In general, a model is a simplified representation of something (typically much more complex) that exists in the real world. For example, architectural drawings are a type of model. Certainly the drawing isn’t the actual home. But by looking at the drawing we can get some sense of how the home will look and function.
A model’s oversimplification of reality makes it easier to understand fundamental principles. As a child I remember playing with simple balsa wood model airplanes. I didn’t really need a full-size operational aircraft to learn first principles about propulsion, lift, crashing and stuff like that (though I much wanted one).
Similarly, economic models allow economists to distill down some abstract aspect of how society functions into a form that will allow us to better understand the real world. For example, one problem facing most of us is limited money. Do we have enough to eat? Most of us do. Do we have enough to buy clothes when we need them? Generally. Do we then also have enough to also buy a Tesla S, spend our summers in Bali, and wear a Franck Muller Aeternitas Mega 4? Hopefully you can, but I can’t.
In reality, most of us have a limited amount of money to meet what often is unlimited wants. And so, we must make choices about what to purchase and, as importantly, what not to purchase.
Let’s construct a simple graphical model of this particular “problem”. In the spirit of simplicity, we’ll start with a fairly straightforward (and vastly oversimplified) example. The holidays are approaching and, though money is always scarce, you have $100 set aside to buy gifts for your friends. Being the efficient and thoughtful giver that you are, you’ve narrowed down the possible list to two items: The Best of Peter Frampton CD at $10 or a special hardcover edition of The Ultimate Hitchhikers Guide to the Galaxy for $20.
If you choose to give everyone the CD, you can buy ten in total. If instead you choose to buy everyone a copy of the book, you can buy only five. Or, you realize, you could buy two books (2 @ $20) for $40 leaving you $60 to buy six CDs (6 @ $10). These three options are indicated in the diagram below.
In this diagram, the vertical axis measures the number of CDs we might purchase while the horizontal axis measures the number of books. So, any point in the box bordered by these two axes represents some number of CDs and number of books. If you draw a line from the point indicating our third option to the vertical axis, you see that it corresponds to six CDs. And if you drop a line down to the horizontal axis, you see that it also corresponds to two books. Below I also indicate the other three possible combinations of books and CDs possible. Note that these six points lie along a line. This line is referred to as a “budget constraint” in Economics, and it is our first model.
What about the combination of six CDs and four books? It’s to the right of our budget constraint indicating, if it isn’t obvious enough, that you simply don’t have enough money. Actually, every combination of books and CDs outside the constraint is unaffordable (and thus the name ‘constraint’.)
This in turn leads to the second, and more important, insight of this model. Suppose you had settled on the combination of two books and six CDs. But then you start having second thoughts and decide one of your friends that you had planned on giving a Frampton CD to would rather have the Hitchhikers Guide. As shown below, this means moving from one combination on the line to the one just below and next to it. But to buy that additional copy of the book you must give up two Frampton CDs. So, when scarcity is present, to get something additional, something else must be foregone. Economists refer to this as Opportunity Cost. The Opportunity Cost of one additional copy of the book is two foregone CDs. And what would be the Opportunity Cost of buying one more Frampton CD? The answer is one half a book – not that I know what you’d do with half a book.
Finally, what if you were able to find a less expensive copy of The Hitchhikers Guide to the Galaxy? Now, instead of only five copies imagine you could afford ten. The budget constraint would rotate outward to where the endpoints were at ten CDs and ten books respectively. How might this affect your decision as to what to give for Christmas? By combining this model with a second describing consumer preferences economists can answer this question as well as draw other insights into consumer behavior.
Economic models allow economists to ask and answer all types of important (and sometimes not very important) “what if” questions. What if we raise the tax on gasoline? What if we raise interest rates? What if eliminate the tax advantages to marriage? These models are so useful because a) they eliminate extraneous information making it possible to see the forest for the trees and b) they impose upon the questioner a logical rigor to their thinking.