Normative Economics

The perspective on economics that deals with normative statements.

Normative economics refers to the perspective on economics that deals with normative statements.

These statements express a value judgment on the desired situation.

In simpler terms, the view of economics is built on the idea of fairness. It tells us what the outcome or goals of a public policy should be.

These judgments can be made toward economic policies and development, investment projects, statements, and scenarios. 

Ideological opinions about the effects of changes in public policy help economists evaluate an outcome as morally good or bad. They rely on the values originating from individual opinions of economists and are usually rigid.

They can be political or authoritarian. As a school of thought, it classifies situations in the economy as helpful or harmful.

Since these statements are based on economists' judgments and personal opinions in the decision-making process, they cannot be verified or tested. Thus, the views of economists may differ when making such judgments.

This approach to economics is subjective as it deals with theoretical or prospective situations.

Statements are formulated based on economic theory, not facts.

These statements can be classified as basic or non-basic.

  • Basic normative judgments- these statements do not change with situations and conditions. Women should be provided with higher school loans is an example of such a statement.
  • Non-basic normative judgments- these statements are held conditionally and are valid only under a given set of situations or knowledge-these change according to the case. For example, taxes should be cut in half to increase the disposable income of residents.

These statements are based on personal opinions and lack objectivity. These statements tell us what should be or ought to be and are often characterized by the words could and should.

The government should provide basic healthcare to citizens.

Examples of such statements are:

  1. Individuals should not be entitled to inheritances as they belong to society.
  2. Developing countries with an educated and liberated population should only accept democracy.
  3. Investors ought to have a social responsibility to stop investing in vice stocks.
  4. Companies should be charged for the pollution they cause.
  5. Working citizens should not pay for hospital care.

Positive economics

Positive economics is the opposite of the normative perspective, although they both complement the formulation of policy objectives. 

Positive economics is based on facts about situations. Therefore, these statements can be verified as they are made through observations about what is prevalent.

They are objective and cannot vary according to the economist.

Positive statements involve describing, quantifying, and clarifying economic activities, development, and related factors.

These statements include data analysis of relevant information to formulate a cause-and-effect relationship.

These statements thus are precise, descriptive, and measurable.

However, these statements can also be incorrect.

'An increase in taxes is favored by citizens' is a positive statement as it states 'what is' and not 'what should be.'

However, this statement is incorrect and can be disproven using facts.

Since these statements tell us what they are, they can also be examined and tested through significant evidence or historical references.

Government-funded healthcare increases public expenditure.

This statement can be proven or disproven by studying the public expenditure patterns of the government.

Examples of positive statements

  1. Historically, monopolies have proved to be inefficient.
  2. The desired rate of returns on gambling stocks is higher compared to others.
  3. Income and quantity demanded are inversely rated in the case of inferior goods.
  4. Significant tax cuts are infeasible due to government budget constraints.
  5. An increase in taxes reduces consumption.

Normative vs. positive economics

Both statements are considered the two arms of economic policy.

The relationships derived from positive economics are used to achieve normative objectives through policy changes.

Positive statements describe situations and issues, whereas normative statements aim to provide solutions to such matters by recommending changes to economic policies.

Normative statements cannot be the only basis of economic decisions as they lack objectivity and ignore facts.

On the other hand, positive statements only look at facts. Since people look at the desired outcome to make economic decisions, they need normative statements as guidelines.

Comparison
BASISNORMATIVE STATEMENTSPOSITIVE STATEMENTS
DefinitionThese statements are based on personal perspectives or opinions formulated through economic theory.These statements are to the point and supported by data, facts, and figures.
PerspectiveSubjective, as they are not supported by factual evidence.Objective, as actual data, back them.
FunctionProvides value judgment. These phenomena may or may not happen in the future.Describes cause and effect relationship between economic variables.
Area of StudyThe study of what ought to be or what should beThe study of what is
TestingThese statements cannot be tested as they are based on an individual's beliefs.These statements can be proven or disregarded through testing.
Economic ClarificationProvides solutions to issues based on personal values.Provides scientific and calculated clarification on economic issues.

Scope

The use of normative economics is crucial in many areas of study, including but not limited to social choice theory, behavioral economics, cooperative game theory, and mechanism design.

1. Behavioral economics ​​

Behavioral economics combines economic theory and psychology to understand how and why people behave the way they do while making economic decisions. It differs from classical and neoclassical theories, which assume consumers make well-informed decisions and have well-defined preferences. 

Scope

It compares people's actions with normative judgments to study the consequences of their actions. It reaches what people do with what people should do.

Some essential ideas on the subject were given by the 18th-century Scottish economist Adam Smith. Smith stated sympathy as the initiation of economic actions in his book 'The Theory of Modern Sentiments.'

He also recognized that people are more afraid of losing than they are eager to win and are, thus, not rational. This risk-averse nature makes them more likely to pursue short-term benefits over long-term benefits.

He also stated that people are often overconfident in their abilities and tend to ignore uncertainties. 

These ideas, supported by his argument of moral sentiments being the foundation of rules and justice, allowed several other economists like Richard Thaler to formulate leading theories on behavioral economics.

20th-century Indian economist Amartya Sen in his book 'Economic Behavior and Moral Sentiments,' suggested that welfare economics, which has a crucial impact on consumer behavior, should also include ethical considerations. 

2. Social choice theory

Social choice theory is a framework for analyzing and combining individual choices, preferences, or decisions to reach collective or social welfare. It includes elements of both welfare economics and public choice theory.

3. Cooperative game theory

Cooperative game theory refers to the interaction of groups of players, or coalitions, that cooperate and make a collective economic decision to maximize their payoffs or welfare.

Game Theory

A typical example is joint ventures by firms to increase their relative advantage against competitors. 

4. Mechanism design

This field of economics and game theory has an objective first approach. Mechanism design requires that economists first set desired objectives before designing economic mechanisms to achieve these objectives. 

This approach is also called reverse game theory. The objectives are set using normative judgments on what ought to be.

Valuation Modeling Course

Everything You Need To Master Valuation Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and authored by Manya Bhardwaj  | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: