What is economics?

Last updated: Mar 13, 2021

When defining economics as a subject two aspects must be considered. Firstly, the subject matter of economics, and secondly the methodology employed.

The subject matter of economics

In terms of subject matter, economics studies ‘economic systems’ - which are comprised of economic ‘agents’ – individuals, firms, and governments - and how resources are allocated between competing uses to solve the ‘economic problem’.

Scarcity and the economic problem

The economic problem arises as a result of scarcity – while resources required by individuals, firms and governments are finite, the demand for these resources is infinite. Because of this, choices must be made about how best to use these resources.

Economic agents interact with each other in an attempt to ‘solve’ this problem and satisfy their particular needs and wants.

In market-based systems, interactions take place within markets - understanding markets forms the basis of microeconomics. However, markets do not always function efficiently and market ‘failures’ are also the subject matter of microeconomics.

Economics also adopts a macroeconomic view in an attempt to understand the wider structure and functioning of the economic system, the problems that arise, such as unemployment and inflation, and the policy options that are available to remedy these problems.

The methods of economics

In terms of methodology, economics attempts to explain economic interactions and systems through the application of scientific methods.

Pure science employs a method based on observation, creating a hypothesis, gathering data from the ‘field’ or through experiments, testing the hypothesis, and then supporting or rejecting the hypothesis. Economics adopts the same approach, but is limited in the extent to which it can replicate all the methods of pure science. For example, for ethical and practical reasons experimentation is difficult.

Deductive, inductive and abductive reasoning

Deductive reasoning

The difficulty of applying scientific method to economics (and other social sciences) means that economists must employ 'reasoning' to analyse economic systems.

Deductive reasoning about economic behaviour starts with some form of question about the causes of an economic event or phenomenon – for example, what causes a rise in prices? The next step is to formulate a hypothesis, which proposes a possible reason which can then be tested – for example, a ‘theory’ of price determination - such as 'price rises are caused by an excess of demand over supply'. The next step would be to find evidence to support or reject the hypothesis. Price changes at certain times and in specific markets can be tracked, along with possible ‘causes’, to find support for the basic proposition.

For example, historically it is likely to be the case that prices rise during wars, when resources are much in demand, and yet production focusses on the war effort rather than on satisfying consumers. At this stage quantitative research is likely to be used to confirm or reject the hypothesis by looking at other examples in history, including correlation analysis to establish the strength or weakness of the relationship between two variables. This kind of deductive reasoning dominates economic thinking.

Inductive reasoning

Inductive reasoning starts the other way round – its starts with something specific that we have observed, or already know, and then by gathering data we arrive at a hypothesis, and finally formulate a general theory.

Inductive reasoning ultimately means looking at real behaviour or interactions and then trying to explain the observed patterns through the construction of a simplified and general model which can help find ‘meanings’ in these patterns.

methodology in economics

Hence, deductive reasoning starts with a theory which can be tested, while inductive reasoning ends with a theory.

Abductive reasoning

Abductive reasoning is the attempt to present an idea or hypothesis from very limited available evidence and incomplete observations. An example of this was the early attempt to explain the role of risk taking as a potential cause of the financial crash.

While risk analysis had existed for some time, at the time of the crisis current theories did not provide a compelling analysis, nor was there sufficient real world evidence to create a workable theory – in the early days of the crash no banks had actually failed. This forced economists to make inferences and ‘best guesses’ on the limited evidence that was available.

A similar example of where abduction was required was the arrival of stagflation in the 1970s as a consequence of oil shocks. Oil shocks had not widely existed before, and no traditional theory could accommodate a sensible explanation of stagflation – so simple deduction or deduction could not provide an explanation. Hence, abductive reasoning meant looking for possible causes of stagflation, and selecting the most likely from competing explanations.

Positive and normative statements

It should be clear that economics involves analysis, reasoning, judgment and recommendation – however, the role of the economist is not to make decisions but to inform the decisions of others – whether business owners and managers, or governments.

Positive economics

Economic theories are developed and tested through the use of ‘positive’ statements rather than ‘normative’ ones. Positive statements involve attempting to objectively describe and analyse actions and systems by considering what ‘is’ happening at the current period of time, what ‘has’ happened in the past, and what ‘might’ happen in the future.

Positive economics concerns the attempt to understand the ‘causes’ of actions and problems, and their likely ‘effect’. The most significant feature of positive statements is that they are verifiable – for example, stating that the US experienced stagflation in the mid 1970s is positive in that it can be verified – stagflation can be defined and quantified, and the data can be checked to complete the verification. Positive statements are not always ‘true’ but it is the fact that the truthfulness of the statement can be discovered.

Normative statements

In contrast, ‘normative’ statements cannot be verified or falsified. To say that unemployment is ‘worse than’ inflation is normative – it is based on a ‘value judgment’ that unemployment creates more difficulty that inflation. This type of approach is not generally useful in the practice of economics, although it may influence the choice of subject matter to investigate. What the economist can do it to define the problem, analyse possible causes, and consider the effects of inflation on individuals, firms and the whole economic system.

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