Introduction

Chapter 1
The foundations of
economics
This chapter is an introduction to the study of economics. It is also an introduction to many topics that will be
explored in depth in later chapters.

1.1 Scarcity, choice and Yet it is not possible for societies and the people
within them to produce or buy all the things they
opportunity cost want. Why is this so? It is because there are not
enough resources. Resources are the inputs used to
The fundamental problem of economics: produce goods and services wanted by people, and for
scarcity and choice this reason are also known as factors of production.
They include things like human labour, machines and
The problem of scarcity factories, and ‘gifts of nature’ like agricultural land
and metals inside the earth. Factors of production do
Explain that scarcity exists because factors of production not exist in unlimited abundance: they are scarce, or
are finite and wants are infinite. limited and insufficient in relation to unlimited uses
that people have for them.
The term ‘economics’ is derived from the ancient Greek Scarcity is a very important concept in economics.
expression oı′kov vε′ µεiv (oikon nemein), which originally It arises whenever there is not enough of something in
meant ‘one who manages and administers all matters relation to the need for it. For example, we could say
relating to a household’. Over time, this expression that food is scarce in poor countries, or we could say
evolved to mean ‘one who is prudent in the use of that clean air is scarce in a polluted city. In economics,
resources’. By extension, economics has come to refer to scarcity is especially important in describing a
the careful management of society’s scarce resources to situation of insufficient factors of production, because
avoid waste. Let’s examine this idea more carefully. this in turn leads to insufficient goods and services.
Human beings have very many needs and wants. Defining scarcity, we can therefore say that:
Some of these are satisfied by physical objects and
others by non-physical activities. All the physical Scarcity is the situation in which available
objects people need and want are called goods (food, resources, or factors of production, are finite,
clothing, houses, books, computers, cars, televisions, whereas wants are infinite. There are not enough
refrigerators, and so on); the non-physical activities are resources to produce everything that human beings
called services (education, health care, entertainment, need and want.
travel, banking, insurance and many more).
The study of economics arises because people’s needs Why scarcity forces choices to be made
and wants are unlimited, or infinite. Whereas some
individuals may be satisfied with the goods and services Explain that as a result of scarcity, choices have
they have or can buy, most would prefer to have more. to be made.
They would like to have more and better computers,
cars, educational services, transport services, housing, The conflict between unlimited wants and scarce
recreation, travel, and so on; the list is endless. resources has an important consequence. Since

Chapter 1 The foundations of economics 1

people cannot have everything they want, they Three basic economic questions: resource
must make choices. The classic example of a choice allocation and output/income distribution
forced on society by resource scarcity is that of ‘guns
or butter’, or more realistically the choice between Explain that the three basic economic questions that
producing defence goods (guns, weapons, tanks) must be answered by any economic system are: ‘What to
or food: more defence goods mean less food, while produce?’, ‘How to produce?’ and ‘For whom to produce?’
more food means fewer defence goods. Societies Explain that economics studies the ways in which
must choose how much of each they want to have. resources are allocated to meet needs and wants.
Note that if there were no resource scarcity, a choice
would not be necessary, since society could produce Scarcity forces every economy in the world, regardless of
as much of each as was desired. But resource scarcity its form of organisation, to answer three basic questions:
forces the society to make a choice between available
• What to produce. All economies must choose
alternatives. Economics is therefore a study of
what particular goods and services and what
choices.
quantities of these they wish to produce.
The conflict between unlimited needs and
wants, and scarce resources has a second important • How to produce. All economies must make
consequence. Since resources are scarce, it is choices on how to use their resources in order to
important to avoid waste in how they are used. If produce goods and services. Goods and services
resources are not used effectively and are wasted, can be produced by use of different combinations
they will end up producing less; or they may end of factors of production (for example, relatively
up producing goods and services that people do more human labour with fewer machines, or
not really want or need. Economics must try to find relatively more machines with less labour), by using
how best to use scarce resources so that waste can different skill levels of labour, and by using different
be avoided. Defining economics, we can therefore technologies.
say that: • For whom to produce. All economies must make
choices about how the goods and services produced
are to be distributed among the population. Should
Economics is the study of choices leading to the everyone get an equal amount of these? Should
best possible use of scarce resources in order to best some people get more than others? Should some
satisfy unlimited human needs and wants. goods and services (such as education and health
care services) be distributed more equally?
As you can see from this definition of economics,
economists study the world from a social perspective, The first two of these questions, what to produce and
with the objective of determining what is in society’s how to produce, are about resource allocation, while the
best interests. third, for whom to produce, is about the distribution of
output and income.
Resource allocation refers to assigning available
Test your understanding 1.1 resources, or factors of production, to specific uses
chosen among many possible alternatives, and
1 Think of some of your most important needs involves answering the what to produce and how to
and wants, and then explain whether these are produce questions. For example, if a what to produce
satisfied by goods or by services. choice involves choosing a certain amount of food
2 Why is economics a study of choices? and a certain amount of weapons, this means a
3 Explain the relationship between scarcity decision is made to allocate some resources to the
and the need to avoid waste in the use of production of food and some to the production of
resources. weapons. At the same time, a choice must be made
about how to produce: which particular factors of
4 Explain why diamonds are far more expensive
production and in what quantities (for example, how
than water, even though diamonds are a luxury
much labour, how many machines, what types of
while water is a necessity without which we
machines, etc.) should be assigned to produce food,
cannot live.
and which and how many to produce weapons.

2 Introduction
 If a decision is made to change the amounts of goods
produced, such as more food and fewer weapons, this (c) Whereas rich countries typically spend
involves a reallocation of resources. Sometimes, 8–12% of their income on providing health
societies produce the ‘wrong’ amounts of goods and care services to their populations, many poor
services relative to what is socially desirable. For countries spend as little as 2–3% of income.
example, if too many weapons are being produced, (d) Many developing countries devote a large
we say there is an overallocation of resources in proportion of their government budget
production of weapons. If too few socially desirable funds for education to spending on
goods or services are being produced, such as education university level education, while large parts
or health care, we say there is an underallocation of of their population remain illiterate.
resources to the production of these. (e) If countries around the world spent less
on defence, they would be in a position
to expand provision of social services,
An important part of economics is the study of how
including health care and education.
to allocate scarce resources, in other words how to
(f) Pharmaceutical companies spend most
assign resources to answer the what to produce and
of their research funds on developing
how to produce questions, in order to meet human
medicines to treat diseases common in rich
needs and wants in the best possible way.
countries, while ignoring the treatment of
diseases common in poor countries.
The third basic economic question, for whom to produce,
involves the distribution of output and is concerned with
how much output different individuals or different
groups in the population receive. This question is also Resources as factors of production
concerned with the distribution of income among
individuals and groups in a population, since the amount We have seen that resources, or all inputs used to
of output people can get depends on how much of it produce goods and services, are also known as factors
they can buy, which in turn depends on the amount of production.
of income they have. When the distribution of income
or output changes so that different social groups now The four factors of production
receive more, or less, income and output than previously, Economists group factors of production under four
this is referred to as redistribution of income. broad categories:

• Land includes all natural resources, including all

Test your understanding 1.2 agricultural and non-agricultural land, as well as
everything that is under or above the land, such as
1 What are the three basic economic questions minerals, oil reserves, underground water, forests,
that must be addressed by any economy? rivers and lakes. Natural resources are also called
2 Explain the relationship between the three ‘gifts of nature’.
basic economic questions, and the allocation • Labour includes the physical and mental effort
of resources and the distribution of income or that people contribute to the production of
output. goods and services. The efforts of a teacher, a
3 Consider the following, and identify each one construction worker, an economist, a doctor,
as referring to output/income distribution a taxi driver or a plumber all contribute to
or redistribution; or to resource allocation, producing goods and services, and are all
reallocation, overallocation or underallocation examples of labour.
(note that there may be more than one answer). • Capital, also known as physical capital, is a man-
(a) Evidence suggests that over the last two made factor of production (it is itself produced)
decades in many countries around the used to produce goods and services. Examples of
world the rich are getting richer and the physical capital include machinery, tools, factories,
poor are getting poorer. buildings, road systems, airports, harbours,
(b) In Brazil, the richest 10% of the population electricity generators and telephone supply lines.
receive 48% of total income. Physical capital is also referred to as a capital good
or investment good.

Chapter 1 The foundations of economics 3

• Entrepreneurship (management) is a special
human skill possessed by some people, involving
Test your understanding 1.3
the ability to innovate by developing new ways of 1 (a) Why are resources also called ‘factors
doing things, to take business risks and to seek new of production’? (b) What are the factors of
opportunities for opening and running a business. production?
Entrepreneurship organises the other three factors 2 How does physical capital differ from the other
of production and takes on the risks of success or three factors of production?
failure of a business.
3 Why is entrepreneurship considered to be a
factor of production separate from labour?
Other meanings of the term ‘capital’ 4 (a) What are the various meanings of the term
The term ‘capital’, in a most general sense, refers
‘capital’? (b) What do they all have in common?
to resources that can produce a future stream of
benefits. Thinking of capital along these lines, we can
understand why this term has a variety of different
uses, which although are seemingly unrelated, in fact Scarcity, choice and opportunity cost: the
all stem from this basic meaning. economic perspective
• Physical capital, defined above, is one of the Explain that when an economic choice is made, an
four factors of production consisting of man-made alternative is always foregone.
inputs that provide a stream of future benefits in
the form of the ability to produce greater quantities Opportunity cost
of output: physical capital is used to produce more Opportunity cost is defined as the value of the next
goods and services in the future. best alternative that must be given up or sacrificed in
• Human capital refers to the skills, abilities and order to obtain something else.
knowledge acquired by people, as well as good When a consumer chooses to use her $100 to buy
levels of health, all of which make them more a pair of shoes, she is also choosing not to use this
productive. Human capital provides a stream of money to buy books, or CDs, or anything else; if CDs
future benefits because it increases the amount are her favourite alternative to shoes, the CDs she
of output that can be produced in the future by sacrificed (did not buy) are the opportunity cost of the
people who embody skills, education and good shoes. When a business chooses to use its resources to
health. produce hamburgers, it is also choosing not to produce
hotdogs or pizzas, or anything else; if hotdogs are
• Natural capital, also known as environmental
the preferred alternative, the hotdogs sacrificed (not
capital, refers to an expanded meaning of the
produced) are the opportunity cost of the hamburgers.
factor of production ‘land’ (defined above). It
Note that if the consumer had endless amounts of
includes everything that is included in land,
money, she could buy everything she wanted and the
plus additional natural resources that occur
shoes would have no opportunity cost. Similarly, if
naturally in the environment such as the air,
the business had endless resources, it could produce
biodiversity, soil quality, the ozone layer, and
hotdogs, pizzas and a lot of other things in addition
the global climate. Natural capital provides a
to hamburgers, and the hamburgers would have
stream of future benefits because it is necessary to
no opportunity cost. If resources were limitless, no
humankind’s ability to live, survive and produce
sacrifices would be necessary, and the opportunity cost
in the future.
of producing anything would be zero.
• Financial capital refers to investments in
financial instruments, like stocks and bonds, or
the funds (money) that are used to buy financial
The concept of opportunity cost, or the value of
instruments like stocks and bonds. Financial capital
the next best alternative that must be sacrificed to
also provides a stream of future benefits, which take
obtain something else, is central to the economic
the form of an income for the holders, or owners, of
perspective of the world, and results from scarcity
the financial instruments.
that forces choices to be made.

4 Introduction
 Test your understanding 1.4 A
40
1 Explain the relationship between scarcity and B
35 G
choice.
2 Define opportunity cost. 30
C

microwave ovens
3 Think of three choices you have made today, 25
and describe the opportunity cost of each one.
20
F
15 D

The production possibilities model 10

5
Explain that a production possibilities curve (production
E
possibilities frontier) model may be used to show the 0
concepts of scarcity, choice, opportunity cost and a 5 10 15 20 25 30 35 40
computers
situation of unemployed resources and inefficiency.

The production possibilities model is a simple model Figure 1.1 Production possibilities curve
of the economy illustrating some important concepts.
points A and E is known as the production possibilities
Introducing the production curve (PPC) or production possibilities frontier (PPF ).
possibilities curve In order for the economy to produce the greatest
Consider a simple hypothetical economy producing possible output, in other words somewhere on the
only two goods: microwave ovens and computers. PPC, two conditions must be met:
This economy has a fixed (unchanging) quantity and
• All resources must be fully employed. This
quality of resources (factors of production) and a fixed
means that all resources are being fully used. If there
technology (the method of production is unchanging).
were unemployment of some resources, in which case
Table 1.1 shows the combinations of the two goods
they would be sitting unused, the economy would
this economy can produce. Figure 1.1 plots the data of
not be producing the maximum it can produce.
Table 1.1: the quantity of microwave ovens is plotted
on the vertical axis, and the quantity of computers on • All resources must be used efficiently.
the horizontal axis. Specifically, there must be productive efficiency.
If all the economy’s resources are used to produce The term ‘efficiency’ in a general sense means
microwave ovens, the economy will produce that resources are being used in the best possible
40 microwave ovens and 0 computers, shown by point way to avoid waste. (If they are not used in the
A. If all resources are used to produce computers, the best possible way, we say there is ‘inefficiency’.)
economy will produce 33 computers and 0 microwave Productive efficiency means that output is produced
ovens; this is point E. All the points on the curve joining by use of the fewest possible resources; alternatively,
A and E represent other production possibilities where we can say that output is produced at the lowest
some of the resources are used to produce microwave possible cost. If output were not produced using the
ovens and the rest to produce computers. For example, fewest possible resources, the economy would be
at point B there would be production of 35 microwave ‘wasting’ some resources.
ovens and 17 computers; at point C, 26 microwave
ovens and 25 computers, and so on. The line joining The production possibilities curve (or frontier)
represents all combinations of the maximum amounts
of two goods that can be produced by an economy,
Point Microwave ovens Computers
given its resources and technology, when there is full
A 40 0
employment of resources and productive efficiency.
B 35 17 All points on the curve known as production
C 26 25 possibilities.
D 15 31
E 0 33 What would happen if either of the two conditions
(full employment and productive efficiency) is not
Table 1.1 Combinations of microwave ovens and computers met? Very simply, the economy will not produce at a

Chapter 1 The foundations of economics 5

point on the PPC; it will be somewhere inside the PPC, (In the real world, the choice would involve a point
such as at point F. At F, the economy is producing only inside the PPC.)
15 microwave ovens and 12 computers, indicating • The condition of scarcity means that choices
that there is either unemployment of resources, or involve opportunity costs. If the economy were
productive inefficiency, or both. If this economy could at any point on the curve, it would be impossible to
use its resources fully and efficiently, it could, for increase the quantity produced of one good without
example, move to point C and produce 26 microwave decreasing the quantity produced of the other good.
ovens and 25 computers. In other words, when an economy increases its
However, in the real world no economy is ever production of one good, there must necessarily be
likely to produce on its PPC. a sacrifice of some quantity of the other good; this
sacrifice is the opportunity cost.
An economy’s actual output, or the quantity of
output actually produced, is always at a point inside Let’s consider the last point more carefully. Say the
the PPC, because in the real world all economies have economy is at point C, producing 26 microwave ovens
some unemployment of resources and some productive and 25 computers. Suppose now that consumers would
inefficiency. The greater the unemployment or the like to have more computers. It is impossible to produce
productive inefficiency, the further away is the point of more computers without sacrificing production of some
production from the PPC. microwave ovens. For example, a choice to produce 31
computers (a move from C to D) involves a decrease
in microwave oven production from 26 to 15 units,
The production possibilities curve and or a sacrifice of 11 microwave ovens. The sacrifice of
scarcity, choice and opportunity cost 11 microwave ovens is the opportunity cost of 6 extra
The production possibilities model is very useful computers (increasing the number of computers from
for illustrating the concepts of scarcity, choice and 25 to 31). Note that opportunity cost arises when the
opportunity cost: economy is on the PPC (or more realistically, somewhere
close to the PPC). If the economy is at a point inside the
• The condition of scarcity does not allow the curve, it can increase production of both goods with no
economy to produce outside its PPC. With sacrifice, hence no opportunity cost, simply by making
its fixed quantity and quality of resources and better use of its resources: reducing unemployment or
technology, the economy cannot move to any point increasing productive efficiency.
outside the PPC, such as G, because it does not have
enough resources (there is resource scarcity). The shape of the production
• The condition of scarcity forces the economy possibilities curve
to make a choice about what particular In Figure 1.2(a) the PPC’s shape is similar to that of
combination of goods it wishes to produce. Figure 1.1, while in Figure 1.2(b) it is a straight line.
Assuming it could achieve full employment and When the PPC bends outward and to the right, as in
productive efficiency, it must decide at which Figure 1.2(a), opportunity costs change as the economy
particular point on the PPC it wishes to produce. moves from one point on the PPC to another. In part (a),

(a) Increasing opportunity costs (b) Constant opportunity costs

microwave ovens

basketballs

computers volleyballs

Figure 1.2 Production possibilities curve with increasing and constant opportunity costs

6 Introduction
for each additional unit of computers that is produced, 1.2 Economics as a social science
the opportunity cost, consisting of microwave ovens
sacrificed, gets larger and larger as computer production
increases. This happens because of specialisation of
The nature and method of economics
factors of production, which makes them not equally
suitable for the production of different goods and Economics as a social science
services. As production switches from microwave
ovens to more computers, it is necessary to give up Explain that economics is a social science.
increasingly more microwave ovens for each extra unit
of computers produced, because factors of production The social sciences are academic disciplines that
suited to microwave oven production will be less suited study human society and social relationships. They
to computer production. By contrast, when the PPC is a are concerned with discovering general principles
straight line (as in Figure 1.2(b)), opportunity costs are describing how societies function and are organised.
constant (do not change) as the economy moves from The social sciences include anthropology, economics,
one point of the PPC to another. Constant opportunity political science, psychology, sociology and others.
costs arise when the factors of production are equally Economics is a social science because it deals with
well suited to the production of both goods, such as human society and behaviour, and particularly those
in the case of basketballs and volleyballs, which are aspects concerned with how people organise their
very similar to each other, therefore needing similarly activities and how they behave to satisfy their needs
specialised factors of production to produce them. As and wants. It is a social science because its approach
we can see in Figure 1.2(b), for each additional unit of to studying human society is based on the social
volleyballs produced, the opportunity cost, or sacrifice scientific method.
of basketballs, does not change.
The social scientific method

Test your understanding 1.5 Outline the social scientific method.

1 Consider the production possibilities data
in Table 1.1 and Figure 1.1. If the economy As a social science, economics tries to explain in a
is initially at point A and moves to point B, systematic way why economic events happen the way
computer production will increase by 17 units. they do, and attempts to predict economic events
(a) What is the opportunity cost of the increase likely to occur in the future. To accomplish all this,
in computer production? (b) If the economy economists use the social scientific method. This
moves from D to C, what will be the gain and is the same as the scientific method, which you may
what will be its opportunity cost? (c) If it moves already be familiar with through your studies of one
from point C to B, what will be the gain and or more of the natural sciences (for example, biology,
what will be its opportunity cost? chemistry, and physics). It is a method of investigation
used in all the social and natural sciences, allowing us
2 Use the concept of opportunity cost to explain
to acquire knowledge of the world around us.
why the following two statements have the
The social scientific (or scientific) method consists
same meaning: (a) productive efficiency
of the following steps:
means producing by use of the fewest possible
resources, and (b) productive efficiency means Step 1: Make observations of the world
producing at the lowest possible cost. around us, and select an economic question
we want to answer. Let’s consider an example
3 (a) Distinguish between output actually
from economics. We observe that people living in
produced and output on the PPC. (b) Why is
the city of Olemoo buy different amounts of oranges
an economy’s actual output most likely to be
per week at different times in the year. We want to
located somewhere inside its PPC?
answer the question: why are more oranges bought
4 Say an economy is initially at point F, producing in some weeks and fewer in others?
15 microwave ovens and 12 computers (Figure 1.1).
Step 2: Identify variables we think are
What would be the opportunity cost of moving
important to answer the question. A variable
to a point on the production possibilities curve,
is any measure that can take on different values,
such as point C, where it would be producing
such as temperature, or weight, or distance. In our
26 microwave ovens and 25 computers?
example the variables we choose to study are the

Chapter 1 The foundations of economics 7

quantity of oranges that residents of Olemoo buy spend their money on oranges (and other things
each week, and the price of oranges. they want) so that they will get the greatest possible
Step 3: Make a hypothesis about how satisfaction from their purchases. We will examine
the variables are related to each other. A both these assumptions later in this section.
hypothesis is an educated guess, usually indicating Step 5: Test the hypothesis to see if its
a cause-and-effect relationship about an event. predictions fit with what actually happens
Hypotheses are often stated as: if . . ., then . . .. Our in the real world. To do this, we compare the
hypothesis is the following: if the price of oranges predictions of the hypothesis with real-world events,
increases, then the quantity of oranges Olemooans based on real-world observations. Here, the methods
want to buy each week will fall. Notice that this of economics differ from those of the natural
hypothesis indicates a cause-and-effect relationship, sciences. Whereas in the natural sciences it is often
where price is the ‘cause’ and the quantity of (though not always) possible to perform experiments
oranges is the ‘effect’. The hypothesis also involves to test hypotheses, in economics the possibilities for
a prediction, because it claims that changes in the experiments are very limited. Economists therefore
price of oranges will lead to a particular change in rely on a branch of statistics called econometrics
the quantity of oranges Olemooans buy. to test hypotheses. This involves collecting data
Step 4: Make assumptions. An assumption is a on the variables in the hypothesis, and examining
statement we suppose to be true for the purposes whether the data fit the relationships stated in the
of building our hypothesis. In our example we are hypothesis. In our example, we must collect data
making two important assumptions. (a) We assume on the quantity of oranges bought by Olemoo’s
that the price of oranges is the only variable that residents during different weeks throughout the year,
influences the quantity of oranges Olemooans and compare these quantities with different orange
want to buy, while all other variables that could prices at different times in the year. (Econometrics is
have influenced their buying choices do not play usually studied at university level, and is not part of
a role. (b) We assume that the residents of Olemoo IB requirements.)

Theory of knowledge

More on testing hypotheses and the scientific method

We have seen how hypotheses are tested using the social and natural scientists work with hypotheses that
social scientific method. If the data fit the predictions have been tested and not falsified (not rejected). While
of a hypothesis, the hypothesis is accepted. However, the possibility exists that the hypotheses may be false,
this does not make the hypothesis necessarily ‘true’ or they use these hypotheses on the assumption that they
‘correct’. The only knowledge we have gained is that are not false. As more and more testing is done, and as
according to the data used, the hypothesis is not false. unfalsified hypotheses accumulate, it becomes more and
There is always a possibility that as testing methods are more likely that they are not false (though we can never
improved and as new and possibly more accurate data are be sure). This way, it is possible to accumulate knowledge
used, a hypothesis that earlier had been accepted now is about the world, on the understanding, however, that this
rejected as false. Therefore, no matter how many times a knowledge is tentative and provisional; in other words, it
hypothesis is tested, we can never be sure that it is ‘true’. can never be proven to be correct or true.
But by the same logic, we can never be sure that
a hypothesis that is rejected is necessarily false. It is
possible that our hypothesis testing, maybe because of Thinking points
poor data or poor testing methods, incorrectly rejected a • Is it possible to ever arrive at the truth of a statement
hypothesis. Testing of the same hypothesis with different about the real world based on empirical testing?
methods or data could show that the hypothesis had
• Even assuming that testing methods could be
been wrongly rejected.
perfected and data vastly improved, can there ever be
If our results from hypothesis testing are subject to so
complete certainty about our knowledge of the social
many uncertainties, how can economic knowledge about
(and natural) worlds?
the world develop and progress? Economists and other

8 Introduction
 Step 6: Compare the predictions of the
are illustrated by use of mathematical equations.
hypothesis with real-world outcomes.
(Note that both diagrams and mathematical
If the data do not fi t the predictions of the
equations are used to represent models in natural
hypothesis, the hypothesis is rejected, and the
sciences, such as physics, as well.) To construct a
search for a new hypothesis could begin. In our
model, economists select particular variables and
example, this would happen if we discovered that
make assumptions about how these are interrelated.
as the price of oranges increases, the quantity
Different models represent different aspects of
of oranges Olemooans want to buy each week
the economic world. Some models may be better
also increases. Clearly, this would go against
than others in their ability to explain economic
our hypothesis, and we would have to reject
phenomena.
the hypothesis as invalid. If, on the other hand,
Models are often closely related to theories, as
the data fi t the predictions, the hypothesis is
well as to laws. A theory tries to explain why certain
accepted. In our example, this would occur if our
events happen and to make predictions; a law is a
data show that as the price of oranges increases,
concise statement of an event that is supposed to
Olemoo’s residents buy fewer oranges. We can
have universal validity. Models are often built on
therefore conclude that according to the evidence,
the basis of well-established theories or laws, in
our hypothesis is a valid one.
which case they may illustrate, through diagrams or
mathematical equations, the important features of
Economists as model builders the theory or law. When this happens, economists
use the terms ‘model’ and ‘theory’ interchangeably,
Explain the process of model building in economics. because in effect they refer to one and the same
thing. For example, in Chapter 7, we will use models
In economics, as in other social (and natural) to illustrate the ideas contained in the theory
sciences, our efforts to gain knowledge about the of firm behaviour. Later, in Chapter 9, different
world involve the formulation of hypotheses, models of the macroeconomy will be used to
theories, laws and models. The relationships between illustrate alternative theories of income and output
these ideas are explored in the Theory of knowledge determination.
feature on page 10. Here we focus on the role of However, models are not always representations
models. of theories. In some cases, economists use models
Everyone is familiar with the idea of a model. As to isolate important aspects of the real world and
children, many of us played with paper aeroplanes, show connections between variables but without any
which are models of real aeroplanes. In chemistry explanations as to why the variables are connected
at school, we studied molecules and atoms, which in some particular way. In such cases, models are
are models of what matter is made of. Models are purely descriptive; in other words, they describe a
a simplified representation of something in the situation, without explaining anything about it. For
real world, and are used a lot by scientists and example, the production possibilities model, which
social scientists in their efforts to understand or we studied on page 5, is a simple model that is very
explain real-world situations. Models represent important because of its ability to describe scarcity,
only the important aspects of the real world being choice and opportunity cost. The model describes the
investigated, ignoring unnecessary details, thereby basic problem of economics, which is that societies
allowing scientists and social scientists to focus on are forced to make choices that involve sacrifices
important relationships. because of the condition of scarcity. There is no theory
Whereas sciences like biology, chemistry involved here.
and physics offer the possibility to construct Descriptive models that are not based on a theory
three-dimensional models (as with molecules are in no way less important than models that
and atoms), this cannot be done in the social illustrate a theory. Both kinds of model are very
sciences, because these are concerned with human effective as tools used by economists to highlight and
society and social relationships. In economics, understand important relationships and phenomena
models are often illustrated by use of diagrams in the economics world. In our study of economics, we
showing the relationships between important will encounter a variety of economic models and will
variables. In more advanced economics, models make extensive use of diagrams.

Chapter 1 The foundations of economics 9

 Theory of knowledge

Hypotheses, theories, laws and models

We have seen that a hypothesis is an educated guess utility theory’ and ‘indifference curve analysis’ based on
about a cause-and-effect relationship in a single event. a more complicated analysis involving more variables,
A theory is a more general explanation of a set of assumptions and interrelationships. These theories try
interrelated events, usually (though not always) based on to answer the question why people behave in ways
several hypotheses that have been tested successfully that make the observed relationship between price and
(in other words, they have not been rejected, based quantity a valid one.
on evidence; see the Theory of knowledge feature on Yet, the simple relationship between the quantity of
page 8). A theory is a generalisation about the real world a good that people want to buy and its price, while not
that attempts to organise complex and interrelated a theory, has the status of one of the most important
events and present them in a systematic and coherent laws of economics, called the law of demand. This law
way to explain why these events happen. Based on their is a statement describing an event in a simple way. It
ability to systematically explain events, theories attempt has great predictive powers and is used as a building
to make predictions. block for very many complex theories. We will study
A law, on the other hand, is a statement that the law of demand in detail in Chapter 2 and we will
describes an event in a concise way, and is supposed to use it repeatedly throughout this book in numerous
have universal validity; in other words, to be valid at all applications, and as a building block for many theories.
times and in all places. Laws are based on theories and In your study of economics, you will encounter many
are known to be valid in the sense that they have been theories and some laws. Your study of both theories and
successfully tested very many times. They are often laws will make great use of economic models. Models,
used in practical applications and in the development of as explained in the text, are sometimes used to illustrate
further theories because of their great predictive powers. theories (or laws) and sometimes to describe the
However, laws are much simpler than theories, and do connections between variables.
not try to explain events the way theories do.
Referring to the example of oranges (page 7), the
relationship between the price of oranges and the Thinking points
quantity of oranges residents of Olemoo buy at each The relationships between hypotheses, theories, laws and
price was a hypothesis. This kind of hypothesis has been models described here apply generally to all the sciences
successfully tested a great many times for many different and social sciences based on the scientific method. Yet
goods, and the data support the presence in the real they may differ between disciplines in the ways they are
world of such a relationship. However, this relationship used and interpreted. As you study economics, you may
is not a theory, because it only shows how two variables want to think about the following.
relate to each other, and does not explain anything about • How are theories and laws used in economics as
why buyers behave the way they do when they make compared with other disciplines? Do they play the
decisions to buy something. To explain this relationship same role? Are they derived in the same ways? Do
in a general way, economists have developed ‘marginal they have the same meaning?

Two assumptions in economic model-building

Ceteris paribus
Test your understanding 1.6
1 Explain the social scientific method. What steps Explain that economists must use the ceteris paribus
does it involve? assumption when developing economic models.
2 Why is it important to compare the predictions
of a hypothesis with real-world outcomes? When we try to understand the relationship between
two or more variables in the context of a hypothesis,
3 How do models help economists in their work
or economic theory or model, we must assume that
as social scientists?
everything else, other than the variables we are
studying, does not change. We do this by use of the
ceteris paribus assumption:
10 Introduction
Ceteris paribus is a Latin expression that means self-interest’, or rational economic decision-
‘other things equal’. Another way of saying this is making. This means that individuals are assumed to
that all other things are assumed to be constant or act in their best self-interest, trying to maximise (make
unchanging. as large as possible) the satisfaction they expect to
receive from their economic decisions. It is assumed
Consider the simple relationship discussed earlier, in Step that consumers spend their money on purchases
3 of the scientific method. Our hypothesis stated that to maximise the satisfaction they get from buying
the quantity of oranges that will be bought is determined different goods and services. (You may recall that this
by their price. Surely, however, price cannot be the only was the second assumption we made in Step 4 of the
variable that influences how many oranges Olemooans scientific method.) Similarly, it is assumed that firms
want to buy. What if the population of Olemoo (or producers) try to maximise the profits they make
increases? What if the incomes of Olemooans increase? from their businesses; workers try to secure the highest
And what if an advertising campaign proclaiming the possible wage when they get a job; investors in the
health benefits of eating oranges influences the tastes stock market try to get the highest possible returns on
of Olemooans? As a result of any or all of these factors, their investments, and so on.
Olemooans will want to buy more oranges. Why do we assume in economics that people
This complicates our analysis, because if all these act in their best self-interest? As we will discover in
variables change at the same time, we have no way of Chapter 2, in a market economy, the self-interested
knowing what effect each one of them individually behaviour of countless economic decision-makers
has on the quantity people want to buy. We want is also likely to be in society’s best interests. This
to be able to isolate the effects of each one of these conclusion may appear strange to you, but will
variables; to test our hypothesis we specifically wanted become clearer after you have studied the model of
to study the effects of the price of oranges alone. demand and supply and its implications in Chapter 2.
This means we have to make an assumption that all
other things that could affect the relationship we
are studying must be constant, or unchanging. More Test your understanding 1.7
formally, we would say that we are examining the
effect of orange prices on quantity of oranges people 1 Consider the statement, ‘If you increase
want to buy, ceteris paribus. This means simply that your consumption of calories, you will put
we are studying the relationship between prices and on weight.’ Do you think this statement is
quantity on the assumption that nothing else happens necessarily true? Why or why not? How could
that can influence this relationship. By eliminating all you rephrase the statement to make it more
other possible interferences, we isolate the impact of accurate?
price on quantity, so we can study it alone. (Note that 2 What does it mean to be ‘rational’ in
this was the first assumption we made in Step 4 of our economics? Do you think this is a realistic
discussion of the scientific method above.) assumption?
In the real world all variables are likely to be
changing at the same time. The ceteris paribus
assumption does not say anything about what Positive and normative concepts
happens in the real world. It is simply a tool used
by economists to construct hypotheses, models and Distinguish between positive and normative economics.
theories, thus allowing us to isolate and study the
effects of one variable at a time. We will be making Economists think about the economic world in two
extensive use of the ceteris paribus assumption in different ways: one way tries to describe and explain
our study of economics. (For more information on how things in the economy actually work, and the
the ceteris paribus assumption, see ‘Quantitative other deals with how things ought to work.
techniques’ chapter on the CD-ROM, page 11). The first of these is based on positive statements,
which are about something that is, was or will be.
Rational economic decision-making Positive statements are used in several ways:

• They may describe something (e.g. the unemployment

Examine the assumption of rational economic
rate is 5%; industrial output grew by 3%).
decision-making.
• They may be about a cause-and-effect relationship,
Economic theories and models are based on such as in a hypothesis (e.g. if the government
another important assumption, that of ‘rational increases spending, unemployment will fall).

Chapter 1 The foundations of economics 11

• They may be statements in a theory, model or law
unemployment (the positive dimension). The positive
(e.g. a higher rate of inflation is associated with a
dimension provides guidance to policy-makers on how
lower unemployment rate).
to achieve their economic goals.
The second way of thinking about the economic
world, dealing with how things ought to work, is
based on normative statements, which are about what
Test your understanding 1.8
ought to be. These are subjective statements about 1 Which of the following are positive statements
what should happen. Examples include the following: and which are normative?
(a) It is raining today.
• The unemployment rate should be lower.
(b) It is too humid today.
• Health care should be available free of charge. (c) Economics is a study of choices.
• Extreme poverty should be eradicated (eliminated). (d) Economics should be concerned with how
to reduce poverty.
Positive statements may be true or they may be false. (e) If household saving increases, ceteris paribus,
For example, we may say that the unemployment there will be a fall in household spending.
rate is 5%; if in fact the unemployment rate is 5% (f) Households save too little of their income.
this statement is true; but if the unemployment rate
2 Why do you think it is important to make a
is actually 7%, the statement is false. Normative
distinction between positive and normative
statements, by contrast, cannot be true or false.
statements in economics?
They can only be assessed relative to beliefs and value
judgements. Consider the normative statement ‘the
unemployment rate should be lower’. We cannot say
whether this statement is true or false, though we may Microeconomics and macroeconomics
agree or disagree with it, depending on our beliefs
about unemployment. If we believe that the present Economics is studied on two levels. Microeconomics
unemployment rate is too high, then we will agree; examines the behaviour of individual decision-
but if we believe that the present unemployment rate making units in the economy. The two main groups
is not too high, then we will disagree. of decision-makers we study are consumers (or
Positive statements play an important role in households) and firms (or businesses). Microeconomics
positive economics where they are used to describe is concerned with how these decision-makers behave,
economic events and to construct theories and models how they make choices and how their interactions in
that try to explain these events. Positive statements markets determine prices.
are also used in stating laws. It should be stressed Macroeconomics examines the economy as a
that the social scientific method, described above, whole, to obtain a broad or overall picture, by use
is based on positive thinking. In their role as social of aggregates, which are wholes or collections of
scientists, economists use positive statements in order many individual units, such as the sum of consumer
to describe, explain and predict. behaviours and the sum of firm behaviours, and
Normative statements are important in normative total income and output of the entire economy,
economics, where they form the basis of economic as well as total employment and the general price
policy-making. Economic policies are government level.
actions that try to solve economic problems.
When a government makes a policy to lower the
unemployment rate, this is based on a belief that
1.3 Central themes
the unemployment rate is too high, and the value
Explain that the economics course will focus on several
judgement that high unemployment is not a good
themes, which include:
thing. If a government pursues a policy to make
– the distinction between economic growth and
health care available free of charge, this is based on a
economic development
belief that people should not have to pay for receiving
– the threat to sustainability as a result of the current
health care services.
patterns of resource allocation
Positive and normative economics, while
distinct, often work together. To be successful, an
– the extent to which governments should intervene in
the allocation of resources
economic policy aimed at lowering unemployment
(the normative dimension) must be based on a
– the extent to which the goal of economic efficiency
may conflict with the goal of equity.
body of economic knowledge about what causes

12 Introduction
In this section we will examine some central economic growth. Economic growth, or growing output, is
themes that will run through your study of economics. important as a basis for economic development,
Each of the themes is beset by conflicts, or unresolved because it means that more goods and services are
questions, over which there is disagreement among being produced, and therefore the standards of living
economists. There is no single ‘right’ or ‘wrong’ of people could be potentially increased. However,
answer to the issues posed; answers provided by economic development may not follow automatically
different economists depend on different perspectives. from economic growth. It is possible to have growth
Whereas economists attempt to justify one or another in the quantity of output produced, but this may not
perspective on the basis of economic theories or result in a reduction of income inequalities, poverty
models, ultimately a decision in favour of one or or unemployment, or in the provision of increased
another perspective may depend on the economist’s social services such as education, health care and
personal preference for one theory over another. sanitation.

Where economists disagree

The distinction between economic growth While economists agree on the distinction between
and economic development economic growth and economic development, and
on the point that developing countries should have
The meaning of economic growth and policies to encourage growth and development,
economic development there are disagreements over how this should be
All economies produce some output, which includes done. For example, should growth be a priority, on
goods and services produced for consumers, as the assumption that some development will follow
well as capital goods (physical capital). Over time, if growth occurs? Or should development objectives
the quantity of output produced changes. When it be a direct priority? What are the best policies that
increases, there is economic growth; if it decreases, governments and international organisations can
there is economic contraction or negative economic pursue to help countries achieve both economic
growth. growth and economic development? As we will see in
Usually, the quantity of output produced by Section 4 of this book, there are no simple answers to
countries increases over long periods of time, but these questions.
there are enormous differences between countries in
how much output they produce and in how quickly
or slowly this increases over time. Whereas countries Test your understanding 1.9
are commonly referred to as being ‘rich’ or ‘poor’,
1 Explain the difference between economic
economists try to classify them in a more precise
growth and economic development.
way. The World Bank (an international financial
institution that we will study in Chapter 18) divides 2 Which country do you think is more
them into ‘more developed’ and ‘less developed’ ‘developed’: one with higher levels of output
according to their income levels, which as we will and low provision of social services (such as
discover are closely related to quantities of output health care services and sanitation), or one with
produced. lower levels of output and higher provision of
Yet differences between countries in their level social services?
of economic development involve much more than
just differences in incomes and quantities of output
produced. Economic development refers to raising Current patterns of resource allocation as a
the standard of living and well-being of people. This threat to sustainability
means not only increasing incomes and output,
but also reducing poverty among very poor people, The meaning of sustainability
redistributing income so that the differences between Economic growth and economic development in
the very rich and very poor become smaller, reducing many (if not most) countries are often achieved
unemployment, and increasing provision of important at the expense of the natural environment
goods and services such as food and shelter, sanitation, and natural resources. Growth in output, or a
education and health care services so that they can be general improvement in the standard of living
enjoyed by everyone in a population. of the population, very often result in increased
We can see from this definition that economic air and water pollution, and the destruction or
development is quite different from economic depletion of forests, wildlife and the ozone layer,

Chapter 1 The foundations of economics 13

among many other natural resources. Growing resources, as fewer and lower-quality resources are left
awareness of this issue has given rise to the concept of behind for future generations.
sustainable development, defined as ‘development which
meets the needs of the present without compromising Where economists disagree
the ability of future generations to meet their own While virtually everyone today agrees on the
needs’.1 importance of sustainability, there is vast disagreement
Sustainable development occurs when societies grow about what this means from a practical point of
and develop without leaving behind fewer or lower- view, and how this can be achieved in practice. One
quality resources for future generations. If we in the important reason is that the concept of sustainable
present use up resources at a rate that leaves fewer or resource use involves very large numbers of variables
lower-quality resources behind, we are satisfying our relating to scientific, environmental, economic, social
needs and wants now at the expense of people in the and institutional conditions, that are interrelated
future, who with fewer or lower-quality resources will in very complex ways, many of which are not fully
be less able to satisfy their own needs and wants. If we understood by scientists and social scientists, are
enjoy the benefits today of production and consumption subject to numerous uncertainties and cannot even
by changing the global climate and by using up clean be accurately measured given the present state of
air, seas and rivers, forests and the ozone layer, we are scientific knowledge.
putting future generations at a disadvantage. Another reason is that even if it were possible to
Using the definition of sustainable development, provide answers to the technical questions, there are still
we can see that sustainability involves using very important issues of an ethical and philosophical
resources in ways that do not reduce their quantity or nature that science and social science are not equipped
quality over time. As a rule it is used with reference to address. These issues are discussed in the Theory of
to renewable resources, or those kinds of natural knowledge feature in Chapter 5, page 127.
resources that are able to reproduce themselves (such
as forests, fish and sea life, air quality, the fertility of
the soil). Sustainable resource use does not mean that Test your understanding 1.10
these kinds of natural resources should not be used at
1 Explain the meaning of sustainability.
all, but rather that they should be used at a rate that
gives them enough time to reproduce themselves, so 2 Consider the following: ‘But just as the speed and
that they can be maintained over time and not be scale of China’s rise as an economic power have no
destroyed or depleted. clear parallel in history, so its pollution problem
Threats to sustainability arise from the ways that has shattered all precedents. Environmental
societies answer mainly the first two of the three degradation is now so severe that pollution poses
basic economic questions. Major threats come from not only a major long-term burden on the Chinese
our current patterns of resource allocation, in other public but also an acute political challenge to the
words, from the ways societies are choosing to answer ruling Communist Party.’
the what to produce and the how to produce questions. (a) In your opinion, is China achieving
In the what to produce part of resource allocation, the sustainable development?
issue in high income societies involves consumption (b) What can you conclude about China’s rapid
relying strongly on fossil fuels that pollute the economic growth and its impacts on future
environment (for example, excessive use of private generations?
cars, home heating and air conditioners). In the how to
produce part of resource allocation, the issue involves
methods of production (industrial production) that The extent to which governments should
also rely on heavy use of fossil fuels. In very poor intervene in the allocation of resources
societies, inappropriate resource allocation is often
caused by poverty itself, which drives very poor people The meaning of government intervention
to destroy their natural environment as they make in the market
an effort to survive. Examples include cutting down Countries around the world differ enormously in the
forests, overgrazing, soil erosion, and many more. In ways they make allocation and distribution decisions.
all these cases, there may be an unsustainable use of At the heart of their differences lie the methods used

1
Brundtland Commission (World Commission on Environment and
Development) (1987) Our Common Future, Oxford University Press.

14 Introduction
to make the choices required by the what, how and Where economists disagree
for whom to produce questions. There are two main Whereas everyone agrees that some government
methods that can be used to make these choices: the intervention in markets is necessary, economists
market method and the command method. disagree widely over how much governments should
In the market method, resources are owned by intervene and how they should intervene. There
private individuals or groups of individuals, and it are two broad schools of thought on this issue. One
is mainly consumers and firms (or businesses) who focuses on the positive aspects of markets, while the
make economic decisions by responding to prices other focuses on the imperfections of markets.
that are determined in markets (we will see how this According to the first, it is argued that in spite of
happens in Chapter 2). In the command method, imperfections, markets are able to work reasonably
resources (land and capital in particular) are owned by well on their own, and can produce outcomes that
the government, which makes economic decisions by generally promote society’s well-being. Markets can
commands. In practice, commands involve legislation achieve a reasonably good allocation of resources,
and regulations by the government, or in general any answering the what to produce and how to produce
kind of government decision-making that affects the questions quite well. Government intervention
economy. changes this allocation of resources, and often worsens
In the real world, there has never been an it, giving rise to resource waste. Therefore, while some
economy that is entirely a market economy or minimum government intervention may be needed in
entirely a command economy. Real-world economies certain situations, this should not be very extensive.
combine markets and commands in many different According to the second school of thought, markets
ways, and each country is unique in the ways they have the potential to work well, but in the real world
combine them. Economies may lean more toward their imperfections may be so important that they
the command economy (as in communist systems), make government intervention necessary for their
or more toward the market economy (as in highly correction. This means that markets, working on their
market-oriented economies). Whatever the case, in own, do not do a very good job of allocating resources
the last 30 or so years, there has been a trend around in society’s best interests; the purpose of government
the world for economies to rely more and more on intervention therefore is to help markets work better
markets and less on commands. Economies that and arrive at a better pattern of resource allocation and
are based strongly on markets but also have some distribution of income and output.
command methods are called mixed market economies.
In mixed market economies, the command methods
of making allocation and distribution decisions Test your understanding 1.11
are referred to as government intervention,
1 Provide some more examples of command
because the government intervenes (or interferes) in
methods (government intervention) in mixed
the workings of markets. Examples of government
market economies.
intervention include provision of public education,
public health care, public parks, road systems, national 2 What is the main source of the disagreement
defence, flood control, minimum wage legislation, between those who argue there should be little
restrictions on imports, anti-monopoly legislation, tax government intervention in the economy and
collection, income redistribution, and many more. those who argue that government intervention
should be more extensive?
Whatever the reasons for and types of government
intervention in the market, government
intervention changes the allocation of resources
(and distribution of output and income) from what
The extent to which the goals of economic
markets working on their own would have achieved. efficiency and equity might conflict
The meaning of economic efficiency
The market economy offers important benefits that and equity
we will discover in Chapter 2. Yet it does not always Economic efficiency involves making the best
produce the ‘best’ answers to the what, how and for use of resources and avoiding waste. It involves
whom questions for many reasons to be discussed answering the what and how to produce questions by
in later chapters. Therefore, a market economy allocating resources in the best possible way to avoid
cannot operate effectively without some government resource waste (page 2). When economic efficiency
intervention. is achieved, it means resources are allocated in a way

Chapter 1 The foundations of economics 15

that the economy produces the most of those goods larger than others; it is believed that this is unfair, and
society mostly prefers. Therefore, an important goal of a decision is made to change how the pie is divided
government policies virtually everywhere is to increase up so that everyone receives a fair share. A ‘fair share’
efficiency in the economy as much as possible. is interpreted to mean an ‘equal share’, and the pie
Equity refers to the idea of being fair or just. is cut so everyone has equal size pieces. However, in
Equity is not the same as ‘equality’. Equality is one the following year, when the pie is baked again, the
possible interpretation of equity, but there are also overall size of the pie is smaller than the year before.
other possible interpretations. For example, in many The shrinking of the pie means that due to income
countries in the world, it is considered equitable that redistribution, the amount of output produced (and
people with higher incomes and wealth pay higher the income corresponding to this output) decreased.
taxes than people with lower incomes and wealth. The reason behind the decrease can be found in the
Clearly, this notion of equity involves treating people poorer allocation of resources, which did not allow the
unequally. (This will be discussed in the Theory of economy to produce the greatest possible amount of
Knowledge feature on page 315.) output with its resources.
The idea of equity in economics often arises in Why did this happen? Arthur Okun argued that
connection with the distribution of income (and government intervention to redistribute income
output), involving the for whom to produce question. results in changes in work effort (people do not work
Equity, or fairness, in the distribution of income is often as hard), in changes in savings and investment (people
interpreted as greater equality (or less inequality) in save and invest less) and in changes in attitudes (for
the share of income received by individuals or families example, people have less of an incentive to train and
in a society. The aim is not to make the distribution get new skills to become more productive). It follows,
of income completely equal, but to ensure that people then, that there is a conflict between efficiency and
who would have little or no income in a market equity (in the sense of income equality).
economy, and cannot secure enough of essential goods Other economists claim that there need not always
and services, such as food, shelter, health care, and so be a conflict between equity and efficiency. According
on, will be able to survive. Therefore, equity is also an to one argument, government intervention to
important goal of government policies. change income distribution could result in changes
in behaviour that lead to greater rather than less
Where economists disagree efficiency. For example, suppose an economy has
According to many economists, there is a trade-off income inequalities so great that very low income
between efficiency and equity (in the sense of a more people are too discouraged, or too unhealthy, or
equal income distribution): more income equality too unskilled to be able to work. Some income
involves less efficiency, and vice versa. The reason redistribution in their favour could increase their
they may conflict is that government intervention in ability to work and make them more productive, thus
markets to achieve equity (or anything else for that increasing both income equality and efficiency (the size of
matter) changes the allocation of resources. What the future pie). Therefore, in this view there need not be
if these changes in resource allocation make the an inevitable conflict between efficiency and equity,
economy less efficient; what if they do not allow the and the two may be compatible.
economy to answer the what to produce and how to
produce questions in the best possible way?
This idea emerged in the 1970s from a highly Test your understanding 1.12
influential book written by a famous economist,
Arthur Okun, who argued that ‘the conflict between 1 Why are the goals of efficiency and equity
equality and economic efficiency is inescapable’ important for any economy?
(Equity and Efficiency: The Big Trade-off, 1975). 2 Can you think of any situations where
The following example helps explain the idea of a inequality might be equitable?
conflict between efficiency and equity. Imagine a pie 3 What assumptions relating to human behaviour
representing society’s income, distributed between the underlie the different perspectives on the
people in the economy according to how much they relationship between equity and efficiency?
contribute to baking it. Some people’s pieces are much

16 Introduction
 Theory of knowledge

Why do economists disagree?

In examining the four themes that run through your the hypothesis is a valid one. It may be invalid, but the
study of economics, we have discovered four major evidence just has not been discriminating enough to
areas where economists disagree (you will discover reject it. This has important implications for economics.
many more areas of disagreement as you read this book). It means that there may be several conflicting hypotheses
Why do economists disagree so much? It would seem that economists are holding on to and working with, not
that use of the social scientific method in economics, all of which are valid hypotheses, and some of which may
by forcing hypotheses to undergo tests, and allowing be false.
the real-world evidence to sift through valid and invalid Moreover, economists may use these hypotheses to
hypotheses, would eliminate much disagreement. Why build theories. A theory was described in the Theory
do economists continue to disagree in spite of their of knowledge feature on page 10 as being based on
use of the social scientific method? To try to answer several hypotheses that have not been rejected, based
this question, we should consider the point mentioned on evidence. This means it is possible to have theories
earlier on the difficulties of testing hypotheses due built on invalid hypotheses, which simply have not (yet)
to the inability of economists to perform controlled been shown to be invalid. But if the hypotheses on which
experiments (page 8). theories are built are invalid, then surely the theories
The social scientific method, as we have seen, themselves are also invalid. This explains one possible
involves relating evidence to educated guesses about reason why we sometimes see several conflicting
cause-and-effect relationships between variables to theories being used at the same time. Maybe only one
see if they match. Economists face some difficulties of them (or even none of them) is valid. Whatever the
in this effort. First, the inability to perform controlled case, as economists usually prefer to support one theory
experiments means that economists collect data about over another, this may be an important reason why they
real-world events that are the result of many variables sometimes disagree.
changing at the same time. To test hypotheses,
economists devise complicated econometric
models that try to isolate the interfering effects of Thinking points
numerous variables, and try to link causes with effects. As you read this book and learn more about economics,
Sometimes, economists have to deal with incomplete you may want to keep the following questions in mind:
or unreliable real-world data. In some cases, they • Can you think of other possible reasons why
may even be faced with variables that are not economists often disagree?
measurable and have no data, in which case they must
• What other social sciences/sciences cannot test
use substitute variables (called ‘proxy’ variables) or
hypotheses by performing controlled experiments?
substitute relationships between variables. As a result
of these difficulties, it is not unusual for two or more • Do you think economists disagree more or
economists to be testing the same hypothesis and to less than (or the same as) other social and natural
come up with conflicting results. scientists?
For all these reasons, while the testing methods • Do you think the difficulties of economics are due
of economists do produce some useful results, these to its being a ‘young’ social science that will slowly
are sometimes not as accurate and as reliable as the ‘mature’ and resolve these difficulties as econometric
results of experiments in other disciplines performed methods and the quality of data improve, or are they
under controlled conditions. This means it may be more due to problems that are inherent in the nature of the
difficult for hypothesis testing in economics to refute subject and cannot be easily resolved?
(reject) invalid hypotheses. If the evidence does not • Do you think these difficulties seriously affect
reject a hypothesis, economists hold on to it and may the progress and development of new economic
continue to use it in their work (possibly until further knowledge, or can economics continue to progress in
testing in the future). However, this does not mean that spite of these difficulties?

Chapter 1 The foundations of economics 17