What is Economics?

Why Should I Care?

Environmental destruction, global warming, poverty, and the state of democracy are all phenomena which are linked to what we produce, how we produce, and where we produce. Those are pretty important issues, but economics also affects myriads of other issues like literacy, cultural exchanges, health, material comfort, leisure, arts, and sports… Economic production, policy, and theory affect all the things we care about.

This Chapter Has 3 Parts

• Economics in the Social Sciences
• Economic Models
• Empirical Verification

What is Economics?

Economy:
A system of production of goods and services.

Economics:
The academic study of economies. A social science focused on the study of the allocation of limited, or scarce, resources among alternative, competing ends.

The word economy comes from two Greek words: οἴκος (oikos: "home") and νέμω (nomos: “system of rules”). Therefore, the economy was historically understood to be a system of management for the home, where much production takes place.

This word was coined by Xenophon, a Greek philosopher whose views often criticized those of Socrates. His book Oeconomicus is a manual on what today would be called “Good Housekeeping.” A retired military man, Xenophon appreciated efficiency and order, and felt his peers would appreciate his advice on how to run a household rationally. The word was also used by Aristotle in a three-book series on economic themes. Economics was originally seen as the study of the system of rules that govern our homes. Historically, a home was a place where many goods and services were produced, such as shelter, meals, clothes, teaching, cleaning, etc.

Xenophon

Source: https://en.wikipedia.org/wiki/Xenophon

Today, an economy is a system of production of goods and services. It is a human-made complex system involving many inter-dependencies of actors, materials, machines, knowledge and labour.

Economics is the social science that studies economies. A widely accepted definition is: "Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses", first proposed by Sir Lionel Robbins, Economics professor at the London School of Economics in the UK. Previously, the most commonly accepted definition was that economics is the study of explaining the causes of material welfare, which was used by Cannan, and Marshall, notably.

Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.

(Robbins, 1932).

This would certainly be in line with Xenophon's definition. Another way of saying this is that economists are interested in problems of optimization under constraint, where individuals and groups of people try to make the most out of their resources. Robbins argued that the previous definition could exclude the issue of optimisation, while his definition included explanations of both material production levels, and optimization. 

Is Economics about Money?

Lots of people think economics is about money, financial markets, and stocks and bonds... But, no! Economics is not only about money. It's mostly about the choices we make relative to production. Many economists will focus on the importance of making choices, on the trade-offs that are often necessary, and on the availability of information to make appropriate decisions (Stiglitz & Walsh, 2006).

Economics can also be more than this, and delve into other related areas of inquiry. For example, some economists are not so much interested in the optimization of production, but rather by the fair distribution of wealth. Finally, another definition would be to see economics as the broad study of systems of production of goods and services, including the negative aspects of production. This last definition, combined with the focus on scarcity and choice, is useful when using economics to solve environmental issues.

• Economics in the Social Sciences

Economics is a social science. This means economists are interested in the study of human behavior. This also implies that economists use the scientific method to generate knowledge. The scientific method is a widely used research convention that is built on two foundations: the hypothesis, and the empirical verification of the hypothesis.

The focus of economics is particular: it is the study of systems of production of goods and services. So economists will ask questions about people, how the consume, how they produce, and why? Those questions become hypotheses. Then economists use data about people, their habits, their decisions. That data will either confirm, or infirm, the hypothesis. Whatever the result, economists gain a better understanding of our economy, and how it works. This method is used in any of the sciences, whether natural sciences like biology, ecology, physics, and chemistry, or the social sciences listed below.

If you compare economics to other social sciences, you will notice that economists study many similar variables that come up in the work of other disciplines, such as personal characteristics (age, gender, education level), demographic characteristics (religion, language, ethnicity), behaviors, skills, competencies, and many more. However, each discipline has a unique focus. Let's define the main social science disciplines to gain a better insight into how economics can be useful to understanding human activity.

Psychology
The study of individual behavior, and psychologists get really interested in emotions, relationships, and personal struggles. You might think that this has nothing to do with investments, and making airplanes. And that's OK, sometimes psychologists get interested in things that economists don't care about. But sometimes there are overlaps, and hopefully economists and psychologists can work together to better understand humans.

Sociology
The study of societies, and groups of humans. This is obviously a very simple definition, but it serves an important point. There are patterns in society that indicate important problems. For example, there might be an issue with education levels in certain groups of the population. Defining those groups and identifying their issues is important, if sociologists want to help them out. Of course an issue like education can have economic consequences, so its very possible that economists work with sociologists to study the issue.

Political Science
The study of institutions of governance, and power, in our societies. Political scientists will learn every detail about political systems, such as elected parliaments, or totalitarian regimes. They get really interested about the political game as well, for its own sake. There is obviously an overlap here in many instances with economics, because the state is an important actor in the economy, and political institutions are key players in terms of feedback, and control, of the economy.

History
The study of humans over time, but mostly in the past (we can't really study the future). Historians usually acquire an enormous amount of knowledge about past events, specializing on periods, and places in particular. Sometimes they focus on military history, political history, or social history, which chronicles important changes in society such as the end of child labor, or the role of women in society. There is such a discipline as economic history, which is the study of economic issues in the past, including famous depressions, or industrial revolutions.

Geography
The study of humans over space, over areas (not outer space!). Geographers are the experts in making maps. Of course they need to study physical and natural geography, including oceans, lakes, mountains and rivers. But they also study social geography, which answers questions like 'Where do rich people live?', and 'How far will people drive to work?'. Many of these social issues overlap with the study of the economy, which explains the development of the sub-field of economic geography.

Anthropology
The study of human culture. Anthropologists are famously known for studying traditional societies such as Indigenous groups, but they also are very much interested in long-gone civilizations. Anthropologists can bring many disciplines together, such as geography, sociology, psychology, and history, to understand a society. They also will describe the material culture of a society, including tools, and other objects, which is another way of saying its economy. Anthropologists are notorious for conducting field work to collect their data.

Universities are organized in fields, and disciplines. Many of them don't abide by the strict nature of the scientific method. In many cases, this is because the discipline is focused on applying the most advanced knowledge in a technologically useful way. There is absolutely nothing wrong with this and in no way are scientists more worthy or intelligent than technologists. For example, Medicine, Business Administration, Law, and Engineering are technological fields, whose knowledge mostly comes from the sciences, like biology, chemistry, psychology, and economics.

Other disciplines are academic fields of study, who chose to focus on a particular aspect of human activity. Examples include Humanities, Philosophy, Literature, Religion Studies, Cultural Studies, Gender Studies, African Studies, Canadian Studies, etc. These disciplines concentrate on erudition, analysis, interpretation, and the use of logic to develop their insights.

Keep in mind that academics are sensitive folk, and some readers may object to these categorizations, which are constantly up to debate. Also, many disciplines are torn between categories, since some of their research is more fundamental (scientific), and some of the research is more applied (technological). This is the case in economics. Sometimes economists are trying to figure out how the world works (science), but sometimes they are applying their knowledge to help institutions such as corporations, unions, banks or the government (application).

• Economic Models

One of the unique features of economics is the use of mathematical models to help predict what is going to happen in the economy. Sometimes, economists can run experiments in a laboratory with real humans (look up Experimental Economics, and Behavioral Economics). But most of the time, especially when you are thinking in terms of the aggregate economy, it is impossible to set up experiments.

Thus, economists use models, which are sometimes called thought experiments. A model is somewhat similar to a laboratory, but there are no humans directly involved. Much like laboratories, models are an artificial, and controlled, environment. This enables the economist to run simulations.

For example, when the war in Ukraine broke out in 2022, business leaders, union leaders, and politicians started asking all sorts of questions about how this war was going to affect the economy of their country.

• Will it affect food prices?
• Will it change the rate of exchange of the national currency?
• Will it change the price of gasoline?
• Will it generate bottlenecks in transportation?
• Will the government need to finance its operations?
• Will Russia run out of money?

So these people asked economists. Since an economy is a complicated set of inter-dependent relationships, you need a pretty good model to be able to take all sorts of factors into consideration. Economists have been developing these models for more than a century, so they can answer most of the questions that people will ask. Always keep in mind that these answers are not an absolute truth. They are a prediction, based on a simulation, based on lots of mathematical relationships that are assumed to behave a certain way. Once you make a prediction, only time will tell if you guessed correctly.

Models are usually presented as flow charts, as graphs, or as equation sets. They have 3 parts:

Definitions:
Define all of the variables, how they are measured

Assumptions:
Assume certain behaviors, preferences, and relationships between variables

Predictions:
Simulate a change to see its effect on the system

There are two groups of variables in any model. First, the endogenous variables. These are the variables that represent the core of the system, and the outcome of the simulation. Second, the exogenous variables. These are the variables that are defined to be outside the model (exo). These are usually considered to be a shock to the system, or a stimuli in scientific terms. When you run the simulation, you choose to keep most of the exogenous variables constant, except one. When that variable is changed, and all others remain constant (Ceteris Paribus), it will have an effect on the remaining system, which are characterized by the endogenous variables.

For example, most micro-economic models aim to predict a final price (P), and a final quantity sold (Qe) on the market, using a core system, which is characterized by the variables of quantity supplied (Qs) and quantity demanded (Qd). In this case, price and the three quantities are endogenous variables. 

In our micro-economic example, an external shock to this system could be the increase of oil prices on the market for gasoline. Oil price would be the exogenous variable. In this case you hold any other event constant, and let the core system react to the shock. In this case, there is an decrease of Qs, because the model supposes that producers can't keep up quantities if their costs increase. It's also an interactive system, so Qd will adjust to the new normal, because buyers have to adapt to the shortage that was created by the shock. These behaviors are governed by assumptions built into the model. In the end, the system finds its balance at higher prices, and lower quantities sold.

Endogenous variables: variables that are part of the core system

Exogenous variables: variables that are outside the core system

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• Empirical Verification
  

Can you use models to test a hypothesis? Are models scientific? These are questions that haunt the economics discipline. Since you based your prediction on an algorithm, how can you say you are right? The trick is to use historical data. Another term for this is a 'natural experiment'. You study episodes in history when such a shock actually happened, and track the other variables. If the other variables moved the same way your model predicted, then you've got some empirical validity.

Some economists thus liken the modelling technique to testing theory. But the modelling environment remains artificial. The predictions made by models can be very useful, their complex nature (lots of algebra), and their logic may seem implacable. But the predictions from models may or may not be confirmed with real-life empirical observations.

This step of the scientific method is called empirical verification. Research methods used by economists include surveys, and available data disclosed by taxpayers to their state. For example, unemployment data is collected by a monthly telephone survey on a relatively small sample of the population. Another example, income data (GDP) is collected through monthly income tax declarations to the government by citizens and corporations.

As most economic activity can be measured with money, economists are trained at length to analyze quantitative data. This kind of data has its advantages and disadvantages. On one hand, there is lots of data on consumers, investors, institutions, and all sorts of actors in the economy. So, there is lots of data to analyze. On the other hand, keep in mind that most human phenomena may be difficult to quantify, which might give an incomplete picture of the situation. Variables like motivations, personalities, cultural preferences, and cognitive functions, just to cite a few examples, are difficult to include in economics.

Sadly, economists most often cannot use the more powerful research methods such as experiments. We cannot ask the government to slash or raise taxes just to “see what happens”. People would also likely act differently in a lab, compared to using real money in the real world. Also, it would be very expensive to compensate participants of an experiment over long periods of time, to study their behavior more closely. This said, economists do take advantage of the occurrence of major events, such as a recession, which are said to be natural experiments. There are also sub-fields of economics which use small scale experiments, or pilot-projects, which does make for some very interesting science.

Also, economists are generally shy to use fieldwork and other more qualitative research methods. The data would be considered anecdotal and difficult to generalize to the whole population.

Economists don't agree on the validity of every model. Debates rage over the choice of assumptions, the most critical arguments taking place recently over whether agents act 'rationally' when they make decisions. In the end, the most important element is to think critically about what the model is saying. Is it predicting outcomes accurately? Is the model biased by an ideological preference? Economists' opinions are sought after. It is important to make sure they are using the right models to make their predictions.  

Wrap-Up

Economics is a social science that studies the allocation of scarce resources in the service of competing ends. To do so, it studies the system of production of goods and services.

Economics uses the scientific method of using hypotheses and empirical verification to generate knowledge about what, and how, we produce.

Economics uses a particular kind of theory, called models. These are simplifications of reality and help to isolate specific variable. These models must be confronted to empirical data to validate their usefulness.

Cheat Sheet

Economy:
A system of production of goods and services.

Economics:
The study of the allocation of scarce means in the service of competing ends.

Model:
An artificial, and controlled, environment, allowing the economist to run simulations. The model predicts relationships between variables.

References and Further Reading

Daly, H. E., & Farley, J. (2011). Ecological Economics, Principles and Applications, 2e edition. Washington: Island Press.

Robbins, L. (1932, 1935, 2nd ed.). An Essay on the Nature and Significance of Economic Science, London: Macmillan. Links for 1932 HTML and 1935 facsimile.

Stiglitz, J. E. & Walsh, C. E. (2006). Economics, 4th ed. New York: W. W. Norton & Co.

Xenophon. (2012). Oeconomicus. Hardpress Publishing.