THEORY AND REALITY

1. Theory and Reality…… A theory is an abstract from nature. It is a simplified framework of what is happening in real world. Theories do not give what exactly happen in the ground. The purpose of the theory not just economic theory but theory in general is to predict and explain.

Theory and Reality…… Summing up, a theory abstracts from the details of an event, simplifies, generalizes and seeks to predict and explain the event. The first step in the process of arriving at an acceptable theory is the construction of the model and hypothesis.

Theory and Reality…… A theory consist of a set of definitions, stating clearly what is meant by various terms, and a set of assumptions about the way in which the world behaves. It is important to remember, however that all theory is an abstraction of reality. A good theory abstracts from full reality in a useful way; a bad theory does not.

Theory and Reality…… Economic theory is based on relations between various magnitudes for example: The quantity demanded of some commodity in relation to the price of that commodity The amount spent on consumption in relation to income

Theory and Reality ……. Hypothesis A hypothesis is an “if then” proposition usually constructed from a casual observation of a real world which represent a tentative and yet untested explanation of event.

Theory and Reality…… The relations are drawn from the hypothesis, if the inferences do not conform to the facts or reality, the hypothesis is discarded and the new one is formed. If the relations do conform the reality the hypothesis is accepted as a theory

1.1 Price and Income Theory Price theory is a microeconomic principle that uses the concept of demand and supply to determine the appropriate price point for a good or service (our next topic) Income theory Changes in permanent income, rather than changes in temporary income, are what drives a consumer’s consumption pattern

1.2 Pioneer Economic Theories Theories are basically the outcome of scholarly research work conducted a long time ago. A thoroughly research with appealing findings and a work in which has passed several empirical tests can produce a theory. Some theories which are the work of pioneers such as;

Thomas Malthus (1776-1834) – Theory of Population Thomas Robert Malthus argued that, population multiplies geometrically and food arithmetically. Therefore, whenever the food supply increases, population will rapidly grow to eliminate the abundance. If left unchecked a population will outgrow its resources. He discussed 2 ways to ‘check’ a population: preventive checks, like the moral restraint of postponing marriage, or positive checks, like famine, disease and warfare. The theory predicts that if population grows faster than food production, the growth is checked in the end by famine.

David Ricardo (1772-1823) –Theory of Comparative Advantage David Ricardo argues specialisation and free trade benefits all trading partners The idea holds that it is better for a country to trade for products that it can get at a lower cost from another country than producing it domestically. Tradeoffs between nations consider the opportunity cost. When both countries specialise and trade their products, both countries gain. These gains come because each country specalises in producing the goods for which its comparative cost is lower

Adam Smith (1723-1790) – Theory of the Invisible Hand Adam Smith – The forces of market competition act like an “invisible hand” so that self-interest behaviour can work to the benefit of society The forces of individual self interest and competition ensures that resources are used in ways that promote economic growth and national prosperity The market, left on its own, will come to a natural agreement regarding the quantity of goods supplied or produced and the price charged for these goods. Prices will reflect information about consumer preferences

ECONOMIC MODELS

2. Economic models Definition Economic models are simplified analytical framework which describes economic theory. It is actually an interpretation of economic theory. Models are simplified representations of reality, used to study and understand relationships in the real world. Models are, by nature, abstractions. The trick is choosing the correct level of abstraction. Most economic models are built with mathematics; graphs and equations.

Economic Models Building an economic model often follows these steps: 1. Decide on the assumptions to use in developing the model. 2. Formulate a testable hypothesis. 3. Use economic data to test the hypothesis. 4. Revise the model if it fails to explain the economic data well.

Economic models Economic models of human behavior are built upon assumptions; or simplifications that permit rigorous analysis of real world events. Simplification “ceteris paribus” - means all other things equal.

2.1 Economic Modelling Economic modelling consists of the following steps Defining the variable Variables are thought of as numerical quantities. For example price, income, quantities of goods people buy, the number of employed workers in an economy are all represented as real numbers. For purpose of mathematical analysis their numerical values are presented by letters p, y, q, u just as in algebra.

Economic Modelling We distinguish between exogenous and endogenous variables. Endogenous (dependent) variables are those that the model is trying to explain and their values are to be determined within the model. Exogenous (independent) variables are those whose values are determined outside the model, and so are taken as given when analyzing the model

Economic Modelling Specifying functions, identity and equations A function is a statement of a relationship among variables. In setting up a model, we have to specify how the value of one variable depends on the value taken by one or more, and the standard mathematical notation is used. Often a function will be denoted by a letter which suggests the name of the relation.

Economic Modelling For example, demand function will be denoted by D (.) Supply by S (.) and Consumption function by C (.).

Economic Modelling …… An identity is definitional statement that necessarily hold true for all values of the variable it contains. In economics identities are usually accounting definitions: they describe how one value is made up of others.

Economic Modelling For example the famous Y≡C+I says that value of the entire output of goods and services in the economy Y, is made up of: the values of those goods and services which are used for current consumption C, and the value of those used for investment I.

Models can be presented in three ways; 3. Model Presentation Models can be presented in three ways; Verbally e.g. other things being equal, consumption is determined by income Mathematically General C=f (Y) Specific C=α + βY Graphically

Economic Models ……

A model of heights H height A H = a + b(A) a b = H/A age in years Introduction

A better (nonlinear) model of heights naive (linear) Non linear height age in years Introduction

Height = f(age, gender, parents’ heights, nutrition, ...) A better model? Height = f(age, gender, parents’ heights, nutrition, ...) Introduction

Gender effects in the better model Height = f(age, gender, parents’ heights, nutrition, ...) men women height age Introduction

the wrong explanatory variables may be included. Because a model abstracts from reality it sometimes makes mistakes. Models can contain two kinds of errors or mistakes: the wrong explanatory variables may be included. the functional form may be incorrect.

SUMMING UP Three ways to describe models Graphs Tables of values Mathematical functions (equations) Important concepts Dependent and independent variables Linear function, intercept and slope Introduction

EXAMPLE OF AN ECONOMIC MODEL The Production Possibility Frontier Purposes of model Show scarcity constraint Illustrate economic efficiency Introduce opportunity cost concept Variables Quantities of goods that may be produced Givens Total amounts of inputs available Technology of production Introduction