Chapter 1 Basic Concepts in Economics by xiaopangnv


									Queen’s College
AL Economics notes                                      Chapter 2: Methodology of Economics

                  Chapter 2 Methodology of Economics
                              Economics is a social science…

Economics is a social science, and economists use the scientific method to study



A theory is a set of definitions, postulates, test conditions and predictions logically

organized to explain phenomena. It consists of several components:

Components of a theory Example

Definitions                 Terms like “rates”, “own” “cars” are defined

Postulates                  People are constrained maximizers

Test conditions             When the rate of road construction in Hong Kong increases

Implications                It is predicted that more people will own cars

It is important to note that theories are invented by theorists, that it should only be

accepted if it is valid and tested by facts.

Attributes of a good theory

Logically consistent

     The theoretical conclusion should follow logically from the postulate, without

any internal contradictions.

                                                                         Y.H.Chang (2003)
Queen’s College
AL Economics notes                                       Chapter 2: Methodology of Economics

Refutable by facts

    The prediction of the theory should be potentially refutable by facts. For example,

“If an animal is four-legged, it will have four legs.” The prediction that the animal

will have four legs must be correct, having no chance of being refuted. It is called

tautology. A tautological sentence tells us nothing about the world.

Testable implications

     It requires test conditions and predictions to be observable. Even if a theory is

potentially refutable by facts, we might face a problem that we could not collect any

evidences as either test conditions or predictions are not observable.

Assumptions may be unrealistic

     A theory is useful even if assumptions are unrealistic. The value of a theory is

not judged by its realistic assumptions but by its ability to explain and to predict



     The world is infinitely complex, it is impossible to find a theory to describe

everything. Hence every theories must be a simplification of the world. Inessential

details should be dropped to focus on the relevant factors.

The power the generalize

     A good theory should be able to be applied into different real world situations.

The law of demand is an excellent example that with only a few postulates we could

draw a lot of implications in most situations in daily life.

                                                                          Y.H.Chang (2003)
Queen’s College
AL Economics notes                                    Chapter 2: Methodology of Economics

Prediction versus forecast

It has to be noted that a we can make predictions from a theory, but not forecasts. A

forecast is either derived from an established trend or from a crystal ball. We make

forecasts in the stock market and the weather, but predictions in economic


Positive Economics VS Normative Economics

Positive economics contains descriptive statements, propositions and predictions

about the world. It tells us only what will happen under certain circumstances. It says

nothing about whether the consequences are good or bad, or about what we should do.

Normative economics makes statements about what ought to be, or about what a

person, organization, or nation ought to do.

Endogenous variable VS Exogenous variable

Endogenous variable is a variable whose value is determined within a theory.

Exogenous variable is a variable whose value determines the value of endogenous


Stock VS Flow

Stock is a quantity, which shows the value of a variable at a certain moment.

Flow is a rate, which shows the change in the value of a variable within a certain


Total, Average and Marginal

Refer to textbook page 36-40

                                                                       Y.H.Chang (2003)
Queen’s College
AL Economics notes                                      Chapter 2: Methodology of Economics

Deduction VS Fallacy

Deduction is a valid reasoning which draws a valid conclusion from given statements.

Fallacy is an invalid reasoning.

In the statement “If A then B”, A is called the antecedent, while B is called the


There are two kinds of fallacy in reasoning.

Fallacy of denying the antecedent

     In the sentence above, if you observe A is not true, it is invalid to conclude that B

is not true also. It is true that the occurrence of A would lead to the occurrence of B;

however with the absence of A, B could still occur as B could be lead by other factors

not mentioned in the statement.

Fallacy of affirming the consequent

     Similarly, if you observe B is true, you could not conclude that A is true. The

occurrence of B might not be lead by the occurrence of A, but other related factors.

Hence it is uncertain that if A is true or not.

                                                                         Y.H.Chang (2003)
Queen’s College
AL Economics notes                                     Chapter 2: Methodology of Economics

Discussion Questions

1. An economist predicts that as consumers maximize utility, when the price of a

   good rises, consumers would buy less. Identify the components of the theory

   suggested – its postulate, test condition and prediction.

2. Distinguish a refutable theory from a testable theory.

3. For the following pairs of statements, which one is a positive statement and which

   one is a normative statement?

          a) The safety threshold of this lift is nine persons.

              This lift should not carry more than nine persons.

          b) An increase in government expenditure reduces unemployment but

              raises inflation.

              Unemployment is a more serious social problem than inflation.

4. Determine whether the following items are stocks or flows.

          a) Amount of capital owned by a firm

          b) Consumption of three cups of coffee everyday

          c) Money deposited in a savings account

          d) Inventory of a department store

                                                                        Y.H.Chang (2003)
Queen’s College
AL Economics notes                                    Chapter 2: Methodology of Economics

                                Quick review of Chapter 2
2.1 Constructing a theory
A. What is a Theory
B. How does a theory arise?

2.2 Testing a theory
A. If evidences are consistent with predictions
B. If evidences are contrary to predictions

2.3 Criteria of a good theory
A. Usefulness
     1. a good theory should be a confirmed theory which is useful
     2. five criteria of a useful theory
                a) logically consistent or deductively valid
               b)    refutable or conceivable false
               c)    testable
               d)    has not been refuted
               e)    any postulates can be used
B. Applicability
C. Simplicity
    1. tautology
    2. prediction versus forecast

2.4 Classification of statements and variables
A. Positive statements versus normative statements
B. Endogenous variable versus exogenous variable
C. Stock versus flow

2.5 Total, average and marginal
A. the concepts of total, average and marginal
B. relations among total, average and marginal
     1. finding the total and average from the marginal
     2. finding the total from the average
     3. finding the average and marginal from the total

Appendix I deduction versus fallacy

                                                                       Y.H.Chang (2003)

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