An economic theory is a formal explanation of the relationship between economic conditions, or variables.Economic theory is a broad concept for explaining and understanding the movement of goods in a market. Theoretical economic concepts usually have scientific support or studies to prove or disprove a pronounced hypothesis. National authorities also have an interest in theories of economics.
Politicians rely on studies of public spending, tax collections, money supply, and customer spending data to make laws or set policy. Various economic theories exist that focus on various aspects of government’s policy regarding economics.. There are economic theories to explain unemployment, inflation, price increases in the hog market, wage rates paid to teenagers, urban decay, and almost any other economic condition.
For example, one simple economic theory tells with the relationship between the price of an item, say coffee, and the quantity of that item demanded by a consumer. According to this theory, if other circumstances do not change (for example, if there is no newly published health report extolling the virtues of coffee drinking or no shift in people’s taste toward tea), as the price rises, consumers will decrease the amount of coffee they demand. This theory then offers one explanation for a drop in coffee sales.
Classical economic theory
Classical economic theory tends to favor a free market system. Under this theory, little government intervention is needed to support a society. Classical economists believe that individuals are allowed to trade in their own interests Capitalism economists also describe this theory.
Another classic economic theory is command economy run by national authorities. Conditions related to these economies include socialism and communism.The main ideas behind these theories are that governments control the majority of financial resources. Governments allocate resources, provide jobs to certain classes or people, and regulate the economy through heavy taxation. Redistribution of wealth seeks to ensure an equal status for all persons living under the government umbrella.
A more modern economic concept is the Keynesian economy. This theory is a small combination between the two previous theories. Keynesian theory indicates government intervention to help overcome the lack of aggregate demand to reduce unemployment and increase growth. Public spending controls do not often exist in the Keynesian economy as governments can not have limits on consumption. Another inherent problem is the inability to control employment, as public spending does not always result in job creation.
While other economic theories exist, these are often the most important government uses to manage their financial and monetary policy. Economists often spend time consuming time collecting data and reviewing financial information to help provide information to make decisions. These studies and information retrieval sessions represent science that backs up economic theory. Economic methodology is also important; Methodology dictates the best way to collect data and makes it useful for financial decision making.
Why Economics Theory Is Important In Economics
The economist defends economic theories by showing that the relationships under consideration are mathematically or logically valid, or by using statistics to show that the real world behaves as the theories say it should. The federal government and private sources provide valuable information and extensive data on many facets of economic life, and the computer has made possible speedier and more sophisticated testing of ideas. As a result, econometric, which is the use of statistical techniques to describe the relationships between economic variables, has become an important part of economic analysis.
Mathematically show that consumers will decrease the quantity of coffee demanded as the price rises. But this conclusion is a generalization. There are always buyers who do not fit the economist’s pattern. For example, some few individuals may still buy the same amount of coffee regardless of its price.
A second reason that theoretical disputes are likely in economics is that a variety of factors can be considered in analyzing an economic problem, and in constructing a theory an economist may choose to explore the relationship between an event and only one or a few of the many variables affecting that event.
For example, if an unusually large number of students were to receive high grades on the first exam in this course, one could theorize as to why this happened by considering any of several factors: the caliber of the instruction, the excellence of the textbook, the students’ IQs, hours studied, suggested readings completed, amount of sleep and food intake before the exam, and so on. Suppose your instructor statistically examined the relationship between hours studied, study guide exercises completed, and the test scores.
At the same time one of the students explored the relationship between sleep and food intake and the grades. Assume your instructor found that the class studied and read for many long hours, hence the high grades. The student discovered that each classmate took the exam thoroughly rested and after a nutritious breakfast hence the high grades. In reading the results the department chairperson claimed that both studies were unreliable because neither considered IQ or quality of instruction. Enter controversy! Who is correct? In each of these instances, a clear relationship was established: several reasons for the high grades were identified.
Economic theories are also often disputed because of the assumptions that are made in presenting a theory. Assumptions are conditions held to be true that form the framework in which a particular theory is explained For example, if one were to develop an economic theory about the impact of raising property taxes on a community’s revenue, assumptions could be made about the rate of population growth in the community, expected changes in the price of housing and homeowners’ incomes, the reaction of businesses to the tax increase, and so on.
Whether an assumption is true does not matter within the context of a theory. For purposes of developing the theory, it is assumed to be true. For example, in examining the effect of a rise in property taxes in a community, one could assume an annual population growth rate of 0 percent, 3 percent, 12 percent, or any other rate. Whatever rate was assumed would be held constant while the theory was presented.
It is important to understand, however, that different assumptions can cause theoretical relationships and study conclusions to vary, and that the assumptions that form the setting for a theory must be valid in the real world if the conclusions drawn from the theory are to be relevant. Assuming rapidly increasing property values in a crime-ridden area, a substantial amount of competition for a business that is a monopoly, or that the economy is expanding when it is in a recession could lead to theoretical conclusions that are not meaningful in reality.
There has always been serious controversy among economists concerning their theories. Scholarly publications sometimes devote many pages to running disputes between practitioners in the field. Questions arise as to the assumptions underlying a theory, the significance and appropriateness of the variables studied, the importance of the overall problem, and the possibility that a more influential factor has not yet been tested. This questioning, of course, gives rise to the continuing development of economics.
In summary, economic theories explain the relationships between economic variables. By focusing on one or a few key relationships, they simplify reality so that it can be better understood. But since economic conditions are always changing, the assumptions that underlie theories must be carefully evaluated to be sure that they lead to conclusions that are meaningful in the real world.