1) a.What is an economic model and, ideally, what characteristics would we like
ID: 1141925 • Letter: 1
Question
1)
a.What is an economic model and, ideally, what characteristics would we like our economic models to satisfy?
b. Suppose that we have a simple economics model that shipper demands to transportation services depend upon the transportation rate charged.
i. Identify the cause and effect relationship in this model.
ii. Why is this model a qualitative model of shipper demands?
iii. How would you transform this economic model into an econometric model of shipper demands?
iv. In your econometric model, how would you test the hypothesis that demand depends upon transportation rate charged?
Explanation / Answer
Ans 1 A ) An economic model is a hypothetical contrust that embodies economic procedures using a set of economic variables ina logical correlation . it helps in representation of economic behaviour .
charateristics
1. The Model is Predictive. Most importantly, your economic model can actually predict the actual economic results of your business. If you really want to test your economic model, then run it on the last 12 months and see if you can predict your results from the last 12 months using the model.
2. The key economic drivers are separated, clear and measurable. For the most part, your economic drivers are the 3-7 key components of your model that drive the majority of your economic performance. They should demonstrate the key resources that you pay for and how your customers respond to the the market interactions created by your key resources. In other words, your key resources generate market interactions that drive your customer results and that relationship needs to be clear in your economic model.
The best models truly clarify the few important economic drivers, allow them to be viewed and changed separately, and the drivers themselves are measurable. You need to make sure that you have drivers that you actually measure operationally so that you can monitor and manage the performance of those drivers over time and use the measurements to update your economic model.
For example, if your sales and marketing resources are a key driver because they generate new customer revenue, your model estimates the relationship between your sales and marketing resources and the new business that they generate and you can to track and manage the true relationship over time. If your customer attrition rate is a key economic driver, your model estimates the attrition and you track and manage your customer attrition rate over time. If your new customers drive more help tickets, and therefore the need for more customer service staff, then having this relationship in your model would be beneficial.
The key point is that identifying your key drivers, measuring and managing them, and then updating more accurate measures in your spreadsheet model is key to both having a great spreadsheet model and also key to maximizing your economic performance. You will better understand how your business works and be in a position to better manage it!
3. Your level of confidence in your drivers is clear. It is relatively easy to model your resources (a.k.a. expenses, headcount) and to manage to those resources so your confidence in predicting your resources over time should be high if you are good at managing your resource levels. But understanding how those resources stimulate the market and result in revenue to you is more difficult, particularly if you have a new business model or new parts of your business model.
Understanding your confidence level for your key drivers is really important. By better understanding which of your economic drivers are hypotheses (low confidence estimates) vs. which are well understood (completely calibrated drivers), you can then work to better understand the drivers that are less well understood and you can do some sensitivity analysis on the drivers that are hypotheses (more on this below) so that you can better understand the possible range of your future economic performance.
4. You can do a sensitivity analysis, particularly for the drivers that you are less confident in, so that you can see the range of possible outcomes going forward. You also can use this sensitivity analysis to help you to prioritize the economic drivers that are most important to your performance so that you can work on improving them.
As an example, if the relationship between sales and marketing resources and new customer revenue is an important driver, you can adjust the number (a.k.a., parameter of the model in your spreadsheet) that describes that relationship and then see how that change creates different future results. A more sophisticated sensitivity analysis would be the ability to have different numbers at different points in time so that you can see the effects of phasing in improvements (or deterioration) of new customer revenue per unit sales and marketing resource.
5. Your investments are separated from the core economics of your model. This is a somewhat confusing point to a lot of people, but you can have a great economic model without being a profitable company. You can also have a profitable company while having components of your economic model that are not very good. A huge part of the difference between your economic model and your profitability is the investments that you are making in your business.
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