ECONOMIC THEORY
Economics, as we know is the study of economic behaviors of human-beings, so economic theories are the statements of economic tendencies of the people. While propounding economic theory the economist formulates assumption about the economic tendency, he observes the tendency, analyses the fact and reaches the conclusion. In this way, economic theory is a proved economic fact or an observed economic truth.
Methods of Economic Analysis:
An economic theory derives laws or generalizations through two methods:
(1) Deductive Method and (2) Inductive Method.
These two ways of deriving economic generalizations are now explained in brief:
(1) Deductive Method of Economic Analysis:
It is a method, which goes from general to particular on the basis of general truth. We try to find
out particular truth by logical discussions. In the words of Wilson Gee ‘‘By deductive method is meant the reasoning from general to particular or from universal to individual.’’ We accept certain general facts and use them in certain specific cases to prove our own accepted truth. For example, it is a universal truth that ‘man is mortal’, so Ram, Mohan, John, Suraj and Mahendra, who are also men must die.
In the same way, it is an established fact that ‘‘Man is rational’’ so he will try to purchase lesser quantity of a particular commodity when it is costlier. Rajan, who is also a man will behave in the same way and purchase lesser quantity of goods. This method assumes that the behaviour of the general public will also be the behaviour of individual person.
Deductive method is used to propound theory regarding the economy. Studies of national income,
employment, price level and international trade is made on the basis of deductive method.
out particular truth by logical discussions. In the words of Wilson Gee ‘‘By deductive method is meant the reasoning from general to particular or from universal to individual.’’ We accept certain general facts and use them in certain specific cases to prove our own accepted truth. For example, it is a universal truth that ‘man is mortal’, so Ram, Mohan, John, Suraj and Mahendra, who are also men must die.
In the same way, it is an established fact that ‘‘Man is rational’’ so he will try to purchase lesser quantity of a particular commodity when it is costlier. Rajan, who is also a man will behave in the same way and purchase lesser quantity of goods. This method assumes that the behaviour of the general public will also be the behaviour of individual person.
Deductive method is used to propound theory regarding the economy. Studies of national income,
employment, price level and international trade is made on the basis of deductive method.
The deductive method is also named as analytical, abstract or prior method. The deductive method consists in deriving conclusions from general truths, takes few general principles and applies them draw conclusions.
For instance, if we accept the general proposition that man is entirely motivated by self-interest. In applying the deductive method of economic analysis, we proceed from general to particular.
Macro economic theories are based upon deductive method. It is also known as scientific method.
Macro economic theories are based upon deductive method. It is also known as scientific method.
The classical and neo-classical school of economists notably, Ricardo, Senior, Cairnes, J.S. Mill, Malthus, Marshall, Pigou, applied the deductive method in their economic investigations.
Steps of Deductive Method:
The main steps involved in deductive logic are as under:
(i) Perception of the problem to be inquired into: In the process of deriving economic generalizations, the analyst must have a clear and precise idea of the problem to be inquired into.
(ii) Defining of terms: The next step in this direction is to define clearly the technical terms used analysis. Further, assumptions made for a theory should also be precise.
(iii) Deducing hypothesis from the assumptions: The third step in deriving generalizations is deducing hypothesis from the assumptions taken.
(iv) Testing of hypothesis: Before establishing laws or generalizations, hypothesis should be verified through direct observations of events in the rear world and through statistical methods. (Their inverse relationship between price and quantity demanded of a good is a well established generalization).
Merits of Deductive Method:
The main merits of deductive method are as under:
(i) This method is near to reality. It is less time consuming and less expensive.
(ii) The use of mathematical techniques in deducing theories of economics brings exactness and clarity in economic analysis.
(iii) There being limited scope of experimentation, the method helps in deriving economic theories.
(iv) The method is simple because it is analytical.
Demerits of Deductive Method:
It is true that deductive method is simple and precise, underlying assumptions are valid.
(i) The deductive method is simple and precise only if the underlying assumptions are valid. More often the assumptions turn out to be based on half truths or have no relation to reality. The conclusions drawn from such assumptions will, therefore, be misleading.
(ii) Professor Learner describes the deductive method as ‘armchair’ analysis. According to him, the premises from which inferences are drawn may not
hold good at all times, and places. As such deductive reasoning is not applicable universally.
hold good at all times, and places. As such deductive reasoning is not applicable universally.
(iii) The deductive method is highly abstract. It require; a great deal of care to avoid bad logic or faulty economic reasoning.
As the deductive method employed by the classical and neo-classical economists led to many facile conclusions due to reliance on imperfect and incorrect assumptions, therefore, under the German Historical School of economists, a sharp reaction began against this method. They advocated a more realistic method for economic analysis known as inductive method.
(2) Inductive Method of Economic Analysis:
Micro economic theories are formulated according to inductive method.
It moves from particular to general on the basis of our experience. According to Wilson Gee,
‘‘Inductive method is the process of reasoning from particular to general or from individual to universal.’’
We study the behaviours of an individual and reach certain conclusion. We study the behaviours of
other individuals also. If we reach the same conclusion, we generalise the statement as an observed truth
and the theory is propounded. For example, if we find that Ranjana purchases more garments when its
price falls. We observed that Sunita does the same thing. Ratnesh and Nitesh also behave in the same
way. Finally, we can generalise their behaviour and an economic theory that customers have tendency to
buy more of a commodity when its price falls is formed.
Economic laws of consumers’ behaviour, such as laws of diminishing utility, consumers’ surplus
and equi-marginal utility have been developed on the basis of inductive method. Theories of rent, wages
and interest are also based upon inductive method. This method is also known as Historical method,
Concrete method, Analytical method and Realistic method. This is due to the fact that this method starts
investigation of particular facts, historical events, and tries to generalise the findings of the observation
for the whole economy.
‘‘Inductive method is the process of reasoning from particular to general or from individual to universal.’’
We study the behaviours of an individual and reach certain conclusion. We study the behaviours of
other individuals also. If we reach the same conclusion, we generalise the statement as an observed truth
and the theory is propounded. For example, if we find that Ranjana purchases more garments when its
price falls. We observed that Sunita does the same thing. Ratnesh and Nitesh also behave in the same
way. Finally, we can generalise their behaviour and an economic theory that customers have tendency to
buy more of a commodity when its price falls is formed.
Economic laws of consumers’ behaviour, such as laws of diminishing utility, consumers’ surplus
and equi-marginal utility have been developed on the basis of inductive method. Theories of rent, wages
and interest are also based upon inductive method. This method is also known as Historical method,
Concrete method, Analytical method and Realistic method. This is due to the fact that this method starts
investigation of particular facts, historical events, and tries to generalise the findings of the observation
for the whole economy.
Micro economic theories are formulated according to inductive method.
Inductive method which also called empirical method was adopted by the “Historical School of Economists". It involves the process of reasoning from particular facts to general principle.
This method derives economic generalizations on the basis of (i) Experimentations (ii) Observations and (iii) Statistical methods.
In this method, data is collected about a certain economic phenomenon. These are systematically arranged and the general conclusions are drawn from them.
For example, we observe 200 persons in the market. We find that nearly 195 persons buy from the cheapest shops, Out of the 5 which remains, 4 persons buy local products even at higher rate just to patronize their own products, while the fifth is a fool. From this observation, we can easily draw conclusions that people like to buy from a cheaper shop unless they are guided by patriotism or they are devoid of commonsense.
Steps of Inductive Method:
The main steps involved in the application of inductive method are:
(i) Observation.
(ii) Formation of hypothesis.
(iii) Generalization.
(iv) Verification.
Merits of Inductive Method:
(i) It is based on facts as such the method is realistic.
(ii) In order to test the economic principles, method makes statistical techniques. The inductive method is, therefore, more reliable.
(iii) Inductive method is dynamic. The changing economic phenomenon are analyzed and on the basis of collected data, conclusions and solutions are drawn from them.
(iv) Induction method also helps in future investigations.
Demerits of Inductive Method:
The main weaknesses of this method are as under:
(i) If conclusions drawn from insufficient data, the generalizations obtained may be faulty.
(ii) The collection of data itself is not an easy task. The sources and methods employed in the collection of data differ from investigator to investigator. The results, therefore, may differ even with the same problem.
(iii) The inductive method is time-consuming and expensive.
Conclusion:
The above analysis reveals that both the methods have weaknesses. We cannot rely exclusively on any one of them. Modern economists are of the view that both these methods are complimentary. They partners and not rivals. Alfred Marshall has rightly remarked:
“Inductive and Deductive methods are both needed for scientific thought, as the right and left foot are both needed for walking”.
We can apply any of them or both as the situation demands.
STEPS/PROCESS/STAGES OF CONSTRUCTING ECONOMIC THEORYThe following steps are involved in the formulation of economic theory :
1. Definitions of terms and assumptions about economic behaviour. The first step in the formulation of theory is to define the terms used in the theory. These terms should be specifically identified and defined in clear words, in order to avoid any confusion and misunderstanding. We are also required to lay down conditions (known as assumptions) about behaviour of different units involved in the economic analysis just as households and firms. An economic hypothesis (Probable explanation of economic phenomenon) is also assumed for the construction of the theory.
2. Process of logical reasoning (deductions). The second step is to draw conlusions regarding economic phenomenon on the basis of assumptions made. For example, increase in demand of normal goods in case of fall in price and decrease in demand in case of rise in price is an assumption. We make logical analysis and reasoning while making hypothesis.
3. Prediction and implication of theory. Conclusions drawn are called predictions and assumptions.
Economic predictions are conditional statements, because they hold good if certain assumptions
are satisfied. This is why, every economic law carries the words, other things remaining the same or
being equal.
4. Testing of the theory. The economist is further required to test his conclusion and predictions.
He will have empirical observation and testing of his conclusion in the same situations. This painstaking
exercise is a must before the theory could be generalised. If the testing reveals that the behaviour in all
the tests is the same, the conclusions are accepted as economic theory. In the above example, we can
generalise the observed truth that the price tends to fall with the increase in the supply of the normal
commodities, if other things remain the same.
Conclusion
In case our empirical observation goes contrary to our conclusion the asusmption is rejected in
favour of a valid theory or modified in the light of actual facts.
STEPS/PROCESS/STAGES OF CONSTRUCTING ECONOMIC THEORYThe following steps are involved in the formulation of economic theory :
1. Definitions of terms and assumptions about economic behaviour. The first step in the formulation of theory is to define the terms used in the theory. These terms should be specifically identified and defined in clear words, in order to avoid any confusion and misunderstanding. We are also required to lay down conditions (known as assumptions) about behaviour of different units involved in the economic analysis just as households and firms. An economic hypothesis (Probable explanation of economic phenomenon) is also assumed for the construction of the theory.
2. Process of logical reasoning (deductions). The second step is to draw conlusions regarding economic phenomenon on the basis of assumptions made. For example, increase in demand of normal goods in case of fall in price and decrease in demand in case of rise in price is an assumption. We make logical analysis and reasoning while making hypothesis.
3. Prediction and implication of theory. Conclusions drawn are called predictions and assumptions.
Economic predictions are conditional statements, because they hold good if certain assumptions
are satisfied. This is why, every economic law carries the words, other things remaining the same or
being equal.
4. Testing of the theory. The economist is further required to test his conclusion and predictions.
He will have empirical observation and testing of his conclusion in the same situations. This painstaking
exercise is a must before the theory could be generalised. If the testing reveals that the behaviour in all
the tests is the same, the conclusions are accepted as economic theory. In the above example, we can
generalise the observed truth that the price tends to fall with the increase in the supply of the normal
commodities, if other things remain the same.
Conclusion
In case our empirical observation goes contrary to our conclusion the asusmption is rejected in
favour of a valid theory or modified in the light of actual facts.
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