explain hypothesis in economics

1.3 How Economists Use Theories and Models to Understand Economic Issues

Learning objectives.

By the end of this section, you will be able to:

Interpret a circular flow diagram
Explain the importance of economic theories and models
Describe goods and services markets and labor markets

John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes ( Figure 1.6 ) famously wrote in the introduction to a fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches you how to think, not what to think.

Watch this video about John Maynard Keynes and his influence on economics.

Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. They analyze issues and problems using economic theories that are based on particular assumptions about human behavior. These assumptions tend to be different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying.

Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation. We use models to test theories, but for this course we will use the terms interchangeably.

For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product, but can still demonstrate how the new product will work.

A good model to start with in economics is the circular flow diagram ( Figure 1.7 ). It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees.

Firms produce and sell goods and services to households in the market for goods and services (or product market). Arrow “A” indicates this. Households pay for goods and services, which becomes the revenues to firms. Arrow “B” indicates this. Arrows A and B represent the two sides of the product market. Where do households obtain the income to buy goods and services? They provide the labor and other resources (e.g., land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production). Arrow “C” indicates this. In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments. Arrow “D” indicates this. Arrows “C” and “D” represent the two sides of the factor market.

Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. The outer circle shows this, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries, and benefits. The inner circle shows this and represents the two sides of the labor market in which households supply and firms demand.

This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).

Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. Economists express theories as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. We explain both micro and macroeconomics in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others.

As an Amazon Associate we earn from qualifying purchases.

This book may not be used in the training of large language models or otherwise be ingested into large language models or generative AI offerings without OpenStax's permission.

Want to cite, share, or modify this book? This book uses the Creative Commons Attribution License and you must attribute OpenStax.

Access for free at https://openstax.org/books/principles-economics-3e/pages/1-introduction

Authors: Steven A. Greenlaw, David Shapiro, Daniel MacDonald
Publisher/website: OpenStax
Book title: Principles of Economics 3e
Publication date: Dec 14, 2022
Location: Houston, Texas
Book URL: https://openstax.org/books/principles-economics-3e/pages/1-introduction
Section URL: https://openstax.org/books/principles-economics-3e/pages/1-3-how-economists-use-theories-and-models-to-understand-economic-issues

© Jan 23, 2024 OpenStax. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution License . The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the Creative Commons license and may not be reproduced without the prior and express written consent of Rice University.

Want to create or adapt books like this? Learn more about how Pressbooks supports open publishing practices.

1.3 The Economists’ Tool Kit

Learning objectives.

Explain how economists test hypotheses, develop economic theories, and use models in their analyses.
Explain how the all-other-things unchanged (ceteris paribus) problem and the fallacy of false cause affect the testing of economic hypotheses and how economists try to overcome these problems.
Distinguish between normative and positive statements.

Economics differs from other social sciences because of its emphasis on opportunity cost, the assumption of maximization in terms of one’s own self-interest, and the analysis of choices at the margin. But certainly much of the basic methodology of economics and many of its difficulties are common to every social science—indeed, to every science. This section explores the application of the scientific method to economics.

Researchers often examine relationships between variables. A variable is something whose value can change. By contrast, a constant is something whose value does not change. The speed at which a car is traveling is an example of a variable. The number of minutes in an hour is an example of a constant.

Research is generally conducted within a framework called the scientific method , a systematic set of procedures through which knowledge is created. In the scientific method, hypotheses are suggested and then tested. A hypothesis is an assertion of a relationship between two or more variables that could be proven to be false. A statement is not a hypothesis if no conceivable test could show it to be false. The statement “Plants like sunshine” is not a hypothesis; there is no way to test whether plants like sunshine or not, so it is impossible to prove the statement false. The statement “Increased solar radiation increases the rate of plant growth” is a hypothesis; experiments could be done to show the relationship between solar radiation and plant growth. If solar radiation were shown to be unrelated to plant growth or to retard plant growth, then the hypothesis would be demonstrated to be false.

If a test reveals that a particular hypothesis is false, then the hypothesis is rejected or modified. In the case of the hypothesis about solar radiation and plant growth, we would probably find that more sunlight increases plant growth over some range but that too much can actually retard plant growth. Such results would lead us to modify our hypothesis about the relationship between solar radiation and plant growth.

Even a hypothesis that has achieved the status of a law cannot be proven true. There is always a possibility that someone may find a case that invalidates the hypothesis. That possibility means that nothing in economics, or in any other social science, or in any science, can ever be proven true. We can have great confidence in a particular proposition, but it is always a mistake to assert that it is “proven.”

Models in Economics

All scientific thought involves simplifications of reality. The real world is far too complex for the human mind—or the most powerful computer—to consider. Scientists use models instead. A model is a set of simplifying assumptions about some aspect of the real world. Models are always based on assumed conditions that are simpler than those of the real world, assumptions that are necessarily false. A model of the real world cannot be the real world.

We will encounter an economic model in Chapter 2 “Confronting Scarcity: Choices in Production” . For that model, we will assume that an economy can produce only two goods. Then we will explore the model of demand and supply. One of the assumptions we will make there is that all the goods produced by firms in a particular market are identical. Of course, real economies and real markets are not that simple. Reality is never as simple as a model; one point of a model is to simplify the world to improve our understanding of it.

Economists often use graphs to represent economic models. The appendix to this chapter provides a quick, refresher course, if you think you need one, on understanding, building, and using graphs.

Models in economics also help us to generate hypotheses about the real world. In the next section, we will examine some of the problems we encounter in testing those hypotheses.

Testing Hypotheses in Economics

Here is a hypothesis suggested by the model of demand and supply: an increase in the price of gasoline will reduce the quantity of gasoline consumers demand. How might we test such a hypothesis?

Economists try to test hypotheses such as this one by observing actual behavior and using empirical (that is, real-world) data. The average retail price of gasoline in the United States rose from an average of $2.12 per gallon on May 22, 2005 to $2.88 per gallon on May 22, 2006. The number of gallons of gasoline consumed by U.S. motorists rose 0.3% during that period.

The small increase in the quantity of gasoline consumed by motorists as its price rose is inconsistent with the hypothesis that an increased price will lead to a reduction in the quantity demanded. Does that mean that we should dismiss the original hypothesis? On the contrary, we must be cautious in assessing this evidence. Several problems exist in interpreting any set of economic data. One problem is that several things may be changing at once; another is that the initial event may be unrelated to the event that follows. The next two sections examine these problems in detail.

The All-Other-Things-Unchanged Problem

The hypothesis that an increase in the price of gasoline produces a reduction in the quantity demanded by consumers carries with it the assumption that there are no other changes that might also affect consumer demand. A better statement of the hypothesis would be: An increase in the price of gasoline will reduce the quantity consumers demand, ceteris paribus. Ceteris paribus is a Latin phrase that means “all other things unchanged.”

But things changed between May 2005 and May 2006. Economic activity and incomes rose both in the United States and in many other countries, particularly China, and people with higher incomes are likely to buy more gasoline. Employment rose as well, and people with jobs use more gasoline as they drive to work. Population in the United States grew during the period. In short, many things happened during the period, all of which tended to increase the quantity of gasoline people purchased.

Our observation of the gasoline market between May 2005 and May 2006 did not offer a conclusive test of the hypothesis that an increase in the price of gasoline would lead to a reduction in the quantity demanded by consumers. Other things changed and affected gasoline consumption. Such problems are likely to affect any analysis of economic events. We cannot ask the world to stand still while we conduct experiments in economic phenomena. Economists employ a variety of statistical methods to allow them to isolate the impact of single events such as price changes, but they can never be certain that they have accurately isolated the impact of a single event in a world in which virtually everything is changing all the time.

In laboratory sciences such as chemistry and biology, it is relatively easy to conduct experiments in which only selected things change and all other factors are held constant. The economists’ laboratory is the real world; thus, economists do not generally have the luxury of conducting controlled experiments.

The Fallacy of False Cause

Hypotheses in economics typically specify a relationship in which a change in one variable causes another to change. We call the variable that responds to the change the dependent variable ; the variable that induces a change is called the independent variable . Sometimes the fact that two variables move together can suggest the false conclusion that one of the variables has acted as an independent variable that has caused the change we observe in the dependent variable.

Consider the following hypothesis: People wearing shorts cause warm weather. Certainly, we observe that more people wear shorts when the weather is warm. Presumably, though, it is the warm weather that causes people to wear shorts rather than the wearing of shorts that causes warm weather; it would be incorrect to infer from this that people cause warm weather by wearing shorts.

Reaching the incorrect conclusion that one event causes another because the two events tend to occur together is called the fallacy of false cause . The accompanying essay on baldness and heart disease suggests an example of this fallacy.

Because of the danger of the fallacy of false cause, economists use special statistical tests that are designed to determine whether changes in one thing actually do cause changes observed in another. Given the inability to perform controlled experiments, however, these tests do not always offer convincing evidence that persuades all economists that one thing does, in fact, cause changes in another.

In the case of gasoline prices and consumption between May 2005 and May 2006, there is good theoretical reason to believe the price increase should lead to a reduction in the quantity consumers demand. And economists have tested the hypothesis about price and the quantity demanded quite extensively. They have developed elaborate statistical tests aimed at ruling out problems of the fallacy of false cause. While we cannot prove that an increase in price will, ceteris paribus, lead to a reduction in the quantity consumers demand, we can have considerable confidence in the proposition.

Normative and Positive Statements

Two kinds of assertions in economics can be subjected to testing. We have already examined one, the hypothesis. Another testable assertion is a statement of fact, such as “It is raining outside” or “Microsoft is the largest producer of operating systems for personal computers in the world.” Like hypotheses, such assertions can be demonstrated to be false. Unlike hypotheses, they can also be shown to be correct. A statement of fact or a hypothesis is a positive statement .

Although people often disagree about positive statements, such disagreements can ultimately be resolved through investigation. There is another category of assertions, however, for which investigation can never resolve differences. A normative statement is one that makes a value judgment. Such a judgment is the opinion of the speaker; no one can “prove” that the statement is or is not correct. Here are some examples of normative statements in economics: “We ought to do more to help the poor.” “People in the United States should save more.” “Corporate profits are too high.” The statements are based on the values of the person who makes them. They cannot be proven false.

Because people have different values, normative statements often provoke disagreement. An economist whose values lead him or her to conclude that we should provide more help for the poor will disagree with one whose values lead to a conclusion that we should not. Because no test exists for these values, these two economists will continue to disagree, unless one persuades the other to adopt a different set of values. Many of the disagreements among economists are based on such differences in values and therefore are unlikely to be resolved.

Key Takeaways

Economists try to employ the scientific method in their research.
Scientists cannot prove a hypothesis to be true; they can only fail to prove it false.
Economists, like other social scientists and scientists, use models to assist them in their analyses.
Two problems inherent in tests of hypotheses in economics are the all-other-things-unchanged problem and the fallacy of false cause.
Positive statements are factual and can be tested. Normative statements are value judgments that cannot be tested. Many of the disagreements among economists stem from differences in values.

Look again at the data in Table 1.1 “LSAT Scores for Students Taking the Exam in 2008” . Now consider the hypothesis: “Majoring in economics will result in a higher LSAT score.” Are the data given consistent with this hypothesis? Do the data prove that this hypothesis is correct? What fallacy might be involved in accepting the hypothesis?

Case in Point: Does Baldness Cause Heart Disease?

Wikimedia Commons – CC BY 3.0.

A website called embarrassingproblems.com received the following email:

What did Dr. Margaret answer? Most importantly, she did not recommend that the questioner take drugs to treat his baldness, because doctors do not think that the baldness causes the heart disease. A more likely explanation for the association between baldness and heart disease is that both conditions are affected by an underlying factor. While noting that more research needs to be done, one hypothesis that Dr. Margaret offers is that higher testosterone levels might be triggering both the hair loss and the heart disease. The good news for people with early balding (which is really where the association with increased risk of heart disease has been observed) is that they have a signal that might lead them to be checked early on for heart disease.

Source: http://www.embarrassingproblems.com/problems/problempage230701.htm . No longer posted.

Answer to Try It! Problem

The data are consistent with the hypothesis, but it is never possible to prove that a hypothesis is correct. Accepting the hypothesis could involve the fallacy of false cause; students who major in economics may already have the analytical skills needed to do well on the exam.

Principles of Macroeconomics Copyright © 2016 by University of Minnesota is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License , except where otherwise noted.

Share This Book

Want to create or adapt books like this? Learn more about how Pressbooks supports open publishing practices.

1.3 How Economists Use Theories and Models to Understand Economic Issues

Learning objectives.

By the end of this section, you will be able to:

Interpret a circular flow diagram
Explain the importance of economic theories and models
Describe goods and services markets and labor markets

John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes, shown in Figure 1 , famously wrote in the introduction to a fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches you how to think, not what to think.

Watch this video about John Maynard Keynes and his influence on economics.

Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. They analyze issues and problems with economic theories that are based on particular assumptions about human behavior, that are different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to be understood, while complex enough to capture the key features of the object or situation being studied.

Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is more applied or empirical representation. Models are used to test theories, but for this course we will use the terms interchangeably.

For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product will be, but can still demonstrate how the new product will work.

A good model to start with in economics is the circular flow diagram , which is shown in Figure 2 . It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees.

Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. This is shown in the outer circle, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries and benefits. This is shown in the inner circle and represents the two sides of the labor market in which households supply and firms demand.

Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. In economics, theories are expressed as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. Both micro and macroeconomics are explained in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others.

Key Concepts and Summary

Economists analyze problems differently than do other disciplinary experts. The main tools economists use are economic theories or models. A theory is not an illustration of the answer to a problem. Rather, a theory is a tool for determining the answer.

Self-Check Questions

Suppose we extend the circular flow model to add imports and exports. Copy the circular flow diagram onto a sheet of paper and then add a foreign country as a third agent. Draw a rough sketch of the flows of imports, exports, and the payments for each on your diagram.
What is an example of a problem in the world today, not mentioned in the chapter, that has an economic dimension?

Review Questions

How did John Maynard Keynes define economics?
Are households primarily buyers or sellers in the goods and services market? In the labor market?
Are firms primarily buyers or sellers in the goods and services market? In the labor market?

Critical Thinking Questions

Why is it unfair or meaningless to criticize a theory as “unrealistic?”
Suppose, as an economist, you are asked to analyze an issue unlike anything you have ever done before. Also, suppose you do not have a specific model for analyzing that issue. What should you do? Hint: What would a carpenter do in a similar situation?

Answers to Self-Check Questions

Draw a box outside the original circular flow to represent the foreign country. Draw an arrow from the foreign country to firms, to represents imports. Draw an arrow in the reverse direction representing payments for imports. Draw an arrow from firms to the foreign country to represent exports. Draw an arrow in the reverse direction to represent payments for imports.
There are many such problems. Consider the AIDS epidemic. Why are so few AIDS patients in Africa and Southeast Asia treated with the same drugs that are effective in the United States and Europe? It is because neither those patients nor the countries in which they live have the resources to purchase the same drugs.

Share This Book

ECON102: Principles of Macroeconomics

Economics: The Study of Choice

1.3 the economists' tool kit, learning objectives.

Explain how economists test hypotheses, develop economic theories, and use models in their analyses.
Explain how the all-other-things unchanged (ceteris paribus) problem and the fallacy of false cause affect the testing of economic hypotheses and how economists try to overcome these problems.
Distinguish between normative and positive statements.

Economics differs from other social sciences because of its emphasis on opportunity cost, the assumption of maximization in terms of one's own self-interest, and the analysis of choices at the margin. But certainly much of the basic methodology of economics and many of its difficulties are common to every social science - indeed, to every science. This section explores the application of the scientific method to economics.

Research is generally conducted within a framework called the scientific method , a systematic set of procedures through which knowledge is created. In the scientific method, hypotheses are suggested and then tested. A hypothesis is an assertion of a relationship between two or more variables that could be proven to be false. A statement is not a hypothesis if no conceivable test could show it to be false. The statement "Plants like sunshine" is not a hypothesis; there is no way to test whether plants like sunshine or not, so it is impossible to prove the statement false. The statement "Increased solar radiation increases the rate of plant growth" is a hypothesis; experiments could be done to show the relationship between solar radiation and plant growth. If solar radiation were shown to be unrelated to plant growth or to retard plant growth, then the hypothesis would be demonstrated to be false.

school Campus Bookshelves
menu_book Bookshelves
perm_media Learning Objects
login Login
how_to_reg Request Instructor Account
hub Instructor Commons
Download Page (PDF)
Download Full Book (PDF)
Periodic Table
Physics Constants
Scientific Calculator
Reference & Cite
Tools expand_more
Readability

selected template will load here

This action is not available.

1.2: How Economists Use Theories and Models to Understand Economic Issues

Last updated
Save as PDF
Page ID 52803

Learning Objectives

Explain the Economists Toolkit, which includes abstraction, models and theories
Interpret a simple model known as "The Circular Flow" diagram
Describe goods and services markets and labor markets
Apply these concepts to the American economy

John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes, shown in Figure $\PageIndex{1}$, famously wrote in the introduction to a fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches you how to think, not what to think.

The image is a photograph of John Maynard Keynes.

The Economists Tool Kit

Economics is a social science which is different from the natural and physical sciences because it studies human behavior. Of course, humans behave in differing ways and with many more complications at times than the natural environment. Therefore, economists and other social scientists use several tools. They study history to better understand current and future events and institutions. They use mathematic reasoning to help explain events and phenomenon that they observe. They also use statistics to make inferences about data that they collect.

They also use a technique known as abstraction to simplify their tasks. Abstraction means to oversimplify a problem so that a researcher only focuses on the primary or important details in order to ignore the unnecessary ones.

Abstraction helps economists create economic models that can more easily represent and explain the complex world that they are studying. In more academic language, an economic model is a theoretical construct representing economic processes by a set of variables and a set of logical and/or quantitative relationships between them. This allows economists to derive hypothesis, or testable questions. Once these questions are tested and retested numerous times, they become adopted as the general set of principles in the field or the theories.

For example, many economists wondered what would happen if the government raised the minimum wage. This is a testable question or hypothesis. Economists set up many tests of this hypotheses. They tested the question for teens, restaurant workers, individuals who worked in retail, those in urban areas, in more 100 studies, The Federal Reserve Bank of San Francisco summarizes the findings and concludes that there is very little, if any, unemployment caused by raising the minimum wage. Therefore, the theory most widely accepted by most economists is that raising the minimum wage does not cause much, if any, minimum wage.

The Federal Reserve has summarized this research in their article entitled “The Effects of Minimum Wage on Employment”

Many people note, however, that there is an increase in some unemployment. Why is this occurring? Raising the minimum wage can create an environment where people who were not in the labor force wish to enter at the new higher wage (I won’t work for $10/hr but I will for $15/hr). However, since they haven’t been in the labor force, their employability is lower than those already in the labor force. This may take them a little time to find work as a result. In other words, the labor demand curve is highly inelastic but the labor supply curve is elastic (elasticity will be discussed in an upcoming chapter).

Correlation vs Causation

It is important to note that just because two events are correlated, that does not mean they are caused by one another. Moreover, the direction of the causation is important to note. For example, when it rains there are more accidents on the freeway. One could conclude that the accidents caused the rain. This would be a fallacious causal relationship. Therefore, it is important to consider all of the factors when attempting to determine correlation and causation.

Sometimes economists use the term model instead of theory . Strictly speaking, a theory is a more abstract representation, while a model is more applied or empirical representation. Models are used to test theories, but for this course we will use the terms interchangeably.

For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product will be, but can still demonstrate how the new product will work.

The Circular Flow of Goods and Services

A good model to start with in economics is the circular flow diagram, which is shown in Figure $\PageIndex{2}$. It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees.

The circular flow diagram’s outer arrows represent a goods and services market, and the inner arrows represent a labor market. As illustrated by the outer arrows, in a goods and services market, firms give goods and services to households and, in exchange, households give payment to firms. As illustrated by the inner arrows, in a labor market, households provide labor to firms and, in exchange, firms give wages, salaries, and benefits to households.

Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. This is shown in the outer circle, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries and benefits. This is shown in the inner circle and represents the two sides of the labor market in which households supply and firms demand. The labor market is an important market because households earn a majority of their income from this market and also because it comprises the largest cost for most firms. However, firms also pay rent for land and interest payments for capital.

Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. In economics, theories are expressed as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. Both micro and macroeconomics are explained in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others.

The American Economy

Current size of the us economy and us population.

Currently the US Economy produces the most goods and services in the world with the third largest population, according to the World Population Review .

Before the Industrial Revolution most workers in the U.S. were employed as subsistence agricultural producers, who worked on their own farms, producing for their own consumption. Currently, only 1.5% of the labor force is employed in agriculture. Since the 1970s, we have also seen a steady decline in the manufacturing sector with only a little more than 10% of the labor force employed in the manufacturing sector and the remaining 80%+ employed in the service sector, in such fields as finance and banking.

GDP Growth Over Time

The following graph published by the Federal Reserve Bank of St. Louis illustrates the growth rate of GDP over time from 1947 to the present.

It illustrates a few facts:

Growth has been uneven over time. However, fiscal and monetary policy seem to have lessened the severity of recessions and the high growth spurts since about the mid-1960s.
After women entered into the labor force in the 1960s, the growth rate of GDP increased.
Wars increase the GDP growth rate but every time the war ends, the transition to civilian goods tends to reduce the growth rate of GDP and the economy typically experiences a recession or slowing growth.

US Trade and Connection to World Economies

The US is considered a relatively closed economy. In other words, the US trades a small fraction of its goods or services annually. The OECD tracks the percentage of GDP that is imported and exported annually major nations. According to the data, the US exports 12% of GDP and imports 15% of GDP in 2016.

Which other nations export significantly more of their GDP? These nations are considered relatively more “open”.

Key Concepts and Summary

Contributor

Template:ContribOpenSTAXMicroEcon

Life-Cycle Hypothesis

Definition: The Life-cycle hypothesis was developed by Franco Modigliani in 1957. The theory states that individuals seek to smooth consumption over the course of a lifetime – borrowing in times of low-income and saving during periods of high income.

As a student, it is rational to borrow to fund education.
Then during your working life, you pay off student loans and begin saving for your retirement.
This saving during working life enables you to maintain similar levels of income during your retirement.

It suggests wealth will build up in working age, but then fall in retirement.

Wealth in the Life-Cycle Hypothesis

The theory states consumption will be a function of wealth, expected lifetime earnings and the number of years until retirement.

Consumption will depend on

C= consumption
R = Years until retirement. Remaining years of work
T= Remaining years of life

It suggests for the whole economy consumption will be a function of both wealth and income.

Prior to life-cycle theories, it was assumed that consumption was a function of income. For example, the Keynesian consumption function saw a more direct link between income and spending.

However, this failed to account for how consumption may vary depending on the position in life-cycle.

Motivation for life-cycle consumption patterns

Diminishing marginal utility of income. If income is high during working life, there is a diminishing marginal utility of spending extra money at that particular time.
Harder to work and earn money, in old age. Life Cycle enables people to work hard and spend less.

Does the Life-cycle theory happen in reality?

Mervyn King suggests life-cycle consumption patterns can be found in approx 75% of the population. However, 20-25% don’t plan in the long term. (NBER paper on economics of saving )

Reasons for why people don’t smooth consumption over a lifetime.

Present focus bias – People can find it hard to value income a long time in the future
Inertia and status quo bias . Planning for retirement requires effort, forward thinking and knowledge of financial instruments such as pensions. People may prefer to procrastinate – even though they know they should save more – and so saving gets put off.

Criticisms of Life Cycle Theory

It assumes people run down wealth in old age, but often this doesn’t happen as people would like to pass on inherited wealth to children. Also, there can be an attachment to wealth and an unwillingness to run it down. See: Prospect theory and the endowment effect.
It assumes people are rational and forward planning. Behavioural economics suggests many people have motivations to avoid planning.
People may lack the self-control to reduce spending now and save more for future.
Life-cycle is easier for people on high incomes. They are more likely to have financial knowledge, also they have the ‘luxury’ of being able to save. People on low-incomes, with high credit card debts, may feel there is no disposable income to save.
Leisure. Rather than smoothing out consumption, individuals may prefer to smooth out leisure – working fewer hours during working age, and continuing to work part-time in retirement.
Government means-tested benefits for old-age people may provide an incentive not to save because lower savings will lead to more social security payments.

Other theories

Permanent income hypothesis of Milton Friedman – This states people only spend more when they see it as an increase in permanent income.
Ricardian Equivalence – consumers may see tax cuts as only a temporary rise in income so will not alter spending.
Autonomous consumption – In Keynesian consumption function, the level of consumption that is independent of income.
Marginal propensity to consume – how much of extra income is spent.

15 thoughts on “Life-Cycle Hypothesis”

Thanks for the reminder of the theory… Am a moi university Economic student in Nairobi Kenya.

Thanks for the most summarised note ever. it will help me with presentation. Gulu university. JALON

prof premraj pushpakaran writes — 2018 marks the 100th birth year of Franco Modigliani!!!

Thanks for the analysis on the hypothesis

Nice piece of work for economist. Been applicable in my presentation at Kyambogo university Uganda

This piece of paper is very important as far as consumption is concerned…

This piece is the best I have seen so far, this is a great work

Thanks for this work.it Will help me in my presentation at metropolitan international University

Very coincise and well articulated. This work reconnects me with themechanics of consumption theories. I appreaciate for a job well done.

Very nice and comprensive information. It will help me in my exams at university of jos Nigeria, studying economics

thank u for the summarized notes,it will help me in my exam at Kibabii university

Great job. Thanks for this masterpiece.

Good job. Thanks for this masterpiece. It reconnects me with the consumption theories.

A good summarised piece of work on life cycle hypothesis, it will help me in my group presentation. Kenyatta University economics student.

Comments are closed.

The Convergence Hypothesis: History, Theory, and Evidence

Published: January 1998
Volume 9 , pages 85–105, ( 1998 )

Cite this article

Farhad Rassekh 1

1785 Accesses

39 Citations

Explore all metrics

The hypothesis that per capita output converges across economies over time represents one of the oldest controversies in economics. This essay surveys the history and development of the hypothesis, focusing particularly on its vast literature since the mid-1980s. A summary of empirical analyses, econometric issues, and various tests of the convergence hypothesis are also presented. Moreover, the essay analyzes the implications of the hypothesis for economic growth, especially as it relates to underdeveloped economies.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Price includes VAT (Russian Federation)

Instant access to the full article PDF.

Rent this article via DeepDyve

Institutional subscriptions

Econometric Aspects of Convergence: A Survey

Ron P. Smith

The empirics of economic growth over time and across nations: a unified growth perspective

Matteo Cervellati, Gerrit Meyerheim & Uwe Sunde

Economic Growth, Empirical Regularities in

Abramovitz, Moses (1979) “Rapid Growth Potential and its Realization: The Experience of the Capitalist Economies in the Postwar Period.” In Edmond Malinvaud (ed.) Economic Growth and Resources , London and New York: MacMillan Press, vol. I.

Google Scholar

——— (1986) “Catching Up, Forging Ahead, and Falling Behind,” Journal of Economic History , pp. 385–406.

Abramovitz, Moses and Paul A. David (1996) “Convergence and Deferred Catch-Up-Productivity Leadership and the waning of American Exceptionalism.” In Ralph Landau, Timothy Taylor, and Gavin Wright (eds.) The Mosaic of Economic Growth , Stanford, CA: Stanford University Press, pp. 21–62.

Barro, Robert J. and Xavier Sala-i-Martin (1995) Economic Growth . New York: McGraw-Hill.

Baumol, William J. (1986) “Productivity Growth, Convergence, and Welfare: What the Long-Run Data Show,” American Economic Review 76(5), 1072–85.

——— (1994) “Multivariate Growth Patterns: Contagion and Common Forces as Possible Sources of Convergence.” In William Baumol, Richard Nelson, and Edward Wolff (eds.) Convergence of Productivity: Cross-National Studies and Historical Evidence , Oxford: Oxford University Press, pp. 62–85.

Baumol, William J., Sue Anne Batey Blackman, and Edward N. Wolff (1989), Productivity and American Leadership , Cambridge,MA: MIT Press.

Ben-David, Dan (1995a) “Measuring Income Convergence: An Alternative Test.” Tel Aviv University, Working Paper, pp. 41–95.

——— (1995b) “Convergence Clubs and Subsistence Economies,” Mimeograph, Tel Aviv University.

——— (1996) “Trade and Convergence Among Countries,” Journal of International Economics 40, 279–298.

Ben-David, Dan and Michael B. Loewy (1996) “Free Trade and Long-Run Growth.” Mimeograph, Tel Aviv University and University of Houston.

Bernard, Andrew B. and Steven N. Durlauf (1995) “Convergence in International Output,” Journal of Applied Econometrics 10, 97–108.

——— (1996) “Interpreting Tests of the Convergence Hypothesis,” Journal of Econometrics 71, 161–173.

Bernard, Andrew B. and Charles I. Jones (1996) “Comparing Apples to Oranges: Productivity Convergence and Measurement Across Industries and Countries,” American Economic Review 86(5), 1216–1238.

Blomström, Mangus and Robert Lipsey (1996) “Multinational Firms and the Diffusion of Skills and Technology,” NBER Reporter , Summer, pp. 11–13.

Blomström, Mangus, Robert Lipsey, and Mario Zejan (1996) “Is Fixed Investment the Key to Economic Growth?,” Quarterly Journal of Economics 111(1), 269–276.

Caballero, Ricardo and Adam B. Jaffe (1993) “How High are the Giants' Shoulders: An Empirical Assessment of Knowledge Spillovers and Creative Destruction in a Model of Economic Growth,” NBER Macroeconomics Annual 1993 , Cambridge: MIT Press, pp. 15–74.

De Long, Bradford (1988) “Productivity Growth, Convergence, and Welfare,” American Economic Review 78(5), 1138–54.

Dollar, David and Edward N. Wolff (1993) Competitiveness, Convergence, and International Specialization . Cambridge: MIT Press.

Dowrick, Steve and Duc-Tho Nguyen (1987) “Australia's Post-War Economic Growth: Measurement and International Comparison,” Canberra: Center for Economic Policy Research , Australian National University, Discussion Paper No. 160.

Durlauf, Steven N. and Paul Johnson (1995) “Multiple Regimes and Cross-Country Growth Behavior,” Journal of Applied Econometrics 10, 365–384.

Edwards, Sebastian (1993a) “Trade Policy, Exchange Rates and Growth.” NBER , Working Paper 4511.

——— (1993b) “Openness, Trade Liberalization, and Growth in Developing Countries,” Journal of Economic Literature 31(3), 1358–1393.

Elmslie, Bruce T. (1994) “The Endogenous Nature of Technological Progress and Transfer in Adam Smith Thought,” History of Political Economy 26(4), 649–664.

——— (1995) “ Retrospectives: The Convergence Debate Between David Hume and Josiah Tucker,” Journal of Economic Perspective 9(4), 207–216.

Evans, Paul and Georgios Karras (1996a) “Convergence Revisited,” Journal of Monetary Economics 37, 249–265.

——— (1996b) “Do Economies Converge? Evidence from a Panel of U. S. States,” Review of Economics and Statistics , Forthcoming.

Friedman, Milton (1992) “Do Old Fallacies Ever Die?,” Journal of Economic Literature 30(4), 2129–2132.

Gerschenkron, Alexander (1952) “Economic Bakwardness in Historical Perspective.” In Bert F. Hoselitz (ed.) The Progress of Underdeveloped Areas , Chicago: The University of Chicago Press, pp. 3–29.

——— (1962) Economic Backwardness in Historical Perspective, A Book of Essays . Cambridge: Belknap Press.

Grossman, Gene M. and Elhanan Helpman (1994) “Endogeneous Innovation in the Theory of Growth,” Journal of Economic Perspectives 8(1), 23–44.

Gruen, F. H. (1986) “How Bad is Australia's Economic Performance and Why?” Economic Record , pp. 180–193.

von Hagen, Juergen (1989) “Relative Commodity Prices and Cointegration,” Journal of Business and Economic Statistics 7(4), 497–503.

Heckscher, Eli F. (1991) “The Effects of Foreign Trade on the Distribution of Income.” In Harry Flam and June Flanders (eds.) Heckscher-Ohlin Trade Theory , Cambridge: MIT Press.

Hume, David (1758) Essays and Treatie's on Several Subjects . London: A. Millar.

Inada, Ken-Ichi (1963) “On a Two-Sector Model of Economic Growth: Comments and a Generalization,” Review of Economic Studies 30, 119–127.

Irwin, Douglas A. (1996) Against the Tide—An Intellectual History of Free Trade . Princeton: Princeton University Press.

Krueger, Anne O. (1968) “Factor Endowments and Per Capita Income Differences Among Countries,” Economic Journal 78, 641–659.

Lucas, Robert E., Jr. (1988) “On the Mechanics of Development Planning,” Journal of Monetary Economics 22(1), 3–42.

Maddison, Angus (1982) Phases of Capitalist Development . New York: Oxford University Press.

——— (1987) “Growth and Slowdown in Advanced Capitalist Economies,” Journal of Economic Literature 25(2), 649–698.

——— (1995) Monitoring the World Economy 1820–1992. Paris: OECD.

Magee, Stephen P., William Brock, and Leslie Young (1989) Black Hole Tariffs and Endogenous Policy Theory . Cambridge: Cambridge University Press.

Mankiw, N. Gregory, David Romer, and David Weil (1992) “A Contribution to the Empirics of Economic Growth,” Quarterly Journal of Economics 107(2), 407–437.

Mansfield, Edwin (1985) “How Rapidly Does New Industrial Technology Leak out?,” Journal of Industrial Economics 34(2), 217–223.

Mansfield, Edwin, Mark Schwartz, and Samuel Wagner (1981) “Imitation Costs and Patents: An Empirical Study,” Economic Journal 91, 907–918.

McCloskey, Donald N. (1990) If You're So Smart . Chicago: The University of Chicago Press.

Meier, Gerald M. (1995) “International Trade and International Inequality.” In Gerald M. Meier (ed.) Leading Issues in Economic Development (1995) , Sixth edition, New York: Oxford University Press.

Mill, John S. (1848) Principles of Political Economy , (1864 edition). Second volume, New York: D. Appleton and Company.

Myrdal, Gunnar (1956) “Trade as a Mechanism of International Inequality.” In Gunnar Myrdal (ed.) Development and Underdevelopment , National Bank of Egypt Fiftieth Anniversary Commemoration Lectures, Cairo, 47–51. Reprinted in Gerald Meier (1995).

Olson, Mancur (1982) The Rise and Decline of Nations . New Haven: Yale University Press.

O'Rourke, Kevin, Alan Taylor, and Jeffrey G. Williamson (1996) “Factor Price Convergence in the Late Nineteenth Century,” International Economic Review 37(3), 499–530.

Prebisch, Raul (1950) The Economic Development of Latin America and its Principal Problems . New York: United Nations.

Pritchett, Lant (1997) “Divergence, Big Time.” Journal of Economic Perspective 11(3), 3–17.

Quah, Danny T. (1993) “Galton's Fallacy and Tests of the Convergence Hypothesis,” Scandinavian Journal of Economics 95(4), 427–443.

——— (1996) “Empirics for Economic Growth and Convergence,” European Economic Review 40, 1353–1375.

Rassekh, Farhad (1992) “The Role of International Trade in the Convergence of Per Capita GDP in the OECD: 1950–85,” International Economic Journal 6(4), 1–16.

Rassekh, Farhad and Henry Thompson (1993)“Factor Price Equalization: Theory and Evidence,” Journal of Economic Integration 8(1), 1–32.

——— (1998) “Micro Convergence and Macro Convergence: Factor Price Equalization and Per Capita Income,” Pacific Economic Review, February, Forthcoming.

Rassekh, Farhad, Michael J. Panik, and Bharat Kolluri (1997) “Some Aspects of Converging Economies of OECD, 1950–1990,” Mimeograph, University of Hartford.

Romer, Paul M. (1986) “Increasing Returns and Long-Run Growth,” Journal of Political Economy 94(5), 1002–1037.

——— (1994) “The Origins of Endogeneous Growth,” Journal of Economic Perspectives 8(1), 3–22.

Romer, Henry S. (1996) “World Wealth Expanding: Why a Rich, Democratic, and (perhaps) Peaceful era is Ahead.” In Ralph Landau et al. (eds.) The Mosaic of Economic Growth , Stanford, CA: Stanford University Press, pp. 92–125.

Rowen, Henry S. (1996) “World Wealth Expanding: Why a Rich, Democratic, and (perhaps) Peaceful era is Ahead.” In Ralph Landau et al. (eds.) The Mosaic of Economic Growth , Stanford, CA: Stanford University Press, pp. 92–125.

Sachs, Jeffrey and Andrew Warner (1995) “Economic Convergence and Economic Policies.” NBER, Working Paper 5039.

Sala-i-Martin, Xavier (1996) “Regional Cohesion: Evidence and Theories of Regional Growth and Convergence,” European Economic Review 40, 1325–1352.

——— (1997) “I Just Ran Two Million Regressions,” American Economic Review 87(2), 178–183.

Samuelson, Paul A. (1948) “International Trade and the Equalization of Factor Prices,” Economic Journal 58, 163–184.

Singer, Hans W. (1950) “The Distribution of Gains Between Investing and Borrowing Countries,” American Economic Review 40(2), 473–85.

Slaughter, Matthew (1997) “Per Capita Income Convergence and the Role of International Trade,” American Economic Review 87(2), 194–199.

Smith, Adam (1776) The Wealth of Nations , edited by Edwin Cannan (1937), New York: Random House.

Solow, Robert M. (1956) “A Contribution to the Theory of Economic Growth,” Quarterly Journal of Economics 70(1), 65–94.

Stokey, Nancy L. (1991) “The Volume and Composition of Trade Between Rich and Poor Countries,” Review of Economic Studies 58, 63–80.

Teece, David J. (1977) “Technological Transfer by Multinational Firms: The Resource Cost of Transferring Technological Know-How,” Economic Journal 87, 242–261.

Veblen, Thorstein (1915) Imperial Germany and the Industrial Revolution . New York: Macmillan.

Williamson, Jeffrey (1996) “Globalization, Convergence, and History,” Journal of Economic History 56(2), 1–30.

——— (1997) “Globalization and Inequality Then and Now,” World Bank Research Observers , Forthcoming.

Young Alwyn (1991) “Learning by Doing and the Dynamic Effects of International Trade,” Quarterly Journal of Economics 106, 369–405.

Download references

Author information

Authors and affiliations.

Department of Economics, Barney School of Business and Public Administration, University of Hartford, West Hartford, CT, 06117, U.S.A.

Farhad Rassekh

You can also search for this author in PubMed Google Scholar

Rights and permissions

Reprints and permissions

About this article

Rassekh, F. The Convergence Hypothesis: History, Theory, and Evidence. Open Economies Review 9 , 85–105 (1998). https://doi.org/10.1023/A:1008279323832

Download citation

Issue Date : January 1998

DOI : https://doi.org/10.1023/A:1008279323832

Share this article

Anyone you share the following link with will be able to read this content:

Sorry, a shareable link is not currently available for this article.

Provided by the Springer Nature SharedIt content-sharing initiative

convergence
technology transfer
neoclassical growth model
globalization
income divergence
Find a journal
Publish with us
Track your research

Search Search Please fill out this field.

Linder Hypothesis: What it is, How it Works, Testing it

Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator. She is a financial therapist and transformational coach, with a special interest in helping women learn how to invest.

What is the Linder Hypothesis?

Linder Hypothesis is an economic hypothesis that posits countries with similar per capita income will consume similar quality products, and that this should lead to them trading with each other. The Linder hypothesis suggests countries will specialize in the production of certain high quality goods and will trade these goods with countries that demand these goods. The theory was proposed by Staffan Linder in 1961.

Understanding the Linder Hypothesis

Linder proposed his hypothesis in attempt to address problems with the Heckscher-Ohlin theory , which suggests that countries export goods that use their factors of production the most intensely. Because the production of capital-intensive goods is associated with higher income levels compared to labor-intensive goods, this means that countries with dissimilar incomes should trade with each other. The Linder hypothesis suggests the opposite.

The Linder hypothesis works off the assumption that countries with similar income levels produce and consume similar quality goods and services. Research has shown that both export prices and demand are strongly correlated with income, specifically for the same quality of goods, though income is used as an approximation for demand. In this vein, countries with high incomes likely consume more high quality products.

The hypothesis focuses on high quality goods because the production of those goods are more likely to be capital-intensive. For example, while many countries produce automobiles, not all countries have healthy export markets for these products. Japan, Europe and the United States actively trade automobiles.

The Linder hypothesis presents a demand-based theory of trade . This is in contrast to the usual supply-based theories of trade involving factor endowments . Linder hypothesized that nations with similar demands would develop similar industries. These nations would then trade with each other in similar, but differentiated goods.

Testing the Linder Hypothesis

Despite anecdotal evidence suggesting that the Linder hypothesis might be accurate, testing the hypothesis empirically has not resulted in definitive results. The reason why testing the hypothesis has proven difficult is because countries with similar levels of per capita income are generally located close to each other geographically, and distance is also a very important factor in explaining the intensity of trade between two countries.

Studies that do not support Linder have only counted countries that actually trade; they do not input zero values for situations where trade could happen, but does not. This has been cited as a possible explanation for their different findings. Also, Linder never presented a formal model for his theory, which resulted in different studies testing the Linder Hypothesis in different ways, under varying conditions.

Generally, a "Linder effect" has been found to be more significant for trade in manufactured products versus non-manufactured products. Among manufactured products, the effect is more significant for trade in capital goods than in consumer goods, and more significant for differentiated products than for similar, more standard products.

Journal of Business and Retail Management Research. " The Heckscher-Ohlin Versus Linder’s Theory: Evidence From Malaysian Exports ," Page 86. Accessed May 7, 2021.

Terms of Service
Editorial Policy
Privacy Policy
Your Privacy Choices

Submit content
Subscribe to content
Orientation
Participate

Philosophy of Economics

Exploring Economics Foundational Text

Explore Perspectives More foundational texts

A foundational text introduces a paradigm, a school of thought, or a theory in a longer article. In our orientation section, you can learn about and compare ten different perspectives of Pluralist Economics in even more detail.

Authors: Milena Dehn, Ella Needler and Jessica Palka

Table of Contents

Introduction
Terminology
The History of Economic Thought
Welfare and Pareto-efficiency
Distributive Justice
Further Topics and Debates
Decision Theory and Rational Choice Theory
Behavioural Economics
Social Preferences
Neuroeconomics
Normative versus Positive Economics
Modes of Analysis and Fundamental Principles of Economic Research
Neoclassical and Neoclassical Synthesis
Post-Keynesian
Institutional

On Exploring Economics

Institutions, 1. introduction.

Economics and philosophy have always been interconnected; however many economics students today may not be aware of how or why. This foundational text aims to address this gap through an introduction to the Philosophy of Economics. We will explore how economics has always been influenced by the study of philosophy, whether it appears obvious or not (for more on the relation between the separate fields of economics and philosophy, see Vromen (2021) and Claveau et al. (2021)).

A fundamental but often overlooked connection between economics and philosophy is in the work of Adam Smith. While Smith is most famous for The Wealth of Nations, he laid the philosophical groundwork for his economic text in The Theory of Moral Sentiments (Tribe, 1999). Smith not only focused on economics (then political economy) but also considered which moral ideas, such as justice and prudence, are necessary for society – and therefore the economy – to function. He understood that decisions about economic study and policy necessarily involve explicit or implicit value judgements about ethics, human behaviour and scientific inquiry, as we will come to discuss.

Stated generally, the Philosophy of Economics is the study of how or why we do economics the way we do it, and allows us to understand how the field of economics conducts itself today. While Smith was interested in the moral groundings of the economy, the Philosophy of Economics is more than just questions of ethics. 1 Understanding the importance of philosophy in economics means acknowledging all the inputs that go into understanding economic theory: the history of ideas, core assumptions about human behaviour, ethical stances regarding economic outcomes, the role of value judgements in economic research, as well as the preferred methodologies and methods and what they tell us about how economists view the world. Since the work of Smith, and especially in the last four decades, new research areas have emerged in the Philosophy of Economics – far too many to cover here (see Kincaid and Ross, 2021; Hausman, 2021 ; Claveau et al., 2021). The goal of this foundational text is to provide a basic introduction to the vast number of topics in the Philosophy of Economics and provide stepping stones to learn more about each area that piques your interest.

First, we provide a glossary of key terms that may not be familiar to you as an economics student. We then provide a (very) brief overview of the History of Economic Thought and the central role it has played within the Philosophy of Economics in section 3. Next, we cover the field of ethics, a subfield of philosophy that influences normative economics. Section 5 considers how philosophical questions underpin the study of human behaviour and rational choice theory. In section 6 we discuss the Philosophy of Economic Science, also known as Economic Methodology, exploring the often obscured philosophical foundations of the way in which we conduct economic research. Section 7 provides an overview of the neoclassical and various heterodox subfields that have arisen within economics and how they differ regarding their philosophical underpinnings. Finally, we have collected a non-exhaustive list of further resources and materials for those who wish to continue their Philosophy of Economics learning.

Before we dive in, there are two characteristics of the study of the Philosophy of Economics that we must acknowledge. First, the research area in the Philosophy of Economics is not perfectly interdisciplinary. While there is some overlap, there are different strands of research topics and means of analysis between analytical philosophers (see Reiss and Heilman, 2021) and economists (see Ross and Kincaid, 2021). 2 Nonetheless, since this foundational text aims to provide an overview of the Philosophy of Economics, the disciplinary differences between analytical philosophers and economists will not be elaborated on (see Claveau et al., 2021 for clarification). 3

Second, recent reflection has characterised the Philosophy of Economics’ research agenda as having a mainstream bias (Mireles-Flores and Nagatsu, 2022). This means that research topics pursued in the Philosophy of Economics tend towards topics under the umbrella of mainstream economics 4 and away from what is typically understood in heterodox economics (Hands, 2015). This mainstream trend may be noticed throughout this foundational text. While recent research in the Philosophy of Economics tends towards the mainstream, the Philosophy of Economics is highly relevant for pluralist views of economics. Section 7 therefore discusses how core topics and debates in the Philosophy of Economics appear in different schools of thought.

2. Terminology

Epistemology: “What is knowledge?” A philosophical branch studying knowledge, its nature, scope, origin and necessary conditions as well as belief, truth and justification. Asks questions such as “What do we know?” How do we know that we know it?” How are beliefs justified?”

Ethics: the study of what is morally good and bad, what is right and wrong and how society ought to be structured

Methodology: a philosophical system of rules, principles and methods for organising and conducting scientific inquiries

Normative: what ought to be, based on values

Ontology: “What is reality?” A philosophical branch studying being, reality, existence, “what is”; belonging to the metaphysics branch of philosophy - questioning the fundamental nature of reality. Asks questions such as “What fundamentally exists? What do all entities (things that exist) have in common? How can we categorise entities?”

Philosophy of Science: “What is science?” Understanding the foundations, methods and implication of science. Asks questions such as “How is science distinguished from non-science? What is the purpose of science? What is a ‘good’ scientific explanation? How is scientific reasoning justified? What is the role of observation? What is the role of values?”

Positive: what is, based on facts

Scientific Instrumentalism: scientific theories are tools aiming at adequate predictions of what is observed (and given the purpose at hand), they should aim at answering questions and solving problems

Scientific Realism: Scientific theories are approximations of universal truths about reality, and should aim at the pursuit of truth

3. The History of Economic Thought

The history of economic thought is concerned with understanding the previous thinkers, ideas and institutions which have shaped economics. The history of economic thought has become associated with the Philosophy of Economics since it analyses ideas and knowledge over time. Nevertheless, the history of economic thought, or the understanding of the changes and evolutions in the field of economics, should not be confused with economic history, which is the understanding of historical economic events such as the Great Depression.

Understanding how we do economics today means understanding the historical progression of economic thought. As one example, economics today is characterised as having a mainstream view of thinking, however, this was not always the case as noted by Morgan and Rutherford (1998) who set out to understand the decline in pluralism in economics following the Second World War. The Philosophy of Economics is therefore also concerned with the movements and great thinkers which have shaped the field as it is these ideas and knowledge that forged the path of the field (see Heilbroner (2011)) for an overview of the great economic thinkers and Backhouse (2002) for a summary on the movement of ideas in the history of economics).

The history of economic thought can be summarised into a handful of key time periods, however it is worth recognising that ideas are fluid. While there are categorisations which can be used to understand the development of ideas in economics, it should be remembered that these classifications hold nuances. For example, while Carl Menger and Friedrich Hayek can both be classified as members of the Austrian school of thought, they have different approaches to economics (Hagemann, Nishizawa and Ikeda, 2010; Udehn, 2002). While this categorisation is not exhaustive, it is a good overview on the progression of modern economic thinking (Backhouse, 2002). 5

16th - 18th century:

Pre-Classical e.g. John Locke, David Hume, Bernard Mandeville;

The Physiocrats e.g. Francois Quesnay; and

Classical e.g. Adam Smith, Jean-Baptiste Say, David Ricardo.

19th century:

Marginalist e.g. William Stanley Jevons;

Neoclassical e.g. Carl Menger, Alfred Marshall, Mary Paley Marshall; and

Marxian e.g. Karl Marx, Friedrich Engels, Rosa Luxemburg.

Early 20th century:

e.g. John Maynard Keynes, Jan Tinbergen;

Institutional e.g. Thorstein Veblen; and

Austrian e.g. Joseph Schumpeter, Friedrich Hayek.

Post WWII and 20th century to present:

Neoclassical Synthesis e.g. Paul Samuelson, John Hicks, Robert Solow;

Post-Keynesian e.g. Hyman Minsky, Joan Robinson;

Monetarist e.g. Milton Friedman, Anna Schwartz; and

New Keynesian e.g. Robert Lucas.

Many of the significant changes in economic thought which impact economics today occurred during the Neoclassical, Early 20th century and Post-WWII time periods. One of the most substantial shifts occurred following the Second World War, with a significant shift from historical and philosophical towards mathematical and statistical emphases (Backhouse, 2002). While there were a number of factors that influenced this turn, a few notable reasons may include the rise of the econometric society, an increase in statistical tools and knowledge following the World Wars (Guglielmo, 2008), and the introduction of mathematics into economics in the Cambridge University exams (Weintraub, 1999). This is also when scarcity-based definitions of economics took over and the discipline became increasingly delineated based on the economic methodology, rather than substantive definitions based on material welfare (Backhouse and Medema, 2009).

While the post-war period of economics saw a rise in the use of mathematics, many emerging conceptual debates were and still are grounded in philosophy. This includes the place of normative versus positive economics stemming from Friedman’s 1953 essay “The Methodology of Positive Economics”, the debate on the concept of Methodological Individualism between Hayek and John Watkins in the 1950s, and the divide between Post-Keynesian and Neoclassical Synthesis economists in the mid to late 20th century due to concerns of critical realism (see chapter 1-2 of Minsky (1975)).

Moreover, the increasing prominence of mathematical approaches distinct from philosophical considerations has resulted in a chasm between economics and philosophy, which has only more recently and partially begun to coalesce (albeit disjointedly) within what is now known as heterodox economics. Critiques of this estrangement can be found for example in feminist economics (e.g. Nelson (1995)), and we will briefly explore some heterodox sub-fields with explicitly philosophical bases in section 7. While we will explore the content of these debates later in this foundational text, it is necessary to acknowledge the core role that philosophy plays in understanding the debate, negotiation and evolution of economic ideas over time.

4. Ethics and Normative Economics

Ethics generally refers to the study of what is morally good and bad, right and wrong and how a society ought to be structured (Dutt and Wilber, 2010). Normative economics is thus concerned with ethical questions in the practice of economics and the evaluation of economic states of affairs, processes, and institutions (Hausman, McPherson and Satz, 2016). While welfare and (pareto-)efficiency are the dominant assessment criteria for such evaluations in mainstream economics, there exists a more extensive debate concerning the principles of justice and especially distributive justice. The first part of this section thus outlines welfare and (pareto-)efficiency as the normative criteria that dominate mainstream normative economics. The second part will focus on principles of distributive justice, while the last part will point towards some additional debates in ethics and economics.

4.1 Welfare and Pareto-efficiency

In economics, the concept of welfare is not based on hedonism or any other substantive concept of welfare (i.e. a theory that specifies what is intrinsically good for people). Instead, welfare is defined formally in terms of satisfying preferences that are specified by the individuals themselves. The advantage of relying on a formal theory of welfare is said to be that no controversial or potentially paternalistic approach of wellbeing has to be endorsed by economists. However, the reliance on individuals' preferences can be problematic if individuals have false beliefs or insufficient knowledge and it is also questionable if extravagant or antisocial preferences should be taken into account.

Due to the difficulties of interpersonal comparisons of welfare, mainstream economists rely purely on pareto-efficiency when comparing economic outcomes. As a normative criterion, pareto-efficiency essentially means that an outcome is efficient with respect to satisfying individual preferences and a society does not miss any opportunities to better satisfy some preferences. However, distribution or different weights for different preferences are not taken into account. If circumstances are improved for some parties but worsened for others, pareto-efficiency cannot be used as a guiding criterion either.

Pareto-efficiency is also the base for the two influential welfare theorems:

perfectly competitive markets yield equilibria that are pareto efficient, and

any pareto-efficient allocation, involving any desired level of redistribution, can be achieved as competitive equilibrium given the right initial distribution of endowments.

These theorems are sometimes used to justify economists’ reliance on competitive markets, for example in efficiency-based arguments for taxes rather than regulations that restrict pollution. The second theorem can also be interpreted in the sense that policy goals besides efficiency can be ensured by relying on perfectly competitive markets if one adjusts the initial endowments accordingly. However, when invoking the welfare theorems as standards for applied scenarios, it must be remembered that they are based on perfectly competitive markets. The redistribution required for the ‘right initial distribution’ in the second theorem implies additional practical problems. Furthermore, even if one disregards the schism between realistic and highly idealised conditions, the prioritisation of efficiency over other moral standards is in itself a value judgement since there may be other societal goals that we could deem more desirable, such as fairness. It is therefore possible that a policy goal would be best served by deciding for an outcome that is not pareto-efficient, for example when we as a society hold certain moral beliefs that body parts should not be marketed.

A potential argument for the permissibility of economists' primary concern with efficiency is that we should separate the question of efficiency (the size of the pie) and distributive justice (how to slice the pie, our focus in the next section). However, since endowments influence possible allocations, a strict separation is hard to defend (Hausman, McPherson and Satz, 2016). Predominant understandings of welfare and efficiency within economics therefore have at their essense inherently philosophical questions about what society values, our goals, and how we seek to achieve them through economic policy.

4.2 Distributive Justice

Principles of distributive justice are those that provide moral guidance on how to structure the distribution of benefits and burdens across the global society. These principles differ in their potential metrics (welfare, resources, capabilities), scope (individuals, nations, generations), and patterns (equality, sufficiency, priority for the worst-off) (Lamont and Favor, 2017). In this section we cover egalitarianism, John Rawl’s difference principle, libertarianism, sufficientarism, and Amartya Sen’s capability approach, as accounts that differ along their patterns as well as their metrics. For an additional overview on the different theories of distributive justice, see Roemer (2009).

4.2.1 Egalitarianism

Egalitarianism normally refers to the equal distribution of resources, welfare or opportunities. A concern for equality can be defended as intrinsic, in the sense that equality is the fairest way to share scarcity, or that no one should be involuntarily disadvantaged based on morally irrelevant attributes (such as their birth-family). Additionally, there is a close connection between equality and other fundamental ethical principles, since equality seems to be important for ensuring the impartiality of social institutions or because inequality has deleterious effects on human welfare (Hausman, McPherson and Satz, 2016; Roemer, 2009).

Welfare egalitarianism thus contends that we should aim for equality of welfare, rather than the aggregate maximisation of welfare. While this seems to be a logical extension of economists’ concern with welfare, it revives the problem of interpersonal welfare comparisons. Strict egalitarianism is also criticised for not being pareto-efficient and for disallowing performance incentives that could make everyone better off (Hausman, McPherson and Satz, 2016).

Resource egalitarianism argues that people should be equipped with equivalent resources. The idea is to disallow inequality based on unmerited characteristics, but to leave room for different outcomes based on individual ambitions. Core problems include how to measure equality of goods (the index problem) and the timeframe within which the equality principles should apply (see e.g. debates about intergenerational justice: Meyer, 2021; Roemer, 2009). Additionally, the distinction between resources and personal merit is often hard to draw. As people have different needs, such as when they have a disability (see Dworkin (1981)), strict equality of resources might also not be the best way of safeguarding the moral equality of people (Lamont and Favor, 2017). Lastly, even egalitarian initial endowments can lead to stark inequalities if agents can freely engage in transactions as suggested by Nozick’s Wilt Chamberlain example .

4.2.2 John Rawls and the Difference Principle

One important resource-egalitarian approach is John Rawls’ Theory of Justice and his difference principle. Rawls argues that under a veil of ignorance, (i.e. where people do not know anything about their own position, race, gender etc.) they would decide that (1) all people have a set of equal basic rights and (2) inequalities are permissible only if (a) they are attached to positions open to all agents and (b) they benefit the members in society that are worst-off. The difference principle (2b) relies on the maximin criterion rather than maximisation or strict equality and acknowledges that some level of inequality and the related incentives might make everyone – especially the worst-off – better off. Rawls’ account has been criticised for referring only to the absolute and not the relative situation of the worst-off (not sufficiently egalitarian) and for restricting personal liberty too much (too egalitarian) (Rawls, 2001; Rawls, 1999; Lamont and Favor, 2017). In particular, Rawls' liberal egalitarian account of “justice as fairness” has been contrasted with Robert Nozick whose theories can be understood as “justice as entitlement”.

4.2.3 Robert Nozick and Libertarianism

The libertarian Robert Nozick argues that the commitment to an end result of equality inappropriately restricts agents’ liberties. He argues that any distribution of goods is just if it is brought about by free exchange among consenting adults from a just starting position (Nozick, 1974). Justice thus means respecting individual rights and Nozick’s theory must be understood as a theory of procedural (or historical) rather than patterned distributive justice. Based on the thesis of self ownership, Nozick argues that people have the right to use their powers for personal benefit and that they also have the right to claim any external resource that is not yet owned - as long as others are not rendered worse off than when the resource was unowned. While a strict interpretation of the self ownership principle implies counterintuitive consequences (e.g. the permissibility of voluntary slavery), the very vague criterion of justifiable property appropriation can be criticised as arbitrary (van der Vossen, 2019).

4.2.4 Sufficientarianism

It can also be argued that the problem of inequality is not inequalities per se, but the situation of the worst-off people. Sufficientarianism, as an alternative pattern of justice, thus contends that what is important is essentially not equality, but that all people have enough. Therefore, those people that have not reached a given threshold of resources and welfare must be given priority (Benbaji, 2006). This line of thought is based on a wave of doubts about egalitarianism, put forward for example by Frankfurt (1988), Parfit (1995), and Anderson (1999).

4.2.5 Amartya Sen

Lastly, while concerned with equality, Amartya Sen’s Capability Approach is based neither on evaluating purely material goods nor welfare. It instead refers to capabilities, or the set of “functionings” that an individual has the capacity to reach. A functioning is any doing or being, for example reading or being healthy. While the account emphasises freedom of choice over different functionings, it centres on the actual capacity to reach a functioning of wellbeing. Compared to resource approaches, Sen’s approach is able to consider the different life circumstances people face. For example, a pregnant mother might need more calories to realise the capability of being well-nourished than other people. Additionally, Sen explicitly endorses interpersonal utility comparisons and thus moves beyond some of the formerly mentioned limitations of welfare economics. Furthermore, contrary to welfare approaches, Sen stresses the capability (e.g. literacy) over any functioning (e.g. reading). Core problems of the account are the index problem, assigning weights to the capabilities, and the debate about prioritising capabilities or achieved functionings. Despite its stark deviation from mainstream economics, Sen’s (and Martha Nussbaum’s) account is well-known among economists and is highly influential as a substantive alternative to the welfare concept, having influenced the Human Development Index (Sen, 1985; Nussbaum, 2001; Robeyns and Fibieger Byskov, 2021).

4.3 Further Topics and Debates

We have given an introduction to ethics and economics that started with welfare and pareto-efficiency. As these criteria build the core of normative economics within the mainstream, the term normative economics itself is sometimes exclusively applied to welfare economics. Secondly, we introduced dominant approaches to distributive justice. Based on the majority of publications in the field of analytic Philosophy of Economics, this section has been shaped mostly by a liberal-egalitarian outlook (Claveau et al., 2021). We thus conclude this section with a non-exhaustive overview of additional topics in the field of ethics and economics including exploitation, the moral limits of the market, structural injustices, and climate change.

One such topic is the philosophical debate of exploitation, from for example a Marxian or feminist perspective. Exploitation refers to taking unfair advantage of another person through a specific transaction (e.g. in the context of sweatshop labour or surrogacy) or structurally through institutions (with Marx’ theory of exploitation being the most influential theory). While most philosophers agree that the exploiter gains some benefit from the exploitation, there exists a debate about purely harmful exploitation and cases of exploitation that benefit the exploited person to some extent. The moral case against exploitation can generally be approached from the different angles of justice outlined above, such as from an egalitarian or sufficientarist perspective. One important debate in the context of exploitation centres on whether Marx’s assessment of employment relationships under capitalism as exploitative can be defended without relying on the labour theory of value (Zwolinski, Ferguson, and Wertheimer, 2022; Roemer, 1982; Fleurbaey, 2022).

Philosophers have also examined the moral limits of markets using examples such as a market for kidneys or buying votes. Moral arguments for limiting markets can for example be based on the vulnerability of agents who have a limited choice space because of their position and on the weak agency of poorly informed individuals (Satz, 2010). This debate generally emphasises that organisational forms and allocation mechanisms have to accommodate different goods that are valued in different ways (Anderson, 1995; Herzog, 2021). It can also be argued that markets may efficiently satisfy the wants of people while also shifting them to preferences that can easily be satisfied within markets. Markets could thereby change our preferences, our relation to goods, and to other human beings (see for example Jaeggi (2014) on alienation).

Other strands of literature focus on structural injustice in relation to class, race and gender (Balibar and Wallerstein, 1991). Cicerchia (2021) for example asks how class can illuminate the broader field of domination, arguing that class domination harms a diverse group both in spite and because of differences among group members. Bright et al. (2022) analyse the connection between race and capitalism and more explicitly how features of race as social construct facilitate stable, inequitable distributions of resources. There are also theorists analysing the normative underpinnings and consequences of the institutional frameworks that shape our economy. Fraser and Jaeggi (2018) for example analyse capitalism as a social form and carve out the underlying institutional separations, for example between economy and polity or production and social reproduction. Anderson (2017) analyses the workplace and argues that employers can be conceptualised as ‘private governments’ with wide-reaching authoritarian power over the lives of workers.

Finally, it should be mentioned that there is an increasing focus on analysing climate change policies (Heath, 2021) and the wider field of climate justice (Caney, 2020) as a core ethical issue within economic research and policy design. Climate change entails questions about the responsibilities of current generations in relation to future generations, which actors have which responsibilities to address climate change (for example countries in the Global South and North), how the limited “greenhouse gas budget” should be distributed, and how we should make trade-offs between competing principles of climate justice, especially given high levels of non-compliance (Caney, 2020).

Fleurbaey (2022) provides an overview of other relevant topics in ethics and economics, such as cost-benefit analyses, social choice theory, fair allocation of resources, happiness studies, reciprocity and altruism and multidimensional poverty measurement.

5. Human Behaviour and Decision Making

The Philosophy of Economics is also concerned with understanding human behaviour and the choices individuals make. In the philosophical literature, decision theory is about understanding the reasoning behind one’s choices (Steele, 2020). Decision theory is intrinsically philosophical since normative assumptions must be made about an individual’s beliefs, desires, or other attitudes.

Decision theory has become a large area of research in the Philosophy of Economics over the past few decades (Claveau et al., 2021) which is why it holds its own section in this foundational text. However, as mentioned in the introduction, many of the core research areas in the Philosophy of Economics rest upon mainstream assumptions. Decision theory is a core example of this since it is primarily based on ideas of methodological individualism rather than methodological holism. Methodological individualism, which is widely accepted by the mainstream, is the idea that we should understand and model our economic world by starting with the individual actor (see the section 6.2.1 on Methodological Individualism for more).

Over the years, Decision Theory has evolved into core topics and fields, such as Rational Choice Theory and then behavioural economics, which challenges the preconceived notion that individuals are rational. In the last decade, additional topics including neuroeconomics and social preferences have risen to further challenge and understand our views of human behaviour. These areas of study necessarily incorporate philosophical considerations into economic research since beliefs about how humans behave and what motivates their behaviour underpin economic modelling at the micro- and macro-levels. This section will provide a brief overview of these fields and how they incorporate or reflect philosophical considerations.

5.1 Decision Theory and Rational Choice Theory

Rational choice theory is based on the assumption that individuals act in a rational manner when making decisions, with the Philosophy of Economics exploring the epistemological implications of this assumption. For example, the traditional homo economicus assumes humans believe and desire in a purely rational, self-interested manner with no irrational influences.

There are two main models of Rational Choice Theory that determine under which conditions a choice is considered as rational in economics: Ordinal Utility and Cardinal Utility. Ordinal Choice Theory is a model of decision making under certainty. Cardinal Choice Theory is a model of decision making under risk (Reiss, 2013). In addition, game theory is about understanding individuals' decision making in strategic situations with other players. The different assumptions we make about the context of decision making (e.g. certainty or strategy) is of philosophical concern because of the normative question at the core of how individuals ought to choose (for more see Sugden (1991)).

5.2 Behavioural Economics

Beginning in the 1970s, two psychologists were attempting to better understand human behaviour. Amos Traversky and Daniel Kahneman were challenging the widely-held belief that individuals always act in a rational, stable manner. Kahneman and Tversky’s work on topics including prospect theory (1979) and biases and heuristics (1974) showed that humans have non-rational tendencies, laying the groundwork for the emerging field of Behavioural Economics. The field aims to understand and model the non-rational tendencies of human beings and includes topics such as nudging, choice architecture, biases, and heuristics.

While this research movement is broadly considered as a leap towards understanding humans’ non-rational tendencies, Karen Hoff and Joseph Stiglitz suggest it is only a “quasi-rational” step and just the “first wave” of modelling non-rational behaviour (2016). Hoff and Stiglitz suggest we are now facing a second wave in behavioural economics that goes beyond the individual and looks to understand how social norms, cultures, situational contexts, and other social determinants of behaviour may impact decision making.

5.3 Social Preferences

In a rational world, one’s interactions with others would not impact their decision making because our behaviour would be purely self-interested. However, in reality, we know that feelings such as altruism, trust, reciprocity, spitefulness, and fairness impact our decision making. The study of social preferences aims to understand the non-rational human tendencies that lead us to prioritise group payoffs as well as or even above individual ones. This is where the philosophical concern enters; by changing the normative assumptions by which beliefs or attitudes, such as fairness or altruism, influence an individual’s behaviour. For example, Fehr and Schmidt (1999) was an original paper to discover that people’s attitudes towards fairness do not always align with the self-interest model. Rather, they determined people can act fairly and cooperatively during experiments such as an ultimatum game or public goods game because people have a preference towards equitable outcomes.

5.4 Neuroeconomics

In recent decades, a new tool for understanding human behaviour has become increasingly popular: neuroscience. The study of neuroeconomics is about using the tools and methods of neuroscience to measure brain activity to understand human decision making. Similarly to behavioural economics, neuroeconomics does not assume rational decision making but attempts to combine experimental economics, psychology and neuroscience to better understand and predict realistic and representative human behaviour. Gul and Pesendorfer (2008) argue for the “case of mindless economics”, believing the growth of neuroeconomics has the power to alter the methodology of economic research. To them, the field of neuroeconomcis rests on two pillars. First, that psychological and physiological evidence can be used to support (or refute) economic models and methodology and second, that economic welfare analyses prioritise “true utility” over “choice utility” since it can reflect what truly makes individuals happy rather than focusing on the utilities associated with choice.

6. Methodology and the Philosophy of Economic Science

Economic methodology, or philosophy of economic science, is a crucial subfield of philosophy of science that investigates the nature of economic phenomena (ontology), the possibilities of acquiring knowledge of them (epistemology) and which methodologies both the ontology and epistemology imply (how research should proceed to gather knowledge). Methodology is in this context also often used in the broader sense of encompassing both ontology and epistemology, with this broad meaning applied throughout the text here (Hausman, 2021).

This section will be split in two sections to discuss how philosophical questions are inherent to the methodology of economics. First, we introduce the distinction between positive and normative economics and what different stances on the role of value judgements imply for economic research. Second, we introduce some of the most relevant methodological debates and their ontological and epistemological underpinnings. This includes methodological individualism and related ontological and methodological considerations and what the different epistemologies of scientific instrumentalism and realism imply for economics. We then examine the challenge of ceteris paribus laws and highly idealised models as forms of analysis in economics. Lastly, we introduce the topic of causation and the philosophical issue of trying to infer causal links.

Before we dive into the details, it’s worth acknowledging that economic methodology is perhaps the area in which divergences between contemporary analytical philosophy and economics have most arisen. Some philosophers criticise that economic methodology is heavily influenced by outdated philosophical discourse 6 and that the disciplines have become increasingly detached since the post-war period (as discussed above in section 3). One reason for this may be the essential differences between philosophers’ and economists’ goals, which result in a theory-praxis gap. A theorist may not always be aware of or interested in a practical problem, while practitioners may not know of or understand a theory well enough to use it:

Philosophers want to understand knowledge acquisition in economics mainly because of their general interest in the possibilities and limits of human knowledge and because of their general interest in human agency. Economists want to understand knowledge acquisition in economics, mainly because they want to streamline and to improve the process and to reveal the blunders of those who pigheadedly adhere to a different approach to economic theorizing. (Hausman, 1992a p. 231)

Economics therefore often focuses on critiquing and improving the tools and techniques of economic scholarship, while philosophers typically debate the epistemic value of economic theories and methods.

6.1 Normative versus Positive Economics

Since economics is a social science that is highly influential in guiding policies, an especially important question in the Philosophy of Economics is which role normative and moral judgements play in determining how research is conducted. It might be clear that ethics is important when applying economics to policy questions, but (how) are moral judgements reflected by the ways in which we conceptualise, gather and analyse economic information? Furthermore, how ought this best be done for both scientifically and morally sound results?

In the following section, we first outline arguments discussing whether one can strictly separate positive and normative economics. We then move on to the debate of whether positive economics can and should be free of any moral values.

6.1.1 Separating Normative and Positive Economics

John Neville Keynes, father to John Maynard Keynes, distinguished between the three core studies of positive, applied and normative economics. Positive economics investigates what is (how the economy works), applied economics concerns the implementation of otherwise abstract theories to concrete problems, while normative economics specialises on what ought to be (how the economy should work). JN Keynes proposed that the methodologies and methods appropriate for each category are fundamentally different since they require taking ethical, practical or purely scientific standpoints, respectively. Based on this, Colander (1992) suggests that the applied economics that most economists actually do does not belong in positive economics, since understanding the way that the economy works is a “pure science”, while applied economics concerns practical problems which cannot be considered in isolation from social, political, historical, institutional and ethical factors.

Friedman’s highly influential The Methodology of Positive Economics (1953) misrepresented JN Keynes by only distinguishing between normative and positive economics, and this binary thinking has (as expected by JN Keynes) essentially persevered in mainstream economics. Today many economists thus separate normative economics - as a small and readily distinguishable subfield focused on normative questions - from the main field of positive economics that is considered to be free of any moral values (Mongin, 2006) (for more on this distinction in contemporary economists see Atkinson (2009)). In the following section, we outline arguments discussing whether one can indeed separate positive and normative economics. We then move on to the debate of whether positive economics can and should be free of any moral values.

One way of thinking about the separation of positive economics and normative judgements is the ideal of ‘economists as engineers’ (Hausman, McPherson and Satz, 2016). Similar to engineers who advise policy makers on the technical specifications of constructing a dam, positive economists prioritise providing causal evaluations, acting as technical advisors on means-end relationships and not getting involved in evaluating policy goals. While this seems like a clear separation of positive inquiry and normative evaluations, the feasibility of the ideal is questioned by several philosophers.

Hausman (2016) for example argues that economists hardly ever get purely technical questions and that it will often be necessary to elaborate on unclear moral specifications because there will always be a normative element of what is the best answer. When advising on the imposition of tariff barriers, politicians might for example give a partial moral specification in the sense that they want to increase revenues but think that some goods have to be excluded from tariffs due to moral consideration. However, economists will have to understand in more detail what the government actually intends in order to translate this into an economic problem. Should they for example focus on evaluating the effects of tariffs in terms of the life of an average citizen, an average voter, subgroups affected specifically by a tariff on specific goods, or potentially the effect of the tariff on average people in other countries? Even if economists do not share the moral values of policy makers, they must therefore understand at which place moral values come into play and how to fill any gaps in line with the policy makers’ goals. It thus seems as if economists would need quite a sophisticated understanding of ethics even in their role as technical advisors (Hausman, McPherson and Satz, 2016).

Instead of the ideal of economists as engineers, DeMartino (2011) uses the analogy of a medical physician. A physician is regarded as an expert in their field but their expertise does not warrant an absolute disregard for the patient's autonomy or their right to understand, ask questions or give permission for any given option. In this context, DeMartino argues for an oath that economists swear by upon graduation, including to respect the autonomy and agency of any community with/for/on which an economist works as well as to anticipate the potentially harmful consequences of any interventions and to attempt to mitigate such effects.

Another form of defending the positive-normative split posits that there are some cases in which economists should make value statements themselves, but that these cases are few and easy to delineate (Mongin, 2006).

6.1.2 Value-free economics

There is also the question of whether the subfield of positive economics even can or should be objective and undistorted by moral values. Value-freedom is a broader debate in philosophy of science and goes beyond the scope of welfare economics and policy-advising. Economics prefers to present itself as a value-free science and has enjoyed comparing itself to physics, dentistry and, in recent years with the rise of Randomised Control Trials, medicine.

The Value-Free Ideal holds that positive economics is and should be free of contextual values, as these values distort judgments and endanger scientific objectivity (Hausman, McPherson and Satz, 2016). The value-free ideal normally implies that only non-epistemic values must be excluded (Douglas, 2013), while epistemic values like accuracy and simplicity are considered truth-conducive. Such values are therefore viewed as unrelated to political agendas in that they relate only to choosing empirically adequate theories (Longino, 1996; Kuhn, 1979).

Nonetheless, some philosophers question if it is possible or even desirable to exclude non-epistemic values from economics. Longino for example argues that epistemic values can be laden with socio-political values. The epistemic value of simplicity leads economists to choose a unitary theory of the family over a bargaining model (if both are consistent with the evidence) and is thus prone to conceal gendered inequalities and to import non-feminist values (Longino, 1996). Furthermore, Mongin (2006) examines if it is even possible to make a clear split between positive and normative statements. Thick concepts like ‘just’ or ‘rational’ always involve both descriptive and evaluative aspects and can hardly be disentangled. Additionally, he criticises that it is important to acknowledge the difference between evaluative judgments and normative prescriptions (Mongin, 2006).

Douglas (2009) argues that one must distinguish a direct role of values, if which they directly determine scientists’ choices, and an indirect role. If economists evaluate whether a type I error or a type II error would have worse consequences before deciding for an appropriate significance level for their hypothesis test, they use values indirectly. Douglas argues that the indirect role is justifiable and desirable in order to ensure good science (Douglas, 2009).

Given the difficulties of excluding all value judgements, some philosophers argue that objectivity is not necessarily achieved by excluding value-judgements but rather that any normative biases must be mentioned explicitly (Alexandrova, 2018). Some subfields of economics, especially more socio-historical or critical traditions, also embrace non-objectivity in claiming that biases are realistically unavoidable. Critical social sciences oppose the epistemological idea that scientific theories and methods can ever be neutral or independent from the social processes within which they are generated or performed. Furthermore, they espouse actively identifying ideologically impaired theories and practices in order to transform unjust social relations (Habermas, 1971). The argument is that only an explicit commitment to emancipatory values can reveal how dominant power structures and implicit values shape and limit knowledge creation. Explicit value acknowledgement and commitment is therefore crucial to see beyond predominant ideologies and power structures, to provide emancipatory knowledge and, eventually, to improve the living conditions of the worst-off ( de Melo-Martín & Intemann, 2018; Ng, 2015).

Despite these debates within philosophy of science, the value-free ideal remains so influential in economics that Hausman, McPherson and Satz, (2016) frame it as the “standard view” of economics.

6.1.3 Performativity

Besides the discussed complications of excluding any normative values from economics, the ethical responsibility of economists is reinforced by the point that economics is inherently performative. Performativity is the idea that economic or financial models are not objective representations of a reality, but rather these models can influence the reality they are trying to represent. As economic agents are intentional beings, they can react to theories or theory-based policies, which can eventually have an effect on the economic processes that are being studied. As a social science, economics thus involves not only describing or explaining social realities, but often actively shaping them (Boldyrev and Svetlova, 2016).

A famous example is the Black-Scholes-Merton option-pricing theory. Traders used the formula to compare the market price of stock options to the hypothetical price of the model before making a purchasing decision. In the end, the purchasing behaviour led the market prices to converge to the model prices (MacKenzie, 2008). There are also studies suggesting that studying economics might make students more selfish, as economists constantly focus on self-interested rational choice theory rather than other models of behaviour (Frank, Gilovich and Regan, 1993). This is significant as economic research can — and materially does — impact the lives of millions of people across wide and sometimes unknowable geographies and timescales.

Additionally, performativity can disallow economic models from being predictively accurate over time. Lucas for example criticised large-scale macroeconometric forecasting models for capturing transitory correlations that would not remain stable in the face of policy changes (the Lucas Critique). He argues that policies based on macro-economic forecasts must fail because people will adapt to the new policy and not stick to their former behaviour – which will change the resulting macroeconomic outcomes and invalidate the model (Lucas, 1976). This calls into question whether economists can accurately predict and effectively model dynamic behaviour over time, and what this lack of certainty implies for their own performance as policy-designers and -makers.

6.2 Modes of Analysis and Fundamental Principles of Economic Research

6.2.1 methodological individualism.

Methodological individualism is a concept in social science which states that social phenomena can be best understood as the sum of individual decisions and should be explained by showing how they result from individual actions. For example, in economics, strict methodological individualism (or microfoundations) entails that one should not merely study that an increase in supply leads to increasing prices, but that this conclusion should be understood through an underlying individual-level mechanism (Reiss, 2013). This is a generally accepted definition, but it should be recognised that there are varying understandings of methodological individualism concerning its relation between individuals, institutions, and social groups as well as on the ontological and methodological uses of the concept (Udehn, 2002; Hodgeson, 2007).

The idea of methodological individualism began with Carl Menger who argued that “reducing complicated phenomena to their elements” would allow conceptual gains (Menger, 1987, p. 93). Additionally, Max Weber put forward a different rationale for methodological individualism: only individuals possess intentional states, which is the only possible base for understanding the resulting macro-structures. The concept was first termed by Joseph Schumpeter in his 1909 essay, On the concept of social value. The idea was not popularised until debates arose in the 1950s between Friedrich von Hayek and John Watkins on the ontological and epistemic nature of methodological individualism. There was another surge in the topic in the 1980s, when Jon Elster critiqued that the functional explanations of Marxian theory overlook collective action problems, for example in a socialist revolution. He thus argued for methodological individualism from an analytical Marxist perspective (Heath, 2020).

Debates on methodological individualism can be based on methodological or ontological considerations (Hodgeson, 2007). Methodologically, the question is whether explanations that refer only to the macro level have some value or might even be more appropriate in some circumstances (Reiss, 2013). At the ontological level, it can be debated whether individuals and their behaviour are really the only entities that exist, or if there are macro entities (e.g. money, institutions, norms) that go beyond aggregated individuals and are causally effective because they for example influence the behaviour of individuals (Durkheim, 1982). In this context emergence means that macrophenomena can have properties that are qualitatively different from, and thus irreducible to, the properties of their constitutive micro phenomena; and emerge only through the interaction of the micro particles. Tornados can for example not be reduced to any specific underlying composition of micro-entities, even though they certainly contain micro particles (O’Connor, 2021). Neurosciences have also popularised the concept of supervenience: if mental states supervene on brain states it means that the same configuration of neurons will always lead to the same mental state, but the same mental state can occur for different configurations of brain states (McLaughlin and Bennett, 2021). This idea can be applied to economics as well if one argues that macroeconomic states supervene on microeconomic actors and their decisions, but are not reducible to microeconomics as the mapping is not one-to-one (Hoover, 2001). Methodological individualism is thus controversial from both a technical and a philosophical point of view, making it a key area of contention within the philosophy of economic science.

One alternative approach to methodological individualism is methodological holism which can be understood as taking into account social phenomena and the views or aims of the collective. Methodological holism has seen little favour amongst economists over the last century because of the ontological question on if it is even possible for the collective to have an aim and the methodological concern on how to measure that aim (see Zahle (2021)).

6.2.2 Instrumentalism and Realism

Despite being largely criticised by philosophers, Milton Friedman’s 1953 essay “The Methodology of Positive Economics” is one of the most well-known essays on economic methodology (Hausman, 1992b,c; Hands, 2001; Claveau et al 2002). Friedman considers the point that many economic assumptions are unrealistic. He argues that the goal of (positive) economics is to obtain theories that provide successful – that is, valid and meaningful – predictions about a relevant class of economic phenomena (instrumentalism). The theories should thus only be tested on the basis of their predictive success, while the question of assumptions being realistic is irrelevant for evaluating a theory. Instead, it only matters if assumptions are sufficiently close approximations for creating an effectively predictive model of the specific case at hand.

Hausman (1992c) criticises Friedman’s argument using the analogy of testing a used car. Even if one agrees that a car is good if it drives safely, economically, and comfortably, most people would reject that the only useful test of the car should be a road test. Instead, it seems useful to open the hood and to check separate components of the car; especially if one wants to use the car in new circumstances, wants to assess if it will likely work well in future, or if it has broken down before. Analogously, it seems like a very narrow test of a theory's qualities if one only considers the current predictive success and denies the relevance of assumptions and any predictions outside the initial scope, even if one agrees with the instrumentalist approach.

Additionally, instrumentalism is not the only way to legitimise unrealistic assumptions as explored for example by Usali Mäki (see section 6.2.4 on models).

Lawson (1997) also argues for a realist approach to economics, also understood as critical realism. Based on the work of Bhaskar (1975), Lawson criticised that mainstream economics focuses merely on identifying observable surface regularities. This places causality at the level of events rather than mechanisms and reduces what is considered as real (ontology) to what we can know (epistemology). Instead, science should acknowledge the underlying mechanisms that produce regularities even if they are revealed only partly in observable relations. Both Mäki’s and Lawson’s accounts therefore reject the purely instrumentalist approach of Friedman and agree that underlying causal mechanisms are relevant.

6.2.3 Inexact laws and ceteris paribus clauses

Due to the study of physics, the laws of nature – objectively true and universal statements – take centre stage in the philosophy of science. However, laws such as the law of prices are not universal and are not disproven by just any counterexample (Reiss, 2017). Economic laws are thus accompanied by ceteris paribus (‘other things being equal’) clauses, implying that they hold only if all the factors that one does not focus on, including unmentioned factors, do not vary (Reiss, 2017). The problem arising from ceteris paribus clauses is that they can be seen as empirically empty as they merely state: ‘Y always follows X, unless it does not’ (Earman & Roberts, 1999). This would disallow testing and especially falsifying ceteris paribus laws, which is highly problematic for a positivist approach to economics (Hausman 1992c).

This topic was already discussed in John Stuart Mill’s (1836) highly influential essay “On the Definition and Method of Political Economy”, in which he argues that the scientific method starts by breaking down complex phenomena and inductively determining the laws that govern individual causal factors. The combined consequences of various laws are then deduced. In this context, Mill justifies inexact predictions as laws can be disrupted by various interferences in the real world. While the law of prices may only be accurate under perfect conditions, this does not mean that one cannot make any predictions under imperfect conditions. Rather, the tendency of prices to react to changing supply will remain intact. Consequently, one can test the law in a non-ad-hoc way by testing it under different conditions that approximate the ceteris paribus conditions to different extents and falsify it by deciding between permissible and impermissible reasons for it not to hold (Kincaid and Harold, 1996; Reiss, 2017). Additionally, it can be argued that even physical laws are not actually universally valid and exceptionless (Cartwright, 1983). Instead, they are untrue in a strict empirical sense because they are highly idealised in order to be widely applicable. Strictly speaking, they would thus also require a ceteris paribus clause.

Nonetheless, these accounts do not necessarily solve the problem of inexactness but rather suggest a shift from laws to tendencies. Tendencies can however only be used and cumulated successfully if causal factors combine mechanically, and never react like chemical elements that form a new element when added together (Reutlinger, Schurz and Hüttemann, 2017; Kincaid and Harold, 1996; Mill, 1843). The debate about the use of laws in the social sciences and economics thus remains a philosophically relevant topic.

6.2.4 Models: Simplification and isolations

The debate regarding models and axioms has largely replaced that of laws or tendencies among economists in recent decades (Hausman, 2021). However, the goal remains to investigate how causal factors would operate in the absence of interference. As with ceteris paribus laws and unrealistic assumptions, models similarly entail philosophical questions about the legitimacy of using severe abstractions and idealisations to describe and ultimately shape the economy.

Uskali Mäki argues that unrealistic models can be useful for understanding and predicting real-world economic phenomena and that every science needs to apply isolation, which means that an entity is sealed off from the influence of other factors. Isolation comprises two factors: idealisation over certain factors (e.g. assuming perfect calculation skills) and omission over factors thought not to impact the economic phenomena under investigation. Isolative models are ‘unrealistic’ as they are necessarily incomplete and contain falsehoods. However, instead of justifying this through instrumentalism (like Friedman, see section 6.2.2), Mäki argues that isolation can be compatible with the pursuit of truth “if it correctly represents the isolated essence of the object” (Mäki, 1992:344). Important conditions are that the causal factors that the model refers to are real, that they are indeed causally relevant for the phenomena that one wants to explain, and that they are causally relevant based on the mechanism that is posited in the model. However, overall effects can only be derived from isolated causes if causes combine mechanically, while economic models which postulate factors that do not exist in reality cast doubt on Mäki’s account (Wimsatt, 2007).

Robert Sugden for example asserts that economic modellers do not start from real-world phenomena and proceed by isolating specific features. Rather, they construct models as credible counterfactual worlds that parallel real-world targets. This can be illustrated by Schelling’s checkerboard model, which claims that a preference to not be heavily outnumbered by neighbours of a different race can lead to completely segregated neighbourhoods. The basic elements of this model are not realistic and do not comply with Mäki’s conditions of isolation since people are modelled as coins in two colours living on a 8x8 checkerboard. Nonetheless, the model is applied to explain real effects through real causes. Sugden argues that the necessary inference between model and world must be grounded in the credibility of the model-world: only if the model and the real world are similar in some significant way (e.g. individuals holding mildly segregationist preferences), do we have reasons to believe that the causal relationship established in the model will also hold in the real world (Sugden, 2000). Nonetheless, credibility of a model is only necessary but not sufficient to justify inductive inferences from the model to the real world (Weisberg, 2006).

Nancy Cartwright (2009) criticises that there are serious obstacles to making inferences from credible world models to the real world, especially in economics. She argues that even analogous world models generally serve as isolating tools: we suppose that we can learn something about a more complex world with many operating factors by studying a sparse model with only one preference – such as a weakly segregationist preference - operating in isolation. This modelling approach is problematic because economics has few uncontroversial principles to base such models on. The consequence is that mere segregationist preferences together with the fundamental principle of maximisation under constraints will cause nothing unless we add structural assumptions for the neighbourhoods and some dynamics that imply action on the preferences. The result of weak segregationist preferences thus depends on exogenous structural assumptions – which leads Cartwright to argue that economic models are often overconstrained and conclusions will differ based on these constraints. Furthermore, given the issues of mechanistic addition, Cartwright concludes that even robustness tests might not be able to establish that our model results will hold across a variety of structural changes. Instead, robustness tests can help us to understand how circumstances shape the contributions that economic factors make, and this must be the base for extrapolation from model worlds.

Mary S. Morgan (2001) focuses on narrative techniques/stories as bridging the gap between real world and abstract models, in part built upon the account of economic metaphors by McCloskey (1990). Morgan argues that one must use and manipulate models, for example by answering ‘what happens if” questions. Using the example of the supply and demand curve model, Morgan illustrates that this process involves narrative methods. The model can for example be applied to see what happens if a consumer’s income increases, even though income is not a part of the model set-up. The ‘what if’ question is the starting point for a story that connects a change in consumer’s income to a change in the model, which is then used to deduce what will happen as a result. It is thus “only by asking questions and telling stories that we explore and demonstrate the full range of features and outcomes compatible with the [model]” (Morgan, 2001, p.370). Stories connect abstract models and their unrealistic assumptions to the real world by building an “intervening level between complete and exhaustive detail and complete generalisation” (Morgan, 2001, p. 379). Narratives must therefore be considered as an essential part of modelling - they sit between theory and reality and thereby help us to understand the world. For more, see The world in the model: How economists work and think (2012), in which Morgan discusses various case studies of historically significant economic models and analyses them from a philosophical perspective.

6.2.5 Causation

It is straightforward to observe correlation between two variables, but much trickier to determine a causal link. But what exactly is causality from the philosophical perspective? Causation is a philosophical issue since it entails ontological and epistemic questions on determining what must be present to make a causal inference true. Judea Pearl, a computer scientist and philosopher, is a pioneer on the philosophical understanding of causal inference with his work on the backdoor principle which is a visual approach for understanding omitted or confounding variables (see chapter 3 of Cunnningham (2021)).

Many econometric models aim to determine causal links. These include an independent variable (IV), difference-in-difference, regression discontinuity design (RDD), synthetic control method (SCM), and Randomised Control Trials (RCT). Each model is said to allow the economist to make a causal inference about the interaction between two variables. However, there are philosophical debates amongst these models. For example, with RCTs there are questions about determining the external or internal validity of a causal inference made. External validity can be understood as how well the results of a study can be generalized to another context and internal validity is understood as how accurate, primarily unbiased, the causal inference is within the context of a study. For example, if a randomised control trial is used to understand the effectiveness of a policy intervention in Kenya, external validity questions whether the causal inferences made on the policy intervention in Kenya will be applicable if the same policy is implemented in Bangladesh since the culture, institutions, and other factors may lead to different outcomes between Kenya and Bangladesh (White and Masset, 2007; Pelletier et.al., 2005). Whereas questions of internal validity would be how strong the causal inference is about the policy intervention in Kenya itself. For the case of RCTs, internal validity is usually strong because many elements of the study can be controlled. However, this is not always the case for other causal models.

In addition to the issue of external validity in making a causal inference, there are mathematical concerns such as the practices of data mining, data fitting, and extrapolating results. Edward Leamer in his 1983 paper “Let’s take the Con Out of Econometrics” voiced many of these concerns by calling out econometric practices for being biased and inaccurate, sparking a debate echoing the reasonableness of objectivity. Leamer’s paper led a handful of economists to pursue improving the research designs of empirical economics in order to make conclusions more reliable. These economists include Joshua Angrist, Steven Pischke, Alan Kreuger, David Card, Guido Imbens, and others who formed what came to be known as the credibility revolution. Anrgrist, Card and Imbens won the Nobel Prize in Economics in 2021 for their work on causal methods, suggesting that these efforts to improve the credibility and philosophical robustness of econometric methods is a relevant and impactful topic in the field of economics.

7. Philosophical Assumptions in Orthodox and Heterodox Economics

This section will contrast orthodox and heterodox economics approaches to Philosophy of Economics topics, especially regarding methodology. Research that is labelled as heterodox is that which typically critiques, challenges or entirely rejects the assumptions, theories, models, or conclusions of mainstream economics, therefore often incorporating or overlapping with topics of Philosophy of Economics. For example, while neoclassical economists are strong proponents of rational choice theory, Post-Keynesian economists critique its use and instead advocate for critical realism (Claveau et al., 2021). The Exploring Economics Orientation site is a great starting point for comparing the philosophical underpinnings of different schools of economics.

7.1 Neoclassical and Neoclassical Synthesis

It is well documented that the dominance of neoclassical economics has been accompanied by an increasing methodological dependence on formal, mathematically logical analyses (e.g. Mayer, 1993; Mirowski, 1989; McCloskey, 1994) that has been consistently reinforced through more refined and complex mathematical modelling techniques (Mehta, 2008). However;

"Less well charted is the coincidence of this development with a severing of ties with philosophy, ties that once bound economics to active negotiation of the set of assumptions and presuppositions about the world that underwrite its approach to phenomena." (Mehta, 2008, p. 75)

Mainstream economics, and primarily neoclassical thinking, adhere to theories of methodological individualism and rational choice when making assumptions about human decision making and behaviour. The assumption of pure rationality was challenged by the rise of behavioural economics which originally started outside the mainstream of thinking but within the last two decades has slowly grown to become accepted by many mainstream economists.

However, one of the most striking characteristics about mainstream economics is their avoidance of any explicitly philosophical investigation in an attempt to be viewed as an objective science (Atkinson, 2009). As discussed above, while mainstream economics has aimed to be viewed as an objective science with little to no value judgements or normative statements acknowledged, economists do - and most often implicitly - make assumptions about which values and normative views to uphold. This opens space for critique from alternative schools of thought which are often broadly grouped together as heterodox.

7.2 Marxian

Originally educated as a philosopher, Karl Marx is still one of the best known economists throughout the world for his critique of classical economics. In “Das Kapital'' (1867) he argues that the capitalist economy builds on the exploitation of labour by (the owners of) capital by appropriating the surplus value of production (labour theory of value). The Marxian economists that have critiqued and built upon his original work continue to explicitly combine economics and philosophy. Contemporary figures like John Roemer are thus renowned in both Marxian economics and Philosophy of Economics (more specifically in the field of analytical Marxism) and the work of Marxian economists like Richard Wolff and Stephen Resnik is also shaped by philosophical debates.

Marxian economists generally reject the idea of value-neutrality. Instead, a critical social science needs explicit value commitments to generate knowledge that can emancipate the oppressed (Ng, 2015). Despite methodological differences, Marxian economists share general value commitments in the sense that capitalism as an economic and social system is considered to be flawed and that a non-capitalist alternative would be preferred. Topics of exploitation and alienation relate back to those ethical issues discussed in section 4 (Leopold, 2022).

One important philosophical tenet of Marxian economics is that most theoreticians reject the suitability of methodological individualism. Marxian political economy generally focuses on class rather than the individual as the dominant unit of analysis and stresses the dialectic relationship between modes of production and social relations of production; essentially disallowing reductionism to the individual level. Additionally, Marxian economics relies on functional explanations, meaning that something that has an effect is explained in terms of its effect. In the subfield of analytical Marxism, functional explanations are defended for example by Joshua Cohen and criticised by Jon Elster (Leopold, 2022; Heath, 2020).

7.3 Post-Keynesian

Post-Keynesian economists are closely connected with ideas of critical realism and a critique of neoclassical economists (McKenna and Zannoni, 1993). Most famously, Joan Robinson (1978) called the neoclassical economists “bastard Keynesians” for forcing the verbal reasoning of John Maynard Keynes’ “The General Theory” (1936) into simplified mathematical models and minimising the role of fundamental uncertainty. Moreover, Hyman Minsky (1975) expanded on this by criticising their models, including the IS-LM model, for making unrealistic assumptions, most notably by ignoring uncertainty. These concerns and criticisms echo the concerns of critical realism, which form the basis for Post-Keynesian economics (Rotheim, 1999).

Additionally, many Post-Keynesians rely on holistic approaches rather than strict methodological individualism and reject that macro phenomena are reducible to individual actions. And even newer models that rely on microfoundations often reject microfoundations in terms of formal constrained-optimisation models.

7.4 Austrian

The Austrian school of economics distinguishes itself in the Philosophy of Economics by its attention to the topic of methodological individualism and its sceptical views towards formal economic methods (Linsbichler, 2021). Austrian economics believes social phenomena and the collective can be understood through the individual for methodological and ontological purposes. Contemporary Austrian economists do however adhere to a weaker view of methodological individualism than neoclassical economists by accepting more holist perspectives with the incorporation of also understanding individuals as social and cultural beings (Udehn, 2002). Contrary to neoclassical economists, Austrian economists also emphasise the interpretative element of methodological individualism and reject a mean-choice framework with given and stable means. Instead, individuals are creative problem-solvers, can commit errors in their reasoning, but can also refine and expand the possible choice room as entrepreneurs.

Moreover, Austrian economics tends to be sceptical of formal methods in economics including the use of mathematical modelling, statistics, and econometrics in its economic reasoning. Linsbichler (2021) suggests the main reason for this hesitation is that many Austrian economists believe human behavior is imprecise and so the means of representing that should be realistic and thus it is impractical to use formal modelling. Moreover, there are pragmatic reasons for Austrian economists to avoid formal modelling because many of their beliefs, assumptions and concepts would be difficult to formalise including radical uncertainty and the place of institutions. This approach to representing the world also explains why Austrian economists align with a weaker form of methodological individualism as they recognize the place of institutions and social relations. Austrian economists desire to create realist representations of the economy.

7.5 Institutional

Institutional economics (we focus here on original and not new institutionalist economics) aims to understand how institutions impact human behaviour (Mirowski, 2019). Thorstein Veblen, originally trained as a philosopher, was a sociologist who is regarded as the founding father of institutional economics for his critique of the economy as dynamic and socially embedded. The starting point is thus not the individual or any particular conception of human behaviour, but the social structures that will shape individuals and their decisions. While individuals also shape institutions, institutions are conceptualised as emergent macro phenomena that cannot be reduced to individual action (Elsner, 2007).

Institutionalists proceed inductively rather than deductively and prioritise research methods with a high degree of detail and contextualisation over the idea of universal and ahistorical laws. Knowledge creation is considered as situated, and the value-free ideal is thus rejected by most (Milonakis and Fine, 2009). This conception of research can also break down a strict separation of science and other forms of practice: institutionalists have for example relied on participatory research approaches that involve immersing oneself into the practices that are being studied and many are involved actively in politics (Elsner, 2006).

7.6 Feminist

Feminist Philosophy of Economics emphasizes that knowledge is situated and thus rejects the mainstream ideal of value-freedom. The three main branches of feminist epistemology (standpoint theory, feminist empiricism, postmodern epistemology) examine the question of situated knowledge from different angles. Feminist standpoint theory argues for example that researchers from oppressed backgrounds can have an epistemic advantage because as “outsiders within” (Hill Collins, 1986) they are in the best position to identify implicit assumptions if they commit to critical reflection (Intemann, 2010; Harding, 1991).

The situatedness of knowledge implies that the systematic exclusion of women from the field of economics (both as research subjects and practitioners) should be examined to understand how it has influenced the evolution of the discipline. Feminist economists have for example examined the discipline’s blind eye regarding social reproduction and unpaid care work or whether specific methods or epistemic values import non-feminist values, for example in theories of discrimination or models of the family (Longino, 1996). Additionally, the discipline’s concern for rigour, objectivity and detachment can be analysed from the perspective of gendered attributes and a gendered devaluation of attributes like connection and qualitative research (Nelson, 1995).

8. Additional Resources

We want to conclude this foundational text with a few additional resources including the links to other articles on Exploring Economics which relate to the Philosophy of Economics, as well as relevant journals and institutions who engage in this research or offer programs for bachelors and masters students. First, if you would like to understand some of these concepts more in depth from the philosophical perspective, the Stanford Encyclopedia of Philosophy (SEP) is a useful source for any topic that may have a philosophical nuance. Each entry in the database provides a comprehensive overview of the given topic and is typically written by a knowledgeable member of the field.

The History of Economics

Dan Hausman, Philosophy of Economics

Kevin Hoover, The Philosophy and Methodology of Economics

Patricia Marino, Philosophy of Economics

N. Emrah Aydinonat and Michiro Nagatsu, Understanding Economic Models

Cambridge Journal of Economics

Economics & Philosophy

Erasmus Journal for Philosophy and Economics

The Journal of Philosophical Economics

Politics, Philosophy & Economics

Bayreuth University

Centre for the History of Political Economy (HOPE) at Duke University

Erasmus Institute for Economics and Philosophy at Erasmus University

London School of Economics and Political Science

University of Edinburgh

University of Vienna

Alexandrova, A., 2018. Can the science of well-being be objective?. The British Journal for the Philosophy of Science.

Anderson, E., 1995. Value in ethics and economics. Harvard University Press.

Anderson, E.S., 1999. What is the Point of Equality?. Ethics, 109(2), pp.287-337.

Anderson, E., 2017. Private government: How Employers Rule Our Lives (and Why We Don't Talk about It). In Private Government. Princeton University Press.

Atkinson, A.B., 2009. Economics as a moral science. Economica, 76, pp.791-804.

Backhouse, R.E., 2002. The Penguin history of economics. Penguin UK.

Backhouse, R.E. and Medema, S.G., 2009. Defining economics: The long road to acceptance of the Robbins definition. Economica, 76, pp.805-820.

Balibar, E., Wallerstein, I.M. and Wallerstein, S.R.I., 1991. Race, nation, class: Ambiguous identities. Verso.

Benbaji, Y., 2006. Sufficiency or priority?. European Journal of Philosophy, 14(3), pp.327-348.

Bhaskar, R., 1975. A realist theory of science. Routledge.

Boldyrev, I. and Svetlova, E., 2016. After the turn: How the performativity of economics matters. Enacting dismal science: New perspectives on the performativity of economics , pp.1-27.

Bright, L.K., Gabriel, N., O'Connor, C. and Taiwo, O., 2022. On the Stability of Racial Capitalism.

Caney, S., 2020. Climate Justice. Stanford Encyclopedia of Philosophy.

Cartwright, N., 1983. How the Laws of Physics Lie. OUP Oxford.

Cartwright, N., 2009. If no capacities then no credible worlds. But can models reveal capacities?. Erkenntnis, 70(1), pp.45-58.

Cicerchia, L., 2021. Why does class matter?. Social Theory and Practice, 47(4), pp.603-627.

Claveau, F., Truc, A., Santerre, O. and Mireles-Flores, L., 2021. Philosophy of Economics?: Three Decades of Bibliometric History. In The Routledge Handbook of Philosophy of Economics (pp. 151-168). Routledge.

Collins, P.H., 1986. Learning from the outsider within: The sociological significance of Black feminist thought. Social problems , 33 (6), pp.s14-s32.

Cunningham, S., 2021. Causal inference. In Causal Inference. Yale University Press.

DeMartino, G.F., 2011. The economist's oath: On the need for and content of professional economic ethics. Oxford University Press.

de Melo-Martín, I. and Intemann, K., 2018. The fight against doubt: How to bridge the gap between scientists and the public . Oxford University Press.

Douglas, H., 2009. Science, policy, and the value-free ideal. University of Pittsburgh Press.

Douglas, H., 2013. The value of cognitive values. Philosophy of science, 80(5), pp.796-806.

Durkheim, E., 1982. What is a social fact? In the rules of sociological method (pp. 50–59).

Dutt, A. and Wilber, C., 2010. Economics and ethics: An introduction. Springer.

Dworkin, R., 1981. Part 1: Equality of Welfare. Philosophy and Public Affairs, 10(3), pp.185-246.

Earman, J. and Roberts, J., 1999. Ceteris paribus, there is no problem of provisos. Synthese, 118(3), pp.439-478.

Elsner, W., 2001. Interactive economic policy: toward a cooperative policy approach for a negotiated economy. Journal of Economic Issues, 35(1), pp.61-83.

Elsner, W., 2007, January. Why meso? On “aggregation” and “emergence”, and why and how the meso level is essential in social economics. In Forum for social economics (Vol. 36, No. 1, pp. 1-16). Taylor & Francis Group.

Fleurbaey, M., 2022. Normative Economics and Economic Justice, in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Fehr, E. and Schmidt, K.M., 1999. A theory of fairness, competition, and cooperation. The quarterly journal of economics , 114 (3), pp.817-868.

Frank, R.H., Gilovich, T. and Regan, D.T., 1993. Does studying economics inhibit cooperation?. Journal of economic perspectives, 7(2), pp.159-171.

Frankfurt, H.G., 1988. The importance of what we care about: Philosophical essays. Cambridge University Press.

Fraser, N. and Jaeggi, R., 2018. Capitalism: A conversation in critical theory. John Wiley & Sons.

Frigg, R., Hartmann, Stephan., 2020. Models in Science, in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Friedman, M., 1953. The methodology of positive economics. In Essays In Positive Economics. University of Chicago Press.

Guglielmo, M., 2008. The contribution of economists to military intelligence during World War II. The Journal of Economic History , 68 (1), pp.109-150.

Gul, F. and Pesendorfer, W., 2008. The case for mindless economics. The foundations of positive and normative economics: A handbook, 1, pp.3-42.

Habermas, J., 1971. Knowledge and human interests. Appendix: Knowledge and human interests: A general perspective (pp. 301–350). Trans. Shapiro. Beacon Press: Boston .

Hagemann, H., Nishizawa, T., & Ikeda, Y. (Eds.). (2010). Austrian economics in transition: from Carl Menger to Friedrich Hayek. Springer.

Hands, D.W., 2001. Reflection without rules: economic methodology and contemporary science theory. Cambridge University Press.

Hands, D.W., 2015. Orthodox and heterodox economics in recent economic methodology. Erasmus Journal for Philosophy and Economics , 8 (1), pp.61-81.

Harding, S., 1991. Whose science? Whose knowledge?: Thinking from women's lives . Cornell University Press

Hausman, D., 1992a. Reflections on philosophy and economic methodology, in: Hausman, D. (Ed.), Essays on Philosophy and Economic Methodology. Cambridge University Press, pp. 230–236.

Hausman, D.M. 1992b. The inexact and separate science of economics. Cambridge University Press.

Hausman, D., 1992c. Why look under the hood?, in: Hausman, D. (Ed.), in: Essays on Philosophy and Economic Methodology. Cambridge University Press, pp. 70–74.

Hausman, D., McPherson, M. and Satz, D., 2016. Economic analysis, moral philosophy, and public policy. Cambridge University Press.

Hausman, D.M., 2021. Philosophy of economics, , in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Heath, J., 2020. Methodological individualism, , in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Heath, J., 2021. Philosophical Foundations of Climate Change Policy. Oxford University Press.

Heilbroner, R.L., 2011. The worldly philosophers: The lives, times and ideas of the great economic thinkers. Simon and Schuster.

Heilmann, C. and Reiss, J. eds., 2022. The Routledge Handbook of the Philosophy of Economics . Routledge, Taylor & Francis Group.

Herzog, L., 2021. Markets. Stanford Encyclopedia of Philosophy, in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Hodgson, G.M., 2007. Meanings of methodological individualism. Journal of Economic Methodology, 14(2), pp.211-226.

Hoff, K. and Stiglitz, J.E., 2016. Striving for Balance in Economics: Towards a Theory of the Social Determinants of Behavior. World Bank.

Hoover, K., D., 2001. Does macroeconomics need microfoundations?, in: Hausman, D., M. (Ed.), The Methodology of Empirical Macroeconomics. Cambridge University Press, pp. 57–88.

Intemann, K., 2010. 25 years of feminist empiricism and standpoint theory: Where are we now?. Hypatia, 25(4), pp.778-796.

Jaeggi, R., 2014. Alienation. Columbia University Press.

Kahnemann, D., Tversky, A., 1979. Prospect theory: An analysis of decision under risk. Econometrica, 47, pp.263-292.

Keynes, J.M., 1936. The General Theory of Employment, Interest and Money (London, 1936).

Kincaid, H., Harold, K., 1996. Philosophical foundations of the social sciences: Analyzing controversies in social research. Cambridge University Press.

Kincaid, H. and Ross, D. eds., 2021. A Modern Guide to Philosophy of Economics. Edward Elgar Publishing.

Kuhn, T., 1979. The Essential Tension: Selected Studies in Scientific Tradition and Change. Thomas S. Kuhn. Isis 70, 279–280.

Lamont, J. and Favor, C., 2017. Distributive justice, in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Laws and explanation in the social sciences, 2009. , in: Philosophy of the Social Sciences. Cambridge University Press, pp. 99–102.

Lawson, T., 1997. Economics and reality. Psychology Press.

Leamer, E., 1983. Let’s take the con out of econometrics. The American Economic Review 73, 31–43.

Leopold, D., 2022. Analytical Marxism. Stanford Encyclopedia of Philosophy.

Linsbichler, A., 2021. Philosophy of Austrian Economics. In The Routledge Handbook of Philosophy of Economics (pp. 169-185). Routledge.

Longino, H.E., 1996. Cognitive and non-cognitive values in science: Rethinking the dichotomy, in: Feminism, Science, and the Philosophy of Science. Springer Netherlands, Dordrecht, pp. 39–58.

Lucas, R.E., Jr, 1976. Econometric policy evaluation: A critique. Carnegie-Rochester Conference Series on Public Policy 1, 19–46.

MacKenzie, D., 2008. An engine, not a camera: How financial models shape markets. MIT Press.

Mäki, U., 1992. On the Method of Isolation in Economics, in: Dilworth , C. (Ed.), Intelligibility in Science (Poznan Studies in the Philosophy of the Sciences and the Humanities). Rodopi, Amsterdam, pp. 317–50.

Marx, Karl, 1867. Das Kapital. Kritik der politischen Oekonomie.

Mayer, T., 1993. Truth versus precision in economics . E. Elgar.

McCloskey, D.N., 1990. Storytelling in economics. Economics and hermeneutics, p.61-75.

McCloskey, D.N., 1994. Knowledge and persuasion in economics . Cambridge University Press.

McKenna, E.J. and Zannoni, D.C., 1993. Philosophical foundations of Post Keynesian economics. Journal of Post Keynesian Economics , 15 (3), pp.395-407.

McLaughlin, B., Bennett, K., 2021. Supervenience, in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Menger, C., 1987. Investigations into the method of the social sciences with special reference to economics. Economica 54, 134.

Mehta, J., 2008. the Ontological in Economic Inquiry. Future Directions for Heterodox Economics , p.73.

Meyer, L., 2021. Intergenerational justice, in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Mill, J.S., 1836. On the definition and method of political economy. The philosophy of economics, pp.41-58.

Mill, J.S., 1843. A system of logic, ratiocinative and inductive: Being a connected view of the principles of evidence, and methods of scientific investigation.

Milonakis, D. and Fine, B., 2009. From political economy to economics: Method, the social and the historical in the evolution of economic theory. Routledge.

Minsky, H., 1975. John Maynard Keynes. McGraw-Hill Education.

Mireles-Flores, L. and Nagatsu, M., 2022. Methodology and philosophy of economics: a tale of two biases. The History of Economic Thought, 64(1), pp.33-57.

Mirowski, P., 2005. The philosophical bases of institutionalist economics. In Economics and hermeneutics (pp. 85-121). Routledge.

Mirowski, P., 2019. Hell is truth seen too late. boundary 2: an international journal of literature and culture , 46 (1), pp.1-53.

Mongin, P., 2006. Value judgments and value neutrality in economics. Economica, 73(290), pp.257-286.

Morgan, M.S. and Rutherford, M., 1998. From interwar pluralism to postwar neoclassicism. History of Political Economy, 30.

Morgan, M.S., 2001. Models, stories and the economic world. Journal of Economic Methodology, 8(3), pp.361-384.

Morgan, M.S., 2012. The world in the model: How economists work and think. Cambridge University Press.

Nelson, J.A., 1995. Feminism and economics. Journal of Economic Perspectives, 9(2), pp.131-148.

Ng, K., 2015. Ideology critique from Hegel and Marx to critical theory. Constellations, 22(3), pp.393-404.

Nozick, R., 1974. Anarchy, state, and utopia (Vol. 5038). new york: Basic Books.

Nussbaum, M.C., 2000. Women and human development: The capabilities approach (Vol. 3). Cambridge university press.

O’Connor, T., 2021. Emergent Properties. in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Parfit, D., 1995. Lindley lecture: equality or priority?. University of Kansas, Kansas City, pp.1-43.

Pelletier, D., Shekar, M., Du, L. and Kostermans, K., 2005. The Bangladesh Integrated Nutrition Project Effectiveness and Lessons. Bangladesh Development Series–Paper, (7).

Prado, C.G., 2003. A house divided: Comparing analytic and continental philosophy.

Rawls, J., 1999. A Theory of Justice, revised edition. Belknap Press.

Rawls, J., 2001. Justice as fairness: A restatement. Belknap Press.

Reiss, J., 2013. Philosophy of Economics: A Contemporary Introduction. Routledge.

Reiss, J., 2017. Are there social scientific laws? , in: McIntyre, L., Rosenberg , A. (Eds.), The Routledge Companion to Philosophy of Social Science. Taylor & Francis, Abingdon, pp. 295–309.

Reutlinger, A., Schurz, G., Hüttemann, A., 2017. Ceteris paribus laws, in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Robeyns, I., & Fibieger Byskov, M. 2021. The capability approach, in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Robinson, J., 1978. Contributions to modern economics. Academic Press.

Roemer, J.E., 1982. New directions in the Marxian theory of exploitation and class. Politics & Society, 11(3), pp.253-287.

Roemer, J., E., 2009. Equality: It’s justification, nature, and domain, in: Salverda, W., Nolan, B. and Smeeding, T.M. (Eds.), in: The Oxford Handbook of Economic Inequality. OUP Oxford.

Rotheim, R.J., 1999. Post Keynesian economics and realist philosophy. Journal of Post Keynesian Economics, 22(1), pp.71-103.

Satz, D., 2010. Why some things should not be for sale: The moral limits of markets. Oxford University Press.

Schumpeter, J., 1909. On the concept of social value. The quarterly journal of economics, 23(2), pp.213-232.

Sen, A., 1985. Commodities and capabilities. OUP India.

Steele, K. 2020. Decision Theory. Stanford Encyclopedia of Philosophy.

Sugden, R., 1991. Rational choice: a survey of contributions from economics and philosophy. The economic journal, 101(407), pp.751-785.

Sugden, R., 2000. Credible worlds: The status of theoretical models in economics. Journal of Economic Methodology 7, 1–31. https://doi.org/10.1080/135017800362220

Tribe, K., 1999. Adam Smith: Critical theorist? Journal of Economic Literature 37, 609–632.

Tversky, A., Kahneman, D., 1974. Judgment under uncertainty: Heuristics and biases. Science 185, 1124–1131.

Udehn, L., 2002. The changing face of methodological individualism. Annual review of sociology, pp.479-507.

van der Vossen, B., 2019. Libertarianism, in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Vromen, J., 2021. What are we up to?. Journal of Economic Methodology, 28(1), pp.23-31.

Weintraub, E., 1999. How should we write the history of twentieth-century economics? Oxford Review of Economic Policy 15, 139–152.

Weisberg, M., 2006. Robustness Analysis. Philosophy of Science 73, 730–742.

White, H. and Masset, E., 2007. Assessing interventions to improve child nutrition: a theory‐based impact evaluation of the Bangladesh Integrated Nutrition Project. Journal of International Development: The Journal of the Development Studies Association, 19(5), pp.627-652.

Wimsatt, W., C., 2007. Reengineering philosophy for limited beings. Harvard University Press, Cambridge.

Zahle, J., 2021. Methodological Holism in the Social Sciences, in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

Zwolinski, M., Ferguson, B., Wertheimer, A., 2022. Exploitation, in: Edward N. Zalta (Ed.), in: Stanford Encyclopedia of Philosophy.

1 It is worth noting that within the discipline of philosophy, the area of study for the Philosophy of Economics is a subfield of analytical philosophy; not continental philosophy. Analytical philosophy is generally concerned with the analysis of thought, language, logic, and knowledge and often uses arguments and proofs similar to those used in mathematics and logic. Continental philosophy addresses “large questions in a synthetic or integrative way” (Prado, 2003:10) and uses more wide-reaching methods that are often less formal. The study of Philosophy of Economics is about understanding the knowledge and logic of the discipline of economics and thus from the philosophical side is viewed as a subfield of analytical philosophy. The focus of our overview is thus also analytic philosophy.

2 A recent citation analysis mapped two separate branches of research of the topics and concerns most often covered in the Philosophy of Economics field (Claveau et al., 2021). One cluster focuses on specialised philosophical topics, typically pursued by analytical philosophers, including moral philosophy, decision theory, behavioural economics and methodology, and is highly concentrated in the Journal of Economic Methodology and the Journal of Economics and Philosophy. A second cluster, which focuses on topics such as critical realism, institutional economics, political economy, the history of economic thought and methodology, is found across an array of economic journals and is more frequently pursued by economists.

3 We’d like to acknowledge that this piece may tend towards highlighting the philosophical views because of the way most Philosophy of Economics courses are taught and our own personal education.

4 Mainstream or orthodox economics are those usually neoclassical theories which are most commonly accepted and taught in universities worldwide. An expanded umbrella was characterised by D. Wade Hands as being “pluralist mainstream” and includes the topics of experimental economics, behavioural economics, neuroeconomics, and other related subfields (Hands, 2015).

5 Economic thinking dates back to the time of Plato and Aristotle. However, for our purposes we only address economics from Smith onwards. To learn more about the early years of economic thinking see chapters 1 through 4 of Backhouse (2002).

6 As for example Friedman’s (1953) defence of instrumentalism is influential within economics, but criticised by most philosophers (see section 6.2.2).

This project is brought to you by the Network for Pluralist Economics ( Netzwerk Plurale Ökonomik e.V. ). It is committed to diversity and independence and is dependent on donations from people like you. Regular or one-off donations would be greatly appreciated.

Work & Careers
Life & Arts

Immigration helps explain US economic strength: Goldman

Immigration helps explain US economic strength: Goldman on x (opens in a new window)
Immigration helps explain US economic strength: Goldman on facebook (opens in a new window)
Immigration helps explain US economic strength: Goldman on linkedin (opens in a new window)
Immigration helps explain US economic strength: Goldman on whatsapp (opens in a new window)

Robin Wigglesworth

Simply sign up to the Global Economy myFT Digest -- delivered directly to your inbox.

It’s the kind of headline that the worst people alive will probably warp to fit their narratives, but Goldman Sachs thinks that the answer to some puzzling US economic data is a jump in immigration.

US economic growth was far stronger than most people expected last year, thanks to some absolutely monster jobs reports and consumer spending that made a mockery of fears that bad vibes might cause a recession.

However, despite robust job creation the US unemployment rate has actually edged up from a five-decade low of 3.4 per a year ago to 3.9 per cent. At the same time, employment surveys of companies and households have been diverging sharply , further confounding many economists.

Goldman Sachs reckons that the answer to “one of the biggest puzzles of the last year” is a sharp increase in net immigration, which has increased the size of the American labour force and enhanced US economic growth potential.

Recent studies suggest that Census data used for the household survey of the employment report understated immigration in 2023. We estimate that immigration was 1½mn above the trend of roughly 1mn per year in 2023, which implies an 80k boost to the monthly breakeven rate of job growth to 155k. We expect immigration to be about 1mn higher than usual this year, implying breakeven job growth of around 125k and a 0.3pp boost to potential GDP growth in 2024 from faster labor force growth.

The result is that Goldman — already one of the more optimistic investment banks on Wall Street — is once again lifting its actual US growth forecast for 2024.

We have updated our payrolls and GDP forecasts to incorporate the ongoing boost from above-trend immigration. We now expect payroll growth to average 175k/month this year and slow to 150k/month by year-end, though we expect this to only lower the unemployment rate a touch to 3.8% by year-end. We have also raised our 2024 real GDP growth forecast by 0.3pp to +2.4% on a Q4/Q4 basis (or +2.7% on a full-year basis), mostly by upgrading consumption growth.

Basically, Goldman Sachs thinks that immigration will short-circuit the Sahm Rule , which stipulates that a recession is in the mail when the three-month moving average of the US unemployment rate rises by half a percentage point off its 12-month low.

. . . The recent increase in the unemployment rate has been led by a higher unemployment rate amongst foreign-born workers, which itself likely reflects the combination of elevated immigration and a higher rate of unemployment amongst recent immigrants. This implies that the increase in unemployment over the last year mostly reflected an increase in labor supply from new immigrants, which is unlikely to trigger a vicious cycle of job loss, income loss and further unemployment that is typically associated with increases in the unemployment rate.

Promoted Content

Follow the topics in this article.

Global Economy Add to myFT
US employment Add to myFT
FT Alphaville Add to myFT
Robin Wigglesworth Add to myFT

International Edition

Disinformation is a threat to our trust ecosystem. Experts explain how to curb it

“Trust is our most valuable asset,” says Emma Tucker, Editor-in-Chief of the Wall Street Journal. Image: Robin Worrall/Unsplash

.chakra .wef-1c7l3mo{-webkit-transition:all 0.15s ease-out;transition:all 0.15s ease-out;cursor:pointer;-webkit-text-decoration:none;text-decoration:none;outline:none;color:inherit;}.chakra .wef-1c7l3mo:hover,.chakra .wef-1c7l3mo[data-hover]{-webkit-text-decoration:underline;text-decoration:underline;}.chakra .wef-1c7l3mo:focus,.chakra .wef-1c7l3mo[data-focus]{box-shadow:0 0 0 3px rgba(168,203,251,0.5);} Jesus Serrano

.chakra .wef-9dduvl{margin-top:16px;margin-bottom:16px;line-height:1.388;font-size:1.25rem;}@media screen and (min-width:56.5rem){.chakra .wef-9dduvl{font-size:1.125rem;}} Explore and monitor how .chakra .wef-15eoq1r{margin-top:16px;margin-bottom:16px;line-height:1.388;font-size:1.25rem;color:#F7DB5E;}@media screen and (min-width:56.5rem){.chakra .wef-15eoq1r{font-size:1.125rem;}} Media, Entertainment and Sport is affecting economies, industries and global issues

A hand holding a looking glass by a lake

.chakra .wef-1nk5u5d{margin-top:16px;margin-bottom:16px;line-height:1.388;color:#2846F8;font-size:1.25rem;}@media screen and (min-width:56.5rem){.chakra .wef-1nk5u5d{font-size:1.125rem;}} Get involved with our crowdsourced digital platform to deliver impact at scale

Stay up to date:, media, entertainment and sport.

Digital technology and fragmented media ecosystems have allowed disinformation to proliferate.
The spread of disinformation has fuelled an erosion of trust across societies.
Rebuilding trust and preserving a healthy media environment requires a joint effort of governments, media houses, technology firms and civil society.

In an era where digital technology is part of almost every aspect of our lives, the dissemination of information has never been easier or more instantaneous. Yet, in a world where false information can spread worldwide with the click of a button, a critical question arises: how do we safeguard the truth while a wave of disinformation threatens our information ecosystems and democratic societies?

Today, the proliferation of false content online is pervasive and exacerbates the erosion of global trust in institutions. In fact, only 40% of people say they consistently trust news . As the World Economic Forum's Global Risks Report 2024 highlights , disinformation is considered to be the world’s top risk in the next two years, and the fifth global risk in the next ten years.

Addressing disinformation requires a concerted effort across sectors. Governments, media organizations, tech companies and civil society must collaborate to create a multi-layered defence against the spread of false information. Empowering Internet users with media information literacy, ensuring the independence and viability of news organizations, and leveraging technology to distinguish between credible journalism and disinformation are vital to countering the spread of false information.

These key actions were discussed at the Forum’s 54 th Annual Meeting in Davos in the session titled ‘Defending Truth’, which included experts across sectors and specializations. Participants included Věra Jourová, European Commission Vice-President for Values and Transparency; Meredith Kopit Levien, New York Times President and Chief Executive Officer; Jeanne Bourgault, Internews President and Chief Executive Officer; and Emma Tucker, The Wall Street Journal Editor-in-Chief.

New digital landscape

The current digital age has revolutionized the way we access information and consume news. This has helped fuel the rise of fragmented and siloed media ecosystems, which can oversimplify complex issues.

Such a shift has made it harder for audiences to fully appreciate the value of independent journalism and has obfuscated the distinctions between independent, fact-based journalism and partisan opinions. It has also allowed disinformation to spread unabated, fuelling distrust and division.

“We need to help the public be more media literate as to the value and importance of independent journalism. People find it very hard for many reasons to distinguish what it is and is not,” Levien of the New York Times said during the session in Davos.

Tucker of the Wall Street Journal added: “Trust is our most valuable asset. And the minute we let go of that, our business models will fall apart. That also means we have to correct our mistakes. We have to be honest when we make mistakes.”

Reporting truth is expensive, slow and dangerous

In an era of instant communication, one of the key challenges is that disinformation travels faster than the truth can be verified, creating a breeding ground for confusion and mistrust. Unlike the viral spread of disinformation, the process of uncovering truth is often slow and laborious, demanding meticulous verification and careful investigation.

“Truth does unfold in many cases slowly. Most big stories about very consequential things, where the public needs understanding and to know who to hold to account and for what, takes days, weeks, and sometimes they take months,” Levien added, citing the Times’ months-long investigation into allegations of sexual assault in Hollywood that helped spark the #MeToo movement.

Another fundamental concern for defending truth is the dangerous nature of reporting from conflict zones or under authoritarian regimes. While reporting in such environments, journalists are often at risk, making it more difficult to deliver accurate, on-the-ground information, which is essential for a well-informed public.

“It is such a massive issue,” Tucker said, noting that there are “countries where we cannot send our journalists, and that is a challenge for all of us because we rely on eyewitness accounts to really make sure we are getting to the truth. It is a very grim trend.”

Bourgault of Internews echoed the concern for journalist operating in danger zones, noting that the ongoing conflict in the Middle East is the “single deadliest conflict in the history of journalism since it has been tracked by the Committee to Protect Journalists.”

Have you read?

The four key ways disinformation is spread online, rebuilding trust in the age of ai and disinformation.

The Principles for the Future of Responsible Media in the Era of AI , a World Economic Forum white paper, points out that media fragmentation, coupled with the increase of generative AI content often being indistinguishable from non-synthetic content, have made it harder for consumers to know what to trust and have increased the believe that the media is biased or untrustworthy. In turn, news consumers have become more susceptible to disinformation from alternative sources.

As noted, rebuilding trust and preserving a healthy trust ecosystem in the age of disinformation is a complex task that requires the joint effort of governments, media houses, technology firms and civil society. The concerted push to defend the truth should focus on fostering media literacy, reinforcing the independence and sustainability of quality news organizations, and embrace an openness to innovation and the responsible adoption of AI, among other measures.

Efforts to combat disinformation are underway. The European Union, for instance, recently adopted the Digital Services Act, which takes aim at harmful content online and includes comprehensive AI regulations , covering areas like transparency, the use of AI in public spaces and high-risk systems.

Meanwhile, the Forum’s Global Coalition for Digital Safety is actively confronting the challenge of disinformation by exploring the role of media literacy and fostering a whole-of-society approach to countering its proliferation.

Tackling disinformation may seem like a Sisyphean mission, yet it is essential to persist in these collective efforts to preserve the truth because, in no small way, our democracies depend on it.

Don't miss any update on this topic

Create a free account and access your personalized content collection with our latest publications and analyses.

License and Republishing

World Economic Forum articles may be republished in accordance with the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International Public License, and in accordance with our Terms of Use.

The views expressed in this article are those of the author alone and not the World Economic Forum.

The Agenda .chakra .wef-n7bacu{margin-top:16px;margin-bottom:16px;line-height:1.388;font-weight:400;} Weekly

A weekly update of the most important issues driving the global agenda

.chakra .wef-1dtnjt5{display:-webkit-box;display:-webkit-flex;display:-ms-flexbox;display:flex;-webkit-align-items:center;-webkit-box-align:center;-ms-flex-align:center;align-items:center;-webkit-flex-wrap:wrap;-ms-flex-wrap:wrap;flex-wrap:wrap;} More on Media, Entertainment and Sport .chakra .wef-17xejub{-webkit-flex:1;-ms-flex:1;flex:1;justify-self:stretch;-webkit-align-self:stretch;-ms-flex-item-align:stretch;align-self:stretch;} .chakra .wef-nr1rr4{display:-webkit-inline-box;display:-webkit-inline-flex;display:-ms-inline-flexbox;display:inline-flex;white-space:normal;vertical-align:middle;text-transform:uppercase;font-size:0.75rem;border-radius:0.25rem;font-weight:700;-webkit-align-items:center;-webkit-box-align:center;-ms-flex-align:center;align-items:center;line-height:1.2;-webkit-letter-spacing:1.25px;-moz-letter-spacing:1.25px;-ms-letter-spacing:1.25px;letter-spacing:1.25px;background:none;padding:0px;color:#B3B3B3;-webkit-box-decoration-break:clone;box-decoration-break:clone;-webkit-box-decoration-break:clone;}@media screen and (min-width:37.5rem){.chakra .wef-nr1rr4{font-size:0.875rem;}}@media screen and (min-width:56.5rem){.chakra .wef-nr1rr4{font-size:1rem;}} See all

What does freedom of speech mean in the internet era?

John Letzing

March 5, 2024

AI and Hollywood: 5 questions for SAG-AFTRA’s chief negotiator

Spencer Feingold

March 4, 2024

AI, leadership, and the art of persuasion – Forum podcasts you should hear this month

Robin Pomeroy

March 1, 2024

Social media in the crossfire: This is how you establish 'digital trust'

Kate Whiting

February 20, 2024

Digital safety: We are shaping a more secure digital future

January 16, 2024

Facts over fiction: Why we must protect evidence-based knowledge if we value democracy

Ben Feringa and Sir Paul Nurse

Theory of Rational Expectation | Theories| Macroeconomics

The new classical macroeconomics is based on the rational expectations hypothesis. This means that people have rational expectations about economic variables. The implication is that people make intelligent use of available information in forecasting variables that affect their economic decisions.

According to this hypothesis, forecasts are unbiased and based on all available information. The hypothesis holds that people make unbiased forecasts. A more controversial assumption is that people use all available information and economic theory in making decisions.

This implies that people understand how the economy works and how the government policies alter macroeconomic variables such as the price level, the level of employment and aggregate output. And because of rational expectations, the government cannot fool the people with systematic economic policies.

The idea of rational expectations was first discussed by John F. Muth in 1961. However, the idea was not widely used in macroeconomics until the new classical revolution of the early 1970s, popularized by Robert Lucas and T. Sergeant. No doubt, the theory of rational expectations is a major breakthrough in macroeconomics.

ADVERTISEMENTS:

Until the early 1970s, macroeconomists thought of expectations in one of two ways:

1. Animal Spirits:

The term ‘animal spirits’ was coined by J .M .Keynes to refer to movements in investment that could not be explained by movements in current variables. In other words, shifts in expectations were considered important but unexplained.

2. Adaptive Expectations:

The second one was the result of simple, backward-looking rules. For example, people were often assumed to have static expectations, that is, to expect the future to be like the present. This assumption is used while discussing the Phillips curve and explaining investment decisions. In other words, people were assumed to have adaptive expectations.

If, for example, their forecast of a given variable in a given period turned out to be too low, people were assumed to “adapt” by raising their expectation for the value of the variable for the next period. For example, seeing an inflation rate higher than they had expected, led people to revise upward their forecast of future inflation upward.

In the early 1970s, Robert Lucas and Thomas Sergeant argued that their assumptions did not reflect the way people form expectations. They argued that in thinking about the effect of alternative policies, economists should assume that people have rational expectations, that people look into the future and try to predict the future as best (accurately) as they can. This is not the same as assuming that people know the future, but rather that they use the information they have, in the best possible way.

Practical Implications: Policy Ineffectiveness :

One of the most important contentions of rational expectations is the ineffectiveness of systematic fiscal and monetary policies in reducing unemployment. The basic idea is that a predictable attempt to stimulate the economy would be known in advance, and would have no effect on the economy. This is known as the policy ineffectiveness theorem. With rational expectations and flexible prices and wages, anticipated government policy cannot affect real output or employment.

Lucas and Sergeant showed how replacing traditional assumptions about the formation of expectations, by the assumption of rational expectations, could fundamentally alter the results. In particular, Lucas challenged the notion that disinflation necessarily required an increase in unemployment for some time. This is known as the Lucas critique.

Lucas pointed out that when trying to predict the effects of a major policy change—like the change considered by the central bank at the time—it could be very misleading to take as given the relations estimated from past data.

Lucas argued that, if wage setters believed that the central bank was committed to lower inflation, they might well expect inflation to be lower in the future than in the past. If they lowered their expectations of inflation, then actual inflation would decline without the need for a protracted recession.

The logic of Lucas’s argument can be explained briefly. If wage setters kept forming expectations of inflation (π e ) by looking at the last year’s inflation (π e ), i.e., π e = π t-1 then the only way to decrease inflation would be to accept high unemployment for some time.

But, if wage setters could be convinced that inflation was indeed going to be lower than in the past, they would decrease their expectations of inflation. This would, in turn, reduce actual inflation, without any change in the rate of unemployment.

For example, if wage setters were convinced that inflation, which had been running at 10% in the past, would be only 3% in the future, and if they formed their expectations accordingly, then inflation would fall to 3%, even if the actual rate of unemployment was the same as its natural rate.

Nominal money growth, inflation, and expected inflation could all be reduced even in the absence of a recession. Alternatively stated, decreases in nominal money growth could be neutral not only in the medium term, but also in the short run.

Lucas and Sergeant did not believe that disinflation could really be achieved without tolerating more unemployment. But Sergeant argued that increase in unemployment could be small. The sacrifice ratio—the amount of excess unemployment needed to achieve disinflation— might not be much lower than that suggested by the traditional approach.

Credibility of Policy :

The essential ingredient of successful disinflation is credibility of monetary policy—the belief by wage setters that the central bank is truly committed to reducing inflation. The credibility view is that, fast disinflation is likely to be more credible than slow disinflation. Credibility decreases the unpleasant cost of disinflation. So it is judicious for the central bank to go for fast disinflation.

Only credibility would cause wage setters to change the ways they formed their expectations. In addition, a clear and quick disinflation programme was much more likely to be credible than a protracted one that offered plenty of opportunities for reversal.

Implications :

The rational expectations assumption has important implications. For example, if monetary non-neutrality is due to temporary misperceptions of the price level and people have rational expectations about prices, monetary policy does not affect the real economy systematically.

According to Lucas, the central bank cannot systematically surprise the public if the public has rational expectations. Lucas’s basic point is that public’s forecasts of various economic variables, including money supply, the price level and, the GDP are based on reasoned and intelligent examination of available economic data.

If people have rational expectations they will eventually understand the central bank’s general pattern of behaviour. If expectations are rational, purely random changes in the money supply may be unanticipated and non-neutral However, because the central bank would not be able to surprise the public systematically it cannot use monetary policy to stabilise output. Thus, even if control of business cycles were desirable, according to rational expectations, the central bank cannot use monetary policy to do so.

Monetarist Rules and the Lucas Critique :

The rational expectations hypothesis has challenged the key assumption of the monetarist school, namely, stability (constancy) of the velocity of money. The monetarists believe that it is possible to stabilise MV= PY, nominal GDP, by imposing a fixed-money rule.

But Lucas argues that people may change their behaviour when policy changes. The apparently constant velocity may change if the central bank adopts a fixed-money growth rule. Lucas’s argument is a stern warning to monetarists that economic behaviour can change when policymakers rely too heavily upon past regularities.

A Complete Rethinking :

In a more general sense, Lucas and Sergeant’s research showed the need for a complete rethinking of macroeconomic models under the assumption of rational expectations. And this is exactly what had happened over the next two decades.

A Challenge to the Phillips Curve Hypothesis :

In a sense, the rational expectations hypothesis threw a challenge to the Phillips curve hypothesis on the short-run trade-off between inflation and unemployment. If economic agents simply adapt their behaviour to the difference between expected and realised events, they will be constantly disappointed during periods of rising inflation.

So they are instead conceived as forming their expectations on the basis of exactly the same information that is available to policymakers. An expansionary fiscal policy or an easy monetary policy, designed to reduce unemployment, is correctly perceived to lead to higher prices; in consequence, private spending accelerates.

As a consequence, there is instant inflation without much effect on real variables such as GDP and employment. This is a refutation of the Phillips curve conjecture that there is a trade-off between inflation and unemployment even in the short run.

The only way a government can bring about deviations from the ‘natural rate of unemployment’ is by surprising people. But if people learn from experience, this will only work once or twice; sooner or later people will learn correctly to anticipate any systematic government policy and, at that point, unemployment will never deviate, except momentarily, from its natural rate.

Theory and Practice :

Most macroeconomists today use rational expectations as a working assumption in their models and analysis of policy. When thinking about the likely effects of a particular economic policy, the best assumption to make seems to be that people and firms will do the best they can to work out its implications. Designing a policy on the assumption that people will make systematic mistakes in responding to it is unwise.

Under rational expectations, what happens today depends on expectations of what will happen in the future. But what happens in the future also depends on what happens today. The success of Lucas and Sergeant in convincing most macroeconomists to use rational expectations comes not only from the strength of their argument, but also from showing how it could actually be done.

An Application of the Re-Hypothesis: Accuracy of Inflation Forecasts :

The rational expectations approach has been used by economists to test the accuracy of inflation forecasts. Suppose P e t is an individual’s forecast, made in year t – 1 of the price level in year t. Suppose also the actual price level in year; be P t . Then the difference between the actual price level and the individual’s forecast measures his forecast error for year t. P t – P e t = r t = the individual’s forecast error in year t.

If people have rational expectations, these forecast errors are due to exogenous factors, i.e., unpredictable random numbers. However, if errors are consistently positive or negative implying that people systematically tend to under predict or over predict the price level expectations are not rational. If forecasts follow a systematic pattern for example, if people tend to over predict the price level when prices have been rising in the recent past again, expectations are not rational.

Conclusion :

Much progress has been made in the last three decades in developing solution methods for larger and larger models. Today, a number of macroeconomic models are solved under the assumption of rational expectations.

In the ultimate analysis, it appears that the rational expectations assumption is attractive to economists including many new-Keynesian and new-classical economists because it fits well economists’ presumption that people systematically, logically and intelligently pursue their economic self-interests. If people’s expectations are not rational, the economic plans that individuals make would not be generally as good as they could be.

However, the theoretical effectiveness of rational expectations obviously is not enough. Economists would like to know whether people really do have rational expectations about important economic variables such as the money supply growth, the price level and stock prices.

Inflation and Unemployment: Philips Curve and Rational Expectations Theory
Rational Expectations : Meaning, Nature and Everything Else
Essay on Inflation Targeting | Macroeconomics
Disinflation and the Sacrifice Ratio (With Diagram)

1.3 The Economists’ Tool Kit

Learning objectives.

Explain how economists test hypotheses, develop economic theories, and use models in their analyses.
Explain how the all-other-things unchanged (ceteris paribus) problem and the fallacy of false cause affect the testing of economic hypotheses and how economists try to overcome these problems.
Distinguish between normative and positive statements.

Researchers often examine relationships between variables. A variable Something whose value can change. is something whose value can change. By contrast, a constant Something whose value does not change. is something whose value does not change. The speed at which a car is traveling is an example of a variable. The number of minutes in an hour is an example of a constant.

Research is generally conducted within a framework called the scientific method A systematic set of procedures through which knowledge is created. , a systematic set of procedures through which knowledge is created. In the scientific method, hypotheses are suggested and then tested. A hypothesis An assertion of a relationship between two or more variables that could be proven to be false. is an assertion of a relationship between two or more variables that could be proven to be false. A statement is not a hypothesis if no conceivable test could show it to be false. The statement “Plants like sunshine” is not a hypothesis; there is no way to test whether plants like sunshine or not, so it is impossible to prove the statement false. The statement “Increased solar radiation increases the rate of plant growth” is a hypothesis; experiments could be done to show the relationship between solar radiation and plant growth. If solar radiation were shown to be unrelated to plant growth or to retard plant growth, then the hypothesis would be demonstrated to be false.

If the tests of a hypothesis yield results consistent with it, then further tests are conducted. A hypothesis that has not been rejected after widespread testing and that wins general acceptance is commonly called a theory A hypothesis that has not been rejected after widespread testing and that wins general acceptance. . A theory that has been subjected to even more testing and that has won virtually universal acceptance becomes a law A theory that has been subjected to even more testing and that has won virtually universal acceptance. . We will examine two economic laws in the next two chapters.

Models in Economics

All scientific thought involves simplifications of reality. The real world is far too complex for the human mind—or the most powerful computer—to consider. Scientists use models instead. A model A set of simplifying assumptions about some aspect of the real world. is a set of simplifying assumptions about some aspect of the real world. Models are always based on assumed conditions that are simpler than those of the real world, assumptions that are necessarily false. A model of the real world cannot be the real world.

We will encounter an economic model in Chapter 2 "Confronting Scarcity: Choices in Production" . For that model, we will assume that an economy can produce only two goods. Then we will explore the model of demand and supply. One of the assumptions we will make there is that all the goods produced by firms in a particular market are identical. Of course, real economies and real markets are not that simple. Reality is never as simple as a model; one point of a model is to simplify the world to improve our understanding of it.

Economists often use graphs to represent economic models. The appendix to this chapter provides a quick, refresher course, if you think you need one, on understanding, building, and using graphs.

Models in economics also help us to generate hypotheses about the real world. In the next section, we will examine some of the problems we encounter in testing those hypotheses.

Testing Hypotheses in Economics

Here is a hypothesis suggested by the model of demand and supply: an increase in the price of gasoline will reduce the quantity of gasoline consumers demand. How might we test such a hypothesis?

The All-Other-Things-Unchanged Problem

The hypothesis that an increase in the price of gasoline produces a reduction in the quantity demanded by consumers carries with it the assumption that there are no other changes that might also affect consumer demand. A better statement of the hypothesis would be: An increase in the price of gasoline will reduce the quantity consumers demand, ceteris paribus. Ceteris paribus A Latin phrase that means, “all other things unchanged.“ is a Latin phrase that means “all other things unchanged.”

The Fallacy of False Cause

Hypotheses in economics typically specify a relationship in which a change in one variable causes another to change. We call the variable that responds to the change the dependent variable A variable that responds to change. ; the variable that induces a change is called the independent variable A variable that induces a change. . Sometimes the fact that two variables move together can suggest the false conclusion that one of the variables has acted as an independent variable that has caused the change we observe in the dependent variable.

Reaching the incorrect conclusion that one event causes another because the two events tend to occur together is called the fallacy of false cause The incorrect assumption that one event causes another because the two events tend to occur together. . The accompanying essay on baldness and heart disease suggests an example of this fallacy.

Normative and Positive Statements

Although people often disagree about positive statements, such disagreements can ultimately be resolved through investigation. There is another category of assertions, however, for which investigation can never resolve differences. A normative statement A statement that makes a value judgment. is one that makes a value judgment. Such a judgment is the opinion of the speaker; no one can “prove” that the statement is or is not correct. Here are some examples of normative statements in economics: “We ought to do more to help the poor.” “People in the United States should save more.” “Corporate profits are too high.” The statements are based on the values of the person who makes them. They cannot be proven false.

Key Takeaways

Economists try to employ the scientific method in their research.
Scientists cannot prove a hypothesis to be true; they can only fail to prove it false.
Economists, like other social scientists and scientists, use models to assist them in their analyses.
Two problems inherent in tests of hypotheses in economics are the all-other-things-unchanged problem and the fallacy of false cause.
Positive statements are factual and can be tested. Normative statements are value judgments that cannot be tested. Many of the disagreements among economists stem from differences in values.

Look again at the data in Table 1.1 "LSAT Scores for Students Taking the Exam in 2008" . Now consider the hypothesis: “Majoring in economics will result in a higher LSAT score.” Are the data given consistent with this hypothesis? Do the data prove that this hypothesis is correct? What fallacy might be involved in accepting the hypothesis?

Case in Point: Does Baldness Cause Heart Disease?

A website called embarrassingproblems.com received the following email:

“Dear Dr. Margaret,

“I seem to be going bald. According to your website, this means I’m more likely to have a heart attack. If I take a drug to prevent hair loss, will it reduce my risk of a heart attack?”

Source: http://www.embarrassingproblems.com/problems/problempage230701.htm . No longer posted.

Answer to Try It! Problem

What to know about the crisis of violence, politics and hunger engulfing Haiti

A woman carrying two bags of rice walks past burning tires

A long-simmering crisis over Haiti’s ability to govern itself, particularly after a series of natural disasters and an increasingly dire humanitarian emergency, has come to a head in the Caribbean nation, as its de facto president remains stranded in Puerto Rico and its people starve and live in fear of rampant violence.

The chaos engulfing the country has been bubbling for more than a year, only for it to spill over on the global stage on Monday night, as Haiti’s unpopular prime minister, Ariel Henry, agreed to resign once a transitional government is brokered by other Caribbean nations and parties, including the U.S.

But the very idea of a transitional government brokered not by Haitians but by outsiders is one of the main reasons Haiti, a nation of 11 million, is on the brink, according to humanitarian workers and residents who have called for Haitian-led solutions.

“What we’re seeing in Haiti has been building since the 2010 earthquake,” said Greg Beckett, an associate professor of anthropology at Western University in Canada.

Haitians take shelter in the Delmas 4 Olympic Boxing Arena

What is happening in Haiti and why?

In the power vacuum that followed the assassination of democratically elected President Jovenel Moïse in 2021, Henry, who was prime minister under Moïse, assumed power, with the support of several nations, including the U.S.

When Haiti failed to hold elections multiple times — Henry said it was due to logistical problems or violence — protests rang out against him. By the time Henry announced last year that elections would be postponed again, to 2025, armed groups that were already active in Port-au-Prince, the capital, dialed up the violence.

Even before Moïse’s assassination, these militias and armed groups existed alongside politicians who used them to do their bidding, including everything from intimidating the opposition to collecting votes . With the dwindling of the country’s elected officials, though, many of these rebel forces have engaged in excessively violent acts, and have taken control of at least 80% of the capital, according to a United Nations estimate.

Those groups, which include paramilitary and former police officers who pose as community leaders, have been responsible for the increase in killings, kidnappings and rapes since Moïse’s death, according to the Uppsala Conflict Data Program at Uppsala University in Sweden. According to a report from the U.N . released in January, more than 8,400 people were killed, injured or kidnapped in 2023, an increase of 122% increase from 2022.

“January and February have been the most violent months in the recent crisis, with thousands of people killed, or injured, or raped,” Beckett said.

Armed groups who had been calling for Henry’s resignation have already attacked airports, police stations, sea ports, the Central Bank and the country’s national soccer stadium. The situation reached critical mass earlier this month when the country’s two main prisons were raided , leading to the escape of about 4,000 prisoners. The beleaguered government called a 72-hour state of emergency, including a night-time curfew — but its authority had evaporated by then.

Aside from human-made catastrophes, Haiti still has not fully recovered from the devastating earthquake in 2010 that killed about 220,000 people and left 1.5 million homeless, many of them living in poorly built and exposed housing. More earthquakes, hurricanes and floods have followed, exacerbating efforts to rebuild infrastructure and a sense of national unity.

Since the earthquake, “there have been groups in Haiti trying to control that reconstruction process and the funding, the billions of dollars coming into the country to rebuild it,” said Beckett, who specializes in the Caribbean, particularly Haiti.

Beckett said that control initially came from politicians and subsequently from armed groups supported by those politicians. Political “parties that controlled the government used the government for corruption to steal that money. We’re seeing the fallout from that.”

Haiti Experiences Surge Of Gang Violence

Many armed groups have formed in recent years claiming to be community groups carrying out essential work in underprivileged neighborhoods, but they have instead been accused of violence, even murder . One of the two main groups, G-9, is led by a former elite police officer, Jimmy Chérizier — also known as “Barbecue” — who has become the public face of the unrest and claimed credit for various attacks on public institutions. He has openly called for Henry to step down and called his campaign an “armed revolution.”

But caught in the crossfire are the residents of Haiti. In just one week, 15,000 people have been displaced from Port-au-Prince, according to a U.N. estimate. But people have been trying to flee the capital for well over a year, with one woman telling NBC News that she is currently hiding in a church with her three children and another family with eight children. The U.N. said about 160,000 people have left Port-au-Prince because of the swell of violence in the last several months.

Deep poverty and famine are also a serious danger. Gangs have cut off access to the country’s largest port, Autorité Portuaire Nationale, and food could soon become scarce.

Haiti's uncertain future

A new transitional government may dismay the Haitians and their supporters who call for Haitian-led solutions to the crisis.

But the creation of such a government would come after years of democratic disruption and the crumbling of Haiti’s political leadership. The country hasn’t held an election in eight years.

Haitian advocates and scholars like Jemima Pierre, a professor at the University of British Columbia, Vancouver, say foreign intervention, including from the U.S., is partially to blame for Haiti’s turmoil. The U.S. has routinely sent thousands of troops to Haiti , intervened in its government and supported unpopular leaders like Henry.

“What you have over the last 20 years is the consistent dismantling of the Haitian state,” Pierre said. “What intervention means for Haiti, what it has always meant, is death and destruction.”

Image: Workers unload humanitarian aid from a U.S. helicopter at Les Cayes airport in Haiti, Aug. 18, 2021.

In fact, the country’s situation was so dire that Henry was forced to travel abroad in the hope of securing a U.N. peacekeeping deal. He went to Kenya, which agreed to send 1,000 troops to coordinate an East African and U.N.-backed alliance to help restore order in Haiti, but the plan is now on hold . Kenya agreed last October to send a U.N.-sanctioned security force to Haiti, but Kenya’s courts decided it was unconstitutional. The result has been Haiti fending for itself.

“A force like Kenya, they don’t speak Kreyòl, they don’t speak French,” Pierre said. “The Kenyan police are known for human rights abuses . So what does it tell us as Haitians that the only thing that you see that we deserve are not schools, not reparations for the cholera the U.N. brought , but more military with the mandate to use all kinds of force on our population? That is unacceptable.”

Henry was forced to announce his planned resignation from Puerto Rico, as threats of violence — and armed groups taking over the airports — have prevented him from returning to his country.

An elderly woman runs in front of the damaged police station building with tires burning in front of it

Now that Henry is to stand down, it is far from clear what the armed groups will do or demand next, aside from the right to govern.

“It’s the Haitian people who know what they’re going through. It’s the Haitian people who are going to take destiny into their own hands. Haitian people will choose who will govern them,” Chérizier said recently, according to The Associated Press .

Haitians and their supporters have put forth their own solutions over the years, holding that foreign intervention routinely ignores the voices and desires of Haitians.

In 2021, both Haitian and non-Haitian church leaders, women’s rights groups, lawyers, humanitarian workers, the Voodoo Sector and more created the Commission to Search for a Haitian Solution to the Crisis . The commission has proposed the “ Montana Accord ,” outlining a two-year interim government with oversight committees tasked with restoring order, eradicating corruption and establishing fair elections.

For more from NBC BLK, sign up for our weekly newsletter .

CORRECTION (March 15, 2024, 9:58 a.m. ET): An earlier version of this article misstated which university Jemima Pierre is affiliated with. She is a professor at the University of British Columbia, Vancouver, not the University of California, Los Angeles, (or Columbia University, as an earlier correction misstated).

Patrick Smith is a London-based editor and reporter for NBC News Digital.

Char Adams is a reporter for NBC BLK who writes about race.

We've detected unusual activity from your computer network

To continue, please click the box below to let us know you're not a robot.

Why did this happen?

Please make sure your browser supports JavaScript and cookies and that you are not blocking them from loading. For more information you can review our Terms of Service and Cookie Policy .

For inquiries related to this message please contact our support team and provide the reference ID below.

IMAGES

How to Write a Hypothesis: The Ultimate Guide with Examples
Hypothesis
What is a Hypothesis
Life-Cycle Hypothesis
How to Write a Hypothesis in 12 Steps 2023
Efficient Market Hypothesis

VIDEO

Economics terms
What is Hypothesis #hypothesis
Preference similarity Hypothesis (Linder Hypothesis)
Theories Of Population In Economics || UGC Net Economics
1.5. Hypothesis statement
Relative income hypothesis||Macroeconomics||MA economics

COMMENTS

1.3 The Economists' Tool Kit
Explain how economists test hypotheses, develop economic theories, and use models in their analyses. Explain how the all-other-things unchanged (ceteris paribus) problem and the fallacy of false cause affect the testing of economic hypotheses and how economists try to overcome these problems. Distinguish between normative and positive statements.
1.3 How Economists Use Theories and Models to Understand Economic
John Maynard Keynes (1883-1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes famously wrote in the introduction to a fellow economist's book: "[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct ...
1.3 The Economists' Tool Kit
Explain how economists test hypotheses, develop economic theories, and use models in their analyses. Explain how the all-other-things unchanged (ceteris paribus) problem and the fallacy of false cause affect the testing of economic hypotheses and how economists try to overcome these problems. Distinguish between normative and positive statements.
1.3: The Economists' Tool Kit
LibreTexts. Learning Objective. Explain how economists test hypotheses, develop economic theories, and use models in their analyses. Explain how the all-other-things unchanged (ceteris paribus) problem and the fallacy of false cause affect the testing of economic hypotheses and how economists try to overcome these problems.
1.3 How Economists Use Theories and Models to Understand Economic
Figure 1. John Maynard Keynes. One of the most influential economists in modern times was John Maynard Keynes. (Credit: Wikimedia Commons) John Maynard Keynes (1883-1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes, shown in Figure 1, famously wrote in the introduction to a fellow economist ...
1.5: Economic Models
Economic models have two functions: 1) to simplify and abstract from observed data, and 2) to serve as a means of selection of data based on a paradigm of econometric study. Creating a model has two basic steps: 1) generate the model, and 2) checking the model for accuracy - also known as diagnostics.
Economics: The Study of Choice: 1.3 The Economists' Tool Kit
Explain how economists test hypotheses, develop economic theories, and use models in their analyses. ... In the scientific method, hypotheses are suggested and then tested. A hypothesis is an assertion of a relationship between two or more variables that could be proven to be false. A statement is not a hypothesis if no conceivable test could ...
Econometrics: Definition, Models, and Methods
Econometrics is the application of statistical and mathematical theories in economics for the purpose of testing hypotheses and forecasting future trends. It takes economic models, tests them ...
1.2: How Economists Use Theories and Models to Understand Economic
This allows economists to derive hypothesis, or testable questions. Once these questions are tested and retested numerous times, they become adopted as the general set of principles in the field or the theories. For example, many economists wondered what would happen if the government raised the minimum wage. This is a testable question or ...
What Is the Life-Cycle Hypothesis in Economics?
Life-Cycle Hypothesis (LCH): The Life-Cycle Hypothesis (LCH) is an economic theory that pertains to the spending and saving habits of people over the course of a lifetime. The concept was ...
Forming Hypotheses & Questions About Economic Issues
A hypothesis is an educated guess or a guess based on evidence and research. We formulate an economic question, create a hypothesis about this question, and test to accept or reject that ...
The Rôle of Hypothesis in Economic Theory
We have thus arrived at quantity. a definite hypothesis, and many economists have tried to make it a basis for a general theory of economics. f X dx+Y dy+Z dz We can make an estimate of the generality of such. a system. In the first place, it is essentially competi- The general condition for three variables, in order.
Econometrics: Making Theory Count
Economists develop economic models to explain consistently recurring relationships. Their models link one or more economic variables to other economic variables. For example, economists connect the amount individuals spend on consumer goods to disposable income and wealth, and expect consumption to increase as disposable income and wealth increase (that is, the relationship is positive).
Life-Cycle Hypothesis
24 May 2019 by Tejvan Pettinger. Definition: The Life-cycle hypothesis was developed by Franco Modigliani in 1957. The theory states that individuals seek to smooth consumption over the course of a lifetime - borrowing in times of low-income and saving during periods of high income. The graph shows individuals save from the age of 20 to 65.
PDF Hypothesis Testing
The Hypotheses to be Tested. Formal statement of the null and alternative hypotheses. H 0: >= 5,000 against. H 1: < 5,000. u a ways contains the '=' sign. This is a one tailed test, since the rejection region occupies only one side of the distribution. the alternative hypothesis suggests that the true distribution is to the left of the null ...
The Convergence Hypothesis: History, Theory, and Evidence
The hypothesis that per capita output converges across economies over time represents one of the oldest controversies in economics. This essay surveys the history and development of the hypothesis, focusing particularly on its vast literature since the mid-1980s. A summary of empirical analyses, econometric issues, and various tests of the convergence hypothesis are also presented. Moreover ...
Linder Hypothesis: What it is, How it Works, Testing it
Linder Hypothesis: An economic hypothesis that posits countries with similar per capita income will consume similar quality products, and that this should lead to them trading with each other. The ...
Relative Income Hypothesis (With Diagram)
Thus, under the relative income hypothesis, the basic function is the long-run function. The short-run consumption function is produced by cyclical movements in income. Suppose, in Figure 6.14, income has increased steadily to F 0 and consumption has increased to Co. Now suppose income falls to, say, Y 1. Instead of consumption falling to C 1 ...
Top 4 Types of Hypothesis in Consumption (With Diagram)
The following points highlight the top four types of Hypothesis in Consumption. The types of Hypothesis are: 1. The Post-Keynesian Developments 2. The Relative Income Hypothesis 3. The Life-Cycle Hypothesis 4. The Permanent Income Hypothesis. Hypothesis Type # 1. The Post-Keynesian Developments: Data collected and examined in the post-Second World War period (1945-) confirmed the Keynesian ...
Philosophy of Economics
2 A recent citation analysis mapped two separate branches of research of the topics and concerns most often covered in the Philosophy of Economics field (Claveau et al., 2021). One cluster focuses on specialised philosophical topics, typically pursued by analytical philosophers, including moral philosophy, decision theory, behavioural economics and methodology, and is highly concentrated in ...
The Life-Cycle Theory of Consumption (With Diagram)
The life cycle hypothesis can explain the puzzles that emerged from the early empirical work on consumption functions. According to the life cycle hypothesis, the relationship between consumption and current income would be non-proportional, as seems to be the case in short-run time series estimates.
Immigration helps explain US economic strength: Goldman
US economic growth was far stronger than most people expected last year, thanks to some absolutely monster jobs reports and consumer spending that made a mockery of fears that bad vibes might ...
Disinformation is a threat to our trust ecosystem. Experts explain how
Experts explain how to curb it Mar 7, 2024 "Trust is our most valuable asset," says Emma Tucker, Editor-in-Chief of the Wall Street Journal. ... a World Economic Forum white paper, points out that media fragmentation, coupled with the increase of generative AI content often being indistinguishable from non-synthetic content, have made it ...
Theory of Rational Expectation
The new classical macroeconomics is based on the rational expectations hypothesis. This means that people have rational expectations about economic variables. The implication is that people make intelligent use of available information in forecasting variables that affect their economic decisions. According to this hypothesis, forecasts are unbiased and based on all available information. The ...
The Economists' Tool Kit
Explain how economists test hypotheses, develop economic theories, and use models in their analyses. Explain how the all-other-things unchanged (ceteris paribus) problem and the fallacy of false cause affect the testing of economic hypotheses and how economists try to overcome these problems. Distinguish between normative and positive ...
The Haiti crisis, explained: Violence, hunger and unstable political
Chaos has gutted Port-au-Prince and Haiti's government, a crisis brought on by decades of political disruption, a series of natural disasters and a power vacuum left by the president's assassination.
Sunak Faces Economic Misery Similar to Before 1997 Tory Defeat
Rishi Sunak's government is facing the same levels of economic misery that led to the Conservative Party's defeat in 1997, helping explain why the prime minister plans to delay the next ...

1.3 How Economists Use Theories and Models to Understand Economic Issues

1.3 The Economists’ Tool Kit

Models in Economics

Testing Hypotheses in Economics

The All-Other-Things-Unchanged Problem

The Fallacy of False Cause

Normative and Positive Statements

Key Takeaways

Case in Point: Does Baldness Cause Heart Disease?

Answer to Try It! Problem

Share This Book

1.3 How Economists Use Theories and Models to Understand Economic Issues

Key Concepts and Summary

Self-Check Questions

Review Questions

Critical Thinking Questions

Share This Book

ECON102: Principles of Macroeconomics

Economics: The Study of Choice

1.2: How Economists Use Theories and Models to Understand Economic Issues

The Economists Tool Kit

Correlation vs Causation

The Circular Flow of Goods and Services

The American Economy

GDP Growth Over Time

US Trade and Connection to World Economies

Key Concepts and Summary

Contributor

Life-Cycle Hypothesis

Motivation for life-cycle consumption patterns

Does the Life-cycle theory happen in reality?

Criticisms of Life Cycle Theory

Other theories

15 thoughts on “Life-Cycle Hypothesis”

The Convergence Hypothesis: History, Theory, and Evidence

Cite this article

Access this article

Similar content being viewed by others

Econometric Aspects of Convergence: A Survey

The empirics of economic growth over time and across nations: a unified growth perspective

Economic Growth, Empirical Regularities in

Author information

Rights and permissions

About this article

Share this article

Linder Hypothesis: What it is, How it Works, Testing it

What is the Linder Hypothesis?

Understanding the Linder Hypothesis

Testing the Linder Hypothesis

Philosophy of Economics

Exploring Economics Foundational Text

On Exploring Economics

2. Terminology

3. The History of Economic Thought

4. Ethics and Normative Economics

4.1 Welfare and Pareto-efficiency

4.2 Distributive Justice

4.2.1 Egalitarianism

4.2.2 John Rawls and the Difference Principle

4.2.3 Robert Nozick and Libertarianism

4.2.4 Sufficientarianism

4.2.5 Amartya Sen

4.3 Further Topics and Debates

5. Human Behaviour and Decision Making

5.1 Decision Theory and Rational Choice Theory

5.2 Behavioural Economics

5.3 Social Preferences

5.4 Neuroeconomics

6. Methodology and the Philosophy of Economic Science

6.1 Normative versus Positive Economics

6.1.1 Separating Normative and Positive Economics

6.1.2 Value-free economics

6.1.3 Performativity

6.2 Modes of Analysis and Fundamental Principles of Economic Research

6.2.2 Instrumentalism and Realism

6.2.3 Inexact laws and ceteris paribus clauses

6.2.4 Models: Simplification and isolations

6.2.5 Causation

7. Philosophical Assumptions in Orthodox and Heterodox Economics

7.1 Neoclassical and Neoclassical Synthesis