SCIENTIFIC APPROACH IN THE EMPIRICAL TESTING OF AN ECONOMIC

THEORY

An economic theory is a formal explanation of the relationship between economic

variables. A theory gives a reason why something happens, offers a cause-and-effect
interpretation for a set of events, or shows the effect on one variable when another
changes. For example, one important economic theory deals with the relationship
between changes in the price of an item and the quantity of the item demanded by
consumers.

In order to obtain a valid and predictable relationship between economic variables,

theories are explored within a framework of a model. This framework includes several
elements:

1. Variables – Typically, a theory is created to provide an explanation for something.

This is why the first step in developing a model is the selection of two variables to
explore. Ordinarily these variables have a cause-and-effect relationship. In economics,
disputes may occur because a variety of factors can be considered in analysing a
problem, and only one or a few of those factors are chosen as variables when
developing a theory to explain the problem. In exploring reasons for a slow-growing
economy, for example, some economist focus on the relationship between supply and
growth, and some on the price level.

2. Assumptions – They are the conditions held to be true while exploring the relationship
between variables. For example, if students were to develop an economic theory about
relationship between changes in the number of employers and changes in the number
of available summer jobs, assumptions could be made about demographics, the
economy in general, the number of students wanting to enrol in summer school, and so
on.

3. Data Collection and Analysis – When developing a theory, researchers collect and
analyse data to determine how the variables are related. In other words, a theory can be
supported by showing that the relationship between the variables is logically or
statistically valid using econometrics, which is the use of statistical techniques to
describe the relationships between economic variables.

4. Conclusions – The conclusion in a model gives the resulting relationship between the
variables based on the assumptions, logic, data analysis that went into the model. It is
important to understand that different assumptions, data collection methods, or
statistical techniques can cause the conclusions of studies to vary.

POSITIVE AND NORMATIVE ECONOMICS

While discussing the scope of economics, we also think of whether economics is a

positive or normative science. Positive economics is the study of what is, and how the
economy operates. It asks questions as: How do price restrictions affect market forces?
Or how does the market for rice corn work? These questions fall under the heading of
economic theory. Normative economics is the study of what the objectives of the
economy should be. Normative economics ask such questions as : What should the
distribution of income be? What should tax policy be designed to do successfully? In
discussing such questions, economist must carefully outline what goals they must set.

Therefore, the task of an economist is not to condemn or advocate but to explore and
explain. However, economics should not be treated as only positive science. It should
be allowed to pass moral judgments of an economic situation. It is, therefore,
considered both positive and normative science. Thus, Economics is the social science
that studies the allocation of scarce resources to satisfy unlimited wants. This involves
analyzing the production, distribution, trade and consumption of goods and services.
Economics is said to be positive when it attempts to explain the consequences of
different choices given a set of assumptions or a set of observations, and normative
when it prescribes that a certain action should be taken.
 Measuring the Economy

 There are different methods to assess economic growth such as Gross National
Product (GNP) and Gross Domestic Product (GDP)
 The Gross Domestic Product (GDP) measures the value of goods and services
by a nation
 The Gross National Product (GNP) measures the value of goods and services
produced by a nation and income from foreign investments.

GNP/ GDP: Expenditure Approach

The expenditure method is a system for calculating gross domestic product (GDP) that
combines consumption, investment, government spending, and net exports. It is the
most common way to estimate GDP.

How the Expenditure Method Works

Expenditure is a reference to spending. In economics, another term for consumer

spending is demand. The total spending, or demand, in the economy is known as
aggregate demand. This is why the GDP formula is actually the same as the formula for
calculating aggregate demand. Because of this, aggregate demand and expenditure
GDP must fall or rise in tandem.

However, this similarity isn't technically always present in the real world—especially
when looking at GDP over the long run. Short-run aggregate demand only measures
total output for a single nominal price level, or the average of current prices across the
entire spectrum of goods and services produced in the economy. Aggregate demand
only equals GDP in the long run after adjusting for price level.

The expenditure method is the most widely used approach for estimating GDP, which is
a measure of the economy's output produced within a country's borders irrespective of
who owns the means to production. The GDP under this method is calculated by
summing up all of the expenditures made on final goods and services. There are four
main aggregate expenditures that go into calculating GDP: consumption by households,
investment by businesses, government spending on goods and services, and net
exports, which are equal to exports minus imports of goods and services.

The Formula for Expenditure GDP is:

GDP=C+ I + G + (X – M)

 C= Consumer spending on goods and services

 I= Investor spending on business capital goods
 G= Government spending on public goods and services
 X-M = Net exports (difference between exports and imports of goods and
services)

Example of Expenditure Approach

Assume the consumer spending for country XYZ was ₱ 500,000 for the first three
months of the year. The government spending, on the other hand, stood at ₱400,000.
Upon carrying out extensive research, a policymaker discovers that fixed investment
expenditure in the economy stood at ₱300,000 made up of ₱70,000 on machinery
purchases, ₱130,000 on inventory investment, and ₱100,000 on residential investment.

If the country exported goods worth ₱400,000 for the period and imported goods
worth ₱300,000, the net exports, in this case, would amount to ₱400,000- ₱300,000=
₱100,000.

Calculation of GDP using the expenditure approach would be:

GDP= C + I + G + (X-M)

XYZ GDP = ₱500,000 + ₱300,000 + ₱400,000 + (₱400,000- ₱300,000)

= ₱500,000 + ₱300,000 + ₱400,000 + ₱100,000

= ₱1, 300, 000

GNP/ GDP: Income Approach

The income approach looks at the final income in the country.

National Income is the sum of all the income payments derived from the four factors of
production from (land, labor, capital and entrepreneur) such as the rent, wages,
interests and normal profit.

Components of National Income

A. Compensation of Employees
Include wages and salaries paid to employees. It also includes wage and salary
supplements, payments by employers into social insurance and into variety of
private pension, health and welfare funds for workers.
B. Rents
Consist of the income received by the households and business that supply
property resources.
C. Interest
Consist of the money paid by the private business to the suppliers of money
capital

D. Normal Profit
It is the sum of the Proprietors’ Income and Corporate Profits.

Proprietor’s Income is consist of net income of sole proprietorships, partnerships, and

other unincorporated businesses.

Corporate Profits are the earnings of the owners of corporations, classified into:

1. Corporate income taxes

2. Dividends
3. Undistributed corporate profits
To arrive at the Gross Domestic Product from the National Income, there are 3
factors to be added to National Income as follows:

Indirect business Taxes (general sales taxes, business property taxes, license
fees etc.) should be added to NI. They are not considered to be payments to a factor of
production, but they are part of total expenditures.

Depreciation is also called capital consumption allowance or consumption of

fixed capital. It is defined as the cost of the used capital goods in a given period of time.

Depreciation= Gross Investment – Net Investment

Net primary income used to be the Net Factor Income from Abroad. This is the
difference between the aggregate flow of factor payments from the rest of the world.

The Formula for getting GDP through Income Approach is:

Total National Income= Compensation of Employees + Rents + Interest + Proprietor’s

Income + Corporate Profits

GDP = Total National Income + Indirect business taxes + Depreciation + Net foreign
factor income

Example of Income Approach:

Personal consumption expenditures ₱ 12, 000

Government purchases 1, 600

Net private domestic investment 1, 000

Net exports 550

Net foreign factor income earned 200

Consumption of fixed capital (depreciation) 1, 300

Indirect business taxes 910

Compensation of employees 11, 200

Rents 700

Interest 650

Proprietors' income 1, 600

Corporate income taxes 960

Dividends 800

Corporate profits 2, 800

Note: To calculate for GDP through income approach, we must first get the Total
National Income

Solution:

Total National Income= Compensation of Employees + Rents + Interest + Proprietor’s

Income + Corporate Profits

= ₱ 11, 200 + ₱ 700 + ₱ 650 + ₱ 1, 600 + ₱ 2, 800

= ₱ 16, 950

GDP= Total National Income + Indirect business taxes + Depreciation + Net foreign
factor income

= ₱ 16, 950 + ₱ 910 + ₱ 1, 300 + ₱ 200

= ₱ 19, 360