THE NATURE OF ECONOMIC THEORY

A theory expresses a causal relationship between cause and effect. It attempts to explain “why”. It consists of a set of definitions stating clearly what we mean by various terms, and a set of assumptions about the way in which the world behaves. The next step is to follow a process of logical deduction to discover what is implied by these assumptions. These implications are the prediction of a theory which can be tested by the process of observation and statistical analysis of the data. If the theory passes the test no consequent action is made necessary. If the theory is refuted by the fact, it is either amended in the light of newly acquired facts or is discarded in favour of a superior competing theory.
Economic theory is a theory in this sense. It is mean to be about the real world. Economic theory involves generalizations which are statements of general tendencies or uniformities of relationship among various elements of economic phenomena. A generalization is the establishment of a general truth on the basis of particular experiences. For example, the generalization that demand is ann inverse function of price expresses a relationship between price and demand, other things# remaining the same. If other things remain the same, the law of demand hold valid. If other things do not remain same, it stands refuted. The construction of a theory in economics involves the following steps.

• Selecting the problem—the problem to be investigated must be stated clearly. The narrower a problem to be investigated is, the better it would be for the researcher to conduct its investigation.
• Collection of data—this problem refers to collection of various data that is required for the investigation. For complex studies, it may take months. Many economic principles such as the law of diminishing returns are based on careful observation.
• Classification of data—this refers to grouping data according to their resemblances and differences and to note comparisons and contrasts.
• Formulating hypothesis—a hypothesis is a suggested answer to a problem by the aid of which we endeavour to explain facts by discovering their orderliness. The hypothesis arises from the observed facts, experience or previous knowledge of the researcher.
• Testing the hypothesis—hypothesis formulated should be such that deductions can be made from it and decision reached as to whether it explains the facts considered or not. The hypothesis should be tested by well-established techniques of logic and statistics which may be subjected to confirmation.
• Verification of the theory—the tested hypothesis or theory should be verified. If it turns out to be true, the theory is said to be confirmed or verified. The process of verification may be carried out by observation or by checking the consistency of the theory with related facts that are believed to be true. If a theory is proved to be wrong, it stands rejected or modified.