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Some Commonly used Concepts November 23, 2010

Posted by Chetan Chitre in Introduction, Managerial Economics.
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(i)    Positive and Normative Approach

Social sciences such as Economics can be studied using two different approaches. A study with Positive approach focuses on observation of the social phenomenon and recording the observations as they are. Thus a study with positive approach asks the question – “What is?” On the other hand a study done with Normative approach asks believes in not just recording facts but going further and making a value judgment on the observed facts. Thus a study with normative approach asks the question – “What should be?”

The above difference also results in the methodology adopted by the two approaches. Positive approach relies more on empirical observations, precise recording of observations and statistical analysis of observed data. On the other hand normative approach relies more on contemplation and logical reasoning. As a matter of fact many a times normative studies do not go into empirical observations at all.

While Positivism is rooted in the American Behavioral tradition, the normative approach largely is rooted in the European intellectual traditions more notably those coming from Plato.

An example of a normative study is the statement – When price of a commodity increases, the demand for the same should fall. An empirical or a study with positive approach however, shows that when demand for shirts of a certain style kept increasing despite steep rise in prices. A person adhering to any one of the approaches would dismiss the other’s conclusion as wrong. However, a more gainful understanding is had when one tries to bring about reconciliation between the two conclusions. While the law of demand holds true in general, individual tastes and fashions can influence demand in the opposite direction.

There had been purists adhering to either of the two approaches in the mid 20th century. However, over the years, it has been realized that a study to be useful will have to be a blend of the two approaches. A mere normative reasoning unless backed a statement on factual observations would end up being an exercise in day-dreaming. On the other hand, a mere statistical record of events is not enough to further our understanding of a subject. It is equally important that the statistical observations are consistent with logical and reasonable explanations of the observed phenomenon.

(ii)    Economic Modeling

Economics tries to study human behavior pertaining to their satisfaction of their material needs. However, it can be easily observed that there are numerous factors that influence even a single human act. In such a case, it would be very difficult to say what was the effect of a single factor on that act?

For example, our act of buying a shirt. There are numerous reasons that determine our decision – eg. the color, the price, the brand, the current fashion, the fabric, the behavior of the salesman, etc.

If we simultaneously try to study all these factors that affect human behavior it would make the study very complicated. It will also make it very difficult to understand how each of the various factors is affecting the human behavior – eg. in the above example, it would be very difficult to say exactly what was the proportionate role of the color of the shirt in our final choice.

In order to solve this problem, economists use ‘Economic Models’. Models are representations of reality. From the total real life situation which contains numerous factors acting at the same time, we select a few important factors and observe their effect on the final behavior – i.e. in the above case in case one has to understand the role of color in the decision to buy the shirt, it would be helpful if we present the person of choice of shirts with same price, same fabric, same brand, etc. but with different colors.

Such exercises are called Economic Modeling. Here we select a few variables and study the effect of those variable on human action. Variable to be studied are selected on the basis of their importance in explaining the phenomenon, the purpose of study, availability of data, etc.

Models are useful in understanding the relationships between different variables and thus helping in developing a more complete understanding of reality. The technique is applied in both microeconomic as well as macroeconomic analysis.

Models once developed in this manner can be used for furthering our understanding of the phenomenon by running various simulations on the given model. Models can thus be used for explaining the relationships between variables as also for predictive purposes. For example, once the relationship between price, income of consumers and demand for shirts is understood, this can be used for understanding demand for shirts priced differently among consumers from different income groups.

(iii)    Ceteris Paribus

As mentioned earlier, economists normally resort to economic modeling in order to understand economic phenomenon. A model is a representation of reality. Out of numerous factors that affect human behavior in reality, a model considers the effect changes in only a select few factors. As regards the rest of the factors, economists make the assumption of “Ceteris Paribus.”

Ceteris Paribus is a Latin phrase that means – ‘Other things being constant’. It was popularized by Alfred Marshal while explaining his partial equilibrium analysis.

Thus in the above example of decision to buy a shirt, while one is studying the effect of color on the choice of shirt by offering shirts of different colors but same price, same brand, etc., one is in effect making the Ceteris Paribus assumption regarding all variables such as price, brands, etc. except the variable – color of the shirt.

(iv)    Partial and General Equilibrium

This is another technique used by economists to simplify real life situations in order to develop a clearer understanding.

It is observed that in real life, various economic events are inter-connected. For example, the equilibrium price and quantity for tea is determined in the tea market. However, this equilibrium occurs when the petrol prices, the labor rates, the coffee prices, the soft drink prices, etc. were at a certain given level. Any change in any of these parameters will lead to a change of equilibrium in the tea market. And if the markets for coffee, petrol, labor, etc. are not in equilibrium, there is a great likely hood that the prices of these commodities will actually change and, thus cause a disturbance in tea market.

Theoretically, therefore it can be concluded that unless all the markets achieve their equilibrium simultaneously, it will not be possible for any single market to achieve equilibrium in isolation as in some way all markets goods and services are inter-elated. Such an approach is called as a “General Equilibrium Approach.” This approach was emphasized by economists like Leon Walras.

However, one can imagine the innumerable amount of goods and services being produced at any given time in an economy. It would be virtually impossible for all these markets to arrive at equilibrium at the same time. Such an event is almost entirely impossible and therefore study of such an event is merely of theoretical significance.

Alfred Marshal on the other hand advocated the “Partial Equilibrium Approach”. According to this approach, it is not necessary to study the entire reality simultaneously. One can partition reality into parts and study these parts in isolation. For example – one can look at equilibrium in the tea market in isolation from all the other markets.

While it is recognized that such a division does not exist in real life and the approach is an over-simplification of reality. However, it is advocated that Partial Equilibrium approach nevertheless is able to give a major part of the explanation of a phenomenon. So if one studies the tea market in general equilibrium approach, the level of additional accuracy and understanding gained is negligible when compared to the time and efforts required to make the general equilibrium analysis.

(v)    Marginal Analysis

This is a one of the important decision criterion used in economics. When one has to take a decision regarding optimization of a certain variable, the same is done on the basis of marginal values.

Thus decision regarding the equilibrium of the consumer is taken on the basis on marginal utility and not on the basis of total or average utility.

Similarly a decision regarding level of output required by the firm for achieving optimum profits is taken on the basis of marginal cost and marginal revenues.

This method of decision-making based on marginal quantities is called as Marginal Analysis.
Thus if a firm has to arrive at the profit maximizing level of output, it will not look at total costs or total revenues. It may be possible that the Total Revenue from selling 100 units of output is more than the Total Cost of producing them. However, this cannot be the correct basis for decision-making. The real question is whether the Marginal Cost (addition to total cost due to the last unit of output produced) of producing 100th unit was less than the marginal revenue obtained from it. If not then that additional money put in business has generated a loss. It could have been used more productively in some other manner.

It has to be noted that while traditional accounting and costing theories do not recognize marginal costs, revenues, etc., it is one of the important factors to be considered for managerial decision. Quite often the MIS will have to be designed to specially incorporate recording and recall of such Marginal quantities required for marginal analysis.

(vi)    Statics, Comparative statics and Dynamics

Methods of study used in economics can also be broadly classified as Statics, Comparative statics and Dynamics. The real world is continuously undergoing changes. The social reality and human behavior which is the subject matter of economics is being continuously influenced by numerous factors. It is moving at a very fast pace. At any given moment billions of humans engage in economic activity of buying selling, producing, trading, etc. if one has to undertake a study of such a dynamic society which is in a continuous state of motion and change, it would be very difficult.

As a result Economics tries to simplify the task by using the Static approach. In simple words it means studying the economic phenomenon as if it is stationary. It is similar to taking a photograph of a moving object and studying the photograph. So a statement or observation stating that in the month of January the price of shirts of a particular brand was Rs. 500/- and the total number of shirts sold in the city were 100,000 units. This is a static study.

Comparative static on the other hand compares two static situations. So we may have another static situation where in the month of February the price of shirts was Rs. 600/- and the demand for shirts decreased to 75,000 units. Comparing the static situation in the month of January and February we can conclude that as the price of shirts increased, the sale of shirts dropped. This is comparison of two static situations and the approach is therefore called Comparative static.

Most of the writings found in economics use the method of Comparative Statics. Statics and Comparative Statics helps in understanding relationships between different variables.

A dynamic study on the other hand concentrates on study of movement of variables, the speed of the movement and the path taken.

So in the above example when the price of shirts increased from Rs. 500/- to Rs. 600/-, the question would be – how did the demand decrease from 100,000 to 75,000 units. Did people first increase their purchase fearing a further price rise in future? Or did the demand immediately drop to 50,000 and then gradually increased and settled at 75,000? Or did the demand immediately fall to 75,000? The path of the adjustment would be a matter of dynamic study.

Dynamic studies are generally conducted in macroeconomics where the core concern is development and growth. Dynamic studies in microeconomics also help in studying various strategies adopted by players and its impact on the eventual equilibrium.


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