Methods of Analysis in Economics

11 months ago

Atiqur Rahman

11 minutes

In its study of human behaviour, Economics uses both deductive and inductive methods.

Deductive Method in Economics

The deductive method is the process of arriving at a general conclusion from one or more general premises by means of reasoning. If the premises are true, and the reasoning is right, the conclusion is true as well. The following is an example: Every economy has a primary, secondary and tertiary sector.

All three sectors are dependent on infrastructural facilities. So for the growth of the economy, infrastructural growth is very important. Another example: A particular household has a monthly income of Rs 30 thousand. It has an average monthly consumption expenditure of Rs 23 thousand. It thus has the capacity to save Rs 7 per month.

Inductive Method in Economics

The inductive method is the process of arriving at a general conclusion by means of a number of specific examples or observations. Example: When the price of wheat per kg came down, Khanna ji rushed to buy more wheat. So did Mrs Bose, Mr Subrahmanyam and numerous others. It can thus be induced or inferred that when the price of a commodity is down, its quantity purchased goes up.

Hypothetico-Deductive

The third method is the Hypothetico-Deductive method or Scientific Method.

In this method, the economist frames an explanation/ Hypothesis for some economic phenomenon. A Hypothesis is not a theory. Only if a Hypothesis is verified or found to be true, can we call it a Theory. To be verified or falsified, that is tested, a hypothesis has to be framed in a certain way. Such a hypothesis is called a Scientific Hypothesis.

Sometimes economists have no alternative but to take a certain hypothesis to be true and proceed on the basis of it. Such a hypothesis is called a Working hypothesis. Statistics and Econometrics are the tools used in verifying a hypothesis.

In case there are more than one hypothesis, there are statistical tests to compare their explanatory powers and judge which is more powerful as an explanation of the phenomenon concerned.

There are some hypotheses that could never be proven but have remained quite important in Economics. It is suggested that India had been industrially quite developed before the coming of the British/ India could produce fine textiles and metalware of excellent quality. It is the British Rule that led to their de-generation or destruction. This is known as the De-industrialization Hypothesis. Eminent scholars of Indian economic history have debated upon it but have been unable to either prove or disprove it. It remains as a hypothesis.

Variables, Constants, Parameters & Functions

To abstract from the complex reality that Economics studies, Economists often use Mathematical concepts and tools.

The basic Mathematical Concepts that Economics uses include: Variables, Constants and Parameters.

Variables are entities that take different values. They are usually symbolized by x, y, z. and take values positive and negative ranging from minus infinity to plus infinity.

Constants are entities that, for one particular analytical exercise, take one particular value. They are usually symbolized by a, b, c .. or alpha, beta, or gamma. And again, they can take any value between plus-minus infinity but can take only one such value during a particular analysis. Parameters are entities that can be assigned different values for different variants of an exercise but, in any one particular variant, can take only one such value.

Variables can be dependent or independent. An Independent variable takes on values by itself. A Dependent variable takes on values according to or as per the Independent variable.

This relation of dependence between the Independent and the Dependent variable(s) is known as a functional relationship, or simply, a Function. It means that the Dependent variable functions according to the Independent variable. It is a most powerful tool in the study of Economics, both Micro and Macro.

The following functional relation:

Y = f (X)

Implies that Y behaves or functions as X does. As X takes on different values such as X1, X2 ….Xn, Y takes up different values Y1, Y2….., Yn.

This is the simplest form of a function which can actually be of very many complex forms.

Economic Models

In both Micro-Economics and Macro-Economics, economists sometimes put the complex mass of realities into simplified frameworks called Models.

A Model is a theoretical construct that represents economic realities by a set of mathematical equations involving inter-related variables. These relationships can be logical or quantitative. But putting them in a Model helps economists to analyze realities better and even make future predictions. A famous model of Micro-Economics is the Cournot Model of Duopoly, named after Antoine Augustin Cournot (1801–1877). To exemplify what a model is, we outline it below.

The Cournot model depicts an industrial structure in which companies compete on the amount of output they will produce, which they decide on independently of each other and at the same time.

The model is based on the following assumptions.

There is more than one firm, and all firms produce a homogeneous product, i.e. there is no product differentiation;
Firms do not cooperate, i.e. there is no collusion;
Firms have market power, i.e. each firm’s output decision affects the good’s price;
The number of firms is fixed;
Firms compete in quantities and choose quantities simultaneously;
The firms are economically rational and act strategically, usually seeking to maximize profit given their competitors’ decisions. This “not conjecture” assumption is crucial. Each firm aims to maximize profits based on the expectation that its own output decision will not have an effect on the decisions of its rivals.

Price is a commonly known decreasing function of total output. All firms know N, the total number of firms in the market, and take the output of the others as given. Each firm has a cost function c_i(q_i). Normally the cost functions are treated as common knowledge. The cost functions may be the same or different among firms. The market price is set at a level such that demand equals the total quantity produced by all firms. Each firm takes the quantity set by its competitors as a given, evaluates its residual demand, and then behaves as a monopoly. The outcome is known as the Cournot Equilibrium or Cournot solution.

Another famous model of Micro-Economics is the Stackelberg Model of Monopolistic Competition.

Econometrics is widely used in the estimations involved in the testing of models.

Economic Laws

Earlier economists often used the term `law’ to describe their conclusions/theories, e.g., The Law of Demand, the Law of Diminishing Marginal Utility, and the Law of Diminishing Returns. These are not laws in the sense of being inexorable, enforceable or universal laws but merely general trends or tendencies arrived at by Deductive or Inductive methods, as the case may be.

For example, the Law of Demand states that all else being equal, as the price of a product increases, the quantity demanded falls; likewise, as the price of a product decreases, the quantity demanded increases.

In other words, the quantity demanded, and the price is inversely related, other things remaining constant. If the income of the consumer, prices of the related goods, and preferences of the consumer remain unchanged, then the change in the quantity of goods demanded by the consumer will be negatively correlated to the change in the price of the good. However, there are exceptions to this rule and in modern textbooks, this proposition is not presented as a law.

Again, the law of Diminishing Marginal Utility states that as a person increases consumption of a commodity while keeping that of others constant, there is a decline in the marginal utility that person derives from consuming each additional unit of that product. This, in the Neo-Classical analysis of Alfred Marshall, was the basis of the Law of Demand. Subsequent analysis has shown that the inverse relationship between quantity demanded and practice can be derived without reference to any such `law’ of Diminishing Marginal Utility.

However, the law, in the usual sense of the term, does have a close bearing on Economics. The existence of law and order in the country is a prerequisite for it to function well.

At the same time, too many restrictive laws hamper its smooth functioning. British rule introduced laws such as the Permanent Settlement Act of 1793, which introduced the Zamindari system in Indian agriculture, and the Dekhan Agriculturalists’ Relief Act of 1879 which provided some relief to agricultural indebtedness in Maharashtra. There were many other laws passed by the British which profoundly affected the pre-Independence Indian economy.

Soon after Independence, a new Constitution was established, some old laws were discarded, and new ones were passed. In agriculture, the Zamindari system was abolished, and many Acts to the effect were passed (The Uttar Pradesh Zamindari Abolition and Land Reforms Act, 1950. the Bihar Land Reforms Act, 1950, the West Bengal Estates Acquisition Act, 1953). In respect of industry too, various laws were passed, such as the Industries (Development and Regulation) Act of 1951, followed by the Industrial Policy Resolution of 1956, and the Monopolies and Restrictive Trade Practices Act of 1969).

By 1991 many of the above laws were considered to have become fetters upon the growth of the Indian economy. An era of `Liberalization was ushered in. Old laws were relaxed or removed. For example, the MRTP Act was repealed and replaced by the Competition Act 2002, with effect from September 1.

All this points out the close connection between Law and Economics in theory and practice.

Methods of Analysis in Economics

Deductive Method in Economics

Inductive Method in Economics

Hypothetico-Deductive

Variables, Constants, Parameters & Functions

Economic Models

Economic Laws

Read More- Microeconomics

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Deductive Method in Economics

Inductive Method in Economics

Hypothetico-Deductive

Variables, Constants, Parameters & Functions

Economic Models

Economic Laws

Read More- Microeconomics

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Related

Share Your ThoughtsCancel reply