Economic Theories: Role and Assumptions

Economic Theories: Role and Assumptions

Economic Theories

An economic theory is a systematic explanation of economic behavior or economic phenomena. If the theory explains the behavior of an individual economic unit, it is a microeconomic theory, such as the theory of consumer behavior, the theory of production, market theory, etc. If the theory is related to aggregate behavior of the economy, then it is a macroeconomic theory, such as the theory of economic growth, the theory of interest rate, and the theory of money supply. etc.

The basic purpose of an economic theory is to analyze and predict the behavior of economic units. So, it has the economic concept of variables and their relationship in order to analyze the behavior of the economic unit.

It means an economic theory shows the relationship between two or more variables, which can be economic or non-economic, to explain the behavior of economic units.

Every economic theory is based on certain assumptions, which are the conditions or framework under which the theory forms. Such assumptions are used to simplify the complex reality and help to develop the theory.

The assumptions help to focus on the specific relationship between the variables and make the theory workable. Since a single theory can not consider everything in real life, it is necessary to have certain assumptions to develop a single theory.

The assumption may be realistic or non-realistic, given the objective of the theory. According to Prof. Friedman, “It is not necessary to have realistic assumptions; what matters the most is the analytical and predictive power of the theory.”

So, as long as the theory is able to explain and predict the economic phenomena or behavior more accurately, it does not matter whether assumptions are realistic or not.

For example, a trade theory may assume that there are only two countries and only two products that are traded between them. It seems unrealistic because a country does not trade with multiple countries in reality. However, the trade between two countries and two products can explain the trade with a large number of other countries and products. So, a theory is valid even though the assumptions are unrealistic, but it can explain the behavior that it intends to explain.

There may be different types of assumptions depending on the nature of economic theory. Such assumptions may be behavioral, such as consumers are rational, producers (firms) try to maximize profit, the central bank tries to minimize the loss from instability, etc.

Similarly, the assumptions may be institutional, such as there is no government intervention, the private sector is in a profit motive, etc. The assumption may be structural, such as markets are perfectly competitive, the traditional sector works for subsistence only (जीविकोपार्जनको लागिमात्र काम गर्ने ).

Difference assumptions

• Behavioral
• Structural
• Institutional

Roles or Uses of Economic Theories

1. To explain the behavior of the individual economy
2. To establish the relationship between the variables
3. To design the economic policy and strategy for an individual or the economy
4. To predict the responses or changes in the economic behavior of an individual or an economy.
5. To evaluate the effectiveness of any policy interventions.
6. To develop the framework for economic analysis.
7. To understand the cause-and-effect relationship between the variables.
8. To test the behavior of the individual or the economy.
9. To justify the rationale of any new policy interventions.
10. To establish a theoretical and logical relationship and response to the economic behavior.

Importance of Microeconomics (Uses)

Microeconomics is the study of the behavior of any individual economic unit, such as a consumer or a producer. It explains/studies how individual consumers, producers, or marketers make decisions under the given conditions. Since it is about the behavior and decision-making of individual economic units, it can be used:-

1. 1. To study consumer behavior, demand analysis for forecasting.
   2. To study the production technology and the producer’s behavior.
   3. To analyze the cost and supply of the firm (producers).
   4. To analyze the market structure and price/output decision.
   5. To study the behavior of the firm or individual during risk and uncertainty.
   6. To make investment analysis and selection of appropriate projects.
   7. To design appropriate public policy for the government.
   8. To design appropriate policies and strategies for the private sector.
   9. To make a welfare analysis of the society.