The basic analytical framework for an economic theory consists of five aspects or steps:
1. Specification of Economic Environments
The first step for studying an economic issue is to specify the economic environment.
The specification on economic environment can be divided into two levels: 1) description of the economic environment, and 2) Characterization of the economic environment.
To perform these well, the description is a job of science, and the characterization is a job of art. The more clear and accurate the description of the economic environment is, the higher the possibility is of the correctness of the theoretical conclusions. The more refined the characterization of the economic environment is, the simpler and easier the arguments and conclusions will obtain.
Modern economics provides various perspectives or angles to look at real world economic issues. An economic phenomenon or issue may be very complicated and be affected by many factors. The approach of characterizing the economic environment can grasp the most essential factors of the issue and take our attention to the most key and core characteristics of an issue so that we can avoid unimportant details. An economic environment usually consists of
(1) A number of individuals,
(2) The individuals' characteristics, such as preferences, technologies, endowments, etc.
(3) Informational structures, and
(4) Institutional economic environments that include fundamental rules for establishing the basis for production, exchange, and distribution.
2. Imposition of Behavior Assumptions
The second step for studying an economic issue is to make assumptions on individuals' behavior. Making appropriate assumptions is of fundamental importance for obtaining a valuable economic theory or assessment. A key assumption modern economics makes about an individual's behavior is that an individual is self-interested. This is a main difference between individuals and other subjects. The self-interested behavior assumption is not only reasonable and realistic, but also has a minimum risk. Even this assumption is not suitable to an economic environment; it does not cause a big trouble to the economy even if it is applied to the economy. A rule of a game designed for self-interested individuals is likely also suitable for altruists, but the reverse is likely not true.
3. Adoption of Economic Institutional Arrangement
The third step for studying an economic issue is to adopt the economic institutional arrangements, which are also called economic mechanisms, which can be regarded as the rules of the game. Depending on the problem under consideration, an economic institutional arrangement could be exogenously given or endogenously determined. For instance, when studying individuals' decisions in the theories of consumers and producers, one implicitly assumes that the undertaken mechanism is a competitive market mechanism takes it as given. However, when considering the choice of economic institutions and arguing the optimality of the market mechanism, the market institution is endogenously determined. The alternative mechanisms that are designed to solve the problem of market failure are also endogenously determined. Economic arrangements should be designed differently for different economic environments and behavior assumptions.
4. Determination of Equilibria
The fourth step for studying an economic issue is to make trade-off choices and determine the "best" one. Once given an economic environment, institutional arrangement, and other constraints, such as technical, resource, and budget constraints, individuals will react, based on their incentives and own behavior, and choose an outcome from among the available or feasible outcomes. Such a state is called equilibrium and the outcome an equilibrium outcome. This is the most general definition an economic \equilibrium".
5. Evaluations
The fifth step in studying an economic issue is to evaluate outcomes resulting from the undertaken institutional arrangement and to make value judgments of the chosen equilibrium outcome and economic mechanism based on certain criterion. The most important criterion adopted in modern economics is the notion of efficiency or the \first best". If an outcome is not efficient, there is room for improvement. The other criterion include equity, fairness, incentive-compatibility, informational efficiency, and operation costs for running an economic mechanism. In summary, in studying an economic issue, one should start by specifying economic environments and then study how individuals interact under the self-interested motion of the individuals within an exogenously given or endogenously determined mechanism. Economists usually use \equilibrium," \efficiency", \information", and \incentive-compatibility" as focal points, and investigate the effects of various economic mechanisms on the behavior of agents and economic units, show how individuals reach equilibria, and evaluate the status at equilibrium. Analyzing an economic problem using such a basic analytical framework has not only consistence in methodology, but also in getting surprising (but logically consistent) conclusions.
Wilfykil answered the question on March 20, 2019 at 06:20