Econ 1221

Chapter 2

The Methodology of Economics

Positive and Normative Statements
• Normative statement: A statement based on value judgement. Someone’s
preferred state of the world, what should be.

- The Bank of Canada should reduce the rate of growth of money.

- Society ought to require welfare recipients to look for jobs.

• Positive statement: A statement based on facts and their analyses (not

necessarily true or correct). About state of the world, what actually is.

- Lower tax rates encourage more work and more saving.

- Trading between two countries increases consumption in both.

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Positive and Normative Statements
Barack Obama is the current president of America
Lower taxes make everyone better off
Bank of Canada should not raise the interest rate any more
You will feel better if you exercise regularly

• Economists make both positive and normative statements.

• As a discipline, economics focuses on facts and their analysis.
• Economists often disagree with one another due to
- Different normative stand points
- Using different competing models
• Economists usually agree on
- importance of using models for analysis.

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What is an Economic Model
• Economists work with models.
• A model is a representation (simplification) of reality, to understand
certain aspect of reality/explain certain things.

- Economists might want to build a model to understand how a reduction in

housing prices in Canada would affect GDP (Overall Production) of the
country.

• A model
- Takes a few variables
- Makes some assumptions about them
- Uses the variable definitions and assumptions (and usually some analysis of
them) to come up with a prediction

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Economic Model/Theory
• Variable: Well defined item that can take many values.

- Endogenous/dependent variable: value of which is determined within the model.

- Exogenous/independent variable: value given from outside the model.

• Assumption: Relations/conditions about the variables that are assumed to

be true by modeler.

• Prediction: Propositions deduced from the model, result of the model.

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What makes a good model
• The predictions from the model are tested with data/empirical
evidence.
• The test may
- Show the data to be consistent with the theory, in which case the model is
not rejected and further testing with additional data might be done.
- Reject the theory if data is not consistent with the theory, in which case new
theories will be developed to explain reality better.

▪ A good model is falsifiable, that can be confirmed or rejected easily

with data. Which requires
- Well specified model
- Good quality data

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Are economic models falsifiable
• Usually no due to lack of good quality data that can come from
controlled experiments.

• The lack of data in economics is handled by making better use of the

limited data.
- using sophisticated statistical analysis

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Correlation vs Causation
• Economic models usually imply a causality, data is used to test that
causal relation.
• A common mistake is to look at data, find a correlation and imply
causality.

Correlation Causation

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Correlation vs Causation
Example: Year round, a giant retailer runs different ad campaigns with
different theme colours. A young analyst, hired by the company notices
that red themed campaigns generated 25% more sales revenue than
other colour themed campaigns over the past few years. Should the
company run more red campaigns?

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Correlation vs Causation
If we have data showing that “students who study more hours also do
better in exams” which of the following can we claim to be true:

1. If you study more, you will do better in exams.

2. Hours of study and exam performance are positively correlated.

3. The data is consistent (does not reject) with a theory that says studying
more causes better performance in exams.

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