What is economics

The nature of economics

Economics is the scientific study of the ownership, use, and exchange of scarce resources – often shortened to the science of scarcity. Economics is regarded as a social science because it uses scientific methods to build theories that can help explain the behaviour of individuals, groups and organisations. Economics attempts to explain economic behaviour, which arises when scarce resources are exchanged.

In terms of methodology, economists, like other social scientists, are not able to undertake controlled experiments in the way that chemists and biologists are. Hence, economists have to employ different methods, based primarily on observation and deduction and the construction of abstract models.

As the social sciences have evolved over the last 100 years, they have become increasingly specialised. This is true for economics, as witnessed by the development of many different strands of investigation including micro and macro economics, pure and applied economics, and industrial and financial economics. What links them all is the attempt to understand how and why exchange takes place, and how exchange creates benefits and costs for the participants.

The study of economics

The study of economics involves three related investigations.

Why scarce resources are exchanged?
How consumers and producers behave as they interact with each other in markets, in their attempt to achieve mutually beneficial exchange?
The role of government in compensating for the limitations of markets in achieving mutually beneficial exchange?

The methods used by economists

Economists use scientific observation and deduction in their investigations. To achieve this they:

Describe and measure the exchanges they observe

Economists describe changes in economic variables, and measure these changes over time. For example, economists describe and measure how interaction in markets determines the prices of such diverse products as motor cars, houses, haircuts, and computer software. Measurement in economics can take many forms, including measuring absolute and relative quantities and values. When measuring relative values it is common to use index numbers.

Explain how interactions arise and create costs and benefits

Economists try to explain the effects, or results, of economic transactions. For example, economists can explain why, despite bubbles and crashes, the long-run trend in house prices in the UK has been upwards over the last 30 years, and can identify those who have been affected positively and negatively by this increase. Of course, economists also try to explain the short-term movements in prices, and how they also have costs and benefits.

Propose hypotheses, construct, and apply ‘models’ to test these hypotheses.

Like all scientists, economists develop hypotheses to explain why economic behaviour takes place, and then construct models to test these hypotheses. For example, economists may propose that price rises are caused by excess demand, and then attempt to construct a model of price that explains how excess demand can raise price. Economists frequently use versions of the demand and supply model to help explain events such as house price trends and movements. Economic models usually employ graphical and mathematical analysis to help explain and illustrate such economic processes.

Gather data to put into the model

Models must be tested against the real world, which means gathering statistical data about real events. In this way, a model can be improved and revised when necessary.

Predict behaviour based on these models.

The ultimate goal of the economist is to predict future behaviour. For example, by using a demand and supply model and by inputting real data about the housing market, economists can show that even a small fall in bank lending can trigger behaviour that leads to a significant fall in house prices in the short run. The ultimate value of an economic model is that it can accurately predict the onset and the effect of an economic event. The better the model is, the more useful it is in helping economists make predictions.

Economists assume that economic events and phenomena do not occur at random, but are determined by underlying and understandable causes. Unlike the pure scientist, economists cannot undertake controlled experiments, so they must test their models in different ways. Statistical analysis of actual economic data can provide a flow of information from which to build models and test hypotheses. For example, by gathering data about changes in house prices it is possible to deduce factors that cause house prices to go up or down, and by how much. Economists use index numbers to help make comparisons between countries and over time.

Correlation analysis can help determine the strength of particular causal relationships so that strong and weak relationships can be identified. For example, it might be possible to demonstrate that, of all the factors that have contributed to falling house prices, the reduced availability of credit is the single biggest factor.

The role of the professional economist

Professional economists apply their skills of description, analysis, model building, and prediction to generate knowledge and, from this, provide advice to private firms, to governments and other organisations.

Providing knowledge

The first function of the economist is to provide information, called economic intelligence, from which decisions can be made. For firms to survive and succeed, they need to take many decisions, but each decision carries with it a risk. The professional economist can help reduce such risks by gathering and analysing economic intelligence. This economic intelligence is only useful when it can be put into an economic model, and then applied to the decisions that need to be taken.
The second function of the professional economist is to interpret the data that has been gathered and provide informed advice to firms, organisations, and governments about the likely costs and benefits of the decisions they make.

In providing advice, the economist will always make an assessment of the other options that could have been chosen. For example, a large petrol refiner and retailer may be faced with a significant rise in the costs of crude oil – should it now raise price? After having made an assessment of all the pricing options, and having taken account of the likely response of rivals, the firm’s chief economist may advise it to hold price constant – perhaps the least ‘common sense’ answer.

To find out why, see: oligopoly

Positive and normative economics

As a social science, economics attempts to use the principles and methods of science to explain economic behaviour. This involves making positive statements about the economic world.

Positive statements are those that can be verified, and are factual, such as:

‘.. House prices have fallen by 15% over the last year…’

In contrast, normative statements are based on opinion and value judgement. Statements suggesting that something ‘ought to’ happen, or that something is ‘unfair’, are normative because they are matters of opinion.

For example, ‘..the recent fall in house prices is unfair to the rich..’.

This statement cannot be tested because it not based on anything testable. If there is an agreed definition of fairness, and it can be measured, then it might be possible to test the effect of the change in house prices on the degree of fairness experienced by a certain identifiable group of people defined as rich. Therefore, this statement is normative, impossible to verify, and based on opinion rather than fact.

The Ceteris Paribus Rule

Economics is a social science, and, unlike the physical sciences, cannot engage in controlled experimentation to demonstrate how variables are connected.

In the real world, economic variables such as price and income, are constantly changing, and this creates a problem in demonstrating the relationship between variables. For example, a fall in price is likely to lead to a rise in consumer demand if we assume nothing else changes.

Of course, for independent reasons, income could also fall while demand does not rise. The fall in price could have been counteracted by a fall in income. The ceteris paribus rule, that all other things remain the same, is used whenever attempting to demonstrate the link between economic variables. Without this assumption, positive economics is impossible.

The Evolving Role of the Economist

Over time the role of the professional economist has broadened. In recent years much interest has been shown in the interconnections between economics and psychology, and there has been a considerable increase in the popularity of behavioural economics. This is both in terms of the number of Universities offering courses in behavioural economics, and in terms of how public policy makers have turned to this branch of economics, especially in the wake of the financial crisis. While it has its critics, behavioural economics has captured the imagination of a new breed of economists looking for answers in an increasingly uncertain and unpredictable world, and to what generally appear to be the failings of some traditional ‘micro’ economic theory. In terms of ‘macro’ economic theory, events can challenge existing assumptions and lead to a requirement to modify existing models, or completely replace them. For example, the financial crash of a 20 years ago led to a thorough re-thinking of the nature of financial risk, and to the establishment of better ways to understand why banking systems can fail, as well as develop more effective ways to regulate them. Similarly, the emergence of cryptocurrencies, such as Bitcoin, have forced economists to reassess the nature of money in a globalised world. Trading relationships between countries, and theories to explain them, have also been put under the spotlight as a result of Brexit.