- 14 March 2011
- Posted by: Puneet Khurana
- Category: Uncategorized
Often in the classrooms Economics is taught to us in a very scientific manner. It tries and establish generalized theories that can be used to explain economic phenomena.
To develop such a theory, we start with postulates and assumptions and from then on all the conclusions are derived by logical and mathematical calculations. For example lets look at the “theory of perfect competition” which in a very newton-ian way is derived by the equilibrium between the supply and demand. The theory also holds that the equilibrium point is reached when each firm produces at a level where its marginal cost is equal to market price and every buyer buys an amount whose marginal utility is also the market price and then with equally sophisticated mathematical applicability, it proves that equilibrium position maximize the benefit of all participants.
All this is fine and sounds perfect but here in lies the fallacy : The assumptions we start with are not real life based and yet every time we try to explain real life outcomes with such economic theories ( and fail badly) which themselves are based on unrealistic assumptions.
Postulates like large enough number of buyers so that no individual buyer or seller can influence the market, homogeneous and divisible products and more importantly the postulate of perfect knowledge are what this theory is based on and yet we all agree that the assumptions are unrealistic.
This is where I find the theory of Karl Popper and George Soros very useful. Popper who elegantly and convincingly have argued the idea of imperfect understanding and George Soros who reiterated Karl popper in someways but developed an equally powerful theory of reflexivity which explains the circularity between the actual state of affairs and the participants who try and understand these state of affairs but then also change the situations by acting according to their understanding leading to a uncertainty and unpredictability of the events.
The idea that demand and supply curves are independent and then theories developed on this idea are false primarily because they incorporate the participant’s expectations about the events that are shaped by their own expectations.
Just like in financial markets, buy and sell decisions are based on expectations about future prices and the future prices are based on present buy and sell decisions.Anyone who is associated with the markets can appreciate the fact that trends are reinforcing i.e. the buyers are attracted when the prices are rising in anticipation of further rises and similarly sellers in decreasing price market, and these trends cannot be reinforcing if the demand and supply functions were independent of market prices. Hence the fallacy in the economic theories.
Besides the above mentioned problem of basing decisions and forecasts of reality using models with faulty assumptions is just one of the many troubles which academic economics face. I will mention the remaining in another article in future…