1.3. From economic Theories to economic Policy

1.3.1. The Building of Theories and Models

A model is a formal statement of a theory. No matter what discipline, be it physics, meteorology, astronomy or economics, researchers use models to explain the world, and models are built upon variables. A variable is a measure that can change from time to time or from observation to observation. Price is a variable, it differs from time to time. But why does it alter itself? No, it does not alter itself. That it hardly stay still is because other variables have impacts on it, either positive or negative, linear or nonlinear. The real world is so complex that we just cannot make out all the variables that govern it, but abstract some of them, to put together a model. In this sense, models are all simplifications, stripping away detail to expose only those that are important to the question being asked. An intuitive example of modeling is the charting of a map. Most maps are two-dimensional representations of a three-dimensional world, showing only things we are concerned about, omitting pretty much of the geographical details.

Now we know what a variable is and why a model is different from the real world. But how exactly it is built? One of the techniques, or scientific methods, is the device of All Else Equal, or ceteris paribus. Very handy it is when we try to isolate the impact of one single factor upon something. What is the impact of a 10% rise in gasoline price on driving behaviors, ceteris paribus, or assuming that nothing else changes? We can tell that a reduction in driving occurs, but how much less, assuming no simultaneous change in other related things, income, number of children, population, laws and so forth?

In a word, the concept helps us simplify reality in order to focus on the relationships that we are interested in. We can then delve into the relationship between just two variables by simply assuming that all else remain intact during any procedure.

Economists literally find 3 means to represent a model or convey an economic idea, words, graphs, and equations. Pros and cons exist for each of them. Words convey simple ideas effectively, but not adequate for multi-variable models or two-variable model that is to show the mathematical nature of the quantitative relationship. Graphs do this job intuitively, and in a more specific as well as accurate way. It does not only give you the big picture, but also shows you what it is like at a specific point. Equations are not used as frequently as the former two, but presents us the underlying process, so more suitable for in-depth research and modeling. Below is a graph depicting the demand curve how Matthew responds to telephone price changes.

Matthew's Telephone Call Demand Curve

The relationship between price and quantity demanded presented graphically is called a demand curve. Demand curves have a negative slope, indicating a negative relationship between them. Lower prices cause quantity demanded to increase, and vice versa.