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How to build a theoretical model I

Watch Frank Krysiak explain some of the standard building blocks used in environmental and energy economics.
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The first step of modeling is to set up the main structure of the model. What economic mechanisms are to be depicted? Which relations between different actors, such as firms and consumers, are important? In this week, we will cover the first step of developing a model. Economic models consist of building blocks. If we want to describe a market, we need a building block that describes demand. We need a building block that describes supply. And we need a building block to describe the interaction of demand and supply. Remember our example of a permit market from a past week.
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In this example, we’ve already used one building block, the building block that describes how much a firm emits if it is regulated with a permit market. In general, many economic models consist of a small number of standard building blocks. These standard building blocks are parts of a model that are well understood and that have been found to be useful in a wide range of settings. In this lecture, I will show you some of the standard building blocks used in environmental and energy economic models. Thereby, we will focus on firm behaviour. In environmental economic models, we tend to focus on describing emissions and environmental policy. As emissions are often caused by firms, the first building block is the most important one.
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For describing firm behaviour, we can choose among three
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standard models: the Emission Choice Model, the Output Abatement Choice Model, and the Input Choice Model.
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These models have an increasing complexity, and we will start with the simplest one, the Emission Choice Model. The Emission Choice Model describes how much a firm emits of a pollutant given an environmental policy. The firm maximises its benefit from emitting, such as gaining profits, minus the costs induced by the regulation, like a tax that has to be paid for emissions. This model is very simple because it does not describe how a firm reduces the emissions. Will the firm produce less? Will it use different inputs? Will it invest in new production equipment? These questions remain open. We simply focus on how much a firm emits if it is regulated in a certain way.
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The second choice among our building blocks is somewhat more complex. In the Output Abatement Choice Model, a firm chooses how much it produces and how carefully it produces. This behaviour is modelled by assuming that a firm maximises its profit, which consists of its revenues from selling the output, minus the costs of production minus the costs induced by the regulation, such as a tax paid for remaining emissions. This building block focuses on the effects of a regulation on production versus environmental quality. It is useful whenever the amount of production is important, for example, because we want to regulate a firm that has market power on its product market.
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The third and final choice of a building block is the Input Choice Model. This model describes how a firm chooses between different inputs when it is subject to an environmental regulation. The typical example is agricultural production, where a firm needs to choose how much labour, how much equipment, and how much fertiliser is to be used in production. The model describes, again, a profit-maximizing firm. The profit consists of the revenue raised by selling the output, which is described via production function, minus the costs paid for the different inputs minus the costs induced by the regulation. This model is the most complex model as it describes how emissions are reduced in much detail.
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It is clear that a more complex model is more powerful. However, remember our discussion from the very beginning of the course. We should not look for the most powerful model, but rather for the simplest model that is fit for purpose. This is important. Firm behaviour is only the first of four building blocks that we need. And if this single block is already very complex, we will end up with a model that is too complex to be useful.

In general, many economic models consist of a small number of standard building blocks. These standard building blocks are parts of a model that are well understood and that have been found to be useful in a wide range of settings.

In environmental economic models, we tend to focus on describing emissions and environmental policy. As emissions are often caused by firms, the first building block is the most important one for us.

For describing firm behaviour, we can choose among three standard models:

  • The Emission Choice Model (ECM) describes how much a firm emits of a pollutant given an environmental policy. The firm maximises its benefit from emitting, such as gaining profits, minus the costs induced by the regulation, like a tax that has to be paid for emissions.

  • In the Output Abatement Choice Model (OACM), a firm chooses how much it produces and how carefully it produces.

  • The Input Choice Model (ICM) describes how a firm chooses between different inputs when it is subject to an environmental regulation. The typical example is agricultural production, where a firm needs to choose how much labour, how much equipment, and how much fertiliser is to be used in production.

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Exploring Possible Futures: Modeling in Environmental and Energy Economics

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