Unit 1: How Economists Approach the World
Understanding Economic Methodology and the Evolution of Economic Thought
Introduction: Economics as a Social Science
Economics is a social science that studies how individuals, businesses, governments, and societies make choices about allocating scarce resources to satisfy unlimited wants. Unlike natural sciences, economics deals with human behavior, making it both complex and fascinating to study.
Why Economics is a Social Science:
- Studies human behavior and decision-making
- Examines interactions between individuals and institutions
- Uses systematic observation and analysis
- Develops theories and models to explain economic phenomena
- Cannot always conduct controlled experiments like natural sciences
Part 1: Economic Methodology
The Scientific Method in Economics
Economists use a modified version of the scientific method to understand economic phenomena:
Steps in Economic Analysis
1. Observation: Identify an economic problem or phenomenon
2. Hypothesis Formation: Develop a testable explanation
3. Data Collection: Gather relevant economic data
4. Analysis: Use statistical and mathematical tools to test the hypothesis
5. Conclusion: Accept, reject, or modify the hypothesis
6. Theory Development: Build broader economic theories from confirmed hypotheses
1. Positive vs. Normative Economics
| Aspect | Positive Economics | Normative Economics |
|---|---|---|
| Definition | Objective, fact-based statements that can be tested and verified | Subjective, value-based statements involving opinions about what should be |
| Nature | Descriptive ("what is") | Prescriptive ("what ought to be") |
| Testing | Can be proven true or false with evidence | Cannot be proven true or false; involves value judgments |
| Example 1 | "Unemployment rate is 5.2%" | "Unemployment is too high and must be reduced" |
| Example 2 | "A 10% tax increase will reduce consumer spending by 3%" | "The government should increase taxes on wealthy individuals" |
| Role | Analysis and explanation | Policy recommendations and value judgments |
Identifying Positive vs. Normative Statements
Positive: "If the central bank raises interest rates, inflation will likely decrease."
Normative: "The central bank should raise interest rates to control inflation."
Key Indicator: Normative statements often contain words like "should," "ought," "better," "fair," or "unfair."
2. Economic Models
Economic Models are simplified representations of reality that economists use to understand complex economic relationships and make predictions. They abstract from real-world complexities to focus on key variables.
Characteristics of Economic Models
- Simplification: Focus on essential variables while ignoring less important details
- Assumptions: Based on specific conditions that may not fully reflect reality
- Predictions: Allow economists to forecast outcomes of economic changes
- Testable: Can be evaluated against real-world data
- Visual: Often represented through graphs, diagrams, or equations
Examples of Economic Models
- Supply and Demand Model: Shows how prices are determined in markets
- Production Possibilities Curve: Illustrates opportunity cost and efficiency
- Circular Flow Model: Demonstrates economic interdependence
- Aggregate Demand-Aggregate Supply: Explains macroeconomic equilibrium
3. Ceteris Paribus ("All Else Being Equal")
Ceteris paribus is a Latin phrase meaning "all other things being equal" or "holding other factors constant." Economists use this assumption to isolate the relationship between two variables by assuming all other relevant factors remain unchanged.
Mathematical Expression
When examining the relationship between price (P) and quantity demanded (Q), ceteris paribus:
\[ Q_d = f(P) \text{ | ceteris paribus} \]This means quantity demanded is a function of price, assuming income, preferences, prices of related goods, and other factors remain constant.
Ceteris Paribus in Action
Statement: "If the price of coffee increases, the quantity demanded will decrease, ceteris paribus."
What's Held Constant:
- Consumer income
- Prices of tea and other beverages
- Consumer preferences for coffee
- Population and demographics
- Weather and seasons
Why It Matters: In reality, multiple factors change simultaneously. The ceteris paribus assumption helps economists understand individual cause-and-effect relationships.
4. Assumptions in Economic Analysis
Economic models rely on key assumptions to make analysis manageable:
Common Assumptions
- Rational Behavior: Economic agents make decisions that maximize their benefit
- Self-Interest: Individuals act to improve their own well-being
- Perfect Information: Decision-makers have complete knowledge (often relaxed in advanced models)
- Diminishing Returns: Additional units provide decreasing additional benefit
Rationality Assumption
Rational Economic Behavior assumes that individuals:
- Have clear preferences and goals
- Gather and process information efficiently
- Make consistent decisions to maximize utility (satisfaction)
- Weigh costs and benefits before acting
Critical Note: Behavioral economics challenges this assumption, showing that humans often act irrationally due to emotions, biases, and limited information.
5. The Role of Data and Statistics
Modern economics heavily relies on econometrics—the application of statistical methods to economic data.
Basic Statistical Concepts in Economics
Mean (Average): Central tendency measure
\[ \bar{x} = \frac{\sum_{i=1}^{n} x_i}{n} \]Correlation: Measures relationship strength between variables
\[ r = \frac{\sum(x_i - \bar{x})(y_i - \bar{y})}{\sqrt{\sum(x_i - \bar{x})^2 \sum(y_i - \bar{y})^2}} \]Where \( -1 \leq r \leq 1 \)
Limitations of Economic Methodology
- Cannot Conduct Controlled Experiments: Difficult to isolate variables in real economies
- Human Behavior is Unpredictable: People don't always act rationally
- Data Quality Issues: Economic data may be incomplete or inaccurate
- Changing Relationships: Economic relationships evolve over time
- Value Judgments: Policy recommendations involve subjective choices
Part 2: History of Economic Thought
Economic thinking has evolved significantly over centuries, shaped by changing social, political, and technological conditions. Understanding this evolution helps contextualize modern economic debates.
Pre-Classical Economics (Before 1776)
Mercantilism (16th-18th Century)
Key Ideas:
- National wealth measured by gold and silver reserves
- Governments should maximize exports and minimize imports
- Trade is a zero-sum game (one nation's gain is another's loss)
- Strong government intervention in the economy
Notable Figures: Jean-Baptiste Colbert, Thomas Mun
Legacy: Influenced colonialism and protectionist trade policies
1. Classical Economics (1776-1870s)
Period: Late 18th to mid-19th century
Context: Industrial Revolution, rise of capitalism
Adam Smith (1723-1790) - "Father of Economics"
Major Work: "The Wealth of Nations" (1776)
Key Contributions:
- Invisible Hand: Self-interested individuals unintentionally promote societal good through market mechanisms
- Division of Labor: Specialization increases productivity
- Free Markets: Competition leads to efficient resource allocation
- Limited Government: Government should provide defense, justice, and public goods
Smith's Concept: Absolute Advantage
A country has absolute advantage if it can produce more of a good with the same resources:
\[ \text{Absolute Advantage: } \frac{\text{Output}_A}{\text{Resources}} > \frac{\text{Output}_B}{\text{Resources}} \]David Ricardo (1772-1823)
Major Work: "Principles of Political Economy and Taxation" (1817)
Key Contributions:
- Comparative Advantage: Countries should specialize in goods they produce most efficiently relative to other goods, even without absolute advantage
- Theory of Rent: Explained how land prices are determined
- Free Trade: Advocated for international trade without restrictions
Ricardo's Comparative Advantage
Country A has comparative advantage in Good X if:
\[ \frac{\text{Opportunity Cost of X in A}}{\text{Opportunity Cost of X in B}} < 1 \]Trade benefits both countries even if one has absolute advantage in all goods.
Thomas Malthus (1766-1834)
Major Work: "An Essay on the Principle of Population" (1798)
Key Ideas:
- Population grows geometrically (\(2, 4, 8, 16...\)) while food supply grows arithmetically (\(2, 4, 6, 8...\))
- This imbalance leads to poverty and famine
- Advocated for population control
Modern Relevance: Debates about sustainability and resource limits
Classical Economics: Core Principles
- Say's Law: "Supply creates its own demand"—production automatically generates purchasing power
- Self-Regulating Markets: Economies naturally move toward full employment
- Laissez-Faire: Minimal government intervention
- Long-Run Focus: Short-term fluctuations are self-correcting
2. Marxist Economics (Mid-19th Century)
Period: 1848 onwards
Context: Industrialization, worker exploitation, class conflict
Karl Marx (1818-1883)
Major Work: "Das Kapital" (1867)
Key Ideas:
- Labor Theory of Value: Value of goods determined by labor time required
- Surplus Value: Capitalists exploit workers by paying less than the value workers create
- Class Struggle: History driven by conflict between social classes
- Capitalism's Contradictions: Predicted capitalism would collapse due to internal tensions
- Historical Materialism: Economic base determines social and political structures
Legacy: Influenced socialist and communist movements worldwide
3. Neoclassical Economics (1870s-1930s)
Period: 1870s-1930s (Marginalist Revolution)
Context: Mathematical formalization of economics
Key Figures and Contributions
William Stanley Jevons, Carl Menger, Léon Walras
Revolutionary Ideas:
- Marginal Utility: Value determined by additional satisfaction from consuming one more unit
- Diminishing Marginal Utility: Each additional unit provides less satisfaction
- Mathematical Economics: Use of calculus and algebra
- General Equilibrium: All markets simultaneously clear
Marginal Utility
The change in total utility from consuming one additional unit:
\[ MU = \frac{\Delta TU}{\Delta Q} \text{ or } MU = \frac{dTU}{dQ} \]Law of Diminishing Marginal Utility:
\[ MU_1 > MU_2 > MU_3 > ... > MU_n \]Alfred Marshall (1842-1924)
Major Work: "Principles of Economics" (1890)
Key Contributions:
- Supply and Demand Framework: The foundation of modern microeconomics
- Elasticity: Measuring responsiveness to price changes
- Partial Equilibrium Analysis: Analyzing one market at a time
- Marshall's Scissors: Both supply and demand determine price
Neoclassical Assumptions
- Rational, utility-maximizing consumers
- Profit-maximizing firms
- Perfect competition in markets
- Perfect information
- Markets clear automatically
4. Keynesian Economics (1930s-1970s)
Period: 1936 onwards
Context: Great Depression, mass unemployment, market failure
John Maynard Keynes (1883-1946)
Major Work: "The General Theory of Employment, Interest and Money" (1936)
Revolutionary Challenge to Classical Economics:
- Demand Drives Economy: Aggregate demand, not supply, determines output and employment
- Market Failures: Economies can get stuck in equilibrium with high unemployment
- Government Intervention: Active fiscal and monetary policy needed
- Short-Run Focus: "In the long run, we are all dead"
- Sticky Wages and Prices: Markets don't adjust instantly
Keynesian Consumption Function
\[ C = C_0 + c(Y - T) \]Where:
- • \(C\) = Total consumption
- • \(C_0\) = Autonomous consumption
- • \(c\) = Marginal propensity to consume (MPC)
- • \(Y\) = Income
- • \(T\) = Taxes
Keynesian Multiplier:
\[ k = \frac{1}{1 - MPC} = \frac{1}{MPS} \]Where MPS = Marginal Propensity to Save
Key Keynesian Policies
During Recession:
- Increase government spending
- Reduce taxes
- Lower interest rates
- Run budget deficits
During Boom:
- Reduce government spending
- Increase taxes
- Raise interest rates
- Run budget surpluses
5. Monetarism (1960s-1980s)
Period: 1960s onwards
Context: Stagflation (high inflation + high unemployment), Keynesian policy failures
Milton Friedman (1912-2006)
Major Work: "A Monetary History of the United States" (1963)
Key Ideas:
- "Inflation is always and everywhere a monetary phenomenon"
- Money Supply Control: Central banks should focus on controlling money supply growth
- Natural Rate of Unemployment: Long-run unemployment determined by structural factors, not demand
- Free Markets: Return to market-oriented policies
- Limited Government: Government intervention often makes things worse
Equation of Exchange (Quantity Theory of Money)
\[ MV = PY \]Where:
- • \(M\) = Money supply
- • \(V\) = Velocity of money (constant in short run)
- • \(P\) = Price level
- • \(Y\) = Real output (GDP)
Implication: If \(V\) is constant and \(Y\) is at full employment, increasing \(M\) leads to proportional increase in \(P\) (inflation).
6. New Classical Economics (1970s-1980s)
Robert Lucas and Rational Expectations
Key Ideas:
- Rational Expectations: People use all available information to predict future
- Policy Ineffectiveness: Anticipated government policies have no real effects
- Real Business Cycle Theory: Economic fluctuations caused by technology shocks, not demand
- Market Efficiency: Markets process information efficiently
7. New Keynesian Economics (1980s-Present)
Synthesis of Ideas
Key Features:
- Micro-foundations: Rigorous microeconomic basis for macroeconomic phenomena
- Market Imperfections: Sticky prices, imperfect competition, information asymmetries
- Role for Policy: Government can stabilize economy
- DSGE Models: Dynamic Stochastic General Equilibrium models
Notable Economists: Joseph Stiglitz, George Akerlof, Ben Bernanke
8. Behavioral Economics (1990s-Present)
Daniel Kahneman and Amos Tversky
Revolutionary Challenge to Rationality:
- Bounded Rationality: People have limited cognitive abilities
- Heuristics and Biases: Mental shortcuts lead to systematic errors
- Prospect Theory: People value gains and losses differently
- Loss Aversion: Losses hurt more than equivalent gains feel good
- Framing Effects: How choices are presented affects decisions
Nobel Prize: Kahneman won in 2002
Behavioral Economics Examples
Anchoring: First piece of information disproportionately influences decisions
Present Bias: People value immediate rewards more than future ones
Status Quo Bias: Preference for keeping things as they are
Herding: Following what others do, even if irrational
9. Development Economics and Institutional Economics
Amartya Sen and Human Development
Key Contributions:
- Capability Approach: Development is about expanding human freedoms and capabilities
- Beyond GDP: Well-being includes health, education, political freedom
- Poverty and Famines: Famines result from distribution failures, not just food shortages
Douglass North and Institutions
Key Ideas:
- Institutions Matter: Rules, norms, and organizations shape economic performance
- Property Rights: Secure property rights essential for development
- Transaction Costs: Institutions reduce costs of economic exchange
- Path Dependence: History matters; past choices constrain future options
10. Contemporary Developments (21st Century)
- Environmental Economics: Climate change, sustainability, carbon pricing
- Information Economics: Role of information and knowledge in economies
- Experimental Economics: Laboratory experiments to test economic theories
- Neuroeconomics: Brain science and economic decision-making
- Digital Economics: Platform economies, cryptocurrencies, AI impacts
Comparison of Major Economic Schools
| School | Role of Markets | Role of Government | Main Focus |
|---|---|---|---|
| Classical | Self-regulating, efficient | Minimal (laissez-faire) | Long-run growth, supply-side |
| Marxist | Exploitative, inherently unstable | Should own means of production | Class conflict, labor exploitation |
| Neoclassical | Efficient when competitive | Correct market failures | Resource allocation, optimization |
| Keynesian | Prone to failure, unstable | Active stabilization necessary | Short-run demand management |
| Monetarist | Generally efficient | Control money supply only | Inflation control, stable growth |
| Behavioral | Imperfect due to human biases | Nudge toward better choices | Decision-making psychology |
Why History of Economic Thought Matters for IB Students
- Context for Current Debates: Understanding why economists disagree on policy
- Evolution of Ideas: How economic thinking adapts to changing circumstances
- Critical Thinking: No single "correct" economic approach; theories have strengths and weaknesses
- Policy Evaluation: Different schools recommend different solutions to economic problems
- Real-World Application: Connect theoretical concepts to historical and contemporary events
Applying Economic Methodology: A Framework
When Analyzing Economic Issues
1. Identify: Is this a positive or normative statement?
2. Clarify: What assumptions are being made?
3. Apply: Use ceteris paribus to isolate relationships
4. Model: Which economic model best explains this situation?
5. Test: What evidence supports or refutes the hypothesis?
6. Evaluate: What are the limitations of this analysis?
7. Recommend: What policy implications follow (if any)?
Key Terms for IB Economics
| Term | Definition |
|---|---|
| Positive Economics | Objective, testable statements about what is |
| Normative Economics | Subjective statements about what should be |
| Ceteris Paribus | All other things being equal |
| Economic Model | Simplified representation of economic reality |
| Rational Behavior | Decision-making that maximizes benefit |
| Laissez-Faire | Policy of minimal government intervention |
| Invisible Hand | Market mechanism that coordinates self-interested actions |
| Marginal Analysis | Examining incremental changes |
IB Exam Tips
- Define clearly: Always define key terms in your answers
- Distinguish: Be precise about positive vs. normative statements
- Show methodology: Explain the assumptions and limitations of economic models
- Historical context: Reference relevant economic schools when discussing policy debates
- Balanced evaluation: Present multiple perspectives from different economic traditions
- Critical thinking: Question assumptions and acknowledge limitations
- Real-world examples: Connect theoretical concepts to current economic issues
✓ Study Checkpoint
You should now understand how economists think systematically about economic problems, distinguish between positive and normative analysis, appreciate the role of assumptions and models, and recognize how economic thought has evolved in response to changing circumstances and new insights. This methodological foundation is crucial for all subsequent topics in IB Economics SL.