Theories in Economics Flashcards
What is a theory?
It is a simplified representation of how two or more variables interact with each other. The purpose is to take a complex, real-world issue and simplify it down to its essentials. This enables the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying.
Theory: a causal law (I have established that A causes B) or a causal hypothesis (I surmise that A causes B). A theory that cannot be arrow diagrammed is not a theory and needs reframing to become a theory (Van Evera 1997).
How do you test a theoretical model?
By examining the reasonableness of the assumptions on which they are based.
How do you test predictions?
By asking if they can accurately predict real-world events.
What is a positive normative distinction?
It argues that models invariably have normative consequences that should be recognized. It’s the development of normative theories about how the world should be.
What is international economics?
The study of the production, distribution, and consumption of goods, services, and capital on a worldwide basis.
What is the optimization principle?
When people try to choose the best patterns of consumption that they can afford.
What is the equilibrium principle?
When prices adjust until the amount that people demand of something is equal to the amount supplied.
What is the Economic Theory of the Consumer?
Economists assume that consumers choose the best bundle of goods they can afford, based on preference. A consumption bundle (x1, x2) is a list of two numbers that tells how much a consumer is choosing to consume good 1, x1, and how much the consumer is choosing to consume good 2, x2. We then suppose that the prices for two goods are (p1, p2), and the amount of money the consumer has to spend is m.
Thus, the budget constraint of the consumer is p1x1+p2x2m, we can then view this as p1x1+x2m, where the amount of money spent on good 1, p1x1, plus the amount spent on all other goods (ceteris paribus), x2, must be no more than the total amount of money the consumer has to spend, m.
What is the Theory of Choice?
It begins by describing people’s preferences. This means accounting for how a person feels about all things he or she might do. This also means that preference is based on the consumer’s behavior. Thus, in terms of consumer preference, utility is seen only as a way to describe preferences.
Economic models use the concept of utility, defined as the satisfaction that a person receives from his or her activities. The objects of consumer choice are consumption bundles, which are a complete list of the goods and services that are involved in the choice problem that is being investigated.
A utility function is a way of assigning a number to every possible consumption bundle such that more-preferred bundles get assigned a larger number than less-preferred bundles. That is, a bundle, (x1, x2), is prefered to bundle (y1, y2), if and only if the utility of (x1, x2) is larger than the utility of (y1, y2): in symbols, (x1, x2) (y1, y2), if and only if u(x1, x2) > u(y1, y2).
What is the Standard Economic Theory?
It describes a formal process for making rational decisions. People consider all the options available to them. They consider the outcomes of all these options and how advantageous each outcome would be. They consider the probabilities of each of these options, and then make a decision.
What is the Labor Theory of Value?
It assumes that labor is the only relevant factor of production.
What is the Factor Proportions Theorem?
The premise that a country will have a comparative advantage and export goods whose production intensively uses its relatively abundant factor of production. A country will have a comparative disadvantage in goods whose production intensively uses its relatively scarce factor of production.
What is the Least Common Denominator Theory?
It minimizes the intellectual distance between the General Theory and the standard classical economics of the day. In this standard economic theory, there are no animal spirits and people act only for economic motives, only acting rationally (Akerlof and Shiller 2009).
What is the Multiplier Theory?
Any initial government stimulus, say a program of increased government expenditure, puts money into people’s hands, which they spend. The initial government stimulus is the first round. Each dollar spent by the government ultimately becomes income to some people, and, once it has been put into their hands, they spend some fraction of it.
This fraction is called the marginal propensity to consume (MPC).
The sum of all the rounds of expenditures $1+$MPC+$MPC2+$MPC3+$MPC4…and is not infinite, this spending equals 1/(1-MPC), called the Keynesian multiplier.
This theory explains that a small dip in expenditure could have greatly magnified effects. There is also a confidence multiplier that represents the change in income that results from one unit change in confidence.
What is the Neoclassical Theory of Wage Determination?
It is the determination of the level of employment and the unit price of labor is dealt with as belonging to a perfectly competitive market, comparable to that of a consumer good. The only difference is that the roles of the agents are reversed. On the one hand, companies are suppliers on the market for goods and demanders on the labor market. On the other hand, households are demanders on the market for goods and suppliers (of their productive services) on the labor market. The wage rate (or equivalently, the unit wage; still more concretely, the hourly wage) and the volume of labor (the number of people employed multiplied by the duration of their work done at a given intensity, or work rates) result in the free confrontation of the global supply of, and demand for, labor.
What is the Economic Theory of Exchange?
It is who trades what to whom in which markets.
What is the Equity Theory - Social Psychological Theory of Exchange?
On either side of an exchange the inputs should equal the outputs. An early version of this theory comes from Peter Blau’s study of government agents involved in complex litigation. (Akerlof and Shiller 2009).
What is the Theory of Fair Exchange?
When subjective elements enter an evaluation, such as the values of ingratiation and thanks. It explains why those of low status are subservient. To equalize the subjective and objective inputs and outputs in the exchange, they have to give more than those of higher status.
What is Money Illusion?
It occurs when decisions are influenced by nominal dollar amounts. Economists believe that if people were “rational” their decisions would be influenced only by what they could buy or sell in the marketplace with those nominal dollars. In the absence of money illusion, pricing and wage decisions are influenced only by relative costs or relative prices, not by the nominal values of those costs or prices.
What is the Unitary Price Theory?
The price of a good should be the same everywhere.
What is the Interest Rate Determination Theory?
Irving Fisher, describes the relationship between inflation and both real and nominal interest rates. The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. It relates the nominal interest rate (i) to the rate of inflation (π) and the “real” interest rate (r). The real interest rate (r) is the interest rate after adjustment for inflation. It is the interest rate that lenders have to have to be willing to loan out their funds. The relation Fisher postulated between these three rates is:
(1+i) = (1+r) (1+π) = 1 + r + π + r π and is equivalent to i = r + π(1 + r).
What is the Standard Theory of the Determination of the Interest Rate?
It is the rate of interest, or the opportunity cost for holding money, or the “price” of holding money. It is the basis of the theory. The demand for money is considered to depend on the level of income and also on the rate of interest. Economists would also say that this demand is price inelastic, because holding some money in one’s checking account is necessary to engage in transactions, but the total cost of holding it is typically not a large part of people’s budgets. There is low elasticity of demand with respect to the interest rate.
What is the Trade Off Theory?
When labor markets get tight, workers will ask for higher wage increases. When the economy is close to full employment, prices will also rise, partly because labor would be asking for wage increase and also because the demand for firms’ products would be high as well.
What is the Natural Rate Theory?
It explains the rise in inflation as the result of the significant shock that occurred and an increase in inflationary expectations, both of which causes a shift in the Phillips curve outward. It explains the rise in unemployment as the result of a decline in demand. It has become the basis for macroeconomic policy relied on by almost all policy makers at the Fed, the Treasury, and the Council of Economic Advisers. It is commonly accepted theory not just in the US but in Europe and in Canada as well. In the absence of money illusion, the natural rate theory will hold, as its key element is that it assumes people do not believe in money illusion. If the theory is correct, it has major consequences for monetary policy and there is little loss from very low inflation targets. However, if it is not true, then there is a long-term trade-off between inflation and unemployment, a zero inflation target is poor economic policy.
