The Issues and Methods of Economics

Economics as a science

As a matter of fact, all key economic questions and problems arise because human wants exceed the resources available to satisfy them. Our inability to satisfy all our wants is called scarcity. Faced with scarcity we must make choices. We must choose the available alternatives. Therefore, economics as a science can be defined as a social science that studies the choices that individuals, businesses, government and the entire society make as they cope with scarcity.

The subject matter of economics is divided into two main components:

1. Microeconomics
2. Macroeconomics.

Microeconomics is the study of the choices that individual economic agents make, the interaction of these choices, and the influence that governments exert on these choices. The key word in understanding microeconomics is individual. Macroeconomics is the study of the aggregate (total) effects on the national economy and the global economy of the choices that individuals, households, businesses and governments make. The key word in understanding macroeconomics is aggregate.

The economic choices that individual economic agents such as individuals, households, businesses and governments make and the interactions of those choices answer the following three major microeconomic questions:

1. What goods and services should be produce and in what quantities?
2. How are goods and services produced?
3. For whom are the various goods and services produced?

Microeconomic theory will help us answer these questions. In answering these questions, economists generally find that individuals want more than is available, and that is why the problem of scarcity arises. Being social scientists, economists try to discover how the economic world works.

In doing so, they distinguish between two types of statements or two types of economic analysis:

1. Positive statements or positive economic analysis
2. Normative statements or normative economic analysis.

Positive statement is a proposition that can be settled by an appeal to facts. It is testable, either true or false and is associated with the statement “what it is” without any policy recommendations.

Example of the statement is “Air pollution in large cities is high”. Positive analysis is a value-free approach to inquiry. Normative statement is associated with the proposition “what ought to be”. It is not based on facts and usually points to some policy recommendations. Example of the statement is: “We ought to clean up our environment”. Normative analysis is based on value judgment. In general, the following words are good indicators of a normative statement: ought to, have to, should, and must.

Modeling in economics

The task of economic science is first to discover and catalogue positive statements that are consistent with what we observe in the world and that enable us to understand how the economic world works.

This task can be broken into three steps:

1. Observing and measuring
2. Model building
3. Testing.

Observing and measuring result in economists keeping track of huge amounts of economic data. These data are needed to build economic models. Economic model is a description of some aspects of the economic world that includes only those features that are needed for the purpose at hand. At large, economic model is an abstraction (simplification) of the real world. It is composed of a number of assumptions and relationships between economic variables from which conclusions and/or predictions are deducted.

Assumptions are statements or what economists call stylized facts. They are accepted without any proof. Assumptions are an important component of an economic model. They help economists create the required environment to make use of mathematical relationships. In general, relationships take on a form of equations and/or inequalities that involve economic variables, constants and parameters. A set of equations and inequalities defines the structure of a model.

Equations in economic models are of 3 types: definitional equations, behavioral equations and conditional equations.

1. A definitional equation is identity which is equality between two alternative expressions that have exactly the same meaning.
2. A behavioral equation specifies the way in which a given variable behaves in response to changes in other variables.
3. A conditional equation states a requirement to be satisfied. Mathematical way of presenting economic models is not the only one. At large economic models can be presented in various forms such as:

• by words = logical or verbal models
• by tables = statistical models
• by graphs = graphical models
• by mathematical expressions = mathematical models.

All of them are useful ways to analyze economic information. For instance, economists make extensive use of graphs because they are very illustrative and help one better absorb specifics of underlying economic processes. And finally, after a model is constructed it has to be tested because the model might conflict with the existing data. A model that has repeatedly passed the test of corresponding with real-world data is the basis of an economic theory. Economic theory is a generalization that summarizes what we understand about economic choices that people make and the economic performance of industries and nations.

Theories are then usually used to address normative aspects of economic analysis. So, economics is a social science that studies the allocation of scarce resources to satisfy unlimited wants. This involves analyzing the production, distribution, trade and consumption of goods and services. Economics is said to be positive when it attempts to explain the consequences of different choices given a set of assumptions or a set of observations, and normative when it prescribes that a certain action should be taken.

Economic way of thinking

The economic way of thinking assumes that a typical response to an economic problem of scarcity is rational behavior. This way of thinking is somewhat different from the natural sciences’. Five core ideas summarize it, and these ideas form the basis of all microeconomics models. They are:

1. People make rational choices by comparing costs and benefits
2. Cost is what you must give up to get something
3. Benefit is what you gain when you get something and is measured by what you are willing to give up to get it
4. Rational choice is made on a margin
5. People respond to incentives.

In general, rational choice is a choice that uses the available resources most effectively to satisfy the wants of an economic agent making the choice. Cost in economics is viewed in terms of opportunity cost. Opportunity cost is the cost of something you must give up to get what you want. The concept arises because of scarcity: If you use resource in some specific way then you actually forgo opportunity to use the scarce resource in any other way. Formal definition of opportunity cost is the value of the most valuable alternative that was not chosen. The benefit of something is the gain or pleasure that it brings. Economists measure benefits by what a person is willing to give up getting it. A choice on the margin is a choice that is made by comparing all the relevant alternatives systematically and incrementally.

Therefore, instead of just costs and benefits we have to take into consideration marginal costs and marginal benefits. Marginal cost is the cost that arises from a one-unit increase in an activity. The marginal cost of something is what you must give up to get one more unit of it. Marginal benefit is the benefit that arises from a one-unit increase in an activity. The marginal benefit of something is measured by what you are willing to give up getting one more unit of it.

People make rational choices and use our scarce resources in the way that makes them as well off as possible when they take those actions for which marginal benefits exceed or equals marginal costs. In making their choices, people respond to incentives. An incentive is an inducement to take a particular action. The inducement can be a reward in the form of an increase in benefit or a decrease in cost. On the other hand, an incentive can be a punishment with the opposite result.

In general, a change in marginal benefit or a change in marginal cost brings a change in the incentives that people face and eventually leads them to change their actions. Therefore, in order to make a rational choice, we must determine the costs and benefits of the alternatives.

Economic efficiency

In economics, efficiency occurs when we produce the quantities of goods and services that people value the most. Resource use is efficient when we cannot produce more of a good or service without giving up some of another good or service that people value more highly.

These two statements characterize economic efficiency as allocative efficiency and productive efficiency:

1. Productive efficiency is a situation in which an economy produces the maximum output with given technology and resources; it cannot produce more of one good or service without producing less of some other good or service. It means that under productive efficiency, production takes place on the PPF.
2. Allocative efficiency is the most highly valued combination of goods and services on the PPF.

Given the above definition we can state that all combinations on the PPF achieve productive efficiency. Each of these combinations, however, is associated with specific distribution. Only one of them achieves allocative efficiency or only one combination is the most highly valued by people – the consumers. In order to find this combination, we need to know the value of each available combination. We can express it in terms of marginal benefits people receive from consumption. In general, the more we have of any good or service, the smaller is our marginal benefit from extra unit of it which is known as the principle of diminishing (decreasing) marginal benefit.

Mathematically the principle of diminishing marginal benefit implies that marginal benefit is a decreasing function of the quantity of a good or service consumed. As previously discussed, the bowed out shape of the PPF is due to the fact that marginal opportunity cost or just marginal cost is an increasing function of quantity. In order to achieve allocative efficiency, we must compare the marginal benefit of a good or service MB with its marginal cost MC. The point when MC = MB is the point of allocative efficiency.

In the above discussed case of two goods, this condition with respect to one good (usually good X) coupled with the PPF for two goods X and Y produces optimal combination of the two goods that is allocatively efficient. It should be pointed out that allocative efficiency is a broader and deeper concept than productive efficiency since it is associated with the so-called Pareto efficiency which is an allocation is Pareto efficient if there is no other allocation in which some other individual is better off and no individual is worse off.