Lutz Hendricks - UNC - Department of Economics

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:

  1. Demographics: what agents are in the model (households, firms, …). How do they enter the model (births)? How do they exit (deaths)?
  2. Preferences: economic agents maximize something. What do they maximize?
  3. 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).
  4. Constraints:
    1. households and firms face budget constraints
    2. they may be additional constraints, such as borrowing limits
  5. Markets: what can be traded? How are markets organized?
  6. 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?

  1. 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?
  2. 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.
  3. Assumptions should be clear and their motivation must be explained.

Other points

  1. Make sure you describe clearly which parts of the model are borrowed from the literature.