Reason is the tool by which the human mind comes to understand the world. There are two processes by which reason tries to understand events: deductive reasoning, based on generally accepted principles, and inductive reasoning, in which general principles are formed from observed events. The field of economics has deductive and inductive sides, which are complementary to each other.
Deduction in Economics
Deductive economics starts with a set of axioms about economies and how they work, and relies on these principles to explain individual cases or events. Supply and demand analysis, a staple in any introductory economics course, is an example of deductive reasoning because it involves a set of generally accepted principles about demand and supply. To summarize, deduction in economics starts with a generally accepted principle and proceeds to the specific.
Induction in Economics
Inductive reasoning in economics does the reverse of deductive reasoning; namely, it begins with an individual problem or question and proceeds to form a general principle based on the evidence observed in the real world of economic activity. For example, an economist who asks if a government program of public works spending will stimulate a region's economy will proceed to research the issue, collect and analyze data, and based on conclusions, form a general theory about the economic impact of fiscal policies.
Although deduction and induction represent two differing approaches to understanding economic phenomena, the 19th century American economist Henry George observed that they are related. George noted that induction involves the use of human reason to investigate facts, while deduction is the derivative of the former.
Applying George's insight on deduction and induction in economics, deduction involves the use of economic principles and theories that have been empirically verified through observation, research, and critical analysis. Generally accepted principles of supply and demand, for example, can inform our understanding of economic transactions only if they are based on empirical evidence, collected and analyzed through the inductive process.
Induction in economics requires rigorous use of the methodology of economic research. This includes use of the mathematical modeling and statistical processes used in econometrics, or economic measurement. Findings from inductive reasoning then form economic theories used in deductive analysis.