Building and Testing Economic Theories Flashcards
What are theories/models?
The economic world is complex. Many things are changing at the same time, and it is usually difficult to distinguish cause from effect. By examining data carefully, however, regularities and trends can be detected. To better understand these patterns in the data, economists develop theories, which they sometimes call models. Theories are used to both explain events that have already happened and to help predict events that might happen in the future.
These and all other theories are distinguished by their variables, assumptions, and predictions.
What are variables?
variable
Any well-defined item, such as the price or quantity of a commodity, that can take on various specific values.
What is a Endogenous Variable?
endogenous variable
A variable that is explained within a theory. Sometimes called an induced variable or a dependent variable.
What is an exogenous variable?
exogenous variable
A variable that is determined outside the theory. Sometimes called an autonomous variable or an independent variable.
What are assumptions in a theory?
Assumptions
A theory’s assumptions concern motives, directions of causation, and the conditions under which the theory is meant to apply.
What are the assumed motives in the theories we will be studying in this book?
Motives
The economic theories we study in this bookmake the fundamental assumption that everyone pursues his or her own self-interest when making economic decisions. Individuals are assumed to strive to maximize their utility, while firms are assumed to try to maximize their profits. Not only are they assumed to know what they want, but we also assume that they know how to go about getting it within the constraints they face.
What is direction of causation?
Direction of Causation
When economists assume that one variable is related to another, they are usually assuming some causal link between the two. Consider a theory about the market for wheat, for example. When the amount of wheat that producers want to supply is assumed to increase when the weather improves, the causation runs from the weather to the supply of wheat. Producers supply more wheat because the growing conditions improve; they are not assumed to experience better weather as a result of their increased supply of wheat.
What are Conditions of Application?
Conditions of Application
Assumptions are often used to specify the conditions under which a theory is meant to hold. For example, a theory that assumes there is “no government” usually does not mean literally the absence of government but only that the theory is meant to apply when governments are not significantly affecting the situation being studied.
“All theory is an abstraction from reality. If it were not, it would merely duplicate the world in all its complexity and would add little to our understanding of it.”
What are predictions?
Predictions
A theory’s predictions are the propositions that can be deduced from it. They are often called hypotheses
How to we test a theory?
A theory is tested by confronting its predictions with empirical evidence. For example, is an improvement in the weather actually followed by an increase in wheat production? Or, is an increase in the world price of oil actually followed by an increase in oil production by Canadian producers?
When dose a theory stop being useful?
A theory ceases to be useful when it cannot predict better than an alternative theory. When a theory consistently fails to predict better than an available alternative, it is either modified or replaced.
Figure 2-1 The Interaction Between Theory and Empirical Observation
Found in chapter 2 on OneNote
Explain the scientific approach in terms of the study of economics.
The scientific approach is central to the study of economics: Empirical observation leads to the construction of theories, theories generate specific predictions, and the predictions are tested by more detailed empirical observation.
What is a causal relationship between variables?
Suppose you want to test your theory’s prediction that “If X increases, Y will also increase.” You are looking for a causal relationship from X to Y, because a change in X is predicted to cause a change in Y.
What is an important distinction between correlation and causation?
A finding that X and Y are positively correlated means only that X and Y tend to move together. This correlation is consistent with the theory that X causes Y, but it is not direct evidence of this causal relationship. The causality may be in the opposite direction—from Y to X. Or X and Y may have no direct causal connection; their movements may instead be jointly caused by movements in some third variable, Z.
Most economic predictions involve causality. Economists must take care when testing predictions to distinguish between correlation and causation. Correlation can establish that the data are consistent with the theory; establishing causation usually requires more advanced statistical techniques.
