How do economists approach the world?
How do economists know anything? This page covers the method (positive economics tests claims against evidence;
normative economics makes value judgments) and the history of the ideas you will meet later: Smith’s invisible hand,
Say’s law, the margin, Marx, Keynes, the monetarists, behavioural economics and the circular economy. The history is
not examined for dates. It matters because today’s arguments about policy, such as Keynesian versus monetarist, are
those old debates still running.
🎯What you need to be able to do
- Explain the role of positive economics: logic, hypotheses, models and theories, ceteris paribus, empirical evidence and refutation.
- Explain the role of normative economics and value judgments in policy making, and distinguish equity from equality.
- Outline how economic thought developed from the 18th to the 21st century, and connect each school to the topics where it reappears.
📚The economics
Positive economics
Positive economics deals with statements about what is, was or will be. They can be tested against evidence and shown to be true or false. “Raising the tax on cigarettes reduces the number of cigarettes smoked” is positive: you may disagree, but data can settle it.
- Logic: reasoning step by step from assumptions to conclusions. If people buy less when prices rise, and a tax raises the price, then a tax reduces purchases.
- Hypothesis: a testable prediction, such as “a 10% rise in the minimum wage reduces youth employment”.
- Model: a simplified representation of reality (the PPC, demand and supply, AD/AS). Models leave out detail on purpose, so that the relationship being studied is visible.
- Theory: a hypothesis that has survived repeated testing, such as the law of demand.
- Ceteris paribus (“other things being equal”): the assumption that only one factor changes at a time. A demand curve shows the effect of price ceteris paribus: income, tastes and other prices are held constant.
- Empirical evidence: real-world data used to test hypotheses. Economists usually cannot run controlled experiments on whole economies, so they compare countries, periods or groups, or use natural experiments.
- Refutation: a theory can never be proved true once and for all, but one clear contradiction can show it is false. Theories are kept until the evidence refutes them.
Normative economics
Normative economics deals with statements about what ought to be. They contain value judgments and cannot be tested: “the government should tax cigarettes more heavily” depends on how you weigh public health against personal freedom and the burden on poor smokers. Words like should, ought, fair, too high and better usually signal a normative statement.
Policy making is always normative in the end. Positive economics can tell a minister what a policy will probably do; deciding whether those results are worth it requires value judgments about goals such as efficiency, equity and sustainability.
Equality
Everyone has the same: the same income, the same wealth, the same access. It is positive: you can measure it (the Gini coefficient, 3.4).
Everyone has the same: the same income, the same wealth, the same access. It is positive: you can measure it (the Gini coefficient, 3.4).
Equity
Fairness. It is normative: people disagree about what is fair. Most would call it fair for a surgeon to earn more than a trainee, so equity need not mean equality; many would call it unfair for a child’s schooling to depend on parental income.
Fairness. It is normative: people disagree about what is fair. Most would call it fair for a surgeon to earn more than a trainee, so equity need not mean equality; many would call it unfair for a child’s schooling to depend on parental income.
Economic thought in its historical context
18th century: Adam Smith and laissez faire
Adam Smith’s The Wealth of Nations (1776) argued that individuals pursuing their own self-interest in competitive markets are led, as if by an invisible hand, to produce what society wants. He emphasized the division of labour and specialization as the source of rising productivity. From this comes laissez faire (“let it be”): the view that governments should interfere as little as possible in markets. Smith himself saw important roles for government: defence, justice and public works. Later: the price mechanism (2.3) and specialization in trade (4.1).
19th century: the classical economists, the margin and Marx
- Classical macroeconomics and Say’s law. Jean-Baptiste Say argued that supply creates its own demand: producing goods generates incomes that are spent on other goods, so a general, long-lasting shortage of demand is impossible. Markets, left alone, return to full employment. This is the ancestor of the monetarist/new classical LRAS (3.2).
- Classical microeconomics: utility and the margin. In the 1870s, Jevons, Menger and Walras shifted attention to utility (satisfaction) and decisions made at the margin: is one more unit worth its cost? Marshall later combined this into the demand and supply diagram. The ideas of diminishing marginal utility (2.1) and marginal cost (2.2) come from here.
- The Marxist critique. Karl Marx (Das Kapital, 1867) argued that capitalism is unstable and unjust: owners of capital extract profit from the labour of workers, wealth concentrates, and crises recur. His ideas shaped the planned economies of the 20th century and still inform debates about inequality (2.12).
20th century: Keynes, macroeconomic policy and the counter-revolution
- The Keynesian revolution. The Great Depression of the 1930s, with mass unemployment lasting years, contradicted Say’s law. John Maynard Keynes (The General Theory, 1936) argued that aggregate demand can stay too low for a long time, so an economy can be stuck below full employment, and that governments should boost demand by spending and running deficits.
- The rise of macroeconomic policy. After 1945, governments accepted responsibility for managing demand to keep unemployment low (fiscal policy).
- The monetarist/new classical counter-revolution. In the 1970s, stagflation (high inflation and high unemployment together) undermined Keynesian policy. Milton Friedman and the monetarists argued that inflation is caused by too much money, that government intervention often makes things worse, and that markets adjust to full employment in the long run. Policy shifted towards controlling inflation, independent central banks and supply-side policies.
21st century: other disciplines, behaviour and the environment
- Dialogue with psychology: behavioural economics. Researchers such as Daniel Kahneman (Nobel prize 2002) and Richard Thaler (2017) showed that people use rules of thumb, are influenced by framing and struggle with self-control. This challenges the assumption of rational consumers and gave governments “nudges” as a policy tool (2.4, HL).
- Interdependence of economy, society and environment. Climate change, biodiversity loss and inequality have pushed economists to treat the economy as part of society and nature, not separate from them.
- The circular economy. A traditional “linear” economy takes resources, makes products and throws them away. A circular economy designs out waste: products are reused, repaired, remanufactured and recycled, so output can grow without using ever more finite resources. Bali’s ban on single-use plastic bags, polystyrene and straws is a small step in this direction (4.7).
✏️Worked example
Classify each statement as positive or normative, and explain why.
(a) “Indonesia’s fuel subsidies cost the government more when world oil prices rise.”
(b) “Fuel subsidies are unfair because richer households with cars benefit most.”
(c) “Richer households with cars receive a larger share of fuel subsidy spending than poorer households.”
(d) “The government should replace fuel subsidies with cash transfers to poor families.”
(a) “Indonesia’s fuel subsidies cost the government more when world oil prices rise.”
(b) “Fuel subsidies are unfair because richer households with cars benefit most.”
(c) “Richer households with cars receive a larger share of fuel subsidy spending than poorer households.”
(d) “The government should replace fuel subsidies with cash transfers to poor families.”
(a) Positive. It describes a cause and effect that can be checked with budget data: the subsidy covers the gap between the world price and the fixed pump price, so a higher world price means a bigger gap.
(b) Normative. “Unfair” is a value judgment about equity. The fact behind it may be true, but whether it is unfair depends on values.
(c) Positive. This is the testable claim hidden inside (b). Household spending surveys can confirm or refute it.
(d) Normative. “Should” recommends a policy. Positive economics can predict its effects (on poverty, the budget, fuel use), but choosing it involves weighing those effects.
Check it. Ask: could evidence, in principle, prove the statement wrong? If yes, it is positive, even if
it turns out to be false. A false positive statement is still positive.
Calling a statement normative because you disagree with it, or positive because it is true. The test is
whether it can be checked against evidence, not whether it is correct.
📝Practise
Work through these on paper, then reveal the answer.
1. Explain what is meant by ceteris paribus, and why economists use it.
Ceteris paribus means “other things being equal”: all other influences are
assumed constant while one variable changes. Economists cannot run controlled experiments on whole markets, so the
assumption lets them isolate the effect of one variable in a model, for example the effect of price on
quantity demanded with income and tastes unchanged.
2. Distinguish between equity and equality, with an example.
Equality means everyone has the same (income, wealth, opportunities); it can be
measured. Equity means fairness, a value judgment. Example: a progressive income tax takes a higher
proportion of income from high earners; it makes after-tax incomes less unequal, and many consider this
equitable because those with more can afford to contribute more, but others consider it unfair to the
high earners. Equity does not require equality.
3. Explain why a theory in economics can be refuted but never finally proved.
However many times the evidence agrees with a theory, a future observation might contradict it: past
agreement does not guarantee it holds everywhere and always. One clear contradiction, though, shows the theory is not
universally true. So theories are accepted provisionally, while they survive testing. In economics the
problem is sharper because behaviour changes with institutions and time, and other factors cannot be held constant.
4. Explain how the experience of the 1930s led to the Keynesian revolution.
Classical economics, following Say’s law, predicted that markets would quickly
return to full employment. In the Great Depression unemployment stayed very high for years, which the theory could not
explain: the evidence refuted it. Keynes argued that aggregate demand could stay too low for long
periods, so the economy could be stuck below full employment, and that governments should raise demand through
spending. This became the basis of postwar demand management.
5. Explain one way behavioural economics challenges earlier economic thinking.
Earlier theory assumed rational consumers with perfect information who maximize utility.
Behavioural economics, drawing on psychology, shows that people rely on rules of thumb, are swayed by how
choices are framed and by defaults, and struggle with self-control (for example,
under-saving for retirement). So predictions based on pure rationality can be wrong, and policies such as automatic
enrolment in pension schemes can change behaviour without changing prices.
6. Explain what is meant by a circular economy, and why it links to the key concept of sustainability.
A circular economy keeps products and materials in use for as long as possible through
reuse, repair, remanufacturing and recycling, and designs out waste, in contrast with the linear take–make–dispose
model. It links to sustainability because it reduces the extraction of finite resources and the
pollution from waste, so present needs can be met without reducing the ability of future generations to meet theirs.
🔗Go deeper — other people’s work
These are external resources, not mine. If one stops working, tell me and everything above it on this page still stands.
- Robert Heilbroner, The Worldly Philosophers — the classic readable history of Smith, Marx, Keynes and others.
- Ellen MacArthur Foundation — clear explanations and case studies of the circular economy.
- The Nobel Prize website — popular-science summaries of the prizes to Kahneman (2002), Ostrom (2009) and Thaler (2017).