Economic Theory

Updated: Dec 1, 2020

Complexity economics is an alternative economic paradigm and modeling framework. In order to understand how it relates to standard economic theory, it is important to first understand a little about economic theories, science, and paradigms in general. This helps to essentially define the problem space that different economic theories have to try and solve. Because theories and paradigms may be different but they are all using the basic building blocks of science and logic to try and describe economic phenomena. Firstly we talk about the nature of abstraction and paradigms, discussing how theories are a conceptual form of abstraction. Recognizing that there is no formal definition of economics, we will lay down a working definition based on the conception of economics as the study of individual choice in the allocation of resources towards some valued end, and how these micro-level actions interact giving rise to macro level patterns of economic organization. From this definition, we go on to outline some of the major considerations involved in the study of economics, including trying to understand the logic behind the decision making of agents, theories of economic value and the idea of intrinsic and extrinsic value. We briefly touch upon different types of interactions between agents in terms of cooperation and competition. We discuss economic institutions with a quick look at their different structures. Lastly, we will talk about economic dynamics, the area of economics that tries to model and understand the behavior of economies over time.


In order to understand something in a coherent fashion, we need to create a model of it. If we want to try and understand something very complex like a national or even global economy, these models are going to involve a very high level of abstraction. An abstraction is a compact representation of a system that removes successive layers of detail in order to capture the underlying structure and functioning of the system. Theories are conceptual abstract models. All theories rest upon a set of assumptions. Nobody likes the term assumption, particularly not in science, but the fact is that we can’t question everything all of the time. We can, in practice, only question some things some of the time, and in order to do this, we need to start from something that we consider self-evident and without question. These assumptions are what are called axioms in mathematics, which is a premise so evident as to be accepted as true without question by the theory. A coherent set of assumptions might be called a paradigm. You cannot question the paradigm from within the theory because the theory is made of the paradigm. You have to go outside of the theory to question the paradigm. Within science, theories may be formalized by encoding them into a formal language.

A formal language that most people would be familiar with might be algebra. Algebra is the most common formal language used in standard economic theory, but there are many others. By formalizing theories, it is possible that they may be parsed by machines, meaning we can put them into computer code and harness the power of computation which has many benefits, particularly when we are dealing with very complex systems. So all economic theories are going to use some paradigm, that is, the set of assumptions, in order to build a theory that will describe some empirical phenomena considered part of the domain of economics. If they are successful, they may, or may not, go on to formalize this within a formal language. That would give it a certain rigor and endow it with computability.


We will also note that no theory is going to be perfect, but some will be more internally consistent, have greater rigor, be more efficient and better able to match the data than others. Because models are not perfect they will have a lifecycle, meaning we should always be working on developing better ones and retiring older ones, once we have these new models developed. Of course, this is not an orderly process. It is very messy in practice, but it is necessary for the science to develop and grow. As an example of this, we might cite the current situation within theoretical physics of what is called the standard model, which is a model of the fundamental particles of matter and their interactions, sometimes called the “theory of almost everything.” Although it has many achievements, this nickname is a tribute to its limitations in not being able to fully describe some very important empirical phenomena surrounding gravity and the expanding universe among others. The standard model is both used day in, day out by researchers and recognized as likely being just a stepping stone to a more fundamental and more inclusive model that researchers are at the same time working on under the name of the “theory of everything.” The point here is to recognize when a model is incomplete and to make that explicit.


The enterprise of science involves trying to interpret the world by developing models that have internal logical consistency and matching these to data. If we are engaged in an empirical science, objective empirical data should ultimately have the last say on everything. As long as the data is accurate if the world does not fit into our model, this is not a problem with the world. It is a problem with our model. Science will develop and grow most effectively when we are able to admit the limitations to our models and accept whichever ones work best as the current standard because at the end of the day science performs an important function within society. That function is to stay developing these models, providing society with the best tools to appropriately interpret empirical phenomena. If we can match models to data and everything is working, then we can hand them out to society with the appropriate warning signs on the side of the tin. Now that we have given some definition to the term theory and the general enterprise of science, we will begin to define what we mean when we refer to the domain of economics.


There is no widely accepted formal definition for the domain of economics. One of the most quoted definitions to economics is from the English economist Lionel Robbins who defined economics as “the science which studies human behavior as a relationship between (given) ends and scarce means which have alternative uses.” On this most basic level economics is defined as the study of how people use efficient means to achieve valued ends. From this perspective, economics is about how we choose to spend any available resource (such as our time or effort) in trying to achieve other things that we value more highly. This is of course not just on the micro level of the individual but also on the macro level, that is to say, how organizations and society at large use scarce resources to produce valuable commodities and distribute them among people. To flesh out our definition a bit further we might say: Economics is the study of individual choices in the allocation of resources and how these micro-level actions interact to give rise to macro level patterns of economic organization. The manifestation of all this activity is what we call an economy consisting of natural resources, technology, social and economic institutions.

Key Factors

Out of this definition, we can draw a number of the central areas of interest that any economic theory is going to have to give some basic description to. These fundamental aspects of economics are typically broken down into micro and macro. On the micro level, we need some account of these agents that are performing the act of economizing in the pursuit of their ends. We will also need some description of what we mean by this idea of economic value, as that is clearly central to this whole enterprise. We will need to take account of the fact that these agents are inevitably going to interact and these interactions are going to be another key part of the whole dynamic. This is all on the micro-level, which will inevitably lead to enduring macro-scale patterns of organization, such as whole economies. Thus, we will need to develop some model to these macro-scale phenomena. Lastly, this whole system is going to be changing over time and we will be interested in trying to model the patterns within this dynamic. We will spend the rest of this paper discussing each of these areas separately.


In most definitions of economics the idea of scarcity is fundamental, that is to say, that the resources that are being allocated are not infinite. There is some limit to their availability. Maybe a better way of putting this is simply to say that there will always be a hierarchy of value. In aggregate there will always be some things that we value more than others. Because we can not have everything, we have to make choices as to how we allocate our resources. We have to choose some things over others. As such, an economic framework will need some description as to the logic under which economic agents act and make choices with respect to the allocation of their resources in the pursuit of their ends. Economic agents wish to achieve their valued ends and economize in trying to achieve this. This is not to say that they will always try to maximize their total economic or financial value. This is clearly not the case. People sometimes take lower paid jobs because of work satisfaction or other factors, but they opted for this choice because it gives them the greatest overall value. Thus, we are using an abstraction where we are talking about value of any kind – social, cultural, financial, ecological etc. This helps to illustrate how economics is not really about money, products or capital. It is an abstract way of representing human behavior in terms of means and ends, based on the assumption that humans will strive for the highest valued ends at the lowest cost means. In so doing, they perform the act of economizing. This basic premise that people will adopt the most efficient means to achieving the highest value ends is not a particular economic theory or paradigm. It is part of the very fabric of the subject of economics, but different paradigms will go on to define value in different ways, some expansive and some reductive.

Theory of Value

This fact that there is scarcity and a hierarchy of outcomes leads us to the idea of value. The concept of value is one of the deepest and most complex concepts within all of the social sciences. The theory of value is a term that encompasses all economic theories that try to define what economic value is, where it comes from, and how to quantify it through some objective metric, what we might call a price. There are two fundamentally different conceptions of value within economic theory; one intrinsic and the other extrinsic. Intrinsic value is the value of a product that comes from the value of its inputs. Intrinsic value theory holds that the value of some commodity is inherent to it. That value is objective in that it is independent of any person’s individual evaluation of it, and thus from this perspective value is seen to be absolute. Extrinsic value can be seen as a value that is ascribed to a commodity due to the perception of society. Extrinsic value is a measure of the benefit provided by a good or service to an economic agent. Extrinsic value is captured in the concept of utility. It represents satisfaction experienced by the consumer of a good. A good then has value in that it satisfies human wants. Put very simply, from this perspective no absolute metric of value exists for any good or service except its price which is a reflection of its demand and supply position and not of any inherent quality of that item.


These economic agents will, during the course of their actions, come into contact with each other – that is to say, they will inevitably interact. Through these interactions, agents may find that they share a common pursuit, and by working together they can achieve those ends more efficiently than in isolation. Thus, they may work together by differentiating their activities with respect to each other, while all the time coordinating those activities towards the common end. In so doing, they will become interdependent. We call this type of interaction cooperation, and it is a fundamental type of social interaction. Inversely, these agents may find that their interests are in fact mutually exclusive. The end goal of one agent’s economic activity may be some finite resource that is the end goal of another’s, and both of these agents want as much of this resource as they can possibly attain given its finite nature. In such a case, we may well get a second type of fundamental social interaction; what is called competition. Also, we may get some form of both, what is called coopetition, a more complex dynamic involving elements of cooperation and competition. All of these different dynamics are studied within the area of game theory.


All of these interactions between agents are going to produce some enduring patterns that become solidified into what are called economic institutions. The idea of an institution is one of the basic concepts within all of the social science. Wikipedia has a good definition for a social institution: “Institutions are stable, valued, recurring patterns of behavior. As structures or mechanisms of social order, they govern the behavior of a set of individuals.” Examples of economic institutions are financial markets, corporations, banks, pension funds, insurance companies and all kinds of special purpose vehicles amongst many others. These institutions facilitate specific interactions by defining a set of rules so that these rules don’t have to be reinvented and renegotiated for every agent, for every new choice, or for every new interaction. Because of this, institutions enable automatic well-defined behavior and interactions that facilitate the coordination of economic activity. These enduring patterns that we call institutions are composed essentially of nothing more than the coordinated choices made by individual agents, their submission to follow predefined protocols. But they become embodied within abstract principles and rules that both enable and constrain individual agents within the institution. If institutions are primarily the aggregation of the choices made by economic agents, then a key consideration is how these choices are aggregated and distributed out, that is to say, what is the structure of the institution. Is this aggregation of choices concentrated within a small subset of the overall system, which would give it a centralized structure, such as a monopolistic market or command and control economy? Or is it more distributed, such as an oligopolistic market? Or is it fully distributed, such as a pure market economy, where producers and consumers have the freedom to make their own economic decisions without those decisions being guided or coordinated by some central controlling mechanism? These different institutional structures will give rise to very different properties to the overall system with different dynamics and different responses to the question of macro level resource allocation.

Economic Dynamics

The last major set of questions we will be interested in asking – and any major economic paradigm will have to try and answer – is that of economic dynamics. Economic dynamics is the study of how the structure and makeup of economic systems change over time. What we are doing here is asking are there patterns in the time series data to the state of the economy, and what logically consistent models can we create to match those patterns? This time series data is, of course, giving us a snapshot of the macrostate to the system at any given time. A macro-scale economy like that of a nation involves many interacting parts, from demographics to education, to employment, to international trade, to government policy, to corporate management, to the availability of capital in the financial markets and so on. Our theory will want to give some basic overall model of how these macro-level subsystems interact, and how they give rise to the overall state of the system at any given time.


If we remember back to our definition, this whole economic project is about striving for more of what we define as valuable. In a certain sense then, this whole enterprise of economics is setup to grow, but that idea of what growth means can be defined in different ways. Is it simply getting more of the things we value, as in more cars, more houses, more holidays? Or is it getting things of a higher value and quality, that is to say, instead of buying more watches I switch to a Rolex watch? Thus, instead of getting more of something I have moved up the value chain, and this moving up the value chain is one form of economic development. The end result of both of these will be a greater total value which we could define as growth, but they are both very different ways of achieving it, with different consequences. Thus, at the end of the day we want our model to aid us in reasoning about such questions as, how do economies grow? Why and when do they go into recession? Is there such a thing as distinct and objective economic stages of development? If so, what are they? And with respect to policy, how can we manage the system in order to achieve this development in an equitable and sustainable fashion?

Conclusions Finally, we will make a quick note about theories in general and economic theories in practice. Model and theories are not real. There is a real world and models do not exist there. They simply help us to interpret and give structure to it, sometimes even predict it. But this is not to say that models do not affect the world – quite the contrary. Within the social sciences, they have a very significant effect. We create these models. People adopt them and go around seeing the world through them and acting on them. In so doing, the models change the world. Thus, in creating models we are responsible for creating the future state of the system. Economic theories are translated into the design of economies through economic policy. If we build robust models and they are properly translated, things will work. If we build incomplete, inconsistent or inaccurate models there will be real consequences that we need to take responsibility for. And thus, as always, we should be careful when dealing with very abstract models and try to play safe. Playing safe means being aware of the assumptions that support the theory and making explicit why one has made those assumptions; when the assumptions are relevant and will work and under what circumstances they will fail, warning people not to use them under such circumstances and always keep in mind that models are not reality, they are simplified representations that aid in our reasoning.

Systems Innovation

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