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What Is An Economic Model?

By Lucy, published on 29/05/2018 Blog > Academia > Economics > 10 Famous Economic Theories

An economic model seeks to explain our 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 behaviour. 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.

He argues that whilst a theoretical model will focus on providing qualitative answers and predictions of an individual’s behaviour or market behaviour, an empirical model will seek to provide numerical substantiation to such theories. Further, how simple, or indeed complex, a model is, will depend on the economist creating the model, and what aims they are seeking to achieve.

There’s More Than One Economic Model

There are many different economic models in existence, each producing different results and conclusions about the economic reality around us. However, despite the variety of theories and models, there are a few core economists and economic schools of thought whose theories you should be familiar with, particularly if you are currently studying economics.

Classical Economics

Classical economics is a school of economic thought whose principles derive from pioneering thinkers such as Adam Smith and John Locke.

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

  • Adam Smith’s concept of the “invisible hand”;
  • The division of labour;
  • Free trade; and
  • A laissez-faire economic system, including the belief that markets have a tendency to self-regulate.

Essentially, the overarching belief of this school was that markets should always move to be in equilibrium. For example, over time, any change to supply should be equalled by a corresponding move in demand.

My economics teacher London is a classical economist!

Laissez-Faire Capitalism

The theory of laissez-faire capitalism is closely linked to classical economics as well as thinkers such as Adam Smith.

Those that advocate such a system argue that markets are effectively self-regulating and that as a result government interference in economic policy, for example through imposing import or export tariffs, is harmful. As such, 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 it’s equally true that 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

As many will be aware, Marx was not an advocate of capitalism and saw many faults with the system, including conflict and instability.

Contrary to thinkers such as Adam Smith, Marx believed that at the heart of capitalism was the history of class struggle itself. In an almost Hegelian-vein, Marx argued that ultimately it would be this struggle that would destroy capitalism and that it would drive society towards a new age of communism.

Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) is a theory within the field of financial economics and is often referenced in relation to investments and the stock market.

Essentially, 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, with detractors arguing, for example, that figures such as Warren Buffett have been able to consistently beat the market for decades.

Each 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.

The Invisible Hand

Adam Smith, an 18th-century philosopher, is a pivotal figure in economics and has been associated with the classical school of economics.

One of Smith’s most famous concepts was that of the “invisible hand,” which he describes in his work The Wealth of Nations. Illustrative of a free market economy, Smith argued that there was an invisible hand that guided the economy towards balance and equilibrium, despite the self-interest of individuals.

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 is one of the most famous figures in economics, largely due to the wide influence that his theories had on global markets in the 20th century.

The key tenet of Keynesian economics was the idea that the government should involve itself in the running of a capitalist economy. Specifically, Keynes argued that governments should spend more during times of economic downturn in order to stabilise the economy and raise demand for goods and services. This, in turn, should help the economy to grow.

Although he is not without his 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, a U.S. economist, was, in contrast to Keynes, an advocate for the free market, and has been closely associated with the theory of monetarism.

Friedman believed in keeping wages and prices flexible as part of a laissez-faire economy. In particular, the theory of monetarism argues that the amount of money in supply within an economy should be kept constant, with just enough room to grow naturally.

As such, in contrast to Keynes, the concept of monetarism goes against proposals or suggestions for excessive government intervention or regulation.

Other Examples Of Economic Models

New economic theories and models are developing all the time, and there have been major contributions to new economic fields, such as behavioural economics, over the past fifty years or so. We outline some of the more recent economic theories that any economics student or university graduate should know about below.

Asymmetric Information

The concept of asymmetric information was brought to prominence by three economists:

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

The argument is that, in a transaction, often one party (usually the seller) has access to more information and knowledge than the other party (usually the purchaser).

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 that the existence of asymmetric information can lead to “adverse selection.”

Prospect Theory

Daniel Kahneman and Amos Tversky were the minds behind prospect theory. The theory posits that individuals, contrary to the assumptions in most economic models, are not always fully rational decision makers.

Kahneman and Tversky used their research to argue that individuals value gains and losses differently, with greater emphasis placed on possible gains than possible losses. For this reason, this theory has also been described as the “loss aversion” theory.

As a result, Kahneman and Tversky argue that some of our decisions are based more on emotion and our memories than logic. This theory falls within the field of behavioural economics and can be used to illustrate why people sometimes follow less than logical behaviours in financial markets.

Game Theory

Although game theory has wide-reaching applications, from:

  • psychology;
  • politics;
  • biology; to
  • business

it also has been welcomed within the area of economics. Essentially, the theory studies human conflict and co-operation in times of competition, and the strategies that individuals adopt as a result.

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

One of the first pioneers of the field was John von Neumann, although there have been many other contributors, such as John Nash, who developed the Nash Equilibrium.

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

Although there are a number of economic theories and models out there, it’s worthwhile spending some time familiarising yourself with the most famous economic models. This is for a variety of reasons, not least because:

  • You can learn more about a particular school of economic thought;
  • You can develop your understanding of a major economic thinker – from Keynes to Friedman; and
  • You can help improve your knowledge of your course or university curriculum.

The best way to learn about particular economic models is to read the relevant works by their proponents, for example, The Wealth of Nations or Das Kapital, but if you need any extra help understanding key economic theories you could also turn to a tutor for help, especially if you don’t have the time to read every major economic text in detail.

If you decide that an Economics tutor would be the best way to help you learn more about these important economic theories, then you could look for your A Level Economics tutor on an online tutoring site. Sites such as Superprof have a range of economics tutors who are very familiar with all the major economic theories listed above, and they would be happy to help you deepen your knowledge of these models.

Superprof has economic tutors online!

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