1.3.

1 Introductory concepts
1 The nature of economics
a) Economics as a social science: Economics is generally classified as a social science and uses the
scientific method as the basis for its investigation. A social science is the study of societies and human
behaviour using a variety of methods, including the scientific method. A scientific method is a method
which subjects theories or hypothesis to falsification by empirical evidence. The scientific method at its
most basic is relatively easy to understand. A scientist:
 Postulates/puts forward a theory or model – a hypothesis which is capable of refutation. E.g. the
Earth travels round the Sun, the Earth is flat.
 Gathers evidence to either support the theory or refuse it. For example, an astronomical observation
gives evidence to support the theory that the Earth travels round the Sun. On the other hand, data
refutes the idea that the Earth is flat. Gathering evidence may be done through controlled
experiments.
 From this, they will then accept, modify or refute/disprove the theory. For example, Earth does
travel round the Sun; the Earth is not flat.
Theories which gain universal acceptance are called “laws”. For example, the law of gravity, and in
economics the laws of demand and supply.

Inability to conduct scientific experiments: In natural sciences, such as physics or chemistry, it is

relatively easy to use the scientific method. In physics, much of the work can take place in laboratories.
Observations can be made with some degree of certainty. Control groups can be established. It then
becomes relatively easy to accept or refute a particular hypothesis. This is much more difficult in social
sciences such as economics, sociology and politics. In economics, it is often not possible to set up
experiments to test hypothesis. It is often not possible to establish control groups or to conduct
experiments in environments which enable one factor to be varied whilst other factors are kept constant.
The economist has to gather data in the ordinary everyday world where many variables are changing
over any given time period. It then becomes difficult to decide whether the evidence supports or refutes
a particular hypothesis.
Even with a particular set of data, economists may come to very different conclusions as their
interpretations may differ. For example, an unemployment rate of 6% in Scotland compared to a
national average of 3% may be interpreted by some as a failure of government policy to help this area,
while others may conclude the policy had been a success as unemployment may have been far greater
without the use of policy.
It is also argued that economics cannot be a science because it studies human behaviour and human
behaviour cannot be reduced to scientific laws. It is very difficult to understand and predict the
behaviour of individuals. In economics, much analysis is couched in terms of “it is likely that” or “this
may possibly happen”. Economists use this type of language as they know they have insufficient data to
make firm predictions and other variables may change at the same time, altering the cause of events.

Summary: A scientist can prove the relationships between two variables by conducting experiments.
This is not possible for an economist. For example, an economist does not conduct an experiment to
determine the impact of a 10% increase in VAT. Instead, an economist creates a simplified model of the
economy to look at the impact of such an increase.

Introductory Concepts by S. Jega 1

 b) The development of theories and models in economics: The terms “theory” and “models” are often
used interchangeably and there is no exact distinction between the two. However, an economic theory is
generally expressed in looser terms than a model. For example, “consumption is dependent upon
income” might be an economic theory. Theories can often be expressed in words. But economic models
are expressed in mathematical terms.

Economists develop models to explain how the economy works. Examples include theories of supply
and demand or the circular flow of income. These are developed by putting forward a model, gathering
evidence and then accepting, changing or disregarding the model.

The purpose of modelling: The universe is a complex place. There is an infinite number of interactions
happening at any moment in time. Somehow, we all have to make sense of what is going on. The
purpose of theories and modelling is to explain why something is as it is. They are simplified to make
them more useful. For example, some people are fascinated by questions such as “why do we fall
downwards and not upwards”. Theories are used in deciding how to act.

Simplification:
One criticism made of economics is that economics theories and models are “unrealistic”. This is
because any theory or model has to be a simplification of reality if it is to be useful. For example, when
dropping a feather and a cannonball from the top of the Leaning Tower of Pisa, it is true that they don’t
descend at the same speed as one law in physics predicts, but according to one law in physics it does
because it assumes that factors such as air resistance and friction don’t exist.
If a model is to be useful it has to be simple. The extent of simplification depends upon its use.
Simplification implies that some factors have been included in the model and some have been omitted.

c) The use of the “ceteris paribus” assumption in building models and drawing conclusions based on
them:
There are too many variables which can change within an economic model and so assumptions must be
made. All sciences make assumptions when developing models and theories. For example, in the case of
the feather and the cannonball being dropped from the Leaning Tower of Pisa, both would fall at equal
speed if it were assumed that there was no air resistance.
Making assumptions allows the scientists to simplify a problem to make it manageable to solve. An
important way in which economists simplify reality is to adopt the ceteris paribus condition. Ceteris
paribus is a Latin word which means that “all other things being equal” or “all other things being
the same”. For example, in demand theory, it is assumed that all the other factors affecting demand for
a good, such as income remain unchanged in order to isolate the price factor. Economists assume that
individuals behave in a rational way. They make the following two assumptions in relation to rationality

 When making economic decisions, economists assume that consumers will aim to maximise
benefit - they always choose a course of action that gives them the greatest satisfaction. This will
help them maximise benefit.
 Businesses aim to maximise their profit – when business owners make decisions, they will
always choose a cause of action that has the best financial results. This is because economists
assume that business owners will want to make as much profit as possible.
Introductory Concepts by S. Jega 2
2 Positive economics and normative economics
Positive economics – Positive economics is the scientific or objective study of the subject. It is concerned with
finding out how economies and markets actually work. In other words, it deals with objective explanation and
the testing and rejection of theories.

Positive economic statement – Positive statements are objective statements about economics which can be
tested with factual evidence, and can consequently be supported or refuted/rejected by evidence. Positive
statements tend to contain words such as ‘is’, ‘are’, ‘was’ and ‘will’. Examples include;

1. There is full employment in Japan is a positive statement because economists can search for evidence as
to whether there are unemployed resources or not and if there are large numbers of unemployed
workers, then this statement can refuted.
2. The amount spent per head on healthcare in the UK is less than that in the USA is a positive statement.
3. A fall in incomes will lead to a rise in demand for own-label supermarket foods
4. If the government raises the tax on beer, this will lead to a fall in profits of the brewers.
5. The rising price of crude oil on world markets will lead to an increase in cycling to work.
6. A reduction in income tax will improve the incentives of the unemployed to find work.
7. A rise in average temperatures will increase the demand for sun screen products.
8. Higher interest rates will reduce house prices.
9. Cut-price alcohol has increased the demand for alcohol among teenagers.
10. A car scrappage scheme will lead to fall in the price of second hand cars.

 The key thing here is that these statements can be tested, the results can be examined and the statement can
then be rejected or accepted.
 Statements about the future can be positive statements too. For example, ‘the service sector in Singapore
will grow by 15% in size over the next five years’ is a positive statement because this statement is capable
of being proved or disproved.

Normative economics – It is concerned with value judgement. It deals with the study of and presentation of
policy prescriptions about economics.

Normative economic statement – Normative statements are subjective statements based on value judgements
and opinion rather than factual evidence. Thus, these statements cannot be tested against the factual evidence
and be supported or refuted.
Normative statements tend to contain words such as ‘should’, ‘must’, ‘ought to’, ‘fair’, unfair, and ‘better’ and
the statement is suggesting that one action is more credible than another.
For example, “The free market is the best way to allocate resources” is a normative statement, because it is
based on opinion and suggests one method of resource allocation is better than another.
Other examples include;
1. It is unfair that people have to pay directly for their treatment in the USA.
2. Pollution is the most serious economic problem.
3. Unemployment is more harmful than inflation.
4. The congestion charge for drivers of petrol-guzzling cars should be increased to £25.
5. The government should increase the minimum wage to £7 per hour to reduce poverty.
6. The government is right to introduce a ban on smoking in public places.
7. The retirement age should be raised to 70 to combat the effects of our ageing population.

Introductory Concepts by S. Jega 3

8. Resources are best allocated by allowing the market mechanism to work freely.
9. The government should enforce minimum prices for beers and lagers sold in supermarkets and off-licences
in a bid to control alcohol consumption.

The role of value judgement

 Economists tend to use positive statements to back up normative statements. For example, ‘The government
should increase the interest rate’ is a normative statement which can be a backed up by ‘The rate of inflation
is at 5%’, - a positive statement.
 Value judgements can influence economic decision making and policy. Different economists may make
different judgements from the same statistic. For example, the rate of inflation can give rise to different
conclusions.

Note: Focusing on the evidence is called adopting an empirical approach – evidence-based work.

Exercise 1
“The USA spends 5.22% of its GDP on education, Germany 4.95% and the UK 5.72%. But, India’s spending of
3.83% of GDP on education is not sufficient to catch up with developed countries”
With reference to the statement, explain the difference between positive and normative statements. (4 marks)
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3 Scarcity
 The basic economic problem is that resources are scarce. That is, it is a problem of unlimited wants and
finite resources. For many of these resources there are infinite wants but finite resources with which to
satisfy them. Scarce resources mean that decisions need to be made regarding what, how, why, and for
whom goods and services are produced. Resources have to be used and distributed optimally.
 Scarcity is a relative concept as resources are not necessarily scarce in themselves but they are scarce in
relation to the demands placed upon them.

Wants and needs

 Needs are the necessities of life and should be satisfied for a person to survive as a human being. Basic
needs are generally limited and they do not change and grow. Further, needs cannot be created by others,
advertisement and technology.
 Wants are the different means of satisfying needs. In other words, wants are the desires for the consumption
of goods and services. Human wants are unlimited. They always keep changing and growing. There is
always something that a person wants more of. This can include more food, a bigger house, a longer
holiday, a cleaner environment, etc. These wants can be created by others, advertisement and technology.

The link between scarcity and opportunity cost

The limited amount of resources allied to the unlimited wants means that choices have to be made. That is,
human wants for goods and services are unlimited, and the resources with which to satisfy those wants are
limited, but they have alternative uses. That is, they can be used in numerous ways. But, the same resources
cannot be used to produce different goods at the same time and they can only be used for a particular purpose
because of scarcity. Since all human wants cannot be satisfied with the limited resources completely,
choices/decisions have to be made by economic agents on how to use them, and in doing so, there is an
opportunity cost. They have to allocate their scarce resources between competing uses.
Scarcity  Choice  Opportunity cost

Opportunity cost refers to the value of the next best alternative forgone for the option that is chosen.
Consumers, producers and governments experience opportunity costs. For consumers, opportunity cost is what
has to be given up when spending on an item. For example, a consumer should decide whether to spend his or
her disposable income on a new textbook or a meal out with friends and if he spends the money on textbook, the
opportunity cost is meal with friends.
As a producer, he has to choose whether to increase the dividend to shareholders or invest in capital goods and
if he invests on capital goods, then opportunity cost will be dividends for shareholders.
As a government, they should decide whether to allocate additional funding to education or invest in new
medical equipment for the NHS and if they decide to spend the money on education, then its opportunity cost
will be the medical equipment for NHS.

Zero opportunity cost

When there is no need to give up anything to obtain a good or service, it is called zero opportunity cost.
Under the following circumstances opportunity cost will be zero.
1. When resources do not have alternative uses.

Introductory Concepts by S. Jega 5

 2. Free goods have no opportunity cos as there is no scarcity. No resources need to be sacrificed when
someone, say, breathes air or swims in the sea.
3. When consuming public goods there is no opportunity cost for consumers.
4. When there is unemployment or under-utilization of resource. This is because the economy can produce
more of either of the two goods or both goods by using the idle of resources, without incurring
opportunity cost.

What is an economy?
An economy is a system which attempts to solve the basic economic problem. This economy acts to generate
goods and services, to satisfy human wants. An economy is organized by the economic system. In the economy,
goods are produced and people are gainfully employed.

Economic resources
They are the inputs to the production process. Economists commonly distinguish four types of resources
available for use in the production process, namely land, labour, capital and enterprise or entrepreneurship.
They call these resources as the factors of production.
 Land – it refers to all natural resources used in the production of goods and services. It includes not only
land itself but all natural resources below the earth, on the ground, in the atmosphere and in the sea.
Examples include coal, oil, gold and copper.
Owners of land may receive rent or lease payment. For resources like oil, copper or gold, royalty is paid
to their owners. (Royalty is a share of the money raised in sales of the resource)

Non-renewable resource is a resource of economic value that cannot be readily replaced by natural
means on a level equal to consumption. This includes fossil fuels such as coal, oil and gas, and gold and
copper.
The stock level decreases over time as it is consumed. Methods such as recycling and finding
substitutes, such as wind farms, can reduce the rate of decline of the resource.

Renewable resource - is resource of economic value that can be replenished or replaced on a level
equal to consumption. For example, oxygen, solar power and fish are renewable.
As long as the rate of consumption is less than or equal to the rate of replenishment, the stock will not
decrease. If the resource is consumed faster than it is renewed, then the stock of the resource will decline
over time. Renewable resources are sustainable. However, currently, resources are being consumed
faster than the planet can replace them.
Renewable resources can be managed by methods such as preventing or limiting deforestation, or
imposing fishing quotas.

Non-sustainable resources are resources that are diminishing over time due to economic exploitation.

 Labour – is all productive physical and mental human effort, paid or unpaid. It is a human resource.
Examples include doctors, teachers and politicians.
Not all workers are the same. Each worker has a unique set of personal characteristics.

Introductory Concepts by S. Jega 6

 Human capital is the value of the productive potential of an individual or group or workers; it is made
up of the skills, talents, education and training of an individual or group and, it represents the value of
future earnings and production.
The reward for labour is wage.
 Capital – refers to all man-made items used in the production of other goods and services. Examples
include machine, tools, factories, offices and roads. There are two types of capital; (i) working or
circulating capital and (ii) fixed capital.
Working capital is stocks of raw materials, semi-manufactured goods and finished goods that are
waiting to be sold. These stocks circulate or move through the production process until they are finally
sold to a consumer.
Fixed capital is the stock of factories, offices, plant and machinery. These fixed capital will not be
transformed into a final product unlike working capital. It is used to transform working capital into
finished products.
Reward for capital is interest.

 Enterprise or entrepreneurship – is the seeking out of profitable opportunities for production by

combining other factors and taking risk in attempting to exploit these.
Entrepreneurs are individuals who seek out of profitable opportunities for production by combining
other factors and taking risk in attempting to exploit these. Example, owners of small and medium-sized
businesses. They perform the following;
o Organising production – organise land, labour and capital in the production of goods and services.
o Taking risks – with their own money and financial capital of others, they buy factors of production
to produce goods and services in the hope that they will be able to make profit. They also know that
they may end up bankruptcy.

The distinction between free goods and economic goods

Free goods are those in unlimited supply and so abundant that its availability is not a constraint on
economic activity and, consequently, there is no opportunity cost. For example, air to breathe, rain
water.

In contrast, economic goods are those resources which are scarce and, therefore, have an opportunity
cost. Further, they imposes some cost on society to produce.

Introductory Concepts by S. Jega 7