Lutz Hendricks - UNC - Department of
Constructing a theoretical model
A model is a simplified version of reality. Everything that is not needed to make the desired argument is deleted from reality.
A model has standard ingredients that need to be described:
- Demographics: what agents are in the model (households, firms, …). How do they enter the model (births)? How do they exit (deaths)?
- Preferences: economic agents maximize something. What do they maximize?
- Endowments: what do the agents have when the world starts? What do they have in each period (e.g. one unit of time to spend working).
- households and firms face budget constraints
- they may be additional constraints, such as borrowing limits
- Markets: what can be traded? How are markets organized?
- Information structure: who knows what and when?
With all this information, you can write down each agent’s constrained optimization problem.
What Is a Good Model?
- A good model is as simple as can be. Anything in the model needs to be motivated. Why is it needed to make the argument?
- A good model is no simpler than needed. If there is a serious concern that omitting something will affect the conclusions, this needs to be defended.
- Assumptions should be clear and their motivation must be explained.
- Make sure you describe clearly which parts of the model are borrowed from the literature.