Economic Theories & Models


Well-Known Member
  • #1
Have you ever heard about how John Maynard Keynes thought about economics? It wasn't all data and numbers to him. It was rather much more a way of thinking. He wasn't a big proponent of teaching what to think, but more how to think. Keynes professed that economics gives us the tools to assist us in finding the answers. We can't learn exactly what those answers will be if we follow explicit instructions, but rather how to use those tools to come to sensible conclusions. As an example, we would never be able to learn every single bolt in every single instance that a socket wrench may be able to loosen or tighten, but we certainly can learn how to use a socket wrench in general. Learning to use the wrench would be an extremely effective endeavor when compared to attempting to become familiar with all the occasions which we might use it.

Theories & Models

Economics is an interesting sport. Let's say someone said something like, "I theorize that A will occur if B occurs." That would be considered a theory. A simple one, but one nonetheless. While anthropologists and biologists create theories, economists create theories of a completely different nature. The ones economists create are based not on what they see that's directly related to something that is or that's happened, but more on how humans interact with one another and on human nature as an entirety. These assumptions are quite different than those that say, a psychologist, might use during his or her research. And really all a theory is, is a very basic representation of something that's much more complex. In the example I gave above, if B occurs, then A will occur, everything else has been boiled away. The complexity, if you will. What activities and data surround A and what results and anticipations surround B? The reason many of the extremities are removed when devising a theory has to do with simplicity. It's for easy understanding. If someone can take a theory and put it to the test and it works, then they can work backwards to extrapolate the more nuanced details later on. Good theories make for good understanding. And understanding is the first step to a much more thorough look into a complex issue.

The terms model and theory are closely related. Models are more complex though. While a theory can be abstract and very simple, a model, while not representing every single detail involved, can be a more thorough representation of an economic issue or problem. And although many folks use these two terms interchangeably, you really should know the difference. Theories make a claim, while models describe how that claim may have come about.

Let's turn to models for a bit. You see them everywhere. Have you ever seen a brand new car design that's bee made from clay? That's a model. Have you ever seen a cityscape made of board and plastic? Architects oftentimes create these to represent something they intend to have built. Creating a small scale model of something is very helpful to express an idea to those who may not think about the subject on a regular basis. While an architect may thoroughly understand a certain concept, if someone is new to the topic, they may have no idea of what's being expressed. A model simplifies things into bite sized chunks. All types of organizations create models in an effort to show the eventuality of a product. When it comes to economics, there isn't necessarily a tangible output, so models represent ideas as opposed to products. And really, many other disciplines create thought models as well, from business to healthcare to science.

A popular economic model is called a circular flow diagram. This diagram can range from extremely simple to a bit more convoluted. He's a good example that I sourced from the UBC Wiki.


There are two sides to this model of the overall economy; businesses and households. The model gives a great representation of how capital flows between the groups. Within the groups exist various markets, goods and services and labor being the largest and more important. Basically, households sell their labor to businesses to produce goods and services. In return, businesses sell those goods and services to the households. That's the most simplistic view of things.

Obviously, within the actual overall economy, there are a huge number of markets as well as forms of labor. We as people don't simply make widgets for business for those businesses to sell back to us. As explained in the specialization of labor post, many different people engage in a wide variety of tasks inside the economy as a whole. Businesses divvy up the produced products and services and sell them back to either other businesses or households. The buyers of the services oftentimes have no participation in the production, but their participation is included in the overall market. The model economists use to represent this flow of goods and labor simplifies the entire process so it's easy to understand for those who aren't intimately involved.

As economies grow, models have a tendency to become more complex. While this model of the general economy is rather simplistic and straightforward, it can just as easily include a wide variety of businesses and markets, such as government, business to business, and service markets such as those found in the financial arena. It could also describe the global economy, which would complicate it even more.

Economists want to know answers. When they encounter an issue, they peel through the layers of their minds to find the model or theory that aligns closest to what they face. With the proper model in hand, they attempt to understand what's in front of them. In general, for more complex issues, most economists will develop a theory as to what's going on before coming to a conclusion. While in other disciplines, this process may be reversed, it's this way for a reason in this one. Complex economic problems need to be seen and understood before delved into. To see an issue, economists use charts, graphs, diagrams, and equations. This is true for both micro and macro economics. I'll talk much more about all of this in later posts, but for right now, this is a fairly complete introduction to economic theories and models.
Last edited by a moderator:


Well-Known Member
  • #2
Questions & Answers

1. What is an example of a problem in the world today, not mentioned in the chapter, that has an economic dimension?

There are countless answers to this question. Basically, an economic problem exists when an individual or a group doesn't have the resources to either produce something or to pay for something someone else has produced. On a local scale, it would be the individual who can't afford to eat or to pay for housing. Or, individuals who don't have the skills or will to contribute to the labor market. On a national scale, it would be those who can't afford to pay for health care. Or, a segment of the population that is underutilized due to their inability to get proper education or health care. On a global scale, it would be a nation that's land-locked (lack of trade routes) or that doesn't have the natural resources to compete in the global marketplace. Or, one that can't afford certain medical drugs that may help its population with certain epidemics or pandemics.

2. How did John Maynard Keynes define economics?

Keynes defined economics in this way: "Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions."

3. Are households primarily buyers or sellers in the goods and services market? In the labor market?

Households are primarily buyers in the goods and services market. We, as individuals, purchase what we need for everyday life. As for the labor market, households are primarily sellers. We, as individuals, sell our knowledge and labor to industry and business in return for money in which to purchase goods and services.

4. Are firms primarily buyers or sellers in the goods and services market? In the labor market?

Primarily, firms are sellers in the goods and services market, as they provide goods and services to households and other businesses. Although, on a smaller scale, firms do purchase goods and services from individuals and other firms. This is called business to business sales.

5. Why is it unfair or meaningless to criticize a theory as "unrealistic?"

It's unfair to deem a theory unrealistic in economics because economic theories are created to help explain something that may occur based on human nature or interactions between humans, as opposed to something that has already occurred. And as we have seen recently, pretty much anything can happen in the realm of humanity.

6. Suppose, as an economist, you are asked to analyze an issue unlike anything you have ever done before. Also, suppose you do not have a specific model for analyzing that issue. What should you do? Hint: What would a carpenter do in a similar situation?

Personally, I would first come up with a general theory as to what's happening and then I'd get more specific with a model to describe the occurrence in more detail.