• What is Managerial Economics? Critically examine its nature and
scope?
Ans.
Economics is a social science. Its basic function is to study how people-
individuals, households, firms & nations- maximize their gains from their
limited resources & opportunities. In economic terminology, this is called
maximizing behavior or, more approximately, optimizing behavior. Optimizing
behavior is, selecting the best out of available options with the objective of
maximizing gains from the limited resources. For most purposes, economics can
be divided into two broad categories: Micro Economics and Macro Economics.
Macroeconomics is the study of the economic system as a whole. It includes
changes in total output, total employment, the unemployment rate and exports
and imports. The goal of macroeconomics is to explain the economic changes that
effect many household, firms and markets at once.
Micro economics focuses on the behavior of the individual actors on the economic
stage, i.e., firms and individuals and their interaction in markets.
Economics is thus a social science, which studies human behavior in relation to
optimizing allocation of available resources to achieve the given ends.
Definitions
of Economics
According to Dr. Alfred Marshall “Economics is a study of man’s action in
the ordinary business of life: it enquires how he gets his income and how he uses it"
According to Pigou “Economics is the study of economic welfare that
can be brought directly
and indirectly,
into relationship with
the measuring rod of money”
The subject matter of economics science consists of logic, tool & techniques
of analyzing
economic as well as. evaluating economic options, optimizing techniques and economic theories.
Application of economic science in business decision making is all pervasive.
More specifically, economic laws and tools of economic analysis are now applied a great
dealing in the process of business decision making. This has led,
as mention earlier, in the emergence of separate branch of study called
"managerial economics.” Economics principles by themselves don’t offer
readymade solutions applicable in the changing business world. After the Second
World War and particularly after 1950 with the expansion of business all over
the world the business managers faced with many problems due to changing
environment and the consequent variability and unpredictability of their
achievements. There is a gap between economic theory and the exact procedure
they have to apply to arrive at correct decisions in the treatment of business
problems. These problems are attracted the attention of academics and resulted
in a separate branch of knowledge for treatment of business problems and this
has come to be Managerial Economics.
Managerial
economics should be thought of as applied micro economics. It is an application
of the part of micro economics that focuses on the topics that are of greatest
interest and importance to managers. Managerial economics may be viewed as
economics applied to
problem solving
at the level of the firm. It is a
science which deals with the application of economic theory in managerial functions, It
is a study of allocation of resources available to a firm relate to choices
managerial economics implies that the focus of the subject is an identifying
and solving the decision problems faced by the managers all the time. It has
gained greater importance in the recent years mainly because it enables the
management to take proper decision in their business at every stage whether it
be allocation of resources, calculation of cost, determination
of output, forecasting, expansion of market of production, profit planning
etc..
While economics
is concerned with determining the means of achieving given objectives in the
most efficient manner, Managerial Economics is the application of economic theory and methodology
to decision
making problems faced by both public and private institutions. The two major
components of managerial
economics
are decision
making and
forward planning. Economics
applied in decision
making.
It fills the gap
between Economic Theory and managerial practice.
In general,
managerial economics can be used by the goal oriented manager in two ways. First, given
an existing economic
environment,
the principles
of managerial economics provide a frame work for evaluating whether resources are being
allocated efficiently with in a firm. Second, these principles help managers respond
to various economic signals.
Managerial
Economics Definitions
Managerial
economics is defined by different authors according to their views. Some of the
well- known definitions are as follows:
Milton H. Spencer and Louis
Siegel man:defines Managerial Economics as “The Integration of Economic Theory
with business practice for the purpose of facilitating Decision Making and
forward planning by management.
According to Edwin
Mansfield:- Managetial economics is concerned with the application of economic
concepts and economic analysis to the problem of formulating rational
managerial decisions”.
According to Janies Bates and
J.R. Parkinson:-Managerial economics orBusiness economics is a study or the
behavior of the firm in theory and practice”.
The Nature and Scope of Managerial
Economics
Nature:
Human needs are unlimited and moreover
ever recurring. These wants may be either basic needs or comforts or even
luxuries in respect of food, clothing, shelter, health, education,
entertainment etc... In fact of such needs are endless. However, the means of
satisfying these wants are in form of products and services. The resources are
limited (scarce) to produce the products and services and at the same time all
these scarce resource have alternative uses, their employment and utilization
have to optimal and efficient. As in the same, all the enterprise engaged in
offering various products and services to be small or large to allocate its
scarce (limited) resources in most efficient manner for its basic survival and
growth. Managerial economics studies about the firm and scarce resources for
maximizing output, finding solutions to the firm to the problem of the firm for
maximizing profit.
Managerial economics is goal
oriented. The course of action is chosen from available alternatives. It uses
tools and techniques which are derived from management economics, statistics,
accountancy, sociology and psychology. Economics is the study of economic
actions of individual in daily life. Economic actions are under taken for the
direct satisfaction of our wants Economics is a study of man’s action in
relation to the satisfaction of his wants. Economics thus study of human
actions and behavior as a relationship between unlimited wants and limited
means.
Economics as a branch of knowledge
is concerned with the study of the allocation of scarce resources among
completions ends. Managerial economics also has inherited this problem from
economics. It is assumed that the firm or the buyer acts in a rational manner.
The basic feature of economics is assuming that, other things remaining the
same. This assumption is made to simplify the complexity of the managerial
phenomenon. So many things are changing simultaneously.
Managerial Economics is also known
as business economics since its major focus is on business problems, is has a
blend of features on many a business elated discipline apart from economics
from which it originates primarily. Since this is newly formed discipline no
uniform pattern is adopted and different authors treat the subject in different
ways.
Thus, the nature of Managerial
Economics can be known through its relation with various other disciplines such
as a micro and macroeconomics, normative and descriptive economics, the theory
of decision making, operation research and statistics. It is said that a
successful business economist will try to integrate the concepts and methods
from all the disciplines.
1.
Micro-Economic Frame
work —
The micro-economic analysis deals
with the problem of an individual firm, industry, etc... In the case of
managerial economics micro economics helps in studying what is going oh with in
the firm. The micro economic theory is also known as the price theory. It
provides various concepts for the determination of the price of commodities,
services and factors of production.
The chief source of concepts and
analytical tool for managerial economics is micro economic theory, some of the
popular micro economic concepts are elasticity of demand, production analysis,
cost analysis, opportunity cost, present value, pricing under various market
structures and profit management etc.., It also includes the behavior of the
consumer in his individual capacity. Managerial Economics use some well
accepted models in price theory such as the model for monopoly price, model of
price discrimination and behavioral and marginal models
Macro
Economics: A successful manager has to
acquaint himself with the general business conditions, which influence supply
and price of commodities as well as factors of production. Especially in
forecasting demand, the general economic environment is taken into accounts The
other macro variables like income, general price levels, rate of foreign
exchange etc.. Influence business so closely. Hence, the managers has to grasp
the various concepts related to them form macroeconomics also.
2. Managerial Economics is normative approach (Normative Vs Descriptive
Economics): Managerial Economics is considered as a part of normative
economics. This is because it is prescriptive in nature rather than
descriptive. It is concerned with those decisions which are to be made keeping
in view the objectives of a firm, if profit is taken as the objective of the
firm. Managerial economics proved various alternatives to achieve the desired
profit. The descriptive economics only describes relations and situation. It
indicates only the possible consequence based on certain relations but the best
choice amongst them is not made. Normative approach of managerial economic
decide the logic which fits into a given purpose.
Integration
of Economic Theory and Business practice:
Managerial economic prefers the
practical approach. It is concerned with the application of economics theories
in the business practices. With the help of economics one can understand the
actual business behavior. Managerial Economics
attempts to estimate and predict the economic quantities and relationships It
cannot ignore the environment within which they operate.
Scope:
The main focus in managerial economics is to find an
optimal solution to a given managerial problem. The problems are concerned with
managerial decisions such as production, reduction or control of costs,
determination of price of a given product or service, make or buy decisions,
inventory decisions, capital management or profit planning and management,
investment ddecisions or human resource management. To overcome these problems
economist makes use of concepts, tools and techniques of economics and other
related disciplines to find an optimal solution to a given managerial problem.
Concepts,
Techniques
and tools of
managerial
economics =>
|
•Production
•Costing
• Capital management
•Inventory =>
•Profit planning
•Human resource
•Demand analysis
•Investment decisions
Make or buy decisions
•
•Determination of price
of given product or service
|
Optimal
solution of
problems
|
Managerial economics can be used to
analyze the demand of a product. The subject also suggests several ways and
methods for estimating the present and future demand of any product.
Managerial economics and its cost
concepts can be employed to analyze the cost of a product. Besides analyzing
cost, a manager would also like to know the exact amount of cost. Managerial
economics provides alternative methods for estimating the cost of a product.
Another important aspect of managerial decision making is a price of a product.
Lastly M.E provides a frame work for
planning the capital expenditure decisions of a firm. It also helps a manager
to estimate the cost of firm’s capital and the cash flows associated with a
project.
Managerial economics has a close
connection with economic theories, OR, statistics, mathematics and the theory
of decision making. It also draws together end relates ideas from various
functional areas of management. Different authors have given different
definitions to the scope of Managerial economics leaving divergence of opinion
about the subject matter.
However the following elements
accepted in general and provides’ scope of managerial economics:
1) Area of study (or) subject matter
of managerial economics
2) Managerial economics with other
disciplines
3 3)
Profits
4 4)
Optimization
l).Area of study (or) subject matter
of managerial economics:
Broadly,
managerial economics is concerned, the following aspects constitute it:
A)
Demand analysis and forecasting
B)
Cost and production analysis
C)
Pricing decisions and policies, practices
D)
Profit management
E)
Capital management (or) capital budgeting
A) Demand analysis and forecasting:
Demand analysis attempts to understand the consumer
behavior. This analysis answers he questions such as why do consumer buy a
commodity? When do they buy or stop consuming a commodity? How they react if
price changes? Thus, knowledge of demand theory and demand analysis is
essential in making decisions in choice of commodities for production. Demand
analysis attempts at finding out the forces determining the sales. It
strengthens market position and also enlarges profits.
Therefore, demand determination, demand distinction
and demand forecasting occupy a strategic role in the subject matter of
managerial economic.
Two main managerial purposes in demand analysis are
1)
Forecasting sales
2)
Manipulating demand
B) Production and Cost Analysis:
Production theory describes the cost behavior. It
explains how average and managerial cost vary when production is varied. It
forecast the level of output due to the changes made in the factor of inputs.
In brief, it helps in determining the size of the firm, size of the total
output, and the factor proportion.
In decision making cost estimates
are very essential, Production, profit planning depend upon sound pricing
practices and accurate cost analysis. The cost analysis makes a manager of a
firm to produce in an ideal way and make it to serve in midst of other
competitive producers, while ensuring considerable profit.
Production analysis deals with physical terms of product Cost analysis deals with monetary terms
C) Pricing Decisions, Pricing
Policies & Practices:
Price theory basically explains the
way the prices are determined under different market structures. The success
(or) failure of a firm mainly depends on accurate price decisions. Price
theories determine the price policies of a firm. Price and production theories
together, in fact help in determining optimum size of the firm.
Thus, the pricing methods, price
determinants, price polices and price forecasting are also dominating the
subject contention of managerial economics.
D)Profit Management:
The survival as well as the success of every firm
depends on its ability to earn and also maximize profit. It must also be
understood that for maximizing profits, the firm needs to take care of its
long-range decisions i.e. investment decisions. However, a satisfactory level
of profit is not always guaranteed as the firm has to carry out its activities
under conditions of uncertainty in regard to demand for the product, inputs
prices in the factor market, degree of competition, price behavioi under
changing conditions etc. therefore an element of risk always exist even if most
efficient techniques are used for predicting future.
The firms are therefore supposed to safeguard their
interest and avert as far as possible the possibilities of risk or minimize the
risk. Profit theory guides in the measurement and management of profit, in
making allowances for risk premium, in calculating the pure return of capital
and pure profit and also in future profit planning. Profit management thinks
the profit policies, techniques and profit planning like BEP analysis.
E) Capital Management:
Capital is a scare and an expensive factor in firms
and it is a foundation of a business. Efficient capital allocation and
management is one of the most important tasks of the managers t he major
issues related to capital are
2. Managerial
economics with other disipline
A) Choice or
capital
B)Assessing the efficiency of capital
C) Allocation of capital
efficient capital theory can contribute a great deal
in investment decision, choice of projects, maintaining capital intact, capital
budgeting etc.. has its own vital bearing in the subjetct code of managerial
economics. capital budgeting deals with planning and control of capital
expenditure, cost of capital, rate of returns.
2) Profits: Profits
are primary measure of success of any business; these are the acid test of the
economic strength. Economic theory makes a fundamental assumption that
maximizing profit. Modem firms pursue multiple objectives such as welfare,
obligations to the society and consumers.
3) Optimization:Optimization
is a basic to managerial economics in decision making It offers numerical
solutions to problem of making optimum choices. Managerial Economics is
concerned with optimization of certain objective functions of a firm within
given constraints. Obviously, the goals of business have to be determined
resources assessed and their use pattern decided upon, so as to accomplish the goal
of business in the best possible manner. In recent years, optimization
researchers have discovered the term “sub optimization”.
Q2. Define demand? Determine
the determinants of demand?
Ans: Demand
Demand is on of crucial requirement for the existence
of any business enterprise. Business executives have to make decision on such
matters as what to produce and how much to produce and demand analysis helps
managing to make decisions with respect to production, advertising, cost
allocation, pricing, inventory holding etc. Information on the size and type of
demand helps management in planning its requirement of men, material, machine
and money. Similarly, executives entrusted with the task of selling the
produces and promoting its sales, have to make a choice between alternative
prices and between markets. For its successful operation the firm has to plan
for future production, inventor of raw materials and advertising etc. Demand
forecasting attempts to estimate the likely demand for a product in future.
Production can be better planned if future demands are identified.
Every want, supported by the willingness and ability,
constitutes demand for a particular product or service. In other words, if a
person wants to buy a car but he cannot pay for it, then there is no demand for
the car from any side. A product or service is said to have demand when three
conditions are satisfied:
•
Desire on
the part of the buyer to buy it
•
Willingness
to pay for it
•
Ability to
pay the specified price for it
Unless
all these conditions are fulfilled, the product is not set to have any demand.
Meaning of Demand:
Demand for a commodity
refers to the desire backed by the necessary, purchasing power. By demand we
mean the various quantities of a given commodity
or service which consumer would buy in one market, in a given period of time,
at a various prices or at various incomes or at
Notes From 11/aug/2016
WHAT IS ECONOMICS?
Economics is the study
of how individuals and societies make choices subject to constraints. The need
to make choices arises from scarcity. From the perspective of society as
a whole, scarcity refers to the limitations placed on the production of goods
and services because factors of production are finite. From the
perspective of the individual, scarcity refers to the limitations on the
consumption of goods and services because of limited of personal income and
wealth.
Definition: Economics is
the study of how individuals and societies choose to utilize scarce resources
to satisfy virtually unlimited wants.
Definition: Scarcity
describes the condition in which the availability of resources is insufficient
to satisfy the wants and needs of individuals and society.
The concepts of scarcity
and choice are central to the discipline of economics. Because of scarcity,
whenever the decision is made to follow one course of action, a simultaneous
decision is made to forgo some other course of action. Thus, any action
requires a sacrifice. There is another common admonition that also underscores
the all pervasive concept of scarcity; if an offer seems too good to be true,
then it probably is.
Individuals and
societies cannot have everything that is desired because most goods and
services must be produced with scarce productive resources. Because productive
resources are scarce, the amounts of goods and services produced from these
ingredients must also be finite in supply. The concept of scarcity is
summarized in the economic admonition that
there is no “free
lunch.” Goods, services, and productive resources that are scarce have a
positive price. Positive prices reflect the competitive interplay between the
supply of and demand for scarce resources and commodities. A commodity with a
positive price is referred to as an economic good. Commodities that have
a zero price because they are relatively unlimited in supply are called free goods.
What are these scarce productive resources? Productive resources, sometimes called factors of production or productive inputs, are classified into one of four broad categories: land, labor, capital, and entrepreneurial ability. Land generally refers to all natural resources. Included in this
category are wildlife, minerals, timber, water, air, oil and gas
deposits, arable land, and mountain scenery.
Labor refers to the
physical and intellectual abilities of people to produce goods and services. Of
course, not all workers are the same; that is, labor is not homogeneous.
Different individuals have different physical and intellectual attributes.
These differences may be inherent, or they may be acquired through education
and training. Although the Declaration of Independence proclaims that everyone
has certain unalienable rights, in an economic sense all people are not created
equal. Thus some people will become fashion models, professional athletes, or
college professors; others will work as clergymen, cooks, police officers, bus
drivers, and so forth. Differences in human talents and abilities in large
measure explain why some individuals’ labor services are richly rewarded in the
market and others, despite their noble calling, such as many public school
teachers, are less well compensated.
Capital refers to
manufactured commodities that are used to produce goods and services for final
consumption. Machinery, office buildings, equipment, warehouse space, tools,
roads, bridges, research and development, factories, and so forth are all a
part of a nation’s capital stock. Economic capital is different from financial
capital, which refers to such things as stocks, bonds,
certificates of deposits, savings accounts, and cash. It should be noted,
however, that financial capital is typically used to finance a firm’s
acquisition of economic capital. Thus, there is an obvious linkage between an
investor’s return on economic capital and the financial asset used to
underwrite it.
In market economies,
almost all income generated from productive activity is returned to the owners
of factors of production. In politically and economically free societies, the
owners of the factors of production are collectively referred to as the
household sector. Businesses or firms, on the
Is air a tree good? Many students would assert
that it is, but what is the price of a clean environment? inhabitants of most
advanced industrialized societies have decided that a cleaner environment is a
socially desirable objective. Environmental regulations to control the disposal
of industrial waste and higher taxes to finance publicly mandated environmental
protection programs, which are passed along to the consumer in the form of
higher product prices, make it clear that clean air and cean water are not
free.
other hand, are
fundamentally activities, and as such have no independent source of income.
That activity is to transform inputs into outputs. Even firm owners are members
of the household sector. Financial capital is the vehicle by which business
acquire economic capital from the household sector. Businesses accomplish this
by issuing equity shares and bonds and by borrowing from financial
intermediaries, such as commercial banks, savings banks, and insurance
companies.
Entrepreneurial ability
refers to the ability to recognize profitable opportunities, and the
willingness and ability to assume the risk associated with marshaling and
organizing land, labor, and capital to produce the goods and services that are
most in demand by consumers. People who exhibit this ability are called entrepreneurs.
In market economies, the
value of land, labor, and capital is directly determined through the
interaction of supply and demand. This is not the case for entrepreneurial
ability. The return to the entrepreneur is called profit.
Profit is defined as the difference between total revenue earned from the
production and sale of a good or service and the total cost associated with
producing that good or service. Although profit is indirectly determined by
the interplay of supply and demand, it is convenient to view the return to the
entrepreneur as a residual.
OPPORTUNITY
COST
The concepts of scarcity
and choice are central to the discipline of economics. These concepts are used
to explain the behavior of both producers and consumers. It is important to
understand, however, that in the face of scarcity whenever the decision is made
to follow one course of action, a simultaneous decision is made to forgo some
other course of action. When a high school graduate decides to attend college or
university, a simultaneous decision is made to forgo entering the work force
and earning an income. Scarcity necessitates trade-offs. That which is forgone
whenever a choice is made is referred to by economists as opportunity
cost. That which is sacrificed when a choice is made is the next best
alternative. It is the path that we would have taken had our actual choice not
been open to us.
Definition: Opportunity
cost is the highest valued alternative forgone whenever a choice is made.
MACROECONOMICS
VERSUS MICROECONOMICS
Scarcity, and the manner
in which individuals and society make choices, are fundamental to the study of
economics. To examine these important
issues, the field of
economics is divided into two broad subfields: macroeconomics
and microeconomics.
As the name implies,
macroeconomics looks at the big picture. Macroeconomics is the study of entire
economies and economic systems and specifically considers such broad economic
aggregates as gross domestic product, economic growth, national income,
employment, unemployment, inflation, and international trade. In general, the
topics covered in macroeconomics are concerned with the economic environment
within which firm managers operate. For the most part, macroeconomics focuses
on the variables over which the managerial decision maker has little or no
control but may be of considerable importance in the making of economic
decisions at the micro level of the individual, firm, or industry.
Definition:
Macroeconomics is the study of aggregate economic behavior. Macroeconomists
are concerned with such issues as national income, employment, inflation,
national output, economic growth, interest rates, and international trade.
By contrast,
microeconomics is the study of the behavior and interaction of individual
economic agents. These economic agents represent individual firms, consumers,
and governments. Microeconomics deals with such topics as profit maximization,
utility maximization, revenue or sales maximization, production
efficiency, market structure, capital budgeting, environmental
protection, and governmental regulation.
Definition:
Microeconomics is the study of individual economic behavior. Microeconomists
are concerned with output and input markets, product pricing, input
utilization, production costs, market structure, capital budgeting, profit
maximization, production technology, and so on.
WHAT
IS MANAGERIAL ECONOMICS?
Managerial economics is
the application of economic theory and quantitative methods (mathematics and
statistics) to the managerial decision-making process. Simply stated,
managerial economics is applied microeconomics with special emphasis on those
topics of greatest interest and importance to managers. The role of managerial
economics in the decision-making process is illustrated in Figure.
Definition: Managerial
economics is the synthesis of microeconomic theory and quantitative methods to
find optimal solutions to managerial decision-making problems.
To illustrate the scope
of managerial economics, consider the case the owner of a company that produces
a product. The manner in which the firm owner goes about his or her business
will depend on the company’s organizational objectives. Is the firm owner a
profit maximizer, or is manage-
FIGURE 1.1 The role of
managerial economics in the decision-making process.
ment more concerned
something else, such as maximizing the company’s market share? What specific
conditions must be satisfied to optimally achieve these objectives? Economic
theory attempts to identify the conditions that need to be satisfied to achieve
optimal solutions to these and other management decision problems.
As we will see, if the
company’s organizational objective is profit maximization then, according to
economic theory, the firm should continue to produce widgets up to the point at
which the additional cost of producing an additional widget (marginal cost) is
just equal to the additional revenue earned from its sale (marginal revenue).
To apply the “marginal cost equals marginal revenue” rule, however, the firm’s
management must first be able to estimate the empirical relationships of total
cost of widget production and total revenues from widget sales. In other words,
the firm’s operations must be quantified so that the optimization principles of
economic theory may be applied.
THEORIES
AND MODELS
The world is a very
complicated place. In attempting to understand how markets operate, for
example, the economist makes a number of simplifying assumptions. Without
these assumptions, the ability to make predictions about cause-and-effect
relationships becomes unmanageable. The “law” of demand asserts that the price
of a good or service and its quantity demanded are inversely related, ceteris
paribus. This theory asserts that, other factors remaining unchanged
(i.e., ceteris paribus), individuals will tend to purchase
increasing amounts of a good or service as prices fall and decreasing amounts
as the prices rise. Of course, other things do not remain unchanged. Along with
changes in the price of the good or service, disposable income, the prices of
related commodities, tastes, and so on, may also change. It is difficult, if
not impossible, to generalize consumer behavior when multiple demand
determinants are simultaneously changing.
Definition. Ceteris
paribus is an assertion in economic theory that in the analysis of the
relationship between two variables, all other variables are assumed to remain
unchanged.
It is good to remember
that economics is a social, not a physical, science. Economists cannot conduct
controlled, laboratory experiments, which makes economic theorizing all the
more difficult. It also makes economists vulnerable to ridicule. One economic
quip, for example, asserts that if all the economists in the world were laid
end to end, they would never reach a conclusion. This is, of course, an unfair
criticism. In business, the objective is to reduce uncertainty. The study of
economics is an attempt to bring order out of seeming chaos. Are economists
sometimes wrong? Certainly. But the alternative for managers would be to make
decisions in the dark.
What then are theories?
Theories are abstractions that attempt to strip away unnecessary detail to
expose only the essential elements of observable behavior. Theories are often
expressed in the form of models. A model is the formal expression of a
theory. In economics, models may take the form of diagrams, graphs, or
mathematical statements that summarize the relationship between and among two
or more variables. More often than not, there will be more than one theory to
explain any given economic phenomenon. When this is the case, which theory
should we use?
“GOOD” THEORIES VERSUS
“BAD” THEORIES
The ultimate test of a
theory is its ability to make predictions. In general, “good” theories predict
with greater accuracy than “bad” theories. If one theory is known to predict a
particular phenomenon with 95% accuracy, and another theory of the same
phenomena is known to predict with 96% accuracy, the former theory is replaced
by the latter theory. It is in the nature of scientific progress that “good”
theories replace “bad” theories. Of course, “good” and “bad” are relative
concepts. If one theory predicts an event with greater accuracy, then it will
replace alternative theories, no matter how well those theories may have
predicted the same event in the past.
Another important
observation in the process of theorizing is that all other factors being equal,
simpler models, or theories, tend to predict better than more complicated ones.
This principle of parsimony is referred to as Ockham’s razor, which was
named after the fourteenth-century English philosopher William of Ockham.
Definition: Ockham’s
razor is the principle that, other things being equal the simplest explanation
tends to be the correct explanation.
The category of “bad”
theories includes two common errors in economics. The most common error, perhaps, relates to
statements or theories regrading cause and effect. It is tempting in
economics to look at two sequential events and
conclude that the first event caused the second event.
Clearly, this is not
always the case, some financial news reports not with standing. For example, a report that the Dow
Jones Industrial Average fell 200
points might be attributed to news of increased tensions in the Middle
East. Empirical research has demonstrated, however, while
specific events may indirectly
affect individual stock prices, daily fluctuations in stock market
averages tend, on average, to be random. This common error is
called the fallacy of post hoc, ergo propter hoc (literally, “after
this, therefore because of this”).
Related to the pitfall
of post hoc, ergo propter
hoc is the confusion that often arises between correlation and causation. Case and Fair (1999) offer the following illustration. Large cities have
many automobiles and also
have high crime rates. Thus,
there is a high correlation between
automobile ownership and crime. But,
does this mean that automobiles cause crime? Obviously
not, although many other factors that are highly correlated with a high concentration of automobiles (e.g., population density, poverty, drug abuse) may provide a better explanation of the
incidence of crime. Certainly, the presence of automobiles is not one of these
factors.
The second common error
in economic theorizing is the fallacy of composition. The fallacy of composition is the belief that what is true for a
part is necessarily true for the whole. An example of this may be found in the
paradox of thrift. The paradox of thrift asserts that while an increase in
saving by an individual may be virtuous (“a penny saved is a penny earned”), if
all individuals in an economy increase their saving, the result may be no
change, or even a decline, in aggregate saving. The reason is that an increase
in aggregate saving means a decrease in aggregate spending, resulting in lower
national output and income. Since saving depends upon income, increased savings
may be less advantageous under certain circumstances for the economy as a
whole. At a more fundamental level, while it may be rational for an individual
to run for the exit when he is the only person in a burning theater, for all
individuals in a crowded burning theater to decide to run for the exit would
not be.
THEORIES
VERSUS LAWS
It is important to
distinguish between theories and laws. The distinction relates to the ability
to make predictions. Laws are statements of fact about the real world. They are
statements of relationships that are, as far as is commonly known, invariant with respect to specified underlying assumptions or preconditions. As such, laws predict with absolute certainty. “The sun rises in the east " is an example of a law. A law in
economics is the law of diminishing
marginal returns. This law asserts that
for an efficient production process, as increasing amounts of a variable
input are combined with one or more fixed inputs, at some point the additions to total output will get
progressively smaller.
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