Ceteris paribus

July 27, 2023
10 MIN READ
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Only the cause-and-effect connection between two variables can be inferred when other external variables stay constant. It aids in the simplification of economic and financial mechanisms, as well as the simple explanation of economic ideas. It is predicated on the idea that other related variables stay constant while investigating the influence of a particular economic factor on another. Its disadvantage is that it is difficult to isolate the dependent variable while holding all the other financial variables constant to examine economic models.

What is ceteris paribus?

Ceteris paribus refers to the assumption that all external influences operating on a variable topic would stay unchanged/constant while assessing its connection with other dynamic subjects. Economists use it to validate a hypothesis in economics. It employs probability and propensity knowledge to determine the source and impact of a link between two distinct economic variables. Most economists utilize ceteris paribus to investigate one connection mechanism and its accompanying cause between two variables. As a consequence, professionals utilize it to explain numerous economic ideas quickly. Furthermore, it aids in analyzing many economic issues in the actual world using exaggerated assumptions.

The concept of ceteris paribus

Ceteris Paribus is a Latin word meaning "other conditions remaining constant" or "all else being equal." It aids in the comprehension of the cause-and-effect connection between two factors. It was initially employed in economics debates by Juan de Medina and Luis de Molina in the sixteenth century. The examination of economic theory is the most extensively used and dominating notion in economics and finance. It cannot provide precise or unequivocal predictions. It does, however, offer a foundation for determining causal relationships.

Expressed, it posits that two factors have a cause-and-effect connection only when the external forces influencing the variables stay constant. All variables in economics are continually changing; this notion aids in understanding any commercial or financial operation. Economic analysts and financial experts find it challenging to simultaneously factor in all dynamic factors and then investigate the variables' relationships. When such correlations are studied, the computations become chaotic and convoluted. Furthermore, this notion highlights several critical elements. Price, for example, directly influences the relationship between two variables: supply and demand.

The pricing factor may link various factors to a product's demand shift. Similarly, supply always grows as demand for an item rises as long as other factors, like input costs, labor, and taxes, stay constant. As a result, ceteris paribus applies, and supply declines anytime demand lowers.

The uses of Ceteris Paribus

It streamlines economics by assisting economists in developing and testing economic models. It provides a firm foundation for economic ideas to survive the test of time. When theorists utilize it to construct a foundation, they set aside other considerations. They then investigate the relationship between the two factors without pausing. Lower interest rates, for instance, would result in stronger economic growth if everything else remained constant.

·       Demand and supply

Consider, for instance, the demand and supply laws. According to economists, the rule of demand indicates that, in general, more items are bought at lower costs. Alternatively, prices will increase if demand for a specific commodity exceeds supply. In this case, the sole factor that should vary is the cost of an item. Everything else should stay constant. Because of the rules of supply and demand, we can accurately foresee the result if just the price changes.

·       Macroeconomics/GDP

Economic analysts and other social researchers will report on how factors impact one another while maintaining everything constantly. So, to conclude that low unemployment is connected with greater inflation, ceteris paribus, we must maintain all other variables constant, such as GDP growth, trade surplus, and the supply of cash. Nevertheless, any of these additional elements, among others, might contribute to inflation.

·       Minimum wage

We can also argue the same point regarding the minimum wage: increasing it is supposed to reduce employment as firms cut expenses. However, this overlooks a plethora of other political and social aspects. Workers, for instance, may work more and be more efficient if their earnings are greater. Better-paid employees may also spend more, increasing overall demand.

·       Rates of interest

Interest rates and lending demand often have an inverse connection. It is because increased interest rates make loans more costly. As a result, increased interest rates generally reduce the demand for debt. Of course, additional considerations (customer demand, consumer choice, client solvency) are all elements that may affect the statement's conclusion. Nonetheless, if other borrower-related variables are considered, higher interest rates imply higher loan costs, reducing demand.

·       The supply chain

Several elements contribute to the manufacturing of a unit. Raw material supply, working hours, appliance accessibility, ingredient cost, shipment, packaging, or distribution are examples. As a result, economists may predict how an item will travel through the supply chain process if all other factors remain constant. Higher raw material costs, for instance, will reduce production supply if firms do not boost their manufacturing budgets. This claim excludes labor hours, packing, and delivery.

Because economic factors can only be separated in principle, not in reality, ceteris paribus can never emphasize absolutes, just trends.

Economic science and ceteris paribus

A shift in focus from deductive reasoning to empirical positivism in mainstream economics can be traced back to two seminal studies. The first was general equilibrium theory, initially described in Léon Walras's Elements of Pure Economics in 1874. The second was 'The General Theory of Employment, Interest, and Money,' the 1936 publication by John Maynard Keynes, often credited as the genesis of contemporary macroeconomics.

Economics grew increasingly mathematically rigorous to gain respectability on par with the "hard sciences" of physics and chemistry. The lack of ability to distinguish between controllable and independent variables in economics-based mathematical equations was a significant challenge. The scientific method's inability to single out individual factors and examine their interdependence to confirm or refute a theory also contributed to the lack of progress.

In contrast to fields like physics, economics does not lend itself well to scientific hypothesis testing. In the study of knowledge, or epistemology, scientists may choose to learn either by deductive reasoning, also known as thought experiments, or through experimental testing, also known as positivism. Geometry is a science that relies heavily on deduction.

Physics is a science that is supported by empirical evidence. Unfortunately, there is a fundamental conflict between economics and the scientific process. No economist can command everyone in the economy to do the same thing simultaneously. Every economy has so many factors that no economist could name them all. There might be dozens or even hundreds of factors in every economic event.

Put in ceteris paribus. To test their hypotheses, mainstream economists use abstract models assuming all other variables are constant. The foundation of general equilibrium theory rests on this kind of wishful thinking, known as ceteris paribus.

In 1953, economist Milton Friedman said that a theory should be evaluated based on its ability to accurately anticipate the behavior of the phenomena it purports to describe. Economists may turn relative deductive market trends into absolute controlled mathematical progressions by thinking that all variables except one are maintained constant. In place of humans, mathematical equations are used.

The assumption of no changes to the other factors drives supply and demand curve forecasts. Only by manipulating the relevant variables while holding all others constant can the price-volume link be established.

Ceteris paribus assumptions

Below are some key assumptions of ceteris paribus:

·       It is predicated on the idea that the connection between two distinct variables may be studied with the other requirements and variables held constant. Nevertheless, this is important in the actual world since external circumstance is always changing, which impacts research into the correlation between two variables.

·       Economists may be unable to explain the connection between the two economic factors if they do not treat them separately. For instance, pricing is a dependent variable that has to be connected to the independent variable of demand. In addition, in the real world, the connection between demand and cost may be profoundly impacted by sudden shifts in external variables such as raw materials or labor availability.

The price-demand connection may be examined since all other elements must be constant. It highlights the importance of the ceteris paribus concept. These presumptions aid in transforming a hopeless or mushy social science into a constructive "hard" science on par with physics and chemistry.

Advantages of ceteris paribus

·       By applying the scientific method approach

Assume an economist wishes to demonstrate that a minimum wage generates unemployment or that losing money creates inflation. They could not conceivably put up two identical test economies, enact minimum wage legislation, and begin producing dollar notes simultaneously. As a result, the positive economist tasked with proving their hypotheses must provide an appropriate framework for the scientific process, even if this requires generating very unrealistic assumptions. Buyers and sellers, according to the economist, are price takers instead of price creators.

·       Leverages excellent information

The financial analyst also assumes that actors have perfect knowledge about their options since any hesitancy or erroneous decision based on inadequate information causes a flaw in the model. The framework is judged effective if the models created in ceteris paribus economics seem to make precise forecasts in the actual world. The models are altered if they do not seem to provide precise projections.

·       Uses positive economics

It may make positive economics difficult; conditions may cause one model to seem accurate one day but erroneous the next. Several economists dismiss positivism in favor of deduction as the primary mode of discovery. Conversely, the majority accepts the limitations of ceteris paribus presumptions to make economics more inclined to chemistry and less like theory.

·       Allows for price discovery

Constant supply and demand charts are created by economists when they aggregate data from numerous situations to establish an approach for prices, supply, or other economic aspects. A demand curve should appear as only one factor is changed, allowing theoretical pricing to be applied without needing to go to market with those real values.

Arguments against ceteris paribus

·       Surmounts impossible situations

Nearly all major microeconomic and macroeconomic frameworks rely on ceteris paribus assumptions. Some opponents of orthodox economics argue that ceteris paribus allows economists to avoid dealing with real human-nature issues.

Though this may be advantageous for theoretical implementation, some circumstances may never occur in the actual world, casting doubt on how practical some discoveries may be.

·       Dilutes logical worth

Even though economists acknowledge that these assumptions are exceedingly implausible, these models lead to notions such as utility curves, cross elasticity, and monopoly. Antitrust law is based on the concept of perfect competition. The Austrian school of economics contends that ceteris paribus concepts have been carried too far, reducing economics to a series of arithmetic puzzles rather than a practical, rational social science.

·       Possible obscuring the analyzable subjects

According to financial adviser Frank Shostak, this supply-demand structure is detached from reality. Instead of addressing equilibrium problems, he believed students should study how prices form. He asserted that these theoretical visual illustrations' future inferences or public policies must be erroneous.

Many other elements that impact the economy or finance, such as pricing, are always changing. Independent research or testing may permit the application of the ceteris paribus concept. However, with things like the securities market, one can never presume "all else being equal." There are too many elements influencing stock prices that may and do vary regularly to isolate just one.

·       Ignorant of human nature and feelings

As appealing as a black-and-white world might seem, the fact is that there are just too many variables associated with human nature. Humans are inherently unpredictable and behave irrationally. Though economic rules make sense, there are times when individuals do not do what is logically best for them. In certain instances, the laws of supply and demand may be disrupted, leading any analysis to fail.

Conclusion

Ceteris paribus is a word that describes which factors change and which stay constant in a particular scenario. Economists often use ceteris paribus to highlight that their assumptions about a specific result are only true if all other factors stay constant. Even though ceteris paribus is rare owing to the complexities of macroeconomic dynamics, it may be beneficial in evaluating variables and discovering what affects results.