The reason behind the economic theory is that investors and consumers are rational and "efficient machines," meaning that they make the best decisions for themselves. In comparison to the conduct expected in most economic theories, laboratory test demonstrates that actual investor behavior is far more sophisticated.
As a result, an increasing number of economists and psychologists are studying real (or laboratory) economic behavior rather than the normative prediction conduct supported by various models. However, economists have revolutionized economic theories a lot. Let’s learn more about economic theory and its types.
What is an economic theory?
An economic theory is a set of concepts and principles that define how various economies work. An economist may use theories for a variety of goals, depending on their specific function. Some theories, for example, seek to explain why certain economic events, such as inflation or supply and demand, occur.
Other economic theories may give a framework of thinking that helps economists to evaluate, understand, and forecast the behavior of financial markets, companies, and governments.
However, economists frequently apply theories to the difficulties or events they see to gain helpful insight, give explanations, and develop viable solutions to problems.
(Suggested read: Economic Institutions: Formation and Classification)
Types of economic theory
Market socialism is a theoretical notion (model) of an economic system in which the means of production (capital) are held by the public or collectively, and resource distribution follows market norms (product-, labor -, capital-markets).
When it comes to current socialist economies, the phrase is usually used more loosely to encompass both systems that come close to it in the strictest sense (as in the Yugoslav system after the 1965 reform) and those that replace commands and physical distribution of producer goods with financial controls and incentives as instruments of central planning (regulated market, as in the Hungarian 'new economic mechanism' after the 1968 reform).
Classical economics is a broad term that refers to the dominant school of economic theory in the 18th and 19th centuries. The originator of classical economic theory, according to most, is Scottish economist Adam Smith. However, earlier contributions were made by Spanish scholastics and French physiocrats.
David Ricardo, Thomas Malthus, Anne Robert Jacques Turgot, John Stuart Mill, Jean-Baptiste Say, and Eugen Böhm von Bawerk were other important contributors to classical economics.
Most national economies were administered by a top-down, command-and-control, monarchic government policy framework before the emergence of classical economics. Many of the most well-known ancient thinkers, like Smith and Turgot, developed their ideas as alternatives to the protectionist and inflationary policies of mercantilist Europe.
Economic and, eventually, political liberty were intricately tied with classical economics. You may learn more about the difference between classical and neo-classical economics from here.
The Malthusian Theory of Population is a theory of population expansion that is based on arithmetic food supply growth. Thomas Robert Malthus proposed the hypothesis. He felt that by preventative and positive controls, a balance between population expansion and food supply could be created.
The Malthusian theory is the most well-known population theory. In 1798, Thomas Robert Malthus published his essay "Principle of Population," then in 1803, he revised several of his conclusions. The rapidly rising population of England, aided by a faulty Poor Law, severely upset him.
He believed England was on the edge of ruin, and he viewed it as his moral duty to warn his fellow people of the impending doom. He highlighted "the weird disparity between over-care in breeding animals and carelessness in breeding men."
According to Marxism, the conflict between social classes, notably the bourgeoisie, or capitalists, and the proletariat, or workers, determines economic relations in a capitalist economy and will eventually lead to revolutionary communism.
Karl Marx established Marxism, a social, political, and economic philosophy that emphasizes the struggle between capitalists and workers. Marxism is a social and political worldview that encompasses both Marxist class conflict theory and Marxist economics.
Karl Marx and Friedrich Engels' publication The Communist Manifesto, which lays out the idea of class struggle and revolution, was the first to openly define Marxism in 1848. Marxian economics focuses on capitalism's flaws.
Karl Marx and Friedrich Engels established Marxism, Ideology, and socioeconomic theory. It is the underlying concept of communism, holding that all people are entitled to enjoy the rewards of their labor but are unable to do so in a capitalist economic system that separates society into two classes: nonworking employees and non-working owners.
Marx referred to the ensuing position as "alienation," and he predicted that when workers reclaimed the results of their labor, alienation would be resolved and class distinctions would be eliminated.
According to Marxism, economic relations in a capitalist economy are defined by the struggle between social classes—specifically, the bourgeoisie, or capitalists, and the proletariat, or workers—and will finally lead to revolutionary communism.
The power relations between capitalists and labor, according to Marx, were essentially exploitative, culminating in class conflict. He predicted that the conflict would eventually culminate in a revolution in which the working class will topple the capitalist class and gain control of the economy.
(Also read: Introduction to Unit Economics)
Supply and demand
The economic connection between sellers and purchasers of various commodities is defined by the law of supply and demand.
According to supply and demand theory, the price of a product is determined by its availability and customer demand The law of demand and the law of supply is the foundations of the theory. The interaction of the two laws determines the real market price and volume of products.
Keeping the price high, on the other hand, might harm how purchasers perceive the product. If clients do not believe the product is worth the high price, they may choose a less expensive alternative. A higher price may result in decreased demand, which may result in a decrease in supply.
The Quantity Theory of Money is the cornerstone of monetarism. The hypothesis is an accounting identity, which means it must be correct. It states that the money supply multiplied by velocity (the rate at which money changes hands) matches the economy's nominal expenditures (the number of goods and services sold multiplied by the average price paid for them).
This equation is uncontroversial as an accounting identity. What is debatable is velocity. According to monetarist theory, velocity is typically steady, implying that nominal income is essentially a function of the money supply.
Nominal income fluctuations reflect changes in actual economic activity (the volume of products and services sold) as well as inflation (the average price paid for them).
Keynesian economics is a collection of theories advanced by John Maynard Keynes in his General Theory of Employment, Interest, and Money (1935–36) and other publications to give a theoretical foundation for government full-employment programs. It was the predominant school of macroeconomics and the dominant approach to economic policy in most Western countries until the 1970s.
While some economists think that allowing wages to fall to lower levels can restore full employment, Keynesians contend that firms will not hire people to manufacture items that cannot be sold.
Keynesianism is a "demand-side" theory that focuses on short-run economic fluctuations because it believes unemployment is caused by insufficient demand for goods and services.
New growth theory
The New Growth Theory (NGT) is focused on individuals' desires and needs as the driving element behind economic growth; people purchase, sell, and invest depending on their wants and needs, leading real GDP statistics to climb.
The theory is a novel take on its predecessor, neoclassical economics; although the latter is more concerned with external causes, NGT is primarily concerned with internal (human) aspects.
The New Growth Theory, perhaps, lays the most emphasis on the crucial aspect of information; intelligent people purchase, sell, and invest effectively, hence accelerating economic growth in a wiser and more meaningful manner. Knowledge, according to the NGT, is an (intangible) asset with the potential for exponential expansion.
Moral hazards theory
A moral hazard is an economic phenomenon that has been seen throughout history in which parties engage in contracts in ill faith.
Moral hazards frequently develop when an organization, such as a business, raises its risk exposure during a transaction to maximize profit because the entity may not have to bear the repercussions of taking on that risk.
In such a case, the risk is normally borne by the opposite party to the transaction. The phrase moral hazard refers to the assumption that a party takes the previously taken action in order to gain the most possible benefit without regard for moral problems
Tragedy of commons
The tragedy of the commons is an economic situation in which every individual has an incentive to use a resource, but at the expense of every other individual – and there is no means to prevent anybody from doing so. It began with the question of what would happen if each shepherd, acting in their self-interest, permitted their flock to graze on the common field.
If everyone acts in their seeming best interests, it leads to destructive over-consumption (all the grass is eaten, to the cost of everyone). The dilemma can also lead to underinvestment (since who is going to pay to sow fresh seed?) and, eventually, total resource depletion.
As the demand for the resource exceeds the supply, each person who consumes an additional unit immediately damages others — as well as themselves — by preventing others from reaping the advantages. In general, all persons can access the resource of interest without difficulty.
(Also read: 10 Factors Affecting Supply of a Product)