Week 2: How Economists Explain

Paradigms, Schools of Thought, Theories, Models

Paradigms

Classical

Neoclassical

Keynesian

Lipsey and Chrystal’s (1995) “Positive Economics“

Theories

For Lipsey and Chrystal

• A set of definitions that clearly describe the variables to be used

• A set of assumptions about the behaviour of these variables

• A set of predictions that are deduced from the theory

• A set of test against actual data

Variables: Exogenous v Endogenous

• Endogenous is explained within the theory

• Exogenous: influences endogenous variables, but is determined by factors

• Endogenous variables appear on the axes

• Exogenous variables do not appear on the axes but do appear in the equations

• We acknowledge that theories are some reduction of reality. There is some kind of trade-off between the complexity of your model vs your theory

Variables: Stock vs Flow

• A stock variable represents a variable at a point in time

• A flow variable is measured over a time interval

Assumptions (1)

• What drives human behaviour

• Physical Relations

Assumptions (2)

• Explicit v unspoken assumptions (aka preconceptions)

  • FOr example, rationality is an explicit assumption

  • But the idea that scarcity is the most important economic phenomenon is often an unspoken assumption

• Why does this difference matter

  • Because economists working within the same paradigm share many unspoken assumptions

    • This makes it difficult to communicate and compare results across paradigms

Assumption (3)

• Should assumptions be realistic

• Objective: simplify enough to capture key mechanisms

  • But not s as to be misleading

  • Increasingly comprehensive models

• HOw realistic should assumptions be

  • it depends on the problem you are studying

  • but if we want to understand the internal functioning of a firm, it may not be

Predictions

• Law: in perfectly competitive markets, price equals marginal cost

• Initial condition: the corn market is a perfectly competitive market

• Prediction: price of corn equals marginal cost

Predictions vs. forecasts

• Forcasts are a subset of predictions: predictions about future values of variables based on present variables

• Many predictions are about discovering a relationship between present values of variables

Tests

• Athoery’s predictions are tested against empirical evidence

• Refutation and confirmation

  • TO what extent is it possible to confirm or refuse a theory

  • Problem of induction: thoery-ladennes of data

• Lipsey and Chrystal claim that theories are “quickly” as one could expect

• more specifically, we need to distinguish between replacing theories and replacing paradigns

Models

• Synonym for theory

  • theory and model are used interchangebly

• Subset of theories

  • neoclassical model meant as a set of theories belonging to the neoclassical paradigm

• Quantitative formulation of a theory

• An illustrative abstaction