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Production Possibilities

Economic Models

A model can be used to help understand real-world relationships by simplifying the situation.

A model is a simplified version of a situation, which can be used to investigate real world events. Within economics and throughout science, these models are often used to help determine the cause-and-effect relationships between two variables: an independent variable that causes the change and a dependent variable that changes because of the influence of the independent variable.

Every model contains a set of assumptions—things that are held to be true. One assumption underlying economics is that society operates in a balance of scarcity and choice. There are limited resources, but people also have unlimited wants and needs. For instance, only a finite amount of water exists, but all people need water. As a result, individuals need to make choices about how to allocate scarce resources in the service of fulfilling wants and needs.

Because models try to depict the real world, which is a chaotic place with many events occurring simultaneously, another common assumption in economic models is ceteris paribus, which means all other things held equal, or all other factors or variables held constant. This assumption means that within the model, everything apart from the relationship between the two variables is not considered. Now the model can show whether one variable has an effect on the other variable, and if so, how big the effect is. Once complete, an investigation can begin to ascertain what else affects the independent variable and build a more complete model of the world.

Models can be used to show the trade-off between two choices to consider what is gained and what is forfeited. Every choice made involves a trade-off, which goes back to scarcity and choice. Still, a model is a simplification of the real world. For example, when deciding how to allocate time, there are multitudes of options for any moment. Time may be spent building a house, writing a novel, or growing a crop, but not all three at once. Using a model shows not the sum of all choices not made but the cost of the next best option not chosen.