What are Economic Models?

Economic models consist of building blocks. In addition to these blocks, we need three more types of building blocks for our construction:

• consumer behaviour
• markets
• natural environment

These blocks serve to connect the dots left open by our model of firm behaviour. They have to be chosen so that they fit to each other and to the model of firm behaviour that we have selected.

Building Blocks For Economic Models

Consumer behaviour

In general, economic models describe consumers as choosing between different goods while being subject to a budget constraint. However, in environmental economic models, we focus on emissions so that the choice among different goods is not that important, but we rarely need much sophistication for the consumer side, and thus usually extend the model of firm behaviour in the simplest possible way.

If we have selected the Emission Choice Model for firm behaviour, there is very little to do for depicting consumer behaviour. The Emission Choice Model describes only emissions. Thus, in the case of the Emission Choice Model, we only add a damage function to our description of firm behaviour.

If we selected the Output Abatement Choice Model, firms produce output and emissions. On the consumer side, we thus have to describe the well-being derived from consuming the product and the damage caused by emissions.

In case of the Input Choice Model, we’ve also to describe where the inputs come from. Thus, we will usually need a model that describes labour supply, capital supply, and the supply of all other factors.

Markets and the natural environment

In most cases, we can use balancing equations to both ends. A market is modelled by assuming that what flows into the market has to equal what is drawn from the market.