Economic Theory and Models

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Economic theories simplify reality to allow us to understand basic economic forces and how individuals cope with the problems of scarcity. We can observe actions and their consequences. Observation and description are not sufficient for understanding and ultimately predicting actions. Theory establishes relationships between cause and effect. We use it to interpret actions and outcomes so we can explain the process by which the actions were undertaken and the outcomes achieved. The purpose of theory in all scientific analyses is to explain the causes of phenomena we observe. To conduct economic analyses we frequently need to engage in abstraction. This involves making assumptions about the economic environment and human motivation that simplify the real world enough to allow us to isolate forces of cause and effect. Any theory is a simplification of actual relationships. An economic model is a simplified way of expressing how some sector of the economy functions. An economic model contains assumptions that establish relationships among economic variables. We use logic, graphs, or mathematics to determine the consequences of the assumptions. In this way we can use the model to make predictions about how a change in economic conditions results in changes in decisions affecting economic variables. Economists often use the term “model” as a synonym for theory.

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Economic System

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People and societies organize economic life to deal with the basic problems raised by scarcity and opportunity cost through economic systems. An economic system works via the interaction of three invisible forces: the invisible hand (economic forces), invisible foot (political forces) and invisible handshake (social forces). An economic system can be described as the collection of institutions, laws, activities, controlling values, human incentives that collectively provide a framework for economic decision-making. An economic system is closely tied to a political system through which people decide what their society desires. In a democracy, voting procedures determine society’s will. In an autocracy, a ruling individual or group of individuals decides what society’s desires are. Before we discuss how the invisible forces operate, we need to find out what people can reasonably expect from an economic system. There are three basic economic questions that every nation must consider. They are (1) What goods and services shall be produced? (2) How shall they be produced? and (3) For whom shall they be produced? Let us briefly examine each of these questions. Within every nation, people must have some method of deciding what combination of goods and services they should produce with their limited resources. For example, they must decide what portion of total production will be devoted to capital goods and what portion will be devoted to consumer goods. Once this decision is made, it is necessary to decide what kinds of consumer and capital goods will be produced. For example, will the production of consumer goods be restricted to the basic necessities, or 40 will luxury goods, such as stereos and cameras, be produced as well? If luxury goods are to be produced, what kind and how many of each will be produced? Once the question of what to produce is answered, it is necessary to decide what production methods are to be used. For example, food can be produced by a large number of workers using simple and inexpensive tools, or by a small number of workers using complex and expensive machinery. The same is true of the production of most items you use every day. Because no nation can produce enough goods and services to satisfy everybody’s wants, it is necessary for people to have a method of deciding who gets the goods and services produced. Should everybody get an equal share, or should some people get more goods and services than others? If some people are to get more, how much more should they receive? This second question is perhaps the most difficult of all because it involves the issue of fairness; and different people have different ideas about what is fair. Any economic system must use one or more decision – making methods or rules. Though the list of ways to make decisions is long, there are three basic approaches to economic decisions. One of them is based on tradition (families often decide to do something the “old way”; people generally repeat the decisions made at an earlier time or by an earlier generation, etc.). The second approach is based on authority or command (the boss, appointed or elected, can decide what is produced and who gets it). The third is based on markets (individuals bargain with one another privately to obtain goods) and so on. Most economic systems use one of three basic methods to make economic decisions.

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