Economic Theory: Essay on the Economic Theory | Microeconomics

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Essay on the Economic Theory

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Essay Contents:

1. Essay on the Introduction to the Economic Theory
2. Essay on the Role of Assumptions in Economic Theory
3. Essay on the Models of Explanations in Economic Theory
4. Essay on the Modes of Inference – Deduction and Induction
5. Essay on the Criteria for Evaluating Theories – Testability
6. Essay on the Conclusion to the Economic Theory

Essay # 1. Introduction to the Economic Theory:

An economist is sometimes described in jest as “one who cannot see something working in practice without asking whether it would work in theory”. As is the case with many jests, this too carries a kernel of truth. Theory is important to economists though not to economists alone. This is because theory advances understanding and improves foresight, with its explanations and predictions.

Let us take an example. Economic theory explains the paradoxical behaviour of firms which continue to produce in spite of the certain knowledge that production will inflict losses upon them. Such behaviour is not necessarily irrational. Some circumstances in which loss-making can be rational are explained by theory. The same theory also predicts the closure of the firm if the product price or demand conditions decline below a certain level.

Sometimes theories can explain without predicting or predict without explaining. However, all economic theories try to explain economic phenomena, and most theories try to provide predictions.

The explanations and predictions provided by economic theory are highly conditional. They are derived from strong simplifying assumptions about human behaviour and economic life. Assumptions are very important to economic theory.

Essay # 2. The Role of Assumptions in Economic Theory:

Economic life is very complex and tangled. Assumptions cut through this tangle and make space for explanations and predictions. All economic theories rest on some assumption or the other. Assumptions are the tools used by economists to tackle the complications introduced by temporal change, manifold interdependence, and endless diversity.

Endless Diversity:

Human beings live and work in widely different circumstances and technical conditions. Moreover, each differently placed individual combines in himself a number of different roles. For instance, even the ‘economic’ man doubles as a consumer and a productive agent. Finally, in playing these roles, human beings are guided differently by habits, conventions, imperfect knowledge and reason. In order to theorize, we must get around this endless diversity in behaviour and conditions. This task is performed by assumptions.

Interdependence:

Assumptions are also used to simplify the manifold interdependence of economic life. One man’s expenditure is some other man’s income, which in turn spends it generating incomes for still others. Thus expenditure-income chains bind together large parts of the economy. Apart from expenditure-income chains, the economy is bound together by the interdependence of markets. Markets are bound together by the mobility of buyers and sellers. When buyers choose to buy some goods, they forego others. Hence their decisions in one market affect the outcome in other markets.

Similarly, when sellers decide to enter some markets, they frequently withdraw from other markets, affecting the outcomes in these other markets. The changed outcomes in other markets in turn influence the decisions of buyers and sellers in one market. Thus the outcomes of all markets are interdependent, although in different degrees. When everything depends upon everything else, theory can advance only a little. So some assumptions are needed to slice through this interdependence.

Temporal Change:

Finally, assumptions are used to analyse changes over time in an ordered and regulated manner. Time is the universal solvent which dissolves all relationships and changes all variables. These changes are introduced in a regulated and orderly manner into analysis through the use of assumptions.

Essay # 3. Models of Explanations in Economic Theory:

Economic theory uses four models of explanations: 

1. Functional,

2. Probabilistic,

3. Genetic and

4. Deductive.

1. Functional Explanations:

When an economist is asked “what is money?” he is prone to reply – “Money is the unit of account, medium of exchange, and the measure and store of value.” This explains the phenomenon of money in terms of the functions it performs in maintaining the system it belongs to. This is an instance of a functional explanation.

2. Probabilistic Explanations:

This model of explanation identifies the conditions which make an event probable, without being either necessary or sufficient to secure it. As an instance of a probabilistic explanation, consider the statement –”Consumers curtail demand when price increases, cet. par. because they are rational”. Now, rationality is not necessary for this kind of behaviour. Even lunatics have been observed to demand less at a higher price. Moreover, rationality is not sufficient to secure this kind of behaviour. Hence this explanation of consumer behaviour is only probabilistic.

Story-Telling:

Since probabilistic explanations only make an event probable, they are persuasive and not deterministic. For this reason, they are likened to story-telling. Story-telling is a variant of probabilistic explanations in which “fact, theory and values are all mixed together”. “The reader of a good story is persuaded.” Such explanations abound in economic history, institutional economics and other ‘soft parts of Economics’.

3. Genetic or Development Explanations:

Genetic or development explanations explain why a subject has certain characteristics by describing how it has evolved out of some earlier one. For instance, economists frequently supplement their answer to the question – “What is money?” by discussing the problems of barter to which money provided a solution. Another instance of this kind of explanation comes from Dobb (1946).

The development of feudalism was fairly similar across Europe up to the thirteenth century. Later however, the decline of feudalism and the rise of capitalism was more rapid in Western Europe than in Eastern Europe. Dobb suggests that this difference stemmed from the different reactions to the scarcity of labour in fourteenth to fifteenth century Europe.

Western Europe responded to the scarcity of labour by loosening the restrictions on serfs and encouraging hired labour. Eastern Europe responded to the same scarcity by intensifying serfdom. This is why capitalism developed faster in Western Europe than in Eastern Europe. In this way, Dobb traces the differences in the development of capitalism to earlier events in the history of Europe which provided the necessary conditions. This is an instance of a genetic or developmental explanation.

4. Deductive Explanations:

The deductive model of explanation is the most prestigious in economic theory, and it is widely used in microeconomics. This model identifies the sufficient conditions for events and sometimes, the necessary conditions as well.

As an instance of a deductive explanation, consider the microeconomic theory of consumer demand. In this theory, using numerous assumptions, a model of consumer behaviour is constructed. Based on this model, the following statement is made – If the consumer demand for a good is more at a higher income, then the demand for the good will be less at a higher price, cet. par. Thus greater demand at a higher income is sufficient to ensure a smaller demand at a higher price, given this model.

In the deductive model of explanation, the movement from the prior category to the posterior category is inevitable. This force of ‘inevitability’ endows this model with great prestige. And if the model uses assumptions that are sufficiently ‘realistic’, its logic extends to the real world as well.

Essay # 4. Modes of Inference – Deduction and Induction:

Inference is the process of reasoning which enables us to move from one proposition to another, using certain rules. The rules that reasoning uses may derive from the different models of explanation, or they may be based on observation.

If inference is based on the rules of reasoning supplied by different models of explanation, it represents the ‘general process of reasoning’, and is called deduction in the broad sense. This is the modern view of deduction. Traditionally, however, deduction is narrowly defined as reasoning that only uses sufficient and sometimes necessary conditions for drawing inferences from assumptions. In such a view, deduction is the process of reasoning that is confined to the deductive model of explanation.

If, on the other hand, inference is based on observation, it is called induction.

1. Deduction:

In a deductive model, reasoning proceeds from the assumptions set out, and infers conclusions implied by them. For instance, consider the following model. A firm (producer/seller) is a profit maximizer, or a loss minimizer when losses are inescapable. The firm produces and sells a single product. It takes the going market price as its own price, and at this price it can sell as much as it wishes to. In such a model, it is possible to infer that the firm will close down its operations if and only if the price of the product fails to cover its average working costs. This result flows from deductive reasoning.

Abstract to Concrete:

Deductive reasoning is abstract. It draws inferences from abstract assumptions and reaches equally abstract conclusions. For instance, the ‘profit maximizing’ firm is only an abstraction. Equally hypothetical is the assumption that the firm sells only at the going market price and can “sell as much as it wishes to” at that price. Hence the conclusions flowing from these abstract assumptions do not automatically refer to reality.

In order to connect the conclusions of our deductive model to reality, we need to make auxiliary assumptions which assert that our original assumptions are in some way relevant to reality. We also have to define in ‘observable terms’ what we mean by closure and the other terms used in the model. Such operational definitions must clarify many empirical questions. For instance, does closure mean suspension of production only, or of production and sales? Does closure imply a lockout? What about the administrative staff and facilities?

By using auxiliary assumptions and operational definitions, we can apply the deductive model to the empirical situation. In this way deduction moves from the ‘general’ and the ‘abstract’ to the ‘particular’ and the ‘concrete’. However, in this movement, many compromises have to be made in choosing operational definitions. Moreover, many assumptions used by economic theory are justified by convenience rather than realism. As a result, the force of inevitability that surrounds conclusions in a deductive model is lost in moving from the model to reality.

In fact, because of the unrealism of assumptions, the leap from deductive theory to empirical reality is largely a matter of faith. To a large measure, this faith is propped up by good persuasive storytelling, and different stories are narrated by competing schools of thought, or paradigms, in economic theory.

Deduction Vs. Induction:

In popular notion, deduction is seen as dry theory. In crude contrast, induction is imagined to be theory free. This contrast is overdrawn.

2. Induction:

Induction is a method of reasoning based on observation. It draws out general conclusions from particular observations, and is therefore believed to move from the particular to the general. In the following example, we will show that the particular observation is not the sole starting point of most induction, and that induction is not free of theory.

Induction is Theory Laden:

Suppose we go to the market and observe different varieties of rice selling at different prices. Observation convinces us that there is a category of ‘rice’ in general which has its ‘price’ and ‘quantity’. Clearly, the price and quantity of rice have to be some index numbers representing the different varieties being sold. Now, continued observation of these index numbers may prompt us into the following inductive inference—price and quantity exchanged of rice, rise over time.

Even this crude example shows how induction starts from theory. For instance, why should we confine our observation to the price and quantity of rice? Why not observe the incomes of buyers and sellers, their caste, creed and complexion? Indeed the list of attributes claiming attention grows infinitely large, unless it is restricted by some theory.

Further, even if our focus is on price, certain questions still have to be answered with the help of theory. For instance, should we observe the wholesale prices or the retail prices? What kind of index number must be used to estimate the quantity and price of rice? In answering these questions, the support of some kind of theory is needed.

Thus, induction is not ‘pure’. It is theory laden. This is why Marshall exclaimed – “Facts by themselves are silent”. To which we may add – “only theory tells”.

The Problem of Induction:

Inductive generalizations cannot be justified except by reference to deductive theory. This is because the movement from particular observations to the general involves a jump, which is called the problem of induction.

This problem of induction was discovered by the hen which observed the farmer fetching chicken feed for a month and induced – “Food comes when the farmer comes”. Alas, on the thirty-first day, the farmer came with a knife. The hen discovered to its cost and rather too late, that its inductive jump was not justified!

Complementarity of Induction and Deduction:

We could justify the inductive jump by the hen, using the following deductive theory – The farmer has a benevolent and altruistic nature (assumption). This may reflect in his actions (probabilistic theory). Hence he will come with food and not a knife. Such a theory would have justified the inductive jump, if its assumptions were relevant to the case. In this way deductive reasoning could have complemented induction.

Deduction and induction are complementary. This complementarity can be used to justify inductive inference. It can also be used to test deductive theory. Thus in our example, the observation on the thirty first day rejects the inductive jump as well as the deductive theory that would have supported it. In this way observation provides a test for theory by checking on its less abstract implications.

An observable implication of the above theory is the coming of the farmer with food and not a knife. In contrast, his benevolent nature is not directly observable. So, in deduction, we move from the less observable to the more observable propositions of the theory. Sometimes, the more observable propositions have to be operationally defined to allow comparison with actual observations. This comparison of theoretical propositions with actual observations is an inductive process (called adduction). This is how induction complements deduction.

In economic theory also, induction and deduction play a complementary role. However, the importance given to the two modes of inference is different in different branches of Economics. For instance, induction plays a more important role in Macroeconomics than in Microeconomics.

Essay # 5. Criteria for Evaluating Theories – Testability:

There is no unanimity over the assumption of profit maximization by firms. This has led to many alternative theories of the firm based upon assumptions other than profit maximization. How are we to choose between these theories?

In order to choose between theories, we have to evaluate them. Several criteria have been advanced to evaluate theories. These are consistency, generality, simplicity, realism, and testability. Of these criteria, testability has been the most important since the 40s.

To test a theory, we must confront its more observable aspects with empirical evidence. While some economists include the assumptions of the theory among these more observable aspects, others restrict testing to the predictions of the theory only. In either case, the more observable aspects must be operationally defined in terms of some statistical magnitudes before they can be compared with empirical reality.

Comparing with empirical reality is meaningful only if the observable aspects of the theory rule out some empirical possibilities. If all empirical possibilities are compatible with the theory, comparison is meaningless and the theory is not testable.

Verification:

What is the object of testing theories? One view is that it helps to verify theories. Verification runs into a problem. Any theory worth the name will have some supporting evidence. The problem is of deciding –”how much supporting evidence is sufficient?”. For instance, our theory may be that “all swans are white”. How many white swans must we observe before concluding that our theory is verified? This is called the problem of enumeration.

Falsification:

Because of the problem of enumeration, some economists advocate falsification. They suggest that the object of testing theories must be to falsify them.

Here the problem is of deciding when the contradicting evidence is sufficient to falsify the theory. This problem arises because, when empirical evidence contradicts the implications of theory, it may not be due to the theory itself, but due to the deficiencies of the ad hoc procedures used to derive unambiguous observable implications from the theory.

These ad hoc procedures include operational definitions, specification of functional forms, statistical procedures used to estimate functional forms, auxiliary assumptions such as stability of the functional forms and parameters etc. These procedures and assumptions are not specified by theory alone. Therefore theory cannot be held responsible for their deficiencies.

As a result, when empirical evidence contradicts theories, it leads to modifications of ad hoc and statistical procedures, auxiliary assumptions, and occasionally to a modification of the theory itself. Thus, in practice, testing usually leads to a modification of theories and not to their falsification.

Essay # 6. Conclusion to the Economic Theory:

Economic theory aims to explain and predict phenomena. Its explanations and predictions are based on assumptions that simplify reality by diverting attention from its complicating features. This detracts from the ‘realism’ of theory, but it adds to the simplicity of explanations and the predictive power of theory. Explanations in economic theory follow four models. But of these four models, the deductive model is the most prestigious and is extensively used in microeconomic theory.

Deduction and induction are complementary modes of inference that are used in economic theory. However, microeconomic theory gives greater emphasis to deductive reasoning than to other branches of economic theory. In Microeconomics we construct deductive models of explanation and use the tools of statics and comparative statics to analyse the properties of the model. The models are based on assumptions about exogenously derived data, and rational behaviour of individual economic agents such as consumers and producers.