David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

2.5 Economic models
.,
Economic models
_ _ _ _ _
Now for an example of economics in action. The London Underground, known locally as the tube, usually
loses money and needs government subsidies. Might different policies help? You have to set the tube fare
that will raise most revenue. How do you analyse the problem?
To organize our thinking, or build a model, we need to simplify reality, picking out the key elements of the
problem. We begin with the simple equation
Revenue = [fare] x [number of passengers] (1)
London Underground can set the fare, but influences the number of passengers only through the fare that
is set. (Cleaner stations and better service may help. We neglect these for the moment.)
The number of passengers may reflect habit, convenience and tradition, and be completely unresponsive
to changes in fares. This is not the view an economist would adopt. It is possible to travel by car, bus, taxi
or tube. Decisions about how to travel will depend on the relative costs of different modes of transport.
Equation ( 1) requires a 'theory' or 'model' of what determines the number of passengers. We must model
the demand for tube journeys.
First, the tube fare matters. Other things equal, higher tube fares reduce the number of tube journeys
demanded. Second, if there are price rises for competing modes of taxis and buses, more people will use
the tube at any given tube fare. Third, if passengers have higher income, they can afford more tube journeys
at any given fare. We now have a bare-bones model of the number of tube passengers:
Number of passengers = /(tube fare, taxi fare, petrol price, bus fare, passenger incomes . .. ) (2)
The number of passengers 'depends on' or 'is a function of ' the tube fare, the taxi fare, petrol prices, bus
fares, incomes and some other things. The notation f ( . .. ) is shorthand for 'depends on all the things
listed inside the brackets The row of dots reminds us that we have omitted some possible determinants of
demand to simplify our analysis. Tube demand probably depends on the weather. It is uncomfortable in
the tube when it is hot. If the purpose of our model is to study annual changes in the number of tube
passengers, we can neglect the weather provided weather conditions are broadly the same every year.
Writing down a model forces us to look for all the relevant effects, to worry about which effects must be
taken into account and which can be ignored in answering the question we have set ourselves. Combining
equations (1) and (2),
Tube revenue = tube fare x number of passengers
= tube fare x f(tube fare, taxi fare, petrol price, bus fare, incomes . .. ) (3)
Why all the fuss? You would have organized your approach along similar lines. That is the right reaction.
Models are simply devices to ensure we think clearly about a problem. Clear thinking requires simplification.
The real world is too complicated for us to think about everything at once. Learning to use models is more
an art than a science. Too much simplicity will omit a crucial factor from the analysis. Too much complexity
and we lose any feeling for why the answer turns out as it does.
Sometimes data guide us about which factors are crucial and which are not. At other times, as with tube
fares, it is not enough to understand the forces at work. We need to quantify them. For both reasons, we
turn now to the interaction of economic models and economic data.
31