. Furthermore, he believed no person was any better or more deserving than anyone else.

His philosophies, much like Adam Smith's, flew in the face of the day’s commonly-held beliefs. Economics driven by a moral code? Impossible in a time when everyone who was able was fighting to get rich!

After the Revolutions of 1848, the transition from serfdom to an economic model where people bartered their labour proved far more difficult than anyone had foreseen.

Young Marx deplored the idea of people selling their time and abilities for just enough sustenance while those they laboured for essentially took the place of the so recently vacated nobility class.

It might seem contrary that Marx had no problem with capitalism as an economic model. Rather, he baulked at the concept of capital; the propensity of workers to become the tools of the business owners.

Contrary to Adam Smith, Marx believed that, at the heart of capitalism was the class struggle itself.

He argued that, ultimately, this struggle would destroy capitalism and would drive society towards a new age of communism.

Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) relates to financial economics. It is often referenced in relation to investments and the stock market.

EMH proposes that an investor can never “beat the market” because the stock market reflects all possible available information.

Although this theory is commonly referenced and used, it has been the subject of fierce debate and criticism, among them that figures such as Warren Buffett have been able to consistently beat the market for decades.

The Efficient Market Hypothesis supposes that all checks and balances are in place and working, that every entity is absolutely honest and that market fluctuations are always predictable.

Because those economic fundamentals are in place and working well, no investor or business would be able to play the market to their advantage and fair trade would be the order of the day.

Were it not for the human factor, this would be a lovely, compact economic theory. Unfortunately, a person's economic behaviour is often as much instinct as it is founded in fact.

For instance, a stockholder may examine market trends and past performance of every stock in their portfolio ad nauseam yet still buy and sell stocks based on a gut feeling.

That phenomenon is called information bias; when you take in more information than is needed or relevant to make decisions.

That is why global financial markets are often described in emotional terms: volatile, edgy, calm, bullish...

This human foible has a dual effect on the economy.

First, it compels investors to sell growth stocks and bypass riskier stocks, thus reducing their value. Less risk-averse investors then profit dually by buying those bypassed stocks, possibly at a reduced rate, while also scooping up recently-unloaded growth stocks.

That's the Warren Buffett formula for investment success.

The Four Types of Economic Models

You might wonder if this segment discusses the merits of simulation models, visual models, mathematical models or static/dynamic models.

Those are indeed four economic models but they describe the models themselves, not the information contained therein.

This section talks about models based on the four types of economic systems: traditional, command, market and mixed.

These systems are predicated on two factors: ownership and allocation of resources. Who controls the resources and who they are consumed by forms the basis for economic systems

The traditional economic system is practised at farmers' markets
The direct-selling approach at farmers' markets is the best example of traditional economics systems Image by Martin Winkler from Pixabay

The Traditional System

In this economic system, individuals own the resource(s). As its name implies, it is the oldest, purest and simplest economic system.

Although it hearkens back to ancient times, this system is alive and thriving in poorer nations as well as in rural areas of more economically advantaged countries.

A hallmark of the traditional economic system is its ties to the land. Farmer’s markets are a prime example of this system in our country.

Profit margins tend to be slim in this system, surplus is virtually unheard of and waste is minimised. These facets of the traditional economy stir envy in proponents and participants of other economic systems.

The biggest disadvantage countries with this system suffer is the lack of modern conveniences such as technology, utilities and infrastructure.

The Command System

One step above the traditional system only because this system is neither complex nor far evolved from its forerunner, the command system’s defining feature is central control of the most valuable resources.

That control is a central entity; usually the government.

When a country has vast resources, it is common for the government to regulate them, but some governments actually declare ownership of everything from raw materials used in any industrial process to the equipment and the industry itself.

Such an economic system could lead to trouble: civil unrest as people are not compensated fairly, for example, or the lack of competition that forces stagnation and prevents innovation.

Still, there are benefits to a nation embracing the command economic system, plenty of jobs and affordably-priced goods among them.

Oddly enough, while such nations’ governments control the most valuable resources, agriculture is not among them. As far as the food supply is concerned, most 'command' countries revert to the traditional system… unless a healthy profit could be made, perhaps through export.

The Market System

This system embraces a central authorities ‘hands-off’ policy: no entity controls goods or resources, nor do any have control/ownership over any significant segment of the economy.

The market economy is often confused with free markets – an illusory concept.

By default, there can be no free markets because governments oversee, tax and regulate industry.

To clarify that point: every country has trade laws and laws against monopolies. Governments often legislate against industry, usually to protect workers and the environment, and to maintain healthy competition between entities.

Back to the market system, now.

Besides economic benefits, the biggest point in favour of the market system is the separation of the market from the government.

In a sense, market economies check government power by not permitting them exclusive access to valuable resources. These distinct realms of influence – economic and legislative, allow greater economic growth and more stability than the models we’ve reviewed so far.

The Mixed System

You might have run across the term ‘dual economy’ in the course of your studies; that is another name for this system of economics.

The mixed system is exactly what its name implies: a combination of market and command systems.

The traditional system is not relevant to mixed economies because, by its very nature, it doesn’t meet the criteria necessary for major economic manoeuvring.

Countries operating mixed economies employ various ratios of command and market strategies. For instance, China and Russia lean more toward a command market while the European Union and the US favour the market economy but incorporate aspects of command systems into their economic policies.

It is important to note that both China and Russia have relaxed their command over resources over the past couple of years, edging closer to a policy of market system economy.

Also, the European markets are somewhat more 'command' than the US economic policy permits.

Every Great Economist Has Their Own Economic Theory

As we mentioned above, there is a wide range of economic theories in existence. However, if you want to study the most influential or widely-supported economic theories, try reading the key theories of major economists.

We've already discussed Adam Smith's 'invisible hand' concept to illustrate the free market economy; now let's look at other economists and the ideas they advanced.

A bust of Adam Smith, who some consider to be the founder of modern economic theory.
Adam Smith's economic model has been hugely influential. (Source: CC BY-SA 3.0, Guinnog, Wikimedia Commons)

Keynesian Economics

John Maynard Keynes' economic theories influenced - some say revolutionised global markets in the 20th century.

The key tenet of Keynesian economics was that the government should involve itself in running a capitalist economy.

Keynes argued that governments should spend more during economic downturns to stabilise the economy and raise demand for goods and services. Doing so helps to sustain the economy in the short term and allows it to grow once the crisis has passed.

The 2008 global economic downturn is a perfect example of Keynesian economics at work!

The Keynesian model revolves around the idea that, if the central bank has oversight and control of local banks, recessions/depressions can be avoided.

In times of slowing economy, the government must run deficits in order to keep people employed because private sector businesses cannot be counted on to invest enough in production to keep the economy afloat.

Such deficits may include lowering taxes and increasing government spending (which would represent a deficit in their budget).

Although Keynes' theories are not without critics, as his ideas marked a step away from Laissez Faire policies espoused by the likes of Adam Smith, there is no denying the influence Keynes’ theories have had.

Friedman Monetarism

Milton Friedman is associated with monetarism. In contrast to Keynes, this U.S. economist advocated for free market.

Monetarism advocates for government control over how much money is in circulation and focus solely on maintaining sustainable rates of economic ability.

Friedman maintained that manipulation of money’s growth rate or, indeed, the supply of money itself would destabilise the economy. The 2016 Venezuela hyperinflation crisis is an excellent case in point of such.

He proposed a fixed money rule, whereby the supply of money would be increased by a set percentage each year.

In contrast to Keynesian theory, monetarism goes against proposals or suggestions for excessive government intervention or regulation.

Monetarists don't want the government to manipulate money!
The monetarist economic theory calls for the government to keep their hands off of your money! Source: Pixabay Credit: Jarmoluk

Other Economic Theories

New economic theories and models develop all the time and new fields of economic study continue to entice economists. From social economics to behavioural economics, these studies of reality demand the keenest minds and most visionary thinkers.

Let's outline some of the more recent economic theories that every economics student or university graduate should know about below.

Asymmetric Information Theory

Three renowned economists brought forth the concept of asymmetric information. They are:

  • George Akerlof;
  • Michael Spence; and
  • Joseph Stiglitz.

In a transaction, one party (usually the seller) often has access to more information and knowledge than the other party (usually the purchaser).

In a perfect world, such negotiations would function like a chess game: all the pieces on the board and all of the possible moves obvious to anyone who studies the pieces.

Information asymmetry is not solely an economic problem: military leaders constantly miscalculate their prospects of victory – a classic case of information asymmetry.

The implication of this theory is that, contrary to some economic models that assume perfect information symmetry, markets do not, in fact, operate in this manner, and the existence of asymmetric information can lead to “adverse selection.”

Prospect Theory

Daniel Kahneman and Amos Tversky authored the Prospect Theory, which posits that individuals are not always fully rational decision makers contrary to what most most economic models presume.

Kahneman and Tversky argue that some of our decisions are based more on emotion and memories than logic.

They used their research to argue that individuals value gains and losses differently, with greater emphasis placed on possible gains than possible losses. This theory has also been called the “loss aversion” theory.

This theory falls within the field of behavioural economics and can be used to illustrate why people sometimes exhibit less than logical behaviours in financial markets.

Game Theory

Game theory has wide-reaching applications, from psychology to politics and biology to business.

Game theory studies human conflict and co-operation in times of competition, and the strategies that individuals adopt.

Game Theory, as applied to economics, underscores the principles of classical economics:

  • Division of labour: ‘players’ help each other out
  • Free trade: participants assign their own values for bartering.
  • Laisser-Faire: the game’s outcome would be self-regulating

The Invisible Hand component refers to every game participant’s common sense of fair play and equanimity.

Game theory has helped to address some issues that could not be explained by other schools of economic thought. For example, this theory helps to explain the concept of imperfect competition.

One of the pioneers of the field was John von Neumann. John Nash, author of the Nash Equilibrium also contributed.

Did you know that the film A Beautiful Mind is about Mr Nash' life?

A picture of a game theory book. Game theory is an example of an economic theory.
Game theory is becoming an increasingly popular economic theory. (Source: CC BY-SA 2.0, brewbooks, Wikimedia Commons)

Find Out More About Your Favourite Economic Theory

There are a number of economic theories and models out there, making it worth your while to spend some time familiarising yourself with the best-known ones. You can do so by reading books on the subject.

The best way to learn about economic models is to read the relevant works by their proponents.

You might try The Wealth of Nations or Das Kapital and, if you need help understanding key economic theories discussed in those works, you could turn to a tutor.

If you decide that an Economics tutor would be the best way to help you learn more about these important economic theories or if you need an A Level Economics tutor, sites such as Superprof have a range of economics tutors.

Superprof even has economic tutors online!

If you'd like to read up on the financial crisis of 2008, click here.

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