Intermediate Macroeconomic Theory Mount Kenya University (MKU) Notes PDF

What is economics about?

Economics is a social science that studies individuals’ economic behavior, economic phenomena, as well as how individual agents, such as consumers, firms, and government agencies, make trade-off choices that allocate limited resources among competing uses. People’s desires are unlimited, but resources are limited, therefore individuals must make trade-offs. We need economics to study this fundamental conflict and how these trade-offs are best made. Four basic questions must be answered any economic institution:

  • What goods and services should be produced and in what quantity?
  • How should the product be produced?
  • For whom should it be produced and how should it be distributed?
  • Who makes the decision?

The answers depend on the use of economic institutions. There are two basic economic institutions that have been so far used in the real world:
(1) Market economic institution (the price mechanism): Most decisions on economic activities are made individuals. This primarily decentralized decision system is the most important economic institution discovered for reaching cooperation amongst individuals and solving the conflicts that occur between them. The market economy has been proven to be only economic institution, so far, that can keep sustainable development and growth within an economy.

(2) Planed economic institution: Most decisions on economic activities are made governments, which are mainly centralized decision systems.

1.2 Economic Theory

An economic theory, which can be considered an axiomatic approach, consists of a set of assumptions and conditions, an analytical framework, and conclusions (explanations and/or predications) that are derived from the assumptions and the analytical framework. Like any science, economics is concerned with the explanation of observed phenomena and also makes economic predictions and assessments based on economic theories. Economic theories are developed to explain the observed phenomena in terms of a set of basic assumptions and rules.

Roles of Economic Theory

An economic theory has three possible roles: (1) It can be used to explain economic behavior and economic phenomena in the real world. (2) It can make scientific predictions or deductions about possible outcomes and consequences of adopted economic mechanisms when economic environments and individuals’ behavior are appropriately described. (3) It can be used to refute faulty goals or projects before they are actually undertaken. If a conclusion is not possible in theory, then it is not possible in a real world setting, as long as the assumptions were approximated realistically.

Generality of Economic

Theory An economic theory is based on assumptions imposed on economic environments, individuals’ behavior, and economic institutions. The more general these assumptions are, the more powerful, useful, or meaningful the theory that comes from them is. The general equilibrium theory is considered such a theory.

Limitation of Economic Theory

When examining the generality of an economic theory, one should realize any theory or assumption has a boundary, limitation, and applicable range of economic theory. Thus, two common misunderstandings in economic theory should be avoided. One misunderstanding is to over-evaluate the role of an economic theory. Every theory is based on some imposed assumptions. Therefore, it is important to keep in mind that every theory is not universal, cannot explain everything, but has its limitation and boundary of suitability. When applying a theory to make an economic conclusion and discuss an economic problem, it is important to notice the boundary, limitation, and applicable range of the theory. It cannot be applied arbitrarily, or a wrong conclusion will be the result.

The other misunderstanding is to under-evaluate the role of an economic theory. Some people consider an economic theory useless because they think assumptions imposed in the theory are unrealistic. In fact, no theory, whether in economics, physics, or any other science, is perfectly correct. The validity of a theory depends on whether or not it succeeds in explaining and predicting the set of phenomena that it is intended to explain and predict. Theories, therefore, are continually tested against observations. As a result of this testing, they are often modified, refined, and even discarded.

The process of testing and refining theories is central to the development of modern economics as a science. One example is the assumption of perfect competition. In reality, no competition is perfect. Real world markets seldom achieve this ideal status. The question is then not whether any particular market is perfectly competitive, almost no one is. The appropriate question is to what degree models of perfect competition can generate insights about real-world markets. We think this assumption is approximately correct in certain situations. Just like frictionless models in physics, such as in free falling body movement (no air resistance), ideal gas (molecules do not collide), and ideal fluids, frictionless models of perfect competition generate useful insights in the economic world.

 

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