What economists do: the one model we use

Economics is jargon-heavy, like, well, everything. Economists, I can attest, are especially fond of that academic disease of using their jargon in everyday conversation, a kind of subconscious economic imperialism. Nevertheless, there’s a difference between specialist knowledge (with its public face, jargon) and the concepts on which a body of knowledge is built.

How could we distill economics to its base? This is a slightly different goal than defining the principles of economics; here we want to identify the actual applicable results that derive from the principles and recur again and again in the whole discipline. As a first pass at this problem, let’s look at the model we use in economics. That’s model, singular.

Modern economics is built on the formalized statement of the definition of the subject: some entity has objectives, and limited resources with which to achieve them. These become the objective function and the constraints. Now the entity could be anything: a firm, a person, a government, a group of people.

The objective function might be expressed in math, but it doesn’t have to be. It reflects, obviously, the objectives of the entity, and these could be anything, but will typically have to be a simplified version of what an entity really wants or needs. This is one place where the abstraction from reality might have to be made, although we can imagine, as a thought experiment, the omniscient modeler who is not subject to this particular problem.

The constraints can, again, be put into math but doesn’t have to be. It is the expression of scarcity; constraints can reflect anything that poses a challenge to our entity’s achieving its goal. The abstraction is often necessary here, too: time, money, social convention, technology are just some of the possible constraints.

Now this is really a very simple idea, but all economics uses this as its base. We are concerned with the allocation of scarce resources in the quest to satisfy objectives, and this is the model of that. The math angle comes in to make this model give tangible and quantifiable results; we could make arguments without the math, but using it often helps to make things clear. The challenge for the modeler is to write the model cleverly, making simplifications enough to make the problem understandable, but not too many to make it irrelevant.

Theoretical economists are explicitly writing this model, over and over, and the illustrative economic models we present in teaching students use this model exclusively. Empirical economists use it too, not just writing it down, but in subtle ways: perhaps the empiricist can identify a precise moment or situation in which the constraints on a particular entity’s problem changed, offering them a useful opportunity to see how choices change in the face of the discrete change in conditions.

This model gives rise to the marginalist result. It says that our entity will allocate resources to a particular use while the benefit of doing so exceeds the cost of doing so, and that the point at which the entity stops will be characterized by the balance of cost and benefit at that particular point. If the decision was changed slightly in either direction, the results would be less satisfying, either because the cost would exceed the benefit, or because the benefit would exceed the cost. That might sound complicated, but it is a familiar idea from everyday life.

In the jargon, the result is that marginal benefit equals marginal cost in the solution to this model of an entity facing a resource allocation model. That simply means that from the “solution”, there is no change that would be a better result for the objective function. Not to say that the solution is a perfect prediction or description; the solution is to the model, not the actual problem faced by the entity. Perhaps the loaded meaning of the word solution is a hindrance here. Much debate has been staged over the extent of predictive or descriptive accuracy of this economic model.

Where it gets a bit complicated is at the point where we’re unsatisfied with the objectives or constraints we are using in our models. Benefit and cost are pretty easy to think about when our abstraction acknowledges only money, for example, but what if my entity’s objective function included the wellbeing of others, the environment, the amount of time spent in the sun, the quality of life? These assumptions are not just more difficult to incorporate, they are more difficult to interpret.

Where does all this fit in with the themes I’ve touched on before? The debate about rationality, economic man and realism informs directly the objective function. For example, the behavioral school could be characterized as seeking to come up with a more realistic, tractable objective function. The economics-as-money fallacy crops up in both the objective and constraints, yet how we denominate these things doesn’t change the model one bit. The debate about math in economics informs the language in which the model is presented; non-mathematical economists still use the model, even if they don’t write all these components down as mathematical relationships.

This is the model of economics. Two examples to show what’s going on.

First: how would a subsidy on the wage of low-income workers, such as the Earned Income Tax Credit, affect the number of people who work and how much they work? The common treatment of this problem in basic economics is to imagine a person who has a desire for money and for time, and to illustrate the wage subsidy as affecting the constraint, in this case the rate at which our person can earn money by giving up their time to work. We can then ask how this change in the constraint affects the hypothetical best choice of our simple person, and even ask how the person’s relative desire for time and money affect this answer.

Theorists can try to answer this question by investigating the model itself; empiricists might look to the data to try to identify the change in actual choices observed when the subsidy is introduced. [Aside: as it turns out, weird things happen with the EITC during the income range when it’s gradually phased out.]

Second: how would a person choose to react to another person they perceive to be unfair? Our person might have an objective function that includes preference for money and fairness, and their constraint could include the social norms for fairness as well as their money budget. This example is well-studied in experimental economics, where our person can decide to sacrifice some common good in order to punish a person who was greedy.

No matter what field of economics one works in, this is the one model most dominant in all of the work. It is, of course, very flexible (in fact, infinitely flexible, as I argued before), and I have stated it in the most general terms. Nevertheless, when economists argue, it is worth remembering that we all play the same game. It might just be the language, but it is a language that can seem daunting and restrictive to outsiders or students. I don’t believe that is the case: the beauty of this most fundamental model is its simplicity and its malleability. To distill economics into its essence, this is the place to start.