Goals and Objectives:
In this chapter, we will do the following:
- Define the subject of economics
- Outline the history of the discipline of economics
- Acknowledge the dominance of neoclassical economics
- Analyze the method of neoclassical economics
- Question the distinction between positive and normative statements in economics
- Investigate the nature of economic models
- Review the basic mathematical concepts that are required to understand economic models
What is Economics?
It is common for people with very little knowledge of economics to assume that the subject is all about money. Other times people assume that economics is a study of commerce and business relationships. Although money and commerce are topics of great interest to economists, the subject is far broader than these areas. A far more accurate definition of economics identifies the subject as a discourse. A discourse is simply a conversation or a discussion. Economics, however, is not just any conversation or discussion. It is a discourse about how human societies function. To be more exact, we may define economics in the following way:
- Economics is an intellectual discourse concerned with the manner in which societies produce, circulate, and distribute products and services, as well as the consequences for human welfare that follow.
As the definition indicates, economics is an intellectual discourse. That is, it requires the use of the intellect. Economics is about big ideas and requires logical thinking and careful reasoning. Frequently, the conversation takes place within academia. Professors discuss these ideas with students within college and university classrooms. They also discuss these ideas with one another at professional conferences and in academic journals that deal with specialized areas of economics. Economic discussion also occurs among government officials as they debate the most appropriate economic policies at the local, state, and federal levels. For example, public officials discuss whether tax rates should be increased or decreased, or whether to increase or decrease government spending. The discourse of economics, however, is something in which all people participate at some point. The discussion need not be highly sophisticated to be an economic conversation. When a person tells a friend why she thinks the price of an item is higher at one store than at another store, the person and her friend are participating in the discourse of economics.
Economics, therefore, is a subject that explores certain social processes in our society, but it is also an investigation into how social processes affect our well-being. For example, economic discussion might involve questions about how changes in tax policy might influence economic growth or how price differentials might affect consumer welfare. Such questions are central to the subject of economics.
This way of thinking about economics might seem straightforward to the reader, but it turns out that most professional economists, if asked, would offer a very different definition of economics than the discourse definition provided above. How most economists define the subject of economics and the reason this author is proposing the discourse definition of economics will become clear once we briefly explore the history of the discipline of economics.
A Brief History of the Discipline of Economics
It might surprise the reader to learn that economics is a relatively young discipline when considering the entire history of human knowledge. The ancient Greeks studied geometry, moral philosophy, and politics, but they did not have a discipline that they referred to as economics. In fact, it was not until the seventeenth and eighteenth centuries that a distinct discipline emerged that is anything like what we today refer to as economics. At the time, people called the subject “political economy.” Economic ideas had been discussed prior to that time, but they were embedded in discussions of politics and moral philosophy, and so no one held a conception of a body of thought referred to as “economics.”
It is natural for the reader to wonder why economics emerged at such a relatively late date in human history. The reason is that certain parts of the world were undergoing a massive transformation during those centuries that ultimately helped bring about a revolution in human ways of understanding the social world. This massive shift in human organization coincided with the decline of the feudal system that existed in Western Europe prior to that time. The old feudal system had been based on a strict social hierarchy with a king at the top, followed by feudal lords who employed serfs to work on large tracts of land. The king ruled by divine (God-given) right, and each person’s place in the social hierarchy was accepted as part of a natural order established by God. Those who questioned it were dealt with harshly, and the system continued in this manner for hundreds of years.
With the growth of markets and long-distance trade, however, the old feudal system began to weaken. As market towns emerged, the surplus income of feudal lords was increasingly spent on items that could only be obtained by merchants engaged in long distance trade. As individual property rights began to spread and commerce flourished, those with the means to do so began to assert property rights over the land. The feudal serfs, who once worked the land in accordance with religious custom and tradition, were now being driven from the land. The so-called enclosure movement, which first began in England and then spread to other parts of Western Europe, involved the forceful expulsion of serfs from privately owned plots of land as private property in agriculture began to spread. Forced from the land, the former serfs made their way to the towns, which grew into large industrial cities. There they sought work in the factories and the mines as wage laborers. Their search for paid work reinforced the spread of private ownership of the means of production. In this manner, market capitalism (a system based on the private ownership of land and the means of production as well as the voluntary exchange of products) gradually displaced the old feudal system.
With the growth of markets and long-distance trade, most people’s livelihoods came to depend for the first time in human history upon movements in prices and wages. It is difficult to overstate the magnitude of this change. Never before had the majority of people experienced anything quite like it. Now they were at the mercy of movements in monetary variables that appeared to follow no clear logic of their own. As unpredictable as the weather, people struggled to understand why and how these variables moved as they did. As a result, they were becoming conscious of something called “the economy,” which was a subject that prior to that time simply did not exist. That is, the act of producing, acquiring, and consuming previously had been deeply embedded in other aspects of social life. These acts had been a part of the religious order and traditional ways of living. Now they appeared to have a separate life of their own, independent of other areas of life, whether religious, cultural, or familial. People struggled to understand the changes. Scholars emerged, claiming to have answers. These scholars were the first political economists.
For a fuller discussion of the first political economists, the reader should consult a history of economic thought textbook. Certain key figures should be mentioned at this stage, however, to justify the discourse definition of economics provided in the previous section. Without question, the person that most professional economists today regard as the father of modern economics is the Scottish political economist and philosopher Adam Smith (1723-1790). Smith’s most famous work, published in 1776, is titled, An Inquiry into the Nature and Causes of the Wealth of Nations. The metaphor for which Smith is famous is introduced in this book and is commonly referred to as the invisible hand of the market. According to this notion, within an economic system that is based on private property and voluntary market exchange, each person is led as if by an invisible hand to pursue the social interest. That is, even though everyone pursues only their own self-interest and no one intends to serve the social interest, the social interest is served nevertheless. To understand the reason, simply consider a person who wishes to receive a haircut. If the person pays a hair stylist $10 for a haircut, then the person obtains the desired haircut and fulfills his or her self-interest. At the same time, the reader should notice that the hair stylist’s primary aim is to obtain an income. When the customer pays the hair stylist the $10, the customer serves the interest of another person (i.e., the hair stylist) even though it was not his or her intention to do so. Similarly, by pursuing an income, the hair stylist serves the interest of the customer by providing the haircut even though serving the interest of the customer was not the primary aim of the hair stylist. Both the buyer and seller of the haircut serve each other’s interest in this case even though each only pursues his or her own interest. To use Adam Smith’s phrase, each market participant is led as if by an invisible hand to serve another person.
Another major figure in the history of political economy is the English political economist and financier David Ricardo (1772-1823). Ricardo’s most famous work, published in 1817, is titled, The Principles of Political Economy and Taxation. Ricardo developed many very influential ideas within this relatively small treatise. One of the most important theories Ricardo developed is today the bedrock of international trade theory. This theory, known as the theory of comparative advantage, holds that countries may benefit from international trade even if one of the countries is better able to produce both the product that it is selling and the product that it is buying from the other country. This startling result suggests that a rich and powerful nation may benefit from trade with a relatively weak nation, and vice versa. Mutual gains from trade thus extend to the international marketplace, according to Ricardo. In Chapter 19, we will consider Ricardo’s argument in detail and demonstrate the conditions under which his claim holds true.
Although Smith and Ricardo offered generally positive assessments of the new market capitalist system that had developed in Western Europe, not all political economists shared their optimism. One final political economist that we will consider is the German political economist and revolutionary socialist Karl Marx (1818-1883). Marx is famous for several works, including The Communist Manifesto (1848) and Capital (1867-1894). Capital (which is written as Das Kapital in German) is a multi-volume work that contains Marx’s most sophisticated theory of market capitalism. According to Marx, the new capitalist system was leading to the most rapid development of human productive technology that the world had ever known. At the same time, these developments were occurring within the context of an economic system in which a majority of the population (the working class or proletariat) was being exploited by a small minority of property owners (the capitalist class or bourgeoisie). In Marx’s view, the struggle between these social classes was the source of economic crises and many other social problems characteristic of the new economic system.
In addition to these political economists, many others wrote long treatises describing in detail their conclusions about the advantages or disadvantages of the new economic system. Around these major thinkers, schools of economic thought developed that aimed to refine and extend the ideas of each major thinker. It will now be easier for the reader to understand why the discourse definition of economics offered in the previous section is the most appropriate one. The clashes between economic ideas and the depth of the disagreements between different schools of economic thought were so great that they were not easily resolved. Conversations and discussions often have participants with very different viewpoints and when the discussion is about something as complex as the functioning of human societies, one cannot expect to find easy resolutions. Therefore, by referring to economics as a discourse, we are being honest about the challenges that face human understanding and how those challenges produce different and competing conceptions of the world in which we live.
The Dominance of Neoclassical Economics
Given what has been said about the history of political economy and the reasons for adopting a discourse definition of economics, the reader might expect economics textbooks to be filled with many different economic worldviews and opinions as represented by different schools of economic thought. In fact, the opposite is true. Readers of introductory economics textbooks are introduced to the ideas of a single school of economic thought. Towards the end of the nineteenth century, this school of economic thought became the dominant voice in the economics discourse, particularly within the western capitalist nations. In the 1870s, three political economists working independently in France, Britain, and Austria developed ideas that would form the foundation of a school of economic thought that shared many features with the classical political economy of Smith and Ricardo. At the same time, the methods and concepts used were sufficiently new and different to warrant the new title of neoclassical economics. By the end of World War II, this school of economic thought had become so dominant in the United States that today students are introduced to economics as if it is a single school of economic thought without any challengers at all. During the Cold War, Marxian economics continued to be the dominant school of economic thought in the command socialist economies such as the Soviet Union. Now that the Cold War is over, however, neoclassical economics reigns supreme. Its dominance is the reason that it is sometimes referred to as mainstream economics or orthodox economics.
How then should we define neoclassical economics? The following definition places emphasis on the dominance of neoclassical economics even as it includes the key elements of the definition of economics that most professional economists accept.
- Neoclassical economics is the dominant school of economic thought that defines economics as the social science concerned with the efficient use of scarce resources to achieve the maximum satisfaction of unlimited individual wants.
Neoclassical economists, therefore, define economics in a manner that is much narrower than the discourse definition provided earlier in this chapter. Neoclassical economists define economics first and foremost as a science, much like physics, and in fact many professional economists have welcomed the analogy. Indeed, many of the concepts that ultimately became part of neoclassical economics were transferred to economics directly from physics. The definition of economics as a science also indicates that it is a subject in which only experts can participate in a meaningful way. It, therefore, restricts the growth of participation in the discourse of economics insofar as many people decide that they simply do not have the expertise to form their own opinions about the subject or to challenge experts on economic issues.
In addition, it should be clear that neoclassical economists strictly limit the scope of their inquiry with their definition of economics. The focus on efficiency in the use of scarce or limited resources is far more specific than the focus on the social processes of production, circulation, and distribution that are emphasized in the discourse definition of economics. Should efficiency (or obtaining the most from the least) really be the primary focus of economics? Should equality also be a concern of economists? If not, why not? Furthermore, the neoclassical definition of economics makes a major claim about human beings that is absent in the discourse definition. It is asserted that humans have wants that are unlimited. Is there really no limit to human desires? Will the answer be the same for all people, at all times, and in all places? These aspects of the neoclassical definition raise serious questions as to whether efficiency should be the exclusive focus of economics and whether human wants really are unlimited.
Regardless of our answers to these questions, it is important to understand that neoclassical economists dominate modern discourse about economic issues. Furthermore, that dominance has become so extensive that introductory textbooks almost universally refuse to acknowledge that the perspective represented corresponds to a single school of economic thought. The great majority of economics textbooks have titles that refer to economics only and almost never to neoclassical economics. Moreover, the textbooks include virtually no discussions of the history of the discipline so that students may consider how the ideas were developed through a process of historical debate and discussion. Students do not learn, for example, that many other approaches to economics exist, including Marxian economics, Austrian economics, Post-Keynesian economics, Sraffian economics, feminist economics, and institutionalist economics. This very diverse group of schools of economic thought that reject at least some part of the neoclassical approach to economics may collectively be referred to as heterodox economics. Because this textbook is subtitled, A Pluralistic Approach to Economic Theory, the reader may look forward to lengthy discussions of many different approaches to economics.
These different schools of economic thought frequently have little in common except for their rejection of neoclassical economics. It is that opposition to the dominant school of economic thought that really binds them. Furthermore, the reader should not assume that the distinction between neoclassical economics and heterodox economics is one of right versus left in the political sense. While neoclassical economics is firmly on the right side of the political spectrum and Marxian economics is firmly on the left side, Austrian economics is even further right than neoclassical economics. It is helpful to understand the political orientation of each school of economic thought, but one should not assume that a rejection of neoclassical economics is driven only by different perspectives on the role of government in the economy. Frequently, methodological differences are behind a school’s rejection of the neoclassical approach to economics, which is a subject to which we now turn.
The Entry Point and Logic of Neoclassical Economics
As explained in the previous section, today most professional economists are members of the neoclassical school of economics. For that reason and because heterodox schools of economic thought frequently define themselves in relation to the dominant school of thought, we give neoclassical economics extensive treatment in this chapter and throughout the book. In this section, we consider the method that most professional economists use.
If asked about the method that they use to acquire knowledge in their discipline, most economists will quickly mention the scientific method. As every high school science student knows, the scientific method has several key steps: the formulation of a question, the formation of a hypothesis, the making of predictions, the testing of the predictions against observed reality, and the analysis of the results. If we were operating with the neoclassical definition of economics, which defines economics as a science, then we would certainly identify the scientific method as the method of economics. Because we have adopted the discourse definition of economics, however, we will describe the method of economics rather differently. Our objective will be to identify the method of neoclassical economics in a manner that is compatible with this definition.
Whenever a person enters a discourse with another person, she brings to the discussion certain bedrock assumptions. These foundational concepts are sometimes mentioned explicitly, but frequently they are introduced without the other participants in the discourse, and perhaps not even the person introducing them, being fully aware of them. For example, a person who argues that tax rates ought to be reduced may implicitly assume that people have a moral claim to any income they earn in the marketplace. That people have moral rights of this kind may be an implicit assumption that the person holds that he has never critically examined. Nevertheless, it will be used as the foundation upon which many arguments will be constructed as that individual participates in the discourse in which he is engaged. To operate without such assumptions is like trying to make an argument without any starting point at all. Can you imagine trying to proceed in this fashion?
Economists also possess certain bedrock assumptions whenever they are engaged in the discourse of economics. When discussing the bedrock assumptions of a school of economic thought, we will refer to those assumptions as the entry point. An entry point serves as the starting point in a discourse. Each school of economic thought has an entry point. For neoclassical economists, the entry point is physical and human nature. That is, neoclassical economists make certain assumptions about the physical world and about the nature of human beings that serve as the foundation upon which they erect a complex economic worldview.
The point of entry of neoclassical economics can be broken down into three parts as follows:
- Society’s endowment of resources is taken as given.
- Society’s production technology is taken as given.
- The individual preferences of every person in society are taken as given.
The first two components of the neoclassical entry point relate to the physical world and so we will discuss these together. Neoclassical economists assume that our society is endowed with a specific amount of resources (i.e., a resource endowment) that can be used to produce products and services. They also assume that our society has a specific amount of knowledge of the methods that may be used to transform those resources into products and services (i.e., technology).
Both the resource endowment and the production technology are taken as given. What does it mean to state that these elements of the physical world are taken as given? It means that the specific amount of available resources and the available production technology are the bedrock assumptions that will form the starting point for any further analysis. Furthermore, neoclassical economists do not aim to explain how society came into possession of this combination of resources or this knowledge of how to produce products and services. It is here that the disciplinary boundaries are sharply drawn so that only certain questions are to be regarded as economic questions. For example, a neoclassical economist would not consider a question about how the United States acquired its territory to be an economic question. The neoclassical economist would consider this question to be one for historians to answer but not economists. Whether the territory of the United States was acquired through conquest or through purchase is not something that a neoclassical economist would consider important in terms of answering strictly economic questions. Similarly, a neoclassical economist would not consider a question about how we came into possession of modern information technology to be an economic question. It would also be regarded as a question for historians but not for economists.
Similarly, the third component of the neoclassical entry point takes individual human preferences as given, which is an assumption about human nature. That is, each person is assumed to have certain preferences for products and services, and the origin of these preferences is beyond the scope of neoclassical economics. For example, a question about how a smoker developed a preference for smoking cigarettes would be regarded as a non-economic question within the neoclassical economics profession. This question might be one for psychologists or marketing experts to explore, but economists simply accept that people have preferences and then build their arguments using that starting point. As the reader can observe, the neoclassical entry point places strict limits on what can be regarded as falling within the purview of economic discourse.
To successfully participate in a discourse, it is necessary also to possess a logic or method of reasoning. Successful argument requires not only the building blocks of analysis but also the ability to link them together in a way that creates a unified structure. The logic of neoclassical economics may be referred as one of unidirectional causality (or cause-and-effect). According to this logic, one variable always affects another variable in a unidirectional manner. That is, variable A causes a change in variable B, but it is never the case that variable B causes a change in variable A. The direction of causality only runs in a single direction. This method of proceeding lends itself well to mathematical reasoning, as we shall observe later in this chapter. Nevertheless, we can imagine situations in which this logic may be restrictive. For example, consider the claim that consumer preferences directly affect the price of diamond rings. According to this simple theory, as consumers desire more diamond rings, the price is driven upwards, other factors held constant. Is it possible, however, that the causal connection might be reversed at times? That is, could a rise in the price of diamond rings cause some consumers to desire more of these items? It may be possible if consumers rely on price as an indicator of the quality of the item. If so, then prices may influence preferences just as preferences influence prices. This situation involving mutual causality between variables is not consistent with the neoclassical logic and such cases are strictly forbidden within neoclassical economic theory. As we will observe later, practitioners of other schools of economic thought have sometimes applied this type of logic in the construction of their theories.
The Positive/Normative Distinction in Neoclassical Economics
Another major aspect of the neoclassical method relates to the distinction between positive statements and normative statements in economics. A positive statement is supposedly purely factual and without any value or moral content. For example, the statement, “Dave is an American citizen,” would be considered a descriptive statement, which may be either true or false. A normative statement, on the other hand, is a value-laden statement that is neither true nor false, regardless of how interesting and important to an individual it may be to determine whether one agrees or disagrees with the statement. For example, the statement, “U.S. officials should pursue a policy of full employment,” would be considered a normative statement.
The distinction has its roots in the ideas of the famous Scottish philosopher and historian David Hume (1711-1776) who famously wrote in his Treatise of Human Nature (1738) that “No ‘is’ implies an ‘ought.’” According to Hume, no matter how much we might investigate a fact, we can never extract any moral content from it. The problem, of course, is that if we cannot derive moral implications from facts then how can we ever acquire any moral knowledge at all? This manner of thinking has become central to the neoclassical method of reasoning. According to neoclassical economists, because moral knowledge is impossible, the only purely scientific statements are positive statements. Neoclassical economists aim to generate meaningful positive statements in economics (using their unique entry point and logic) and then determine whether they are true or false. They are also interested in normative questions, but they do not consider those questions to be ones that can be answered once and for all. Similarly, they do not consider normative statements to have correct or incorrect answers. Of course, if we agree on certain ends (e.g., full employment should be our goal), then positive economics can help us reach that goal. If we disagree about the ends, however, we will never resolve our normative debate.
Many people learn at a young age about the difference between fact and opinion. This distinction might seem to be an easy one for the reader to accept. A critical examination of the distinction between these two kinds of statements, however, reveals that it is more problematic than one might initially believe. For example, consider the following statement: “John is not unemployed.” At first glance, this statement might appear to be a purely positive statement. Let’s add a bit of context to the statement, however, and then reevaluate it. Consider the following facts surrounding the statement:
- John lost his job about 13 weeks ago.
- After losing his job, John searched for a new one for about 7 weeks with great effort.
- About 6 weeks ago, John became so frustrated with his failed job search that he gave up looking for a job. He now sits at home and watches TV all day as his bills pile up.
Returning to our earlier statement that John is not unemployed, the reader might be surprised to discover that the statement is true. The reason is that the U.S. Bureau of Labor Statistics (BLS), which publishes the official unemployment rate each month for the U.S. Department of Labor, defines unemployment such that a person must have been actively searching for a job within the last four weeks to be considered unemployed. A worker like John, who has given up on his search, is officially counted as being outside of the labor force rather than unemployed. According to the BLS definition of unemployment, John is not unemployed.
It should be clear now just how much normative content the statement really possesses. Many people might look at this example and argue that John should be counted as unemployed. After all, he wants a job and cannot find one. Other people will look at this situation and argue that we must exclude John because he has given up his search. From a practical standpoint, how are we to count frustrated workers like John when they are not even making a token effort to find work? The point here is not to argue that John should be counted as employed or unemployed. Instead, the point is that a statement that appears, on the surface, to be entirely descriptive, in fact contains a great deal of normative content.
The reader might wonder whether this example is a far-fetched one that is unlikely to arise. On the contrary, examples such as these are not difficult to find within the discourse of economics. Many economic variables are constructed by economists, and in each case, the theorist must decide which elements to include and which elements to exclude. The very act of selection is a value-laden decision. Once constructed, any statements that refer to changes in these variables may appear to be unambiguously positive statements when in fact they are anything but purely descriptive.
For this reason, it is important to be cautious regarding claims to objectivity in economics. We close this section with words from a famous economist by the name of Joan Robinson who had a habit of challenging many aspects of mainstream economics. In Robinson’s words,
There has been a good deal of confused controversy about the question of ‘value judgments’ in the social sciences. Every human being has ideological, moral and political views. To pretend to have none and to be purely objective must necessarily be either self-deception or a device to deceive others. A candid writer will make his preconceptions clear and allow the reader to discount them if he does not accept them. This concerns the professional honour of the scientist.
The Ceteris Paribus Assumption in Neoclassical Economic Models
Armed with the neoclassical entry point and a unidirectional causal logic, neoclassical economists develop theories to explain different aspects of economic life. These theories are expressed with the use of formal economic models. Economic models are quite like physical models in that the purpose of each type of model is to simplify a complex reality. For example, a model airplane is designed to capture the key features of an actual airplane. To serve as a good model airplane, the model should include a propeller, the landing gear, the fuselage, a rudder, wings, a windshield, and other component parts. If any of the essential components are missing, then the model is not a good model. On the other hand, the model should exclude many inessential elements that actual airplanes possess. In the extreme case, if a model included every element of an actual airplane, then it would cease to be a model and would instead be an actual airplane. As a result, the model builder must make some careful choices about which elements to include and which elements to exclude from the model.
Economic models are very similar to physical models in that both represent simplifications of complex realities. Economic models, however, are abstract in nature, which means that they generally do not possess a physical form. Instead, they are mental constructs that theorists design. Aside from that important difference, they are much like the physical models with which the reader is no doubt already familiar.
One point that the reader should consider at this stage is how likely moral judgments are to creep into neoclassical analysis. All theorists confront an infinite amount of data when they begin to construct theories to explain various phenomena. Because the theorist must choose which elements to include and which elements to exclude from the model, it is inevitable that the personal values of the theorist will influence these choices. Once again, we see that even theories that are framed in purely positive or descriptive terms will inevitably contain implicit moral content. It is the job of the astute observer to detect this normative content when it is not explicitly acknowledged by the model-builder.
Before we look more closely at the construction of neoclassical economic models, it is essential to introduce the key assumption that is present in all such models. The assumption that is often only implicit in neoclassical models is the ceteris paribus assumption. This assumption, also referred to as the other-things-equal assumption, allows a theorist to hold all other variables constant so that she can focus only on the relationship between the variables in which she is most interested.
An example from the natural sciences will help clarify the critical role of the ceteris paribus assumption in the construction of neoclassical economic models. For example, consider a biologist who performs an experiment using two different but identical plants, as shown below in Figure 1.1.
The biologist’s purpose is to test the hypothesis that a moderate amount of sunlight encourages plant growth. Suppose that during the month, the biologist gives each plant the same amount of water and the same amount of plant food. Assume, however, that the biologist gives Plant A a moderate amount of sunlight and Plant B zero sunlight. We might expect Plant A to grow and thrive whereas Plant B dies, thus providing evidence in support of the hypothesis. The conditions chosen for this experiment as well as the observed result are represented in Table 1.1.
Now suppose that the experiment is conducted once again with two new plants that are identical to the ones used in the previous experiment. This time, however, the biologist gives each plant the same amount of plant food, but Plant A is given zero water whereas Plant B is given a moderate amount of water. As before, Plant A is given a moderate amount of sunlight and Plant B is given zero sunlight. The conditions chosen for this experiment as well as the observed result are represented in Table 1.2.
The reader might notice that the reason the observed outcome fails to support the hypothesis in the case of Experiment 2 is that other conditions differ for the two plants other than the variable in which the biologist is most interested. That is, because Plant A received zero water, it no longer matters that it received a moderate amount of sunlight. In other words, the hypothesis can only be tested when all other conditions are the same across the two plants except for the amount of sunlight. Without all other conditions being the same, we lose our ability to draw conclusions about the effect on plant growth of the variable in which we are most interested because these other conditions may interfere with plant growth as well.
This manner of proceeding appears to provide neoclassical economists with a way to test economic hypotheses. For example, suppose a neoclassical economist wishes to test the hypothesis that tax cuts in the United States stimulate economic growth. All the economist needs to do is find another economy just like the United States and then convince the government in one country to cut taxes by the prescribed amount while convincing the government in the other country to keep taxes at a constant level. It is also necessary that nothing else change in the two economies during the period of this investigation. If economic growth occurs in the country where the tax cut occurred, then the hypothesis has been supported by the evidence. The reader will, without a doubt, recognize the absurdity of this example. No economy in the world is identical to the United States economy, and even if one existed, it would not be possible to alter only the variables of interest while holding all other variables constant. The biologist, therefore, has a great advantage over the economist in that the biologist may perform a controlled experiment. That is, the biologist can impose the conditions that she finds most suitable to the testing of her hypothesis. Economists generally cannot perform these kinds of experiments.
To solve the problem, the economist must rely primarily on thought experiments. That is, the economist will imagine that all other variables are held constant except for those that are of greatest interest to the economist. Then allowing the variables of interest to change, she will consider what happens to other variables of interest in the model. Historical economic data and statistical tests may then be used to test economic hypotheses. These statistical tests allow the economist to hold other variables constant to check for the influence of one variable upon another. Clearly, however, these types of tests provide much less convincing evidence than the type that is acquired in a laboratory setting where conditions may be monitored and controlled directly. To the extent that neoclassical economists wish to have their science compared favorably to other sciences, such as physics, it should be clear that the case is a difficult one to make.
The Centrality of Graphical Analysis in Neoclassical Economics
As we have learned, the logic of neoclassical economics requires reference to causal relationships between economic variables. Graphical analysis lends itself well to discussions of relationships between variables, and so the two-dimensional Cartesian coordinate system is widely used in neoclassical economic theory.
The reader might recall that a two-dimensional graph makes it possible to create an image of the way that two variables relate to one another. In addition, an ordered pair may be used to represent any point in a two-dimensional space. With an ordered pair, the coordinate on the horizontal axis is always listed first and the coordinate on the vertical axis is always listed second, as shown in Figure 1.2.
Relationships between variables may also be represented with lines connecting a series of ordered pairs in this same space. When both variables move in the same direction along a line, it is said that they are positively related variables or directly related variables. When one variable increases as another variable declines, it is said that they are negatively related variables or inversely related variables. Figure 1.3 provides examples of positively related variables and negatively related variables.
Suppose that the ordered pairs on the line in the graph depicting a positive relationship represent combinations of the average points scored by basketball players per game and the hours they spend practicing per season. What is the causal relationship between these variables, according to the graph? The reader might conclude that an increase in hours spent practicing per season causes an increase in the average points scored per game. A moment’s reflection reveals, however, that the answer may not be so straightforward. For example, isn’t it possible that players score more points due to greater natural ability and that these players practice more because people generally like activities at which they excel? In that case, the higher average number of points scored per game causes players to practice more and the causal relationship is reversed. The point is that we cannot observe the causal connection between these variables. All we observe when we look at the graph is a correlation between the variables.
A similar question might be raised about the inverse relationship depicted in Figure 1.3. The reader might conclude that the cause of lower average numbers of points scored per game is that the players are spending more hours per season relaxing. It is possible, however, that players with lower average numbers of points scored per game due to less natural ability decide that basketball is not very enjoyable anyway and decide to relax more. In fact, both causal arguments may be true to some degree. The point is that causal relationships are not directly observable and so we only observe correlations between variables.
Once again, this insight stems from the work of the philosopher David Hume. Hume argued that we can never observe a causal connection. For example, suppose we are looking at the balls on a pool table, and we observe one ball strike another. After the first ball contacts the second ball, we observe the second ball moving away from the first ball. We repeat the experiment and observe the same result. If we repeat the experiment hundreds, thousands, even millions of times, we always observe the same result. We conclude that the one ball causes the other ball to move. Hume’s great insight is that we never actually observe this causal connection, only a correlation. No matter how many times we witness the second ball moving after the first ball strikes it, we can never know that the next time the first ball strikes the second ball that the second ball will move. This insight is now known as Hume’s critique of induction. Furthermore, any claim that the second ball moves because the first ball strikes it is a conclusion that only the observer (or the theorist) can draw. It is the theorist who imposes causal connections upon observed correlations. Those causal connections are never observed but always imposed. As all students of science should know, correlation does not imply causation.
A Neoclassical Model of Production Cost
When neoclassical economists construct theoretical models, they assert causal relationships between variables in accordance with the neoclassical logic of unidirectional causality. The variables that are regarded as the causal variables are referred to as independent variables. Similarly, the variables that are regarded as effects in neoclassical models are referred to as dependent variables. In other words, the dependent variables depend upon the independent variables.
As an example, consider the relationship between the total cost (TC) of production and the quantity (Q) of output. In neoclassical economic theory, it is claimed that total cost depends on the level of output and so total cost is treated as the dependent variable and output is treated as the independent variable. The claim can be stated more precisely as TC = f(Q). According to this mathematical statement of the relationship, total cost is a function of output. This function, which plays a key role in neoclassical microeconomic theory, is known as the cost function. Neoclassical economists assert that the relationship is a positive one for a single firm. That is, as production increases, the total cost of production rises. Figure 1.4 represents the relationship as both linear and positive.
Frequently, students have a difficult time placing variables other than x and y on the horizontal and vertical axes. Because we are interested in economic applications, we will generally use variables other than the highly abstract x and y variables. That is, the variables on the axes measure specific economic quantities. In this case, we are measuring the daily cost of production in dollar terms and the daily production of output in physical terms (e.g., boxes of cereal).
In Figure 1.5, a series of points may be found in the graph with a straight line connecting the points.
Each point represents a combination of daily cost and daily output. Point v is especially significant. At point v, daily output is zero and yet the firm still incurs a positive amount of cost. That is, the firm incurs $60 of cost even though its output level is zero. How is this combination possible? Well, firms must incur costs even when they do not produce any output. For example, a firm that has a factory must still pay rent. Because this amount of cost does not appear to depend in any way on the amount of output produced, it is referred to as total fixed cost (TFC). As the level of output rises, total production cost also rises and so any amount over and above the fixed cost of production is referred to as total variable cost (TVC).
It should also be noted that this claim that a positive relationship exists between total cost and output assumes that other variables are held constant. For example, a change in rent would certainly affect total cost even though the output level remains unchanged. A rise in rent, for example, would increase the cost of fixed capital assets for the firm and would increase total cost at every output level. The cost curve would thus shift in an upward direction. The ceteris paribus assumption would be violated in that case, as shown in Figure 1.6, and the upward shift would be the result of a change in the firm’s total fixed cost.
It is also possible to write the cost function that exactly fits the data shown in Figure 1.5. To accomplish this task, it is necessary to first determine the slope of the cost function, which can be achieved using any two combinations of output and cost from the table in Figure 1.5. For example, if we use points x and y, then we can calculate the slope as follows:
The slope in this case is 1/2 or 0.50, which means that a 1 unit increase in output is always associated with a $0.50 increase in total cost. Because the slope tells us the additional cost that the firm incurs when production increases by 1 unit, it is referred to as the marginal cost of production. As explained in the chapter on production technology and cost, a constant marginal cost at every level of output is not to be expected, and neoclassical economists typically make a different assumption about the impact of output changes on marginal cost. We will return to this topic in Chapter 7.
Next, we write the cost function using the following form:
In this function, TFC represents total fixed cost and (ΔTC/ΔQ)Q represents total variable cost. TFC is also the vertical intercept in the graph of the cost function. As mentioned previously, the slope is ΔTC/ΔQ. Finally, TC and Q remain as variables in the function. To determine the amount of total fixed cost, we can pull that information directly from the table in Figure 1.5. That is, when the output level is zero, the cost of production is $60. If that information was not directly available in the table, then that information could be obtained by plugging the slope into the cost function and using any single point in the table. For example, if we use point w, then we obtain the following result:
With this information, we can now write the cost function that fits the data as follows:
Additionally, it is possible to use this cost function to carry out economic forecasts of expected future levels of production cost. That is, it is possible to predict the level of cost for other levels of output, assuming this linear relationship continues to hold. For example, if we want to predict the cost of production when output is 120, then we can simply plug the output level into the cost function that we just found as follows:
That is, the predicted level of cost is $120. In this example, the total fixed cost and the total variable cost are both $60.
A Review of Basic Mathematical Concepts
In this section, a few basic mathematical concepts will be reviewed. We will make use of these concepts in later chapters and so it is important to have a firm grasp of them. In this chapter, we have discussed the concept of the slope of a straight line. At times, we will encounter straight lines that are either perfectly horizontal or perfectly vertical as shown in Figure 1.7.
The reader might recall that the vertical line has a slope that is undefined (or one that we might say is infinite). Similarly, the reader might also recall that the horizontal line has a slope that is equal to zero. It is important, however, to know also why these slopes are the correct ones. To prove that these slopes are the correct ones, we need only select two points on each line and calculate the slope. For example, if we select points (x1, y1) and (x2, y2) on the vertical line and then calculate the slope, we obtain the following:
Similarly, if we select points (x1, y1) and (x2, y2) on the horizontal line and then calculate the slope, we obtain the following:
At other times, we will encounter lines that are not straight. These nonlinear curves do not have constant slopes but rather variable slopes. That is, the slope varies all along the curve in question. Readers who have taken a differential calculus course know that these slopes can be calculated using differentiation techniques.
In this book, we use a simpler approach to measuring slope at a point on a nonlinear curve. According to the tangent line method, the slope of a nonlinear curve at a specific point is equal to the slope of the unique straight tangent line that just touches the curve at that point. For example, Figure 1.8 shows an example of a nonlinear curve.
In Figure 1.8, a unique straight tangent line is drawn through point A such that it just touches the nonlinear curve at that point. The slope of the curve at point A is easily computed by calculating the slope of the tangent line as follows:
The reason that the straight tangent line must be unique is that without uniqueness the slope may be impossible to calculate. An example illustrates the point. Consider the absolute value function, which has the following form:
Figure 1.9 shows how the graph of this function appears in a two-dimensional space.
If the reader tries to draw a straight tangent line that just touches the curve at point (0,0), also known as the origin, to determine the slope, then it should become clear that this method fails to provide a satisfactory result. It is true that one can draw a straight tangent line that just touches the curve at the origin. The problem, however, is that many different tangent lines (in fact, an infinite number) can be drawn that just touch the curve at the origin. Therefore, a unique straight tangent line cannot be drawn that just touches the curve at the origin. For this reason, the slope is not defined at that point. In the language of calculus, the curve is not differentiable at the origin. At different points throughout this book, a curve will be drawn that contains a sharp corner or edge like the one in Figure 1.9. When such examples arise, the reader should recall that the slope is not defined at these points.
Finally, it will sometimes be necessary to determine the equation of a straight line when only given two points. For example, suppose you are given the points (4,5) and (12,3), and then are asked to find the equation of the straight line that passes through the two points. These points as well as the straight line that connects them are represented in Figure 1.10.
To obtain the equation of the straight line, it is necessary to first find the slope (m) as follows:
Once the slope is calculated, it is then possible to use one of two different approaches. One approach is to use the point-slope form of the equation, which is y – y0 = m(x – x0). In this equation, (x0, y0) refers to any point on the line. Plugging in (4,5) as well as the slope leads to the following result:
Solving for y yields the result below:
Plugging in (12,3) and the slope would have led to the same result. The second approach involves the use of the slope-intercept form of the equation, which is y = mx+b. Plugging the slope and point (12,3) (or any other point on the line) into the equation yields the following result:
Solving the equation for b yields the result below:
We thus obtain the same result that we obtained when we used the point-slope form of the equation. That is:
The mathematical concepts used in this textbook are relatively basic. The challenge is not so much in the mathematics but rather in the application of mathematical concepts to economic life. This review of basic mathematics is only intended to provide the reader with a helpful refresher as we begin our exploration of a wide variety of economic theories.
Following the Economic News
In a recent article in The Wall Street Journal, Joseph Epstein raised the question as to whether economics is a science. Epstein explains that doubts about the status of economics have existed for a long time because the subject is so “heavily politicized.” Epstein explains that disagreements within economics often lead to political divisions within the discipline with Marxists, neoclassical economists, Keynesian economists, Austrian economists, and others, in sharp conflict with one another. Epstein tells an interesting story about a conversation he had with his cousin who once served as the Chair of the University of Chicago economics department. Epstein explained to his cousin how an acquaintance once complained to him about a Burger King that moved in across the street from his apartment because it spoiled his view. Epstein’s cousin sharply disagreed with the acquaintance’s reaction to the arrival of the Burger King near his home. Rather than condemning the presence of the fast food restaurant, Epstein’s cousin argued that the acquaintance should celebrate the positive contribution that Burger King would make to local tax revenues, which would ease the resident’s tax burden. It would also employ low-income people and eventually reduce the crime rate. The story is interesting because it provides an example of how different people can interpret the same circumstances in entirely different ways. While one person might see in this scenario an intrusive employer of cheap labor that spoils the appearance and atmosphere of the neighborhood, another person might see a job creator that provides a boost to local employment and commerce. Other observers may hold different opinions. Clearly, economics is a discourse with many competing and contrasting perspectives.
Summary of Key Points
- Economics is best understood as an intellectual discourse about key social processes in our society and how those processes affect human well-being.
- Economics is a relatively young discipline that developed during the transition from feudalism to capitalism in Western Europe.
- Adam Smith, David Ricardo, and Karl Marx were central figures in the evolving discourse of political economy in the eighteenth and nineteenth centuries.
- Neoclassical economics dominates the discourse of economics today, and it is the perspective that is almost always presented to students in college economics courses as simply “economics.”
- Aside from the neoclassical school, all other schools of economic thought may be regarded as practicing heterodox economics.
- The neoclassical entry point includes given resources, given technology, and given preferences, and its logic is one of unidirectional causality.
- The distinction between positive economics and normative economics is central to neoclassical economics, and it is controversial.
- The ceteris paribus assumption is the central assumption in all neoclassical economic models.
- Independent variables are causes and dependent variables are effects in neoclassical models.
- The cost function asserts that a positive relationship exists between output and total cost, other factors held constant.
- The equation of a straight line passing through two points on the line may be found using either the point-slope form or the slope-intercept form.
List of Key Terms
Ceteris paribus assumption
Positively related variables
Negatively related variables
Total fixed cost (TFC)
Total variable cost (TVC)
The tangent line method
Problems for Review
- Suppose a reduction in income taxes occurs in the same year as a decrease in economic growth.
- Is the relationship between these variables positive or negative?
- Would you expect a positive relationship or a negative relationship between these variables?
- If these variables are not related in the way that you were expecting, what might be a possible reason?
- On a graph, plot the points (7,8) and (1,4).
- Using the graph you drew in response to question 2, connect the points with a straight line.
- Using point-slope form, write the equation of the straight line that passes through the points.
- Using slope-intercept form, write the equation of the straight line that passes through the points.
- Using the graph in Figure 1.11, use the tangent line method to determine the slope at point C. Assume the line also passes through point D when calculating the slope.
- Using the data below, write the cost function using the form TC = TFC+(∆TC/∆Q)Q. Then draw the function on a graph with TC on the vertical axis and Q on the horizontal axis. Be sure to label both axes correctly. Also identify the level of total fixed cost on the graph.
Quantity (Q) Total Cost (TC) 90 70 180 100 270 130 360 160 450 190 540 220
- For an advanced analysis of how these developments occurred, see Mirowski (1991). ↵
- The discussion of the neoclassical method described in this chapter draws upon ideas presented in Contending Economic Theories by Wolff and Resnick (2012). ↵
- Wolff and Resnick (2012), p. 37. ↵
- Ibid. ↵
- Ibid. Pp. 35-36. ↵
- Ibid. Pp. 35. ↵
- Ibid. Pp. 38. ↵
- Ibid. Pp. 36. ↵
- Robinson’s quote is from Hunt (2002), p. 465. ↵
- Wolff and Resnick (2012), p. 7. ↵
- I was introduced to this example in Prof. John Hoag's intermediate microeconomics class when I was an undergraduate student at BGSU. ↵
- Epstein, Joseph. The Wall Street Journal, Eastern Edition. New York. 04 Sep. 2019. A.17. ↵