Terms Beginning With 'c'

Ceteris paribus

  • November 06, 2020
  • Team Kalkine

What is meant by ceteris paribus?

Ceteris paribus quite literally translates to “all else left equal”. It is a phrase used in economics to analyse the impact of one factor on the variable of interest, by keeping all other factors constant. It is a tool used to single out the effects of one variable without changing other specifications of a model.

The phrase is commonly used while explaining economic cause and effect relationships. Whenever a determinant factor is said to affect a variable, there is an underlying assumption of ceteris paribus.

For instance, there are various determinants of demand like income, price, tastes and preferences, etc. If the effects of income on the demand of a goo          d were to be observed, then all other factors would have to be held constant. Therefore, the effect of income would be computed under the assumption of ceteris paribus.

If the other factors are not held constant, then there is a chance that the changes arriving in the variable of interest could be a result of other variables. In this case, without the condition of ceteris paribus, any changes in demand could be observed because of changes in prices, or in the tastes and preferences. Therefore, it becomes hard to distinguish between the impact of one factor from the other.

Ceteris paribus condition helps keep other factors insignificant, by focusing only on one factor at a time.

How did the ceteris paribus condition originate?

Ceteris Paribus is a Latin phrase. Up until the 1950s, it was believed that ceteris paribus condition was exclusively limited to the studies made in the field of social sciences. The earliest usage of the term has been recorded in the field of economics and dates back to the 13th century.

However, outside the domain of economics, the condition of ceteris paribus was controversial. It was mathematician Imre Laktos, who, in 1970, argued that every physical theory requires the usage of the ceteris paribus condition, even if it was given by Newton.

By the end of 1980s, discussions surrounding the validity and usage of ceteris paribus condition gained momentum. There were arguments on the structure of all relationships including scientific and economic and on the viability of special sciences being given the status of an ‘autonomous discipline’.

Therefore, this condition was perceived as a more practical way of perceiving the already existing laws and theories. Economists and mathematicians argued that changes in a variable may be influenced by a variety of factors. Therefore, a theory that centres around the effect of only variable on the other automatically assumes other factors being equal.

Why is the usage of ceteris paribus controversial?

It has long been argued that this condition of ceteris paribus is not testable from a practical standpoint. This means that it is practically impossible to single out one determining factor from another. Most causal relationships expressed in theories and laws function because of a combination of factors. Simply assuming that at a time only one factor is affecting the variable of interest is not achievable.

Economists agree that the assumption of other factors being constant is not very practical. Yet, this condition continues to remain integral to various economic theories developed over time.

It is also argued that ceteris paribus is an easier way of reasoning out inexplicable or unaccounted changes that take place in a model. Consider, for instance, the fact that a decline in prices is predicted to increase demand as given by the Law of Demand. However, when the same is not achieved in the real world, theorists may argue that the condition of ceteris paribus does not hold and there are factors other than prices that are influencing demand.

Although, this fact is true, it takes away the practical applicability of reducing prices as explained in the law of demand. On paper, singling out a determining factor may provide a theory, however, if it can not be applied to the real world then it becomes less credible.

The vagueness in the ceteris paribus principle allows for it to be used as a counterexample for any fallacies seen in the existing laws.

It can be concluded from these points that empirical procedures used in testing out a theory are different from the empirical meaningfulness of the theory. The “all else equal” method of empirical testing makes sense if it understood as a testing procedure and not as a law on its own.

Why is ceteris paribus acceptable in economic theories despite the debates?

Economics is a subject that relies heavily on assumptions, and it is with the help of these assumptions that unquantifiable factors can be classified into numerable forms. Demand and supply curves, utility curves are some examples of the same.

The principles and theories based under the assumption of ceteris paribus can not be discounted as impractical as they have high applicability when it comes to testing policies of the government or any new initiative being adopted into the economy.

The assumption-based models help develop a foundation based on which various decisions are taken in an economy. Therefore, when seen through a macroscopic lens, these assumptions make sense, which is part of the reason why they are still used even in sophisticated models.

Thus, ceteris paribus can be thought of as a methodological tool rather than an empirically achievable condition. While it is integral in developing a theory, it may not be a very practical situation to achieve. However, that does not take away its credibility as it helps simplify complex economic phenomena wherein multiple changes are taking place simultaneously.

What is the Law of Demand? Law of demand states that the price of a good is inversely proportional to the quantity demanded of that good. This means that as prices of a good falls, ceteris paribus, the quantity demanded of that good increases, and vice versa. This happens because as goods become cheaper, more and more people want to buy them. Law of demand helps explain how the goods market moves. Through the demand and supply curve, the goods market equilibrium can be predicted. With the help of a demand curve, the demand of a good can be estimated given its price. What is a Demand Curve? A demand curve plots the prices of a good against the quantity demanded of that good. Each point in a demand curve represents a combination of price and quantity that is achievable for that good. A demand curve is made with the help of a demand schedule which is a table representing the quantity demanded against individual prices. Demand curves are downward sloping because of the negative relationship between prices of a good and its quantity demanded. Its slope varies depending on the price elasticity of demand for the good in question. Price elasticity of demand refers to the ratio of the percentage change in quantity demanded to the percentage change in price. As the price elasticity of demand for good increases, the slope of the demand curve decreases. It is important to note that ‘demand’ and ‘quantity demanded’ are not the same. Demand refers to the relationship between prices of a goods and its quantity demanded, whereas quantity demanded refers to the quantity associated with a particular point on a demand curve. Demand curves have different shapes based on different price and quantity relationships. They can be concave or straight lines; however, they are always downward sloping. How does the demand for a good change? The quantity of a good may change due to various factors, prices being one of them. When the prices of a good increase, people start to consume less of that good, unless that good is a necessity good. A necessity good is a type of good that cannot be removed from the consumption basket of people, even if its prices are rising. An example of this can be oil, bread and utilities like power and water. Alternatively, the demand for a good can be influenced through various other factors like income, price of related goods, taste and preferences of the consumer and the number of consumers in the market. Here, related goods refer to substitute and complementary goods. Substitute good is an alternative good that can be used to replace the good in question, while a complimentary good refers to another good that must be purchased along with the good in question to use it. Keeping all other factors equal, when the price of a good changes, the change in demand curve is observed along the curve, as shown below: Here, the negative relationship between price and quantity demanded is visible. As prices fall from P1 to P2, the quantity demanded increases from Q1 to Q2. When factors other than price are changed, then the change in the demand curve is observed through a shift and not through a movement along the curve. In this case each factor is changed separately while all other factors are kept constant. In the figure above, when prices are kept constant, the demand curve shifts due to changes in one of the determinants of demand other than price. However, this change ultimately leads to a corresponding change in the price. In the scenario shown above, both price and quantity demanded are increasing. This does not mean that the law of demand is failing here. The prices have adjusted to the shift in the demand curve. As the quantity demanded shifts from Q1 to Q2, the limited supply of that good makes the prices rise. Thus, the law of demand works with law of supply to find out various allocation levels of a good in a market. Why is there a negative relationship between the price of a good and its quantity demanded? The relationship between the price and quantity of a good is given by the Law of Demand. This relationship exists because individuals in an economy are assumed to be rational. This means that they would want to incur as less costs as possible and gain as much profit as possible from a transaction. This rationality explains why consumers would want to save up on their costs while purchasing a good. Therefore, when price drops for a commodity, most individuals would flock to the stores to buy that commodity, sometimes even irrespective of other factors like their tastes or preferences. For instance, consider the scenario where there is sale on appliances of Company A. Most consumers would start purchasing the goods of Company A, even if they had previously been consuming appliances from another company. Sometimes, people would shift to goods that were previously out of budget for them, simply because of a reduction in prices. For instance, consider an individual who does not own a car because he cannot afford it and depends on public transport instead. However, seeing a temporary dip in the prices of automobiles, he might purchase a car now than wait for him to be able to afford it in the future. This knowledge of price and demand relationship is used by governments and monetary authorities to influence the business cycles. Prices can be raised to reduce demand by the government and can be decreased to encourage consumption of goods in the economy. What are some cases where law of demand does not apply? Law of demand may not apply for certain specific categories of goods. These include Giffen goods and Veblen goods. Giffen goods refer those goods which see an increase in quantity demanded as their price increases. They are certain exceptional types of goods that form a large part of an individual’s consumption basket and lack close substitutes. An example of this can be essential items like bread. As the price of bread rises, people start hoarding more of it. Veblen goods are the luxury goods that see increased demand as their prices increase. People attach a sense of social status to these luxury goods, which is why they buy more of that good as it becomes expensive.

What is the law of supply? The law of supply states that keeping other parameters constant, as the prices of a commodity increase, the supply of that commodity also increases. This means that ceteris paribus, price changes move in the same direction as a commodity’s supplied quantity.  Law of supply, along with the law of demand, helps explain how goods and prices are allocated in a market. Law of supply has been made from the producer’s standpoint while the law of demand has been made from the consumer's perspective. Together, both of these laws help determine the goods market equilibrium. What is the supply curve? A supply curve signifies the relationship between the price of a good and the quantity supplied. The slope of a supply curve is always positive because of the Law of Supply. This happens because as prices of a good increase, the firms focus more on producing that good to earn higher profits. A graphical depiction of a supply schedule is called a supply curve. A supply schedule is a tabular representation of various price level and the quantities of the commodity supplied at those prices. The variation in the slopes depends on the price elasticity of supply of a good. As the price elasticity of supply increases, the slope of the supply curve decreases. In the diagram above, as the price of a commodity increases from P1 to P2, the quantity supplied also increases from Q1 to Q2. This positive relationship is explained through the law of supply. Why is there a positive relationship between the price of a good and the quantity supplied? The producers, like consumers, are rational beings and would like to save up on their costs. As the quantity demanded of a is good increased, the firms must produce more to satisfy the rising demand. This increase in production leads to business expansion, which means greater costs for the firm. The business expansion involves costs like the addition of new labour force, new machinery, maybe setting up new factories etc. Thus, they start to charge more for each commodity, as the supply is increased in an economy. This relationship is explained under the assumption that all other factors affecting supply are kept constant. Conversely, it can be argued that as the prices of goods rise in the economy, the demand falls because of the law of demand. Thus, some demand may still go unsatisfied if prices become too high. How is equilibrium explained through the laws of demand and supply? The price of a good adjusts according to the demand and supply in the economy. If there is excess demand for a good, it means that there is not enough production to meet the consumer’s demand. Consequently, producers could either increase the prices so that demand reduces, or improve their production, which could also lead to higher prices. Alternatively, when there is a shortage of demand in the economy, firms would be compelled to lower prices and encourage consumers’ spending. They could also reduce supply by temporarily shutting down production; however, that seems like the costlier alternative. Therefore, the conditions of excess supply and excess demand can both be brought to equilibrium by appropriate changes in the commodity’s price. Thus, the law of demand and supply collaboratively decide the market equilibrium and can influence the economy’s production levels. How does the supply of a good change? Keeping all other factors equal, the supply of goods may change because of prices or many other factors. When the supply changes because of a change in prices, the changes are observed along the curve. However, the supply curve may shift when any factor, other than the price, is changed one at a time. These factors are income, technology, the cost of production, the scale of production, prices of related goods and government policies. When either of these determinants is changed, keeping the others constant, the demand curve would change by shifting rather than through a movement along the curve. The following diagram represents the movement along the curve: Here the price and quantity allocations shift along the curve. However, when factors other than the price change, a shift in the demand curve is observed, which can be shown as: Are there any exceptions to the law? The backward bending supply curve of labour is one prominent example of an exception to the law of supply. The supply curve of labour follows the law of supply but only up to a certain extent. It starts bending backwards, defying the law of supply after a point. The law of supply applies to labour as they offer a higher number of hours worked against higher wages. However, this only continues till the labour becomes wealthy enough not to find higher wages incentivising enough to work more. Therefore, beyond a point, the workforce may not offer as much labour as before and spend more time doing leisure than doing work. Another important scenario is when the supply of a good is fixed. In such a case, even if there is excess demand in the economy, the producers cannot meet it due to limited supply. Therefore, they only have the option of waiting it out. This can be done by increasing prices. It is important to note, that even when supply is fixed, the prices rise and thus, the law of supply does not follow here.

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