Economic Models, Economists' Toys

When an economist wants to study the economic behavior observed in the complex world around us, the first step is often to build an economic model. A model can focus an analysis by stripping down and simplifying real-world events into a representation of the motivations of the key players in any economic story. Some amount of context and interesting detail must be left out as the economist distills a model rich enough to explain events credibly and realistically but simple enough to put the spotlight on the essential actions in the story. When an economist succeeds in building a model, he or she now has a tool that can be manipulated. By playing with this “toy” representation of economic activity, the economist can learn more about the fundamentals behind an event and can study likely outcomes or possible solutions.

There are many kinds of economic models. The type of model that we will be studying is a computable general equilibrium (CGE) model. It is an “economy-wide” model because it describes the motivations and behavior of all producers and consumers in an economy and the linkages among them. It depicts firms that respond to demand by purchasing inputs, hiring workers, and using capital equipment. The income generated from sales of firms’ output ultimately accrues to households, who spend it on goods and services, taxes, and savings. Tax revenue funds government spending and savings lead to investor spending. The combined demand by private households, government, and investors is met by firms that, to complete the circular flow of income and spending, buy inputs and hire workers and capital used in their production processes. Such a comprehensive model may seem to be very complex, but we hope that its deconstruction in the following chapters will reveal it to be a relatively simple, “toy” representation of our complex world.