Saturday, September 03, 2011

Volume 3 Issue 35: Two-Cent Economics

The Folly of Models... Sometimes

Jokes aside, while models hardly ever reflects truly what happens in the real world, they are still very important because it gives us a way to think about the real world. It is true that in the real world, there can be no ceteris paribus, but it does allow us to isolate certain variables and analyze their causes and effects.

If you really think about it, everything we do is based on models. For example, how do you know that the next time you push the door, your hand would not penetrate the door and you along with it? How do you know that the next time you turn your car keys at the ignition, the engine will start? Some of these things are done so often that we forget they are derived from models of what we do every day. The models are induced from past experience. Our past experience with doors suggest that when we push against the door, it will open.

What happens when one day, we push against the door, and we fall right through it? The consequences would be mind-boggling. It will totally change the way we perceive doors. Economic modelling is much like that. When things are all fine and dandy as things turn out the way we predict, we tend to go along happily with our lives. When things don't quite turn out the way we expect them to, we become dumbfounded, and stricken with fear or shock. In the stock market, the first reaction of many "investors" would be to panic and sell.

This explains why we need to have good models and frameworks. A good model helps us to think of things in good times and in bad. It tells us when things are turning bad or when people are just panicking for no reason. It tells us whether the sky is really falling when chickens are running helter-skelter screaming, "The sky is falling". When you think about it, this applies not only in economics, but in real life as well. What is your framework for life?

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