Theories and observations

There are many situations in which group behavior can be predicted accurately without certain knowledge of individual behavior. The warmer the whether, for example, the more people visit the beach and the higher the sales of ice cream. It may be hard to say if or when one individual will buy an ice cream cone, but a stable response pattern can be seen among a large group of individuals. Although social scientists cannot predict which particular individuals will be involved in auto accidents during the next holiday weekend, they can come very close to knowing the total number who will be. The more objectively measurable data they have (e.g., the state of whether on the days in question and the trend in gasoline prices), the more closely they will be able to predict total accidents. Economists can also predict with fair accuracy what employees as a group will do when their take home pay rises. Although some individuals may do surprising and unpredictable things, the overall response of workers in spending more when their take-home pay rises is predictable within quite a narrow margin of error. This relatively stable response is the basis of economists’ ability to predict successfully the outcome of major changes in income-tax rates that permanently alter people’s take-home pay. Nothing we have said implies that people never change their minds or future events can be foretold simply by projecting past trends. For example, we cannot safely predict that people will increase their spending next year because they increased their spending this year. The stability we are discussing relates to a cause-effect response. For example, the next time take-home pay rises significantly (cause), spending by employees will rise (effect). Predicting the behavior of large groups of people is possible by the statistical “law of large numbers”. This law asserts that random movements of many individual items tend to offset one another. Irregularities in individual behavior tend to cancel each other out, and the regularities tend to show up in repeated observations. So, when some regularity between two or more things is observed, we can ask why. A theory provides an explanation in order to answer this question and therefore to understand events. Theories are established and used in explaining observations and they enable us to predict things we have not yet seen. Furthermore, theories are used to impose order on our observations, to explain how the things we see are linked together. Without theories, we have only a shapeless mass of observations with little understanding. A theory consists of:

- a set of definitions that clearly define the variables to be used;

- a set of assumptions about the behavior of the variables;

- some predictions (called hypotheses) that are deduced from the assumptions of

the theory and can be tested against actual empirical observations.

Variables are the basic elements of theories and price is an importanteconomic variable. The price of a commodity is the objective economic value of that commodity, i. e. the amount of money that must be paid in order to purchase one unit of that commodity. Variables are classed as endogenous and exogenous variables. An endogenous variable is a variable that is explained within a theory. An exogenous variable influences endogenous variables but is itself determined by factors outside the theory. As we will see, in the quantitative theory the money is an exogenous variable, given by the state intervention. On the contrary, in the Post Keynesian analysis, the money is an endogenous variable, explained within the theory and not given by an exogenous state decision. Therefore, according to different theories, the same variable can be seen endogenous or exogenous depending on different alternative hypotheses. Other words are sometimes used for the same distinction. Endogenous variable is also called induced or dependent variable while exogenous variable can be called autonomous or independent variable.

Another key element of any theory is a set of assumptions about the behavior of the variables in which we are interested. These state how the behavior of two or more variables relate to each other. For example, economists make two basic assumptions about consumers. The first concerns how each consumer’s satisfaction (utility) is related to the quantities of all the goods and services that they consume. The second is that in making their choices on how much to consume, people seek to maximize the satisfaction they gain from that consumption. For example, we often use the assumption that the sole motive of individuals is to maximize their satisfaction (utility for the consumers and profits for the owners of firms). This assumption allows us to make predictions about the behavior of individuals on the markets. The matter is not to criticize a theory because its assumptions seem realistic or unrealistic. All theory is an abstraction from reality in order to put the main characteristics of the economic behaviors. A theory’s predictions are the propositions that can be deduced from that theory. They are called hypotheses. When the predictions of a theory have been confirmed in a large number of specific cases, they are referred to as laws. In this vein, economists deal with many relations among variables. A function, also known as a functional relation, is a formal expression of a relationship between two or more variables. When two variables are related in such a way that an increase in one is associated with an increase in the other, they are said to be positively related. When two variables are related in such a way that an increase in one is associated with a decrease in the other, they are said to be negatively related. On the basis of detailed factual studies, economists often have a relevant idea of by how much the quantity demanded will change as a result of specified changes in price; that is, they can predict magnitude as well as direction. An important part of a scientific approach to any issue consists of setting up a theory that will explain it and then seeing if that theory can be refuted by evidence. Statistical analysis is used to test the hypothesis that two or more things are related and to estimate the numerical values of the function that describes the relation. Because economics is primarily a non laboratory science, it must utilize various and numerous uncontrolled experiments that are going on every day. Households are deciding what to purchase given changing prices and incomes; firms are deciding what to produce and how to produce it; and governments are involved in the economy through their various taxes, subsidies, and controls. Because all these activities can be observed and recorded, a mass of data is continually being produced by the economy. The variables that interest economists, such as the volume of unemployment, the price of oil, and the output of computers, are generally influenced by many forces that vary simultaneously (positively or negatively related). If economists are to test their theories about these relations, they must use statistical data and techniques designed for situations in which other things cannot be held constant. Theories and observations are in continuous interaction. Starting with the assumptions of a theory and the definitions of relevant terms, the economist deduces by logical analysis everything that is implied by the assumptions. These implications are the predictions of the theory. The theory is then tested by confronting its predictions with evidence. If the theory is in conflict with facts, it will usually be amended to make it consistent with those facts. This does not mean that the observed facts are without any error or judgment interferences. Although the possibility of error cannot be eliminated when testing theories against observations, it can be controlled. When action must be taken, some rule of thumb is necessary, but it is important to understand that no one can ever be certain about being right in rejecting any hypothesis and there is nothing magical about

arbitrary cutoff points. Some cutoff point must be used whenever decisions have to be made. Although distinguishing positive from normative questions and seeking to answer positive questions are important aspects of science, it does not follow that economic inquiry can be totally value free. Although values intrude at almost all stages of scientific inquiry, the rule that theories should be judged against evidence wherever possible tends to produce advances knowledge over time.

Chapter 2: Market dynamics