Unit 1.

2: How do economists
approach the world?

What you should know by the end of this chapter:

• Economic methodology
• History of economic thought
• Positive and normative economics
• Views of influential economists

Economic methodology
Economic methodology refers to the way economists study the subject. As a social science,
Economics tries to use scientific methods to explain how the economy at a microeconomic and
macroeconomic level works. Because Economics is based on human behaviour its theories cannot be
tested in the same way as a theory or idea can be in natural sciences such as Biology, Physics or
Chemistry. Economists cannot use laboratories and control experiments.

Economists test their theories, laws and ideas by using empirical evidence. This is evidence gathered
by observing how people behave and by using data. For example, we might expect a decrease in the
price of Coca-Cola to lead to a rise in the quantity demanded for it. We can test this by looking at a
situation where Coca-Cola reduced the price of its product and by looking at data from past price
reductions by the company.

The role of positive economics

Positive economic statements are objective statements that can
be proved true or false based on empirical evidence.

Here are some examples of positive economic statements:

• ‘If interest rates are reduced economic growth rises’

• ‘As the price of a personal computer falls its quantity demanded will increase’
• ‘As the value of the US dollar falls US exports get cheaper’
• ‘Economic growth leads to rising income inequality’

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Empirical evidence

By analysing empirical evidence we generate information that can either support or refute a positive
statement such as: ‘Economic growth leads to rising income inequality’. You could, for example, look
at the relationship between Economic Growth in the South African economy in the last 10 years and
changes in its income equality to support or refute the claim. Evidence is important in supporting
claims and it can also be used to refute claims if the evidence does not support them.

Logic and reasoning

Positive economics can also be looked at in terms of logic and reasoning. It is logical to assume that
reducing the price of the Apple iPad Pro from $1000 to $800 will increase its quantity demanded
because more people can afford to buy the product which supports the claim: ‘As the price of a
personal computer falls its quantity demanded increases’.

Hypotheses, models and theories

Hypotheses, models and theories are central to the scientific method used in the study of
Economics. For the claim: ‘If interest rates are reduced economic growth rises’, an economist might
hypothesise that reducing interest rates will increase consumer spending, which will increase
aggregate demand, thus leading to increased economic growth. The circular flow of income model
can be used to support this hypothesis, along with the theory that there is a negative relationship
between interest rates and consumption spending.

Ceteris paribus

Ceteris paribus is an important part of the scientific method used in Economics. Ceteris paribus
means other factors are held constant when looking at the relationship between variables in
Economics. For the claim ‘as the value of the US dollar falls US exports get cheaper’, we can assume,
for example, that US inflation does not make its exports more expensive. Economics is a very
complex subject because so many variables are changing at the same time, meaning it is difficult to
analyse how one variable affects another.

The role of normative economics

Normative economic statements are value judgements that cannot be
proved to be true or false based on empirical evidence. They often form
the basis of economic policymaking.

Here are some examples of normative economic statements:

• ‘Healthcare should be provided by the state’

• ‘Professional footballers are paid too much’
• ‘The governments ought to reduce interest rates to combat a recession’
• ‘Increased consumption of alcohol is bad for society’.

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The claim: ‘Professional footballers are paid too much’ can be based on the view that someone who
plays a professional sport should not be paid as much as they are. Is, for example, Lionel Messi
worth the $127 million a year he earns. The economic policy view might be to put high taxes on
people who earn such high salaries.

Economic thought - The origin of economic ideas

Adam Smith
In the 18th century, the Scottish Economist and Philosopher Adam Smith wrote
the book, An Inquiry into the Nature and Causes of the Wealth of Nations (1776).
One of the key themes of the book was to argue that the over-regulated and
controlled Economic systems that existed at the time hindered economic
development and prevented the gains from economic activity from benefiting
the wider population. Smith believed that allowing a free and unhindered
exchange of goods and services (laissez-faire markets), both within countries and
through international trade, benefited buyers and sellers and increase incomes
throughout the population.

Classical economic thought

Classical economics developed from Adam Smith’s theories into the 19th century. Classical
microeconomics considered areas such as utility theory, which is based on the principle that
individuals consume goods and services to maximise satisfaction from their consumption. An
example of classical microeconomics comes from Say’s Law. The law developed by Jean Baptiste Say
states that producing goods and services creates demand. As people are paid to produce something,
income is created, which creates demand for other goods and services. If a factory opens in a town it
will pay people to work there and those workers will be able to buy goods and services in the town.

Marxism
In the second half of the 19th century, the German Economist and Philosopher Karl Marx became
increasingly influential as a critic of capitalism. He saw rich industrialists gaining wealth and power at
the expense of ordinary workers and believed that workers would rise up to overthrow capitalism
and replace it with socialism.

John Maynard Keynes

Keynes is seen as one of the most important figures in the development of macroeconomics. Keynes
saw a more influential role for governments in the economy than classical economists did. Much of
his work was shaped by the Great Depression of the 1930s. Keynes’ book, The General Theory of
Employment, Interest and Money was published in 1936. Keynes' work was very influential on
macroeconomic policymaking by western governments in the second half of the 20th century.

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Monetarism
Macroeconomic thought was dominated by Monetarism in the
1970s. The theory was based on the principle that the supply of
money in the economy was the key determinant of economic
growth and inflation. A central figure in monetarism was the Nobel
Prize-winning economist, Milton Friedman. He advocated the use
of interest rates by governments to control the money supply and
the rate of inflation.

Monetarists believed that by using monetary policy to maintain low inflation a country would
achieve the long-run economic growth needed for sustained improvements in prosperity.

Behavioural economics
Behavioural economics gives increasing importance to psychology and human behaviour in
economic decision-making. The economist, Richard Thaler, won the Nobel prize for Economics in
2017 for his work on Nudge Theory which looked at how indirect suggestion and positive
reinforcement can make individuals act in a certain way. A supermarket, for example, might put
confectionery at the checkout to encourage people to buy it. Behavioural economics is different to
classical economic thinking which is based on rational economic decision-making. Behavioural
economics allows for irrational behaviour and tries to understand why people might behave in this
way.

Economic thought and sustainability - Doughnut Economics

The Oxford University economist, Kate Raworth developed the model
called Doughnut Economics. Her theory is based on a model of
sustainable economic development. It can be viewed in pictorial form
as a series of concentric rings. Raworth believes economic activity
aims to meet the needs of everyone in the world within the
sustainable resource limits (ecological ceiling) of the planet.

Raworth's view is that governments should move away from being overly focused on Economic
growth because of its environmental consequences (renewable) and be more concerned with how
existing resources can maximise the welfare of everyone (redistributive) now and in the future. The
centre of the 'doughnut' (social foundation) represents the number of people in society who do not
have access to the necessities of life.

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Equity and equality
Zambian-born economist, Dambisa Moyo started with
an undergraduate degree in Chemistry, and went on to
do an MBA at the American University in Washington
DC, an MPA at Harvard University and a DPhil in
Economics at Oxford University. She is on the board of
directors for the Chevron Corporation and the 3M
Company. She has also worked for the World Bank and
Goldman Sachs.

Dambisa Moyo is a high-profile economist who regularly features on business news channels, TedX
lectures and even major television shows such as Real Time with Bill Maher. She has written a
number of best-selling books in Economics and the Political Economy. Her most recent book, Edge of
Chaos: Why Democracy Is Failing to Deliver Economic Growth – and How to Fix It spent some time on
the New York Times bestseller list.

One of the central themes of Edge of Chaos is how population growth, rising income inequality,
commodity scarcity and technological development are undermining economic welfare and social
cohesion in so many countries in the world. Moyo believes a growing underclass of people in the
world economy is stuck in low-paid employment and does not have sufficient political
representation. She believes this underclass is a risk to economic, political and social stability in
countries across the world.

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