1. Roles of Economic Theory
An economic theory has three possible roles:
(1) It can be used to explain economic behavior and economic phenomena in the real world.
(2) It can make scientific predictions or deductions about possible outcomes and consequences of adopted economic mechanisms when economic environments and individuals' behavior are appropriately described.
(3) It can be used to refute faulty goals or projects before they are actually undertaken. If a conclusion is not possible in theory, then it is not possible in a real world setting, as long as the assumptions were approximated realistically.
2. Generality of Economic Theory
An economic theory is based on assumptions imposed on economic environments, individuals' behavior, and economic institutions. The more general these assumptions are, the more powerful, useful, or meaningful the theory that comes from them is. The general equilibrium theory is considered such a theory.
3. Limitation of Economic Theory
When examining the generality of an economic theory, one should realize any theory or assumption has a boundary, limitation, and applicable range of economic theory. Thus, two common misunderstandings in economic theory should be avoided. One misunderstanding is to over-evaluate the role of an economic theory. Every theory is based on some imposed assumptions. Therefore, it is important to keep in mind that every theory is not universal, cannot explain everything, but has its limitation and boundary of suitability. When applying a theory to make an economic conclusion and discuss an economic problem, it is important to notice the boundary, limitation, and applicable range of the theory. It cannot be applied arbitrarily, or a wrong conclusion will be the result.
The other misunderstanding is to under-evaluate the role of an economic theory. Some people consider an economic theory useless because they think assumptions imposed in the theory are unrealistic. In fact, no theory, whether in economics, physics, or any other science, is perfectly correct. The validity of a theory depends on whether or not it succeeds in explaining and predicting the set of phenomena that it is intended to explain and predict. Theories, therefore, are continually tested against observations. As a result of this testing, they are often modified, refined, and even discarded. The process of testing and refining theories is central to the development of modern economics as a science. One example is the assumption of perfect competition. In reality, no competition is perfect. Real world markets seldom achieve this ideal status. The question is then not whether any particular market is perfectly competitive, almost no one is. The appropriate question is to what degree models of perfect competition can generate insights about real-world markets. We think this assumption is approximately correct in certain situations. Just like friction-less models in physics, such as in free falling body movement (no air resistance), ideal gas (molecules do not collide), and ideal fluids, friction-less models of perfect competition generate useful insights in the economic world.
It is often heard that someone is claiming they have toppled an existing theory or conclusion, or that it has been overthrown, when some condition or assumption behind it is criticized. This is usually needless claim, because any formal rigorous theory can be criticized at anytime because no assumption can coincide fully with reality or cover everything. So, as long as there are no logic errors or inconsistency in a theory, we cannot say that the theory is wrong. We can only criticize it for being too limited or unrealistic.
What economists should do is to weaken or relax the assumptions, and obtain new theories based on old theories. We cannot say though that the new theory topples the old one, but instead that the new theory extends the old theory to cover more general situations and different economic environments.
Wilfykil answered the question on March 20, 2019 at 06:25