Why Economic Theory Cannot Tell Us What to Do about Policy

Much of what theory can teach us about the appropriate role for government policy can be gleaned by understanding what theory teaches about international trade. This is because international trade theory has largely used what are known as general equilibrium models to understand the effects of trade and domestic policies. General equilibrium models offer a comprehensive view of an economy because they account simultaneously for impacts in the output markets, labor markets, and capital markets. Any policy affecting one market is shown to affect every other market both domestically and internationally. Although the focus of trade theory is primarily on trade of course, the general conclusions that derive from studying these models have a much broader applicability.