THE METHODOLOGY OF ECONOMICS

Section Objectives  Understand how economists use economic models  Evaluate the economic activity using graphs  Explain why economists can disagree

Methodology  Three tools of analysis  Model building  Graphs  Positive versus normative analysis

Model-Building  Step 1  Identify the problem  Step 2  Develop a model by selecting the variables based on an assumption  Step 3  Collect data and test the model

Model-Building  Step 1: Identify the Problem  Define the problem  What is the question you want to answer “Why were 100 million fewer gallons of gasoline purchased in December than in May?”

Model-Building  Step 2: Develop a Model  Model: a simplification of reality used to understand the relationship between variables. (aka: theory)  Emphasizes those variables that are most important by assuming that all other variables remain unchanged. 

Model-Building  Step 2: Develop a Model  Ex. The gasoline model consists of two variables Price of gas Quantity of gas consumed  All other possible causes for the decline are ignored  Assumption: something that is accepted as being true. Consumer incomes and other variables do not change when gasoline prices rise.

Model-Building  Step 2: Develop a Model  Useful only if it yields accurate predictions.  If evidence confirms a model, it is accepted  If evidence does not support a model, the model is rejected

Model-Building  Step 3: Test the Model  Gather data to test the model  “If the price of gasoline rises, gasoline purchases fall.” Investigation reveals that the price of gasoline rose sharply between May and Dec. The data supports the model, thus the model is valid.

Applying Graphs to Economics  Economists use graphs to present economic models.  Graphs are the simplest way to present and understand the relationship between economic variables  Basic economic analysis concerns the relationship between two variables

Applying Graphs to Economics  Direct Relationship  A positive relationship between two variables When one variable increases the other variable increases When one variable decreases the other variable decreases Both variables change in the same direction  Also assumes that all other variables not shown remain unchanged

Applying Graphs to Economics

 Another tool used is to arrange in rows and columns  This table shows the same info in a different format PointPC Expenditure (thousands of dollars per year) Annual Income (thousands of dollars) A$1$30 B$2$60 C$3$90 D$4$120

Applying Graphs to Economics  Inverse relationship  A negative relationship between two variables When one variable decreases the other variable increases When one variable increases the other variable decreases The variables move in opposite directions

Applying Graphs to Economics

 Law of demand  Inverse relationship between a product’s price and quantity demanded  Law of supply  Direct relationship between a product’s price and the quantity demanded

Why Do Economists Disagree?  Positive Economics  Analysis based on facts Uses statements that can be proven either true or false Often a positive statement is expressed using the words “if” and “then”  A positive statement does NOT have to be true, it has to be testable

Why Do Economists Disagree?  Normative Economics  Analysis based on value judgments Express an opinion on a subject Key words or phrases are normative Good Bad Need Should Ought to be