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Economics THIRD EDITION By John B. Taylor Stanford University Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 1 Chapter 2 Observing and Explaining the Economy Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 2 OVERVIEW • This chapter describes the tools needed to begin forming an economic analysis • The foundation of all economic analysis is the use of economic data, graphs, and models. These topics are introduced and discussed with the issue of health care Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 3 Teaching Objectives • Discuss how economics makes use of data and graphs • Discuss negative and positive correlation between variables. Differentiate between correlation and causation • Introduce economic models • Explain normative versus positive economics • Discuss the role of economics in designing government policies Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 4 1. Observations: What Economist Endeavor to Explain • Virtually all the questions economists seek to answer come from observing the economy. They document and quantify their observations by collecting and examining data • A standard measure of the size and activity of an economy is gross domestic product (GDP) Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 5 Figure 2.1 Gross Domestic Product (GDP) in the United States, 1990-1999 Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 6 Time-Series Graphs • Any series of data that is measured over time is called a time-series. A series that is plotted over time is called a time-series graph. • We use a time-series graph to describe the behavior of a series over time. Economic models are used to explain the behavior. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 7 Figure 2.2 Spending on Health Care in the United States, 1990-1999 Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 8 Figure 2.3 Health-Care Spending as a Percentage of GDP Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 9 Figure 2.4 Relative Price of Health Care Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 10 Correlation • Two series of data may be related. Correlation (positive and negative) measures the potential relationship. • What can you say about the correlation between good grades on economic tests and time spent partying? Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 11 Figure 2.5 Relative Price of Health Care versus Health-Care Spending Share Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 12 Correlation and Causation • Correlation and causation are not the same. To say that two series are correlated does not mean that once causes (leads) another. Correlation between two series may be caused by a third series. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 13 Economic Data • Data measure the interaction of households (consumers), firms, and governments. Most interaction occurs in markets. • A market is a mechanism in which exchange between buyers and sellers take place. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 14 Figure 2.6 A Circular Flow Diagram Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 15 2. Economic Models • A model is an explanation of how the economy, or part of the economy, works. • Models are built on theories and tell economists whether variables are negatively or positively related. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 16 Figure 2.7 A Model with Two Positively Related Variables Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 17 Figure 2.8 A Model with Two Negatively Related Variables Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 18 Figure 2.9 Economic Models in Four Ways Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 19 More on Economic Modeling • Scarcity is a common element in all economic models: to do something, something else must be given up. Scarcity forces individuals to make choices • A standard economic model that includes scarcity is supply and demand • Models are simplifications of (complex) reality. Many other factors must be held constant (ceteris paribus). Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 20 More on Economic Modeling • Economic models may be classified according to whether they seek to explain an economy (macroeconomics) or seek to explain aspects of individual behavior (microeconomics). • Theories and models are not stagnant. New models and theories evolve often. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 21 3. Using Economics for Public Economic Policy • Ever since the Wealth of Nations by Adam Smith (1776), economists have been motivated by a desire to improve government policy. • Positive economics simply explains the results of policy (What it is) • Normative economics attempts to develop and recommend policy (What it should be). • Economics is independent of political parties. It has a set of tools that aid in thinking. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 22