What Is An Economic Model?

What Is An Economic Model? May 17, 2011

Economics is built on a model that assumes people are rational.  This means that people will act in a way that is to maximize something and also work to produce the most favorable outcome.  Though it sounds simple in theory, finding perfectly rational people in real life is nearly impossible.  This is where the economic man comes into play.  He is the perfectly reasonable person who makes decisions based on costs, scarcity and a sound analysis.

The tricky part is balancing the economic man with real people in real life.  People can be irrational and make decisions based on their emotions or without much thought (or analysis).  This is the most fascinating part of economics to me and I hope to understand it even better as we work through studies in these articles.

For now, we’ll quickly address the three main parts of an economic model – which are scarcity, cost, and marginal analysis.  Again, we need to understand how the economic model is founded before we can really understand the basis behind economic theories.


People want more than what their resources can buy.  When something is in limited quantity and is also desirable, it is termed as scarce.

This is the very thing that causes people to make a choice.  Economics is built around people making choices between goods and services and scarcity is the catalyst behind people’s decisions.

Opportunity Costs

When you choose one good over another, you’re giving up having that neglected good.  The value of the ‘best forgone alternative use’ is the very definition of an opportunity cost.

Example – If I have two sandwiches, one drink and a bag of chips, and I can only choose three of the four items (and I choose the sandwich, chips and drink) the opportunity cost of selecting choosing the drink is that second sandwich.  In fact, the same opportunity cost happens to be the same for each item.

Sound simple?  It is, but you’re a living economic textbook when you make your lunch everyday!  The value you get from those three items outweighs the extra sandwich, so you don’t get it.  The fact remains, however, that the extra sandwich was an alternative, so it is your opportunity cost.

Marginal Analysis

To find out how people should best use their scarce resources, marginal analysis is used.  This is basically evaluating the costs and benefits of an added variable.  If adding the extra variable will add more to the total benefits than it would to the total costs, you should increase that variable until it adds more to the costs than to the total benefits.

In other words, your Total Benefits less your Total Costs should be greater than 0 (zero) in order to increase the variable in question.

I hope this quick summary of economic models helps as we continue to explore economic theory in more detail.

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  • Tim – Excellent economic lesson. Economic models appear to be voodoo economics because, as you point out, they assume people are rational. Unfortunately people are not rational and behavior science has to be combined with economic models to forecast the future. Of course this makes modeling almost impossible.

    Yet understanding economics and behavior can help people make better decisions. I posted an article in the same category of thinking that may be of interest: http://blog.arborinvestmentplanner.com/2011/05/loss-aversion-bias-selling-stock-at-a-loss )

    Thank you.


    • Tim

      Thanks Ken! I’ll check out your article!

  • “People want more than what their resources can buy.” I think this is the basic reason why people get into debt!

    “When you choose one good over another, you’re giving up having that neglected good.” When people choose over-spending over saving/investing, they give up future financial security1

    • Tim

      You’re right Darren. I like your quote! People are really giving up financial security for a short term gain.

  • Great post. I agree with Darren that the desire to buy things often pushes people past their limits that they set for themselves. My brother and sister-in-law just recently started the ‘envelope budget’ but I later found out that they just bought an I-Pad. I suspect this wasn’t in their budget. If only people could stick to their budget as much. I think this is the benefit of PF blogs – it helps people weigh the other benefits. Keep up the good work.

  • Sir u did a good job bout my question is this why scarcity is always a problem 2 individual and society? And why must they make choice befor geting what they want?