Methods of Economic Analysis:

An economic theory derives laws or generalizations through two methods:

(1) eductive Method and (2) nductive Method.

%hese two ways of deriving economic generalizations are now explained in brief:

(1) Deductive Method of Economic AnaIysis:

%he deductive method is also named as analytical, abstract or prior method. %he deductive method
consists in deriving conclusions from general truths, takes few general principles and applies them draw
conclusions.

or instance, if we accept the general proposition that man is entirely motivated by self-interest. n
applying the deductive method of economic analysis, we proceed from general to particular.

%he classical and neo-classical school of economists notably, Ricardo, Senior, Cairnes, J.S. Mill, Malthus,
Marshall, Pigou, applied the deductive method in their economic investigations.

$teps of Deductive Method:

%he main steps involved in deductive logic are as under:

(i) Perception of the probIem to be inquired into: n the process of deriving economic generalizations,
the analyst must have a clear and precise idea of the problem to be inquired into.

(ii) Defining of terms: %he next step in this direction is to define clearly the technical terms used
analysis. Further, assumptions made for a theory should also be precise.

(iii) Deducing hypothesis from the assumptions: %he third step in deriving generalizations is deducing
hypothesis from the assumptions taken.

(iv) Testing of hypothesis: Before establishing laws or generalizations, hypothesis should be verified
through direct observations of events in the rear world and through statistical methods. (%heir inverse
relationship between price and quantity demanded of a good is a well established generalization).

Merits of Deductive Method:

%he main merits of deductive method are as under:

(i) %his method is near to reality. t is less time consuming and less expensive.

(ii) %he use of mathematical techniques in deducing theories of economics brings exactness and clarity in
economic analysis.

(iii) %here being limited scope of experimentation, the method helps in deriving economic theories.

(iv) %he method is simple because it is analytical.

Demerits of Deductive Method:

t is true that deductive method is simple and precise, underlying assumptions are valid.

(i) %he deductive method is simple and precise only if the underlying assumptions are valid. More often
the assumptions turn out to be based on half truths or have no relation to reality. %he conclusions drawn
from such assumptions will, therefore, be misleading.

(ii) Professor Learner describes the deductive method as 'armchair' analysis. According to him, the
premises from which inferences are drawn may not
hold good at all times, and places. As such deductive reasoning is not applicable universally.

(iii) %he deductive method is highly abstract. t require; a great deal of care to avoid bad logic or faulty
economic reasoning.

As the deductive method employed by the classical and neo-classical economists led to many facile
conclusions due to reliance on imperfect and incorrect assumptions, therefore, under the German
Historical School of economists, a sharp reaction began against this method. %hey advocated a more
realistic method for economic analysis known as inductive method.

(2) Inductive Method of Economic AnaIysis:

nductive method which also called empirical method was adopted by the "Historical School of
Economists". t involves the process of reasoning from particular facts to general principle.

%his method derives economic generalizations on the basis of (i) Experimentations (ii) Observations and
(iii) Statistical methods.

n this method, data is collected about a certain economic phenomenon. %hese are systematically
arranged and the general conclusions are drawn from them.

or exampIe, we observe 200 persons in the market. We find that nearly 195 persons buy from the
cheapest shops, Out of the 5 which remains, 4 persons buy local products even at higher rate just to
patronize their own products, while the fifth is a fool. From this observation, we can easily draw
conclusions that people like to buy from a cheaper shop unless they are guided by patriotism or they are
devoid of commonsense.

$teps of Inductive Method:

%he main steps involved in the application of inductive method are:

(i) Observation.

(ii) Formation of hypothesis.

(iii) Generalization.

(iv) Verification.

Merits of Inductive Method:

(i) t is based on facts as such the method is realistic.

(ii) n order to test the economic principles, method makes statistical techniques. %he inductive method is,
therefore, more reliable.

(iii) nductive method is dynamic. %he changing economic phenomenon are analyzed and on the basis of
collected data, conclusions and solutions are drawn from them.

(iv) nduction method also helps in future investigations.

Demerits of Inductive Method:

%he main weaknesses of this method are as under:

(i) f conclusions drawn from insufficient data, the generalizations obtained may be faulty.

(ii) %he collection of data itself is not an easy task. %he sources and methods employed in the collection
of data differ from investigator to investigator. %he results, therefore, may differ even with the same
problem.

(iii) %he inductive method is time-consuming and expensive.

oncIusion:

%he above analysis reveals that both the methods have weaknesses. We cannot rely exclusively on any
one of them. Modern economists are of the view that both these methods are complimentary. %hey
partners and not rivals. AIfred MarshaII has rightly remarked:

"nductive and Deductive methods are both needed for scientific thought, as the right and left foot are
both needed for walking.

We can apply any of them or both as the situation demands.

&804725479,3.0412.740.4342.8

Micro economics has many theoretical and practical importance.ue to this even theneo-
classicaleconomists had concentrated on micro economics.Although Keynes popularised
macro-economics,the importance of micro-economics has not declined.%he importance of
micro-economics can be analysed on the basis of following headings:

1. Understand the working the economy:%he knowledge of micro economics is
indispensable to know the working of the economy.%he economy consists of public
and private sector. %he analysis of individual industries, wages and salary
determination, individuals taxes, international trade all rests on micro-
economic foundations. Similarly, most of the government activities can be analysed
with same concepts applied to private sector.As for example,price determination by
post office,cost of national defence.etc

2. Efficient allocation of resources:Micro economics assumes that consumers
and products act rationally.%he producer surveys possible course of
action,measures the expected benefits and costs of each course action.He then
selects those courses of action which promise greatest benefits over costs.%he
rational behaviour leads to best use of resources.Micro -economics teachers to
make best use of resources.t suggests how to achieve a given objective with fewest
resources or at least cost.Micro-economics says how resources are allocated in the
production of goods and service.t says which commodity is to produce.How much to
produce and why to produce.


3. Useful in business decision making :Micro-economics is applied to analyse
faced by business executive.%he price theory in the service of business executive
is known as managerial economics.t contributes improved decision making in the
areas of demand analysis,optimal production decision,pricing decision to maximise
profit.t guides business men to determine the price of different goods and factors of
production.

Definition:

"%he term consumer's equilibrium refers to the amount of goods and services which the consumer may
buy in the market given his income and given prices of goods in the market".

%he aim of the consumer is to get maximum satisfaction from his money income. Given the price line or
budget line and the indifference map:

"A consumer is said to be in equilibrium at a point where the price line is touching the highest
attainable indifference curve from below".

onditions:

%hus the consumer's equilibrium under the indifference curve theory must meet the following two
conditions:

irst: A given price line should be tangent to an indifference curve or marginal rate of satisfaction of good
X for good Y (MRS
xy
) must be equal to the price ratio of the two goods. i.e.

MR$
xy
= P
x
/ P
y

$econd: %he second order condition is that indifference curve must be convex to the origin at the point of
tangency.

Assumptions:

%he following assumptions are made to determine the consumer's equilibrium position.

(i) RationaIity: %he consumer is rational. He wants to obtain maximum satisfaction given his income and
prices.

(ii) UtiIity is ordinaI: t is assumed that the consumer can rank his preference according to the
satisfaction of each combination of goods.

(iii) onsistency of choice: t is also assumed that the consumer is consistent in the choice of goods.

(iv) Perfect competition: %here is perfect competition in the market from where the consumer is
purchasing the goods.

(v) TotaI utiIity: %he total utility of the consumer depends on the quantities of the good consumed.

ExpIanation:
%he consumer's consumption decision is explained by combining the budget line and the indifference
map. %he consumer's equilibrium position is only at a point where the price line is tangent to the highest
attainable indifference curve from below.
(1) Budget Line $houId be Tangent to the Indifference urve:
%he consumer's equilibrium in explained by combining the budget line and the indifference map.
Diagram/igure:

n the diagram 3.11, there are three indifference curves C

1
, C
2
and C
3
. %he price line P% is tangent to
the indifference curve C
2
at point C. %he consumer gets the maximum satisfaction or is in equilibrium at
point C by purchasing OE units of good Y and OH units of good X with the given money income.
%he consumer cannot be in equilibrium at any other point on indifference curves. For instance, point R
and S lie on lower indifference curve C
1
but yield less satisfaction. As regards point U on indifference
curve C
3
, the consumer no doubt gets higher satisfaction but that is outside the budget line and hence
not achievable to the consumer. %he consumer's equilibrium position is only at point C where the price
line is tangent to the highest attainable indifference curve C
2
from below.
(2) $Iope of the Price Line to be EquaI to the $Iope of Indifference urve:
%he second condition for the consumer to be in equilibrium and get the maximum possible satisfaction is
only at a point where the price line is a tangent to the highest possible indifference curve from below. n
fig. 3.11, the price line P% is touching the highest possible indifferent curve C
2
at point C. %he point C
shows the combination of the two commodities which the consumer is maximized when he buys OH units
of good X and OE units of good Y.
Geometrically, at tangency point C, the consumer's substitution ratio is equal to price ratio P
x
/ P
y
. t
implies that at point C, what the consumer is willing to pay i.e., his personal exchange rate between X and
Y (MR$
xy
)is equal to what he actually pays i.e., the market exchange rate. So the equilibrium condition
being P
x
/ P
y
being satisfied at the point C is:
Price of X / Price of Y = MR$ of X for Y
%he equilibrium conditions given above states that the rate at which the individual is willing to substitute
commodity X for commodity Y must equal the ratio at which he can substitute X for Y in the market at a
given price.
(3) Indifference urve $houId be onvex to the Origin:
%he third condition for the stable consumer equilibrium is that the indifference curve must be convex to
the origin at the point of equilibrium. n other words, we can say that the MRS of X for Y must be
diminishing at the point of equilibrium. t may be noticed that in fig. 3.11, the indifference curve C
2
is
convex to the origin at point C. So at point C, all three conditions for the stable-consumer's equilibrium
are satisfied.
$umming up, the consumer is in equilibrium at point C where the budget line P% is tangent to the
indifference C
2
. %he market basket OH of good X and OE of good Y yields the greatest satisfaction
because it is on the highest attainable indifference curve. At point C:
MR$
xy
= P
x
/ P
y