What is the purpose of economic theory?
What is the purpose of economic theory?
An economic theory can be expressed as the ideas and principles that aims to describe how economies operate taking into account elements of micro and macroeconomics (Cambridge University Press, 2013; LNPU, 2010). On one hand, microeconomics pertains to how supply and demand functions in individual markets and consumer behaviour. In contrast, macroeconomics is the study of how the entire economy works as a whole for example, why there might be a specified percentage of inflation or unemployment (Rodrigo, 2012).
In addition, economic theories comprise of a kaleidoscope of economic variables and how they inadvertently influence one another in order to augments an economy’s state to reach its desired outcomes (Ouliaris, 2012). On the other hand, it is important to note that economic theories are based on ceteris paribus or ‘all other things being equal or held constant’ (Bierens and Swanson, 1998). Therefore, it could be said that not all economic theories may work successfully and could be subjected to unknown variables that may have an effect on consumers, firms and governments when applied to real world economics.
A classic example of such theory can be observed with Karl Marx’s theory of value and surplus value which were primarily evident to overthrow capitalistic approaches to a free market economy into a more centrally planned economy approach where a central body would instigate quotas to bring about efficient production and distribution of goods and services which could be apparent in countries such as the Union of Soviet Socialist Republics (USSR) and the Republic of China (ROC) (Marx, 1982).
These theories would be taken in an example to analyse if economic theories are necessary to consumers, firms and governments in order to make rational decisions. According to CAUSA Foundation (2009) Marxist economic theories roots around a central concept that wealth should be redistributed evenly throughout all social classes and that a free market system exploits labour by creating profits through the reduction of wages.
Therefore, Karl Marx attempted to understand, criticise and revolutionise the capitalistic system into a more labour orientated economy where the gap between proletariats (working class) and bourgeoisies (middle class) would be diminished with two theories, namely the labour theory of value and the theory of surplus value (Sleeper, 1983). Firstly, the labour theory of value is a concept of exchanging value rather than adhering to a price set accordingly by the market’s supply and demand (CAUSA Foundation, 2009).
In this instance, ‘value’ is regarded as abstract labour hours which is derived from the calculation of labour hours that was expended from the point of extracting raw materials to the finished product (CAUSA Foundation, 2009). In the real world, this would suggest that price is determined by the amount of labour hours that went into the production process of a product which differs comparatively from the ‘invisible hand’ theory (free market theory) where prices are regulated by the forces of supply and demand in the market.
Furthermore, in the labour theory of value, the price of a product could differ if the labour involved is complex or simple such as assembling a watch as opposed to building a chair respectively. To illustrate, one complex hour of labour would constitute to five abstract hours while one unskilled hour would only correspond to one abstract hour (CAUSA Foundation, 2009). Thus, the labour theory of value could be described as converting simple or complex labour hours into prices. On the other hand, the theory of surplus value illustrates inequalities in the division of revenue between a proletariat and capitalist (Sleeper, 1983).
In this theory, Marx states that the working day comprises of two periods in a capitalistic economy (CAUSA Foundation, 2009). These periods could be classified as necessary labour and surplus labour. The former period is required of the worker in order to cover their living expenses such as food, clothing and shelter while the latter would be profits belonging to the capitalist (CAUSA Foundation, 2009; Marx, 1982). Karl Marx strongly opposed this division of revenue as it meant that the proletariat would only receive a small portion of their wage while the surplus of this wage turns into profits for the capitalist (Marx, 1982).
Karl Marx suggests that workers should receive their complete share of wages. Hence, no profits would be made so as to create a utopic society though this had a direct impact on consumers, firms and governments which operated in accordance to Marxist theories which would be elaborated on in the following paragraphs. In a real world example of the USSR, consumers could not receive goods and services they demanded as production of goods would be centrally planned with a specified quota requirement so as to maintain an equilibrium between the production and distribution of goods (Noebel, 2006).
Therefore, it could be said that there was an inefficiency to converge supply with consumer demands. In addition, due to the price of a product being solely based on labour hours, a competitive business environment may not be evident and the quality of a product could be comprised as vast amounts of labour hours may not necessarily constitute to quality assured products (Sleeper, 1983). As a result, these products may not be appealing to consumers though they may not have any substitutes.
According to the Concise Encyclopaedia of Economics (Prychitko), this economy closely resembles a monopoly, where the goods or services sold could be described as homogeneous and consumers do not have any substitutes. Therefore, it could be said that having a centrally planned economy restricts consumers from receiving the goods and service they require, quality assured goods and substitutes. On the other hand, consumers could potentially benefit from a centrally planned economy as products would be generally cheaper as the cost of raw materials may be forgone since price is determined by labour hours according to the theory of value.
In the aspect of firms in the USSR, there could have been a majority of poorly motivated staff as every staff member received identical wages irrespective of position and did not obtain any additional incentives if they worked arduously as compared to their peers (Grossman, 1977). Thus, this could potentially impact the quality of goods produced from firms. Additionally, it is imperative to note that the USSR primarily entailed state-owned firms and did not incorporate the private sector until they implemented the New Economic Policy where only a small number of private firms were permitted alongside nationalized industries (Gregory, 2004).
Furthermore, these firms were only allocated a specific amount of goods which they could produce and distribute which were usually quoted by a central body. As a result, instead of allowing the supply of a product to be determined by the demand of the market, the central body over and under produced goods which lead to an inefficiency in production (Berliner, 1957). Also, due to the lack of incentives and profits from these businesses, a second economy emerged.
This economy might have been the black market where goods and services are exchanged illegally though this was permitted by the central body through bribes and corruption (Grossman, 1977). It is worth recognising that market economies may provide supplementary benefits and opportunities for economic growth as opposed to centrally planned economies. This could be illustrated with reference to the agricultural industry in the USSR where only 4% of arable land is privately owned yet produces 25% of the total crop output for the entire USSR (CAUSA Foundation, 2009).
In terms of the USSR government, it could be difficult for governments to provide precise quotas on the production of goods that would correspond sufficiently to the market’s demand which might precede to an inefficiency in production with possibilities of over and under production of goods (Erikson, 1991). On the other hand, it could be argued that if the government supplies goods in the quantity it is demanded, the issue of scarcity could be tackled effectively though in reality this may not be feasible (Erikson, 1991).
Another advantage for the government would be that they could effectively control the distribution of wealth and income so that the gap between proletariats and bourgeoisies diminishes (SSAG, 2007; Sleeper, 1983). Last of all, having a centrally planned economy would facilitate the government to formulate an accurate long term plan as economic variables could be closely monitored and influenced by a central body. In all three aspects it could be said that in the centrally planned economy of the USSR, firms and consumers might not be able to influence the economy.
Thus, the government could have absolute control of how the economy functions, though in the example of the USSR, the government may have primarily focused on macroeconomics (SSAG, 2007). On another note, the theory of a free market permits consumers and firms to influence how an economy functions as consumers dictate the supply of goods in a market while firms react to the changes in consumer behaviours and control prices in accordance to the laws of supply and demand (Joyce, 2001).
Thus, the implementation of various economic theories could have an impact on consumers, firms and governments to a large extent depending on the type of economic system they operate in. Therefore, it could be evident that an economic theory may be necessary for consumers, firms and governments if they are in the free market system though in a centrally planned economy, the requirement of an economic theory would only be limited to the government as they control and monitor the economic environment and its variables closely.
Economic theories are not necessarily employed by governments, they could also be employed by consumers and firms. In terms of consumers, they would need to understand the theory of supply and demand when they make investments or purchases. For example, if prices are relatively high due to the market being niche and contemporary which can be often seen in the technological sector, it could be wise to hold a purchase of a product until the market obtains more manufacturers which might cause a reduction of prices in products.
Hence, the price of a product could decrease when the market saturates as opposed to when a product is first introduced to the market. Consequently, this theory would only be applicable to free markets as the theory of supply and demand is controlled by the government in a centrally planned economy. Similarly, firms are required to comprehend the theory of supply and demand to evade an over or under production of goods which could potentially lead to a drop in revenues.
In addition, they would have to understand the relationship between the income of their target markets and the demand for a given product at a specified price in order to find out if the demand for their product will augment or decline in response to changes in income respectively (Starkey and Dolan, 2006). In a free market, it is essential that firms understand consumer behaviour and employ various economic theories in order to promote consistent growth and gain market share. These theories correspond to free market economies as a central body dictates the quantity of goods and services supplied in a centrally planned economy.
In conclusion, it could be evident that economic theories could significantly influence the economic progress of a nation which could be observed with Marxist theories. There could be advantages and disadvantages with any given theory as they are fabricated to comprehend how a specific economy functions (Starkey and Dolan, 2006). It is important to take into consideration that an economy is a dynamic environment and could be subjected to a kaleidoscope of economic variables which may vary at different periods of time thus, the evolution of economic theory from classic economics to socialist and neoclassical economics.
Additionally, economic theories could be an essential tool for consumers and firms to make rational decisions if they operate within a free market system as the centrally planned economies are generally influenced by a central body rather than consumers and firms. References Berliner, J. (1957) Factory and Manager in the USSR [online]. Massachusetts: Harvard University Press. [Accessed 17 April 2013]. Bierens, H. and Swanson, N. (1998) The Econometric Consequences of the Ceteris Paribus Condition in Economic Theory [online].
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