Essay on Economic Theory

In this essay we will discuss about Economic Theory. After reading this essay you will learn about: 1. Meaning of Economic Theory 2. Nature of Economic Theory 3. Steps 4. Uses 5. Economic Theory and Economic Policy 6. Limitations.

Contents:

1. Essay on the Meaning of Economic Theory
2. Essay on the Nature of Economic Theory
3. Essay on the Steps of Economic Theory
4. Essay on the Uses of Economic Theory
5. Essay on Economic Theory and Economic Policy
6. Essay on the Limitations of Economic Theory

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Essay # 1. Meaning of Economic Theory:

Economics is a science which like any other science depends on an organised body of theoretical knowledge. Theoretical knowledge is based on facts. And facts based on verified hypotheses are raised to the status of a theory. As put by Boulding, “Theories without facts may be barren, but facts without theories are meaningless.”

What is a Theory? A theory expresses a causal relationship between cause and effect. It attempts to explain “why”. It consists of a set of definitions stating clearly what we mean by various terms, and a set of assumptions about the way in which the world behaves.

The next step is to follow a process of logical deduction to discover what is implied by these assumptions. These implications are the predictions of our theory which can be tested by the process of observation and statistical analysis of the data. If the theory passes the test no consequent action is made necessary.

If the theory is refuted by the fact, it is either amended in the light of newly acquired facts or is discarded in favour of a superior competing theory. Economic theory is a theory in this sense. It is meant to be about the real world.

“We seek, by the use of theory, to explain, understand and predict phenomena in the real world, and our theory must therefore be related to, and tested by, empirical observation of the world around us.” Ernest Nagel defines an economic theory “as a set of statements, organised in a characteristic way, and designed to serve as partial premises for explaining as well as predicting an indeterminately large (and usually varied) class of economic phenomena”.

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Essay # 2. Nature of Economic Theory:

Economic theory involves generalisations which are statements of general tendencies or uniformities of relationships among various elements of economic phenomena. A generalisation is the establishment of a general truth on the basis of particular experiences.

For example, the generalisation that demand is an inverse function of price expresses a relationship between price and demand, other things remaining the same. If other things remain the same, the law of demand holds valid. If other things do not remain the same, it stands refuted.

Essay # 3. Steps of Economic Theory:

The various steps required to construct a theory of economics are detailed below:

(1) Selecting the Problem:

The first step in the formulation of a theory is the selection of the problem which must be stated clearly and correctly. The problem to be explored may be very wide like poverty, unemployment, inflation, etc., or it may be narrow relating to an industry.

The narrower the problem, the better it would be for a researcher to conduct his enquiry satisfactorily. “It is desirable that investigators….should concentrate upon narrow problems—narrow in area or period or aspect of a problem—and the scope for further intensive rather than extensive work should be an important criterion for selecting a problem.”

(2) Collection of Data:

The second step is to collect data or facts pertaining to the problem to be explored. If the problem is simple the data can be easily collected. However, complicated problems may require many months or even years to collect the necessary data.

This step is called descriptive economics. Sometimes, ‘facts’ can be known only after careful observation. Many economic principles are based on careful observation, such as the law of diminishing returns, the Malthusian theory of population, the Marshallian price theory, etc.

(3) Classification of Data:

After collection, the data are enumerated, classified and analysed. Classification is a way of knowing things. It is the grouping of data or facts according to their resemblances and differences, and to note comparisons and contrasts.

For instance, if the problem is to study the trend in population growth, the census data may be collected and classified by sex, age groups, literacy, marital status, occupational distribution etc. Thus enumeration, classification and analysis of data are crucial to scientific theory.

(4) Formulation of Hypothesis:

The next step is to formulate hypothesis about the economic phenomena to be analysed. A hypothesis is a suggested answer to a problem by the aid of which we endeavour to explain facts by discovering their orderliness. The hypothesis arises from the observed facts, experience or previous knowledge of the researcher.

At this stage, simplifying assumptions may be introduced so that a particular hypothesis may be developed fully. It is these special assumptions which become formulated consciously as a hypothesis. For example, the assumption that producers aim at maximising their profits is a plausible hypothesis on which the theory of business behaviour can be constructed.

(5) Testing of Hypothesis:

The next step is the testing of the hypothesis formulated. The hypothesis formulated should be such that deductions can be drawn from it and a decision reached as to whether it explains the facts considered or not. The hypothesis should be tested by well-established techniques of logic and statistics which may then be subjected to confirmation.

Further, the hypothesis should provide the answer to the problem which led to the enquiry. This requires prediction. Prediction may refer to past, present or future events as long as it are not known previous to or at the time of prediction. A hypothesis is said to be verified, and not proved, through the successful prediction it makes.

Of the various hypotheses formulated that hypothesis should be preferred “which can predict what will happen, and from which we can infer what has already happened, even if we did not know what has happened when the hypothesis was formulated.” A successfully tested hypothesis is a theory.

(6) Verification of Theory:

The tested hypothesis or theory should be verified. If it turns out to be true, the theory is said to be confirmed or verified. The process of verification may be carried out by observation or by checking the consistency of the theory with related facts that are believed to be true.

If a theory is proved to be wrong, it stands rejected. But it is a gross error to suppose that a theory which is rejected is useless. Rather, a wrong theory may direct our attention to unsuspected facts or new facts and lead to the amendment of the theory.

(7) Formulation of Solutions:

Once the theory is verified and proved true, possible solutions or suggestions to the problem under investigation are to be formulated. This is essential in the case of social sciences like economics “because economists tend to be socially oriented, and do not like spending their energies on trivial and irrelevant issues.” This final stage relates to applied economics and involves value judgements.

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Essay # 4. Uses of Economic Theory:

Economic theory provides us with tools of economic analysis, helps in explaining economic phenomena, in predicting economic events, in judging the performance of the economy, and in formulating economic policies.

1. To Provide Economic Tools:

Economic theory provides economic tools to economists. That is why Mrs. Joan Robinson characterised economic theory as a “box of tools”. Rightly so. It provides a number of tools with which the economists analyse economic problems.

The methods and techniques used in economics are the “box of tools” of economists. Economic tools are applicable to all economic systems whether they are capitalist, socialist or mixed. They also apply to developed and developing economies.

2. To Explain Economic Phenomena:

Economic theory helps in interpreting and explaining economic phenomena of the real world. By the process of abstraction, it chooses relevant facts, classifies and interprets them in the light of the previous or existing knowledge, establishes a causal relationship among different variables in order to establish the validity of an economic problem.

For instance, to find out the causes of unemployment in the country, data or facts are collected, enumerated, analysed and classified. Then they are interpreted in the light of our knowledge of the nature of unemployment. Ultimately, a causal relationship is established among the probable factors responsible for unemployment in order to arrive at the causes.

3. To Predict Economic Events:

It provides a basis for predicting unobserved economic events. It possesses much predictive accuracy in exploring the economic problems of the real world. For instance, if we find that with the increase in the supply of wheat, its price does not fall, given the demand for wheat, we can predict that there is likely to be shortage of wheat in the coming year.

The reason may be failure of rains or drought conditions, or the expectation of some untoward event like war.

4. To Judge the Performance of the Economy:

Economic theory helps in judging the performance of the various sectors of the economy and of the economy as a whole. For instance, if the prices of vegetable oils are rising, knowledge of the price mechanism is necessary to decide whether the rise in their prices is due to shortage of raw materials, or increase in demand, or due to malfunctioning of the industry or the economy.

5. To Formulate and Understand Economic Policies:

It helps in formulating and understanding economic policies. Suppose the economist is asked to offer advice to reduce unemployment. This problem is complementary to the goals of removal of poverty and reduction of inequitable distribution of income and wealth. But it conflicts with the goal of price stability.

So the economist will have to think out how much unemployment can be sustained with a minimum of inflation. The choice of problem of unemployment is the first step in theoretical economic analysis which is being investigated for policy formulation.

The next step is to collect data, or if they are already available, the economist has to arrange and interpret them in the light of the existing theories of unemployment in order to find out the causes of unemployment.

Then he has to propose alternative means of achieving the given goal of lowering the level of unemployment. “In other words, when faced with evaluating a policy measure for achieving some goal, he must ask whether other measures that are feasible at the time and place would better achieve the desired goal.”

6. To Evaluate Economic Policies:

Given the objectives of the society, theoretical economics can be used to evaluate various economic policies. And it is the economist who is called upon to evaluate policy measures. “It is the role of the economist not only to analyse the consequences of a proposed policy (or to compare two or more policies), but also to suggest policies. Given a statement of the objects economic theory can be used to invent or publicize proposed policies that have not previously been under consideration.” Thus theoretical economics helps in formulating and understanding economic policies. It also guides consumers, producers, traders, workers, administrators and economists to plan rationally.

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Essay # 5. Economic Theory and Economic Policy:

Economic policy (or practice or applied economics) provides a practical shape to economic theory. In practice, we apply economic principles for analysing the actual conditions of the economy. Economic theory and policy are closely related to each other.

For economic policy to be successful, it has to be formulated on the basis of economic theories. It is the knowledge of economic theories that leads to the laying down of economic policies.

Economic theory is an indispensable tool for understanding the policy measures of the government. And it is the economist who is asked to formulate policy measures. As pointed out by Lipsey, “It is the role of the economist not only to analyse the consequences of a proposed policy (or to compare two or more policies), but also to suggest policies. Given a statement of the objects economic theory can be used to invent or publicize proposed policies that have not previously been under consideration”.

First, the economist should know the goals of economic policy. The goals of economic policy may be economic growth, full employment, price stability, removal of poverty and equitable distribution of income and wealth.

Second, suppose he is asked to offer advice about the ways in which unemployment can be reduced. This goal is complementary and overlaps the goals of removal of poverty and equitable distribution of income and wealth. But it conflicts with the goal of price stability. So he will have to think out how much unemployment can be sustained with a minimum of inflation.

Third, he will have to collect data, or if they are already available, arrange and interpret in the light of the existing theories of unemployment in order to find out the causes of unemployment.

Fourth, then he has to propose alternative means of achieving the given goal of lowering the level of unemployment. “In other words, when faced with evaluating a policy measure for achieving some goal, he must ask whether other measures that are feasible at the time and place would better achieve the desired goal”.

Lastly he should point out the probable effects of these measures on the economy. “This entails a clear-cut understanding of the economic impact, costs and political feasibility of alternative programmes.”

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Essay # 6. Limitations of Economic Theory:

But too much should not be expected of economic theory. It has its limitations.

1. Accurate Data not Available:

Economic theory being a “kit of tools” presupposes the availability of accurate data or facts which are, however, not easily available. As a matter of fact, a theory is based on facts. If the facts are not true, the theory is also wrong. A theory to be true must be tested against actual economic entities or facts. But the collection and interpretation of data are often arbitrary which make economic theories unrealistic.

2. Accurate Predictions not Possible:

Accurate predictions are not always possible in economic theory. The probability of accurate predictions in economics is much less than in physical sciences. A scientist can conduct his investigations by experimenting under controlled conditions in a laboratory. But an economist is not able to predict accurately because he cannot have controlled experimentation of economic phenomena.

3. Human Behaviour not Rational:

Economic theory deals with the behaviour of human beings who do not always act rationally. Their behaviour is influenced more by the existing social and legal institutions of the society in which they live than by economic principles. “It is impossible to isolate a group of consumers or businessmen in a test-tube to see how they would react to a given change.”

4. Unrealistic Assumptions:

All economic theories are based on certain assumptions. But some of the assumptions of economic theory are unrealistic. For instance, we assume that individuals as consumers and producers behave rationally. But we find that consumers and producers Seldom behave rationally. The negation of the assumption of rationality makes wrong the predictions based on this.

As aptly put by Boulding:

“Economic analysis is not a perfect picture of economic life; it is a map of it. Just as we do not expect a map to show every tree, every house, and every blade of grass in a landscape, so we should not expect economic analysis to take into account every detail and quirk of real economic behaviour.”

5. Not Fully Applicable to Economic Policies:

Economic theories are not fully applicable to economic policies. The application of economic theory to economic problems, irrespective of time and place, has led to the failure of many economic policies implemented with good intentions.

Firstly, the applicability and correctness of an economic theory depends upon the fact whether the assumptions of the theory are in keeping with the actual economic condition on which the economist wants to apply it.

If the assumptions are not in agreement with the actual economic situation, the results may be wrong. For instance, if we try to apply the profit-maximisation theory of the firm on a particular industry, our conclusions might turn out to be wrong if the conditions of perfect competition do not prevail in practice in that industry.

Secondly, another reason for the failure of economic theory to be useful in policy is the existence of particular situations in the country which happen to be different from those considered in the theory. Such a situation arises when efforts are made to apply economic theories meant for developed countries on the developing economies.

Thirdly, an economic theory which is the basis of a policy measure at one time in the economy cannot be true for all times because an economy is “a dynamic, changing organism”. An economic theory which is correct today may become obsolete tomorrow and the policy based on this might also become useless.

6. Failure of Economic Theory on Policy:

But a blind application of economic theory to policy is not helpful in evolving correct economic policies. The application of economic theory to economic problems, irrespective of time and place, has led to the failure of many economic policies implemented with good intentions. The reasons for such failures have been as under.

The applicability and correctness of an economic theory depends upon the fact whether the assumptions of the theory are in keeping with the actual economic condition on which the economist wants to apply it. If the assumptions are not in agreement with the actual situation, the results may be wrong.

For instance, if we try to apply the profit-maximisation theory of the firm on a particular industry, our conclusions might turn out to be wrong if the conditions of perfect competition do not prevail in practice in that industry.

Another reason for the failure of economic theory to be useful in policy is the existence of particular situations in the country which happen to be different from those considered in the theory. Such a situation arises when efforts are made to apply economic theories meant for developed countries on the developing economies.

Further, an economic theory which is the basis of a policy measure at one time in the economy cannot be true for all times because an economy is “a dynamic, changing organism”. An economic theory which is correct today may become obsolete tomorrow and the policy based on this might also become useless.

We may conclude with Professor Lipsey:

“Even a perfectly consistent theory may be utterly wrong, and this can only be found out by testing it against observation. A significant advance in the use of economics in policy matters would be achieved if people accepted the statements of economists only after they had asked ‘What is the evidence?’ and ‘Has this theory been subjected to a test where it had a real chance of meeting with conflicting evidence?”

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