VSAT 2022

What is an Economic Theory?

An economic theory is a body of concepts and precepts that describes how various economies work. An economist may use theories for a variety of reasons, depending on their specific function. For instance, some theories attempt to explain certain economic events, such as inflation or supply and demand, as well as the reasons behind them.

Other economic theories could offer a way of thinking that enables economists to assess, understand, and forecast the actions of financial markets, businesses, and governments. However, economists frequently use theories to the problems or events they see in order to gain meaningful insight, offer explanations, and come up with viable remedies.


Economics Nobel Prize Winners

The Bank of Sweden created the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 1968, and it was first given in 1969, more than 60 years after the first Nobel Prizes in Economics were distributed. Although it is not officially a Nobel Prize, the Prize in Economic Sciences is associated with it; its winners are announced alongside the Nobel Prize Economics honorees, and it is delivered during the Nobel Prize Award Ceremony. The Royal Swedish Academy of Sciences bestows it in Stockholm.


Types of Nobel Prizes in Economics

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been given to 86 laureates 52 times, each of whom has investigated and put to the test a number of innovative approaches. Here are six economic ideas that have won awards that you should be aware of.

  • The Black-Scholes theory earned Robert Merton and Myron Scholes the 1997 Nobel Prize in Economics.

  • James M. Buchanan created the public choice theory, for which he was awarded the Nobel Prize in 1986.

  • The prize was given to John C. Harsanyi, John F. Nash Jr., and Reinhard Selten in 1994 for their work on the theory of non-cooperative games.

  • The asymmetric information study of George A. Akerlof, A. Michael Spence, and Joseph E. Stiglitz was honoured by the Nobel Prize committee in 2001.

  • The prize was given to Daniel Kahneman in 2002 for his work on behavioural finance.

  • The award for research and analysis on the economics of common-pool resources was given to Elinor Ostrom in 2009.


Economic Theories and Models

  • Distinguished Mention: Black-Scholes Theorem

The Black-Scholes theorem, a crucial idea in contemporary finance theory that is frequently employed for evaluating European options and employee stock options, earned Robert Merton and Myron Scholes the 1997 Nobel Prize in Economics.

Despite the formula's complexity, investors may use an online options calculator to obtain the results by entering the strike price, the price of the underlying stock, the period to expiry, the volatility, and the risk-free interest rate of the market for each option. Fischer Black made a contribution to the theory as well, but he was unable to accept the award due to his passing in 1995.

  • The Theory of Public Choice

This theory seeks to explain the reasoning behind public policy decisions. This entails the engagement of the general public, elected leaders, political groups, and society's bureaucracy. With Gordon Tullock, James M. Buchanan Jr. created the public choice theory.

In 1986, the prize was awarded to James M. Buchanan Jr. for "developing the contractual and constitutional grounds for the theory of economic and political decision-making."

  • Theoretical Game Theory

The study of strategic interaction is analysed in game theory, a subfield of which is the theory of non-cooperative games. When players reach non-binding agreements, the game is considered non-cooperative. While none of the participants knows how the other participants will actually behave, everyone makes decisions based on how they anticipate the other participants to behave.


"For their pioneering investigation of equilibria in the theory of non-cooperative games," the academy gave the 1994 prize to John C. Harsanyi, John F. Nash Jr., and Reinhard Selten. Analysis by Harsanyi, Nash, and Selten.

The Nash Equilibrium, a strategy for forecasting the result of non-cooperative games based on equilibrium, was one of Nash's most significant achievements. Nash explains his idea in his PhD dissertation, "Non-Cooperative Games," from 1950. Prior studies on two-player, zero-sum games were developed by The Nash Equilibrium.


In order to further the area of information economics, Selten extended Nash's results to dynamic strategic interactions while Harsanyi applied them to situations with insufficient information. Their contributions have influenced new fields of study and are frequently used in economics, such as in the theory of industrial organisation and the analysis of oligopoly.

  • Information Asymmetry

This field of study is often referred to as information failure. It happens when one side of an economic transaction has a significant advantage in knowledge over the other. This phenomenon usually occurs when the buyer is less knowledgeable than the vendor of an item or service. The opposite dynamic, however, may also be feasible under specific circumstances. Asymmetric information is present in nearly every business transaction.


Joseph E. Stiglitz, A. Michael Spence, and George A. Akerlof shared the award in 2001 "for their analysis of markets with asymmetric knowledge." The trio demonstrated that economic theories based on complete knowledge are frequently flawed. This is due to the fact that in a transaction, one side frequently possesses superior knowledge. Our comprehension of information asymmetry has increased our understanding of the function of different markets and the significance of corporate openness. Although we now take these ideas for granted since they are so common, when they were originally introduced, they were revolutionary.

  • Asymmetric Analysis

This field is also known as information failure. It occurs when one participant in an economic transaction has much more knowledge than the other. This phenomenon often occurs when the supplier of an item or service has more expertise than the customer. However, in rare instances, the inverse dynamic may be feasible. Almost all economic interactions contain asymmetric knowledge.


George Akerlof, A. Michael Spence, and Joseph E. Stiglitz were awarded the prize in 2001 "for their analysis of markets with asymmetric knowledge." The trio demonstrated that economic models based on complete knowledge are frequently incorrect. This is because one participant in a transaction frequently has greater information.


Understanding information asymmetry has enhanced our understanding of how different markets operate and the significance of corporate transparency. These principles are now so common that we take them for granted, but they were revolutionary when they were initially conceived.

Assessment by Akerlof, Spence, and Stiglitz

Akerlof demonstrated how information asymmetries in the used automobile market, where sellers are better aware of the calibre of their vehicles than purchasers, may lead to the emergence of a lemon market (a concept known as "adverse selection"). The Market for "Lemons": Quality Uncertainty and the Market Mechanism, a 1970 journal article by Akerlof, is a crucial work associated with this award.


The main topic of Spence's study was signalling, or the process through which more knowledgeable market players might instruct less knowledgeable ones. He demonstrated how job seekers might tell potential employers about their expected productivity by indicating their level of schooling, as well as how businesses can let investors know about their profitability by paying dividends.


Stiglitz demonstrated how insurance firms might identify which clients pose a higher chance of racking up expensive bills. This procedure was known as screening. Stiglitz claims that varied deductible and premium combinations lead to asymmetric knowledge.

  • Accounting for Behaviour

Behavioural economics takes the form of behavioural finance. It researches the psychological biases and effects that have an impact on the actions and choices of both investors and financial experts. These factors tend to explain a variety of market oddities, particularly those that exist in the stock market. The price of securities may also change dramatically, rising or falling.

Daniel Kahneman, a psychologist, won the prize in 2002 "for integrating discoveries from psychological research into economic science, notably concerning human judgement and decision-making under ambiguity."

The Work of Kahneman

As the economic theory of anticipated utility maximisation would imply, Kahneman demonstrated that people do not always behave in their own best interests. This idea is essential to behavioural finance. The study discovered prevalent cognitive biases that lead people to utilise flawed thinking to arrive at illogical judgments. The anchoring effect, the planning fallacy, and the illusion of control are a few of these biases.

Amos Tversky, with whom he collaborated on his study, was not qualified to accept the award because of his passing in 1996.

  • Handling Common Pool Resources (CPRs)

Common pool resources (CPRs) are assets that are not held by a single company. Instead, they are kept by the government or assigned to properties that are owned privately but made accessible to the general public. Forests, canals and water basins, and fishing areas are examples of CPRs (also known as commons), which are resources that are accessible to anyone but have a limited quantity.


"The Tragedy of the Commons," written by ecologist Garrett Hardin, was published in Science in 1968. In regard to these resources, he discussed the overpopulation of the human species in his study. Hardin predicted that everyone would make decisions based on their own interests, leading them to consume as much as they could. This would make it even more difficult for others to locate these resources.


Elinor Ostrom, a professor of political science at Indiana University, became the first female winner of the award in 2009. She was given it in recognition of her understanding of economic governance, particularly the commons.

  • Ostrom's Pioneering Investigations

Ostrom's study shows how people use communal property rights to manage resources, including water supplies, fish, lobster populations, and grasslands. She demonstrated that when individuals share a resource, the tragedy of the commons, which is now dominant, is not the only conceivable or even most likely conclusion.


Ostrom demonstrated that, as long as persons who utilise a resource are physically close to it and have relationships with one another, CPRs may be efficiently managed cooperatively, without governmental or private control.


As a result of their lack of connections with the community and lack of familiarity with local conditions and traditions, outsiders and government organisations may mismanage shared resources. Those who are part of the community and have a voice in resource management, on the other hand, will self-police to make sure that everyone abides by the rules.


Advanced Economic Theory

The International Monetary Fund (IMF) refers to the most developed nations in the world as having an advanced economy. An advanced economy is typically defined as having a high level of per capita income, a very significant degree of industrialisation, a diverse export base, and a financial sector that is integrated into the global financial system. While there is no established numerical convention to determine whether an economy is advanced or not.

Keynesian economics, Neoclassical economics, and Marxian economics are the three major economic theories. Other economic theories include monetarism, institutional economics, constitutional economics, and so on.


Conclusion

Each of the hundreds of Nobel Memorial Prize winners in Economics has made great contributions to the subject, and the other award-winning ideas are also worth learning about. Working understanding of the ideas discussed here, on the other hand, can help you position yourself as someone who understands the economic principles that are central to our lives today.

FAQs on Economic Theory

1. Economic theories are hypothetical. Discuss.

An economic model is a fictitious environment with several variables devised by economists to aid in the understanding of various elements of an economy and human behaviour. The supply and demand model is one of the most well-known and classic examples of an economic model. According to the concept, a product's price will rise as demand grows but fall when supply does. Furthermore, it asserts that prices will rise and vice versa when consumer demand for a certain good rises.

2. How are economic theories used in the real world?

Economists research how businesses are structured within sectors and how those businesses compete. Economists examine investments, risks, and savings. Economists research how domestic and international policies affect commerce. Economists research both the labour market's worker supply and its employer demand. Farmers lower the crop's price as the output of the corn crop rises, so that they may sell more of their harvest. When developing predictions about an item in the real world, such as what will happen to Maggie's consumption when its price rises, economic theories are often applied.

3. What is the main aim of economic theory?

Economic links are being investigated. Its primary aims are to analyse and justify the behaviour of the different economic components. The two primary divisions in the corpus of economic theory are positive theory and welfare theory. The positive theory attempts to study how the economy runs without regard for ultimate goals when assessing whether or not the outcomes are beneficial. The primary goal of welfare theory is to evaluate the economic system in terms of moral ideals that are independent of economic analysis.

4. Are economic theories scientific?

Economics is a social science, yet it is not founded on scientific principles. Economics is a social science that describes the elements that determine the optimal allocation of resources given societal budget restrictions. The scientific method is a method of describing how the world works. The application of the scientific method to economic analysis is referred to as positive economics. The scientific method is the process through which economic phenomena are studied, explained, and analysed. Models are used in the discipline to record the connections between variables for the purposes of analysis and forecasting.

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