You are on page 1of 8

Chapter2:EconomicTheories,Data,

andGraphs
2.1PositiveandNormativeStatements

NormativeStatementsdependsonvaluejudgmentsandcannotbeevaluatedsolelyby
arecoursetofacts
PositiveStatementsdonotinvolvevaluejudgment,thesearestatementsaboutmatters
offactandsodisagreementsaboutthemareappropriatelydealtwithbyanappealto
evidenceandcanbetested
Whatdoeshappenintheworldfromtheirviewsonwhattheywouldliketohappen?
Distinguishingwhatisactuallytruefromwhatwewouldliketobetruerequires
distinguishingbetweenpositive/normativestatements
Positivestatementsdontneedtobetrue
Inclusionofavaluejudgmentinastatementdoesnotnecessarilymakethestatement
itselfnormative
StatementDisapositivestatementaboutthevaluejudgmentsthatpeoplehold
Noneedfortheeconomisttorelyonavaluejudgmenttocheckthevalidityofthe
statementitself
Twoteststousewhenanalyzingstatements:
1. Isthestatementonlyaboutactualorallegedfacts?=Positive
2. Arevaluejudgmentsnecessarytoassessthetruthofstatements?=Normative

DisagreeingAmongEconomists

Economistsoftendisagreewithoneanotherinpublicdiscussionsduetopoor
communication
Anotherdisagreementcomesfromeconomistsfailuretoacknowledgethefull
sateoftheirignorance
Aresponsibleeconomistmakescleartheextendtowhichhisorherviewbasedon
judgmentabouttherelevantfacts
Manypublicdisagreementsarebasedonpositive/normativedistinction
Differenteconomistshavedifferentvaluesandthesenormativeviewsplayalarge
partinmostdiscussionofpublicpolicy
Itistheresponsibilityoftheeconomisttosateclearlywhatpartoftheproffered
adviceisnormativeandwhatpartispositive

2.2 BuildingandTestingEconomicTheories

Sincetheeconomyworldiscomplex,manythingschangeanditcanbedifficultto
distinguishcausefromeffect
Economistswhoareobservingtheworldseeregularitiesinthedatasuchas:
Unemploymenttendstorisewhennationalincomeslows
Periodofhigherinflationoftenfollowperiodsoflowinterestrates
Tobetterunderstandsuchregularitiesinthedataandtoidentifythelikelycausesand
effects,economistsdeveloptheories/models

WhatareTheories?

Theoriesareconstructedtoexplainthings
Ex:economistsmayseektoexplainwhatdeterminesthequantityofeggsbought
andsoldinaparticularmonthinManitobaandthepriceatwhichtheyaresold
Ex:Mayseektoexplainwhatdeterminesthequantityofoilboughtandsold
aroundtheworldonaparticulardayandthepriceatwhichitistraded
Economistsdevelopedtheoriesofdemandandsupply
Theseandothertheoriesthataredistinguishedbytheirvariables,assumptions,
andpredictions

Variables
Basicelementsofanytheoryareitsvariables
Isawelldefineditemsuchaspriceorquantitythatcantakeondifferentpossiblevalues
Ex:theoryofeggmarket,thevariablequantityofeggsmightbedefinedasthenumberof
cartonsof12GradeAlargeeggsandthevariablepriceofeggsistheamountofmoney
thatmustbegivenuptopurchaseeachcartonofeggs.Theparticularvaluestakenby
thosetwovariablesmightbe20,000cartonsperweek@$2.60inJuly2011,18,000
cartonsperweek@$2.75inJuly2012,and19,500cartonsperweek@$2.95inJuly
2013.
Twobroadvariablesthatareimportantinanytheory:
Endogenousvariableonewhosevalueisdeterminedwithinthetheorysometimes
calledaninducedvariableordependentvariable
Exogenousvariableavariablethatisdeterminedoutsidethetheorysometimescalled
anautonomousvariableoranindependentvariable
Ex:thepriceandquantityofeggsareendogenousvariablesinourtheoryoftheegg
market.Thestateoftheweatherisanexogenousvariable,itmayaffectthenumberof
eggsconsumersdemandorproducerssupplybutwecansafelyassumethatthemarket
foreggsdoesnotinfluencethestateoftheweather

Assumptions
Atheorysassumptionsconcernmotives,directionsofcausation,andtheconditions
underwhichthetheoryismeanttoapply
Motives
Theoriesmakefundamentalassumptionthateveryonepursueshis/herownself
interestwhenmakingeconomicdecisions
Individualsareassumedtostrivetomaximizetheirutilitywhilefirmstryto
maximizetheirprofits
DirectionofCausation
Wheneconomistsassumethatonevariableisrelatedtoanother,theyare
assumingsomecausallinkbetweenthetwo
Ex:whentheamountofwheatthatproducerswanttosupplyisassumedto
increasewhenthequalityoftheirfertilizerimproves,thecausationrunsfromthe
qualityoffertilizertothesupplyofwheat
Producerssupplymorewheatbecausetheynowhaveaccesstobetterfertilizer
ConditionsofApplication
Assumptionsareoftenusedtospecifytheconditionsunderwhichatheoryis
meanttohold
Ex:atheorythatassumesthereisnogovernmentdoesnotliterallymeanthe
absenceofgovernmentbutonlythatthetheoryismeanttoapplywhen
governmentsarenotsignificantlyaffectingthesituationbeingstudied
Theassumptionofprofitmaximizationallowseconomiststomakepredictions
aboutthebehavioroffirmssuchasfirmswillsupplymoreoutputifthemarket
priceincreases
Doesthisnotdiscredittheassumptionofprofitmaximizationbyshowingittobe
unrealistic?
o Nobecausetomakesuccessfulpredictions,thetheorydoesnotrequire
thatmangersbesolelyandunwaveringlymotivatedbythedesireto
maximizeprofitsatalltimes,allthatisrequiredisthatprofitsbea
sufficientlyimportantconsiderationthatatheorybasedontheassumption
ofprofitmaximizationwillleadtoexplanationsandpredictionsthatare
substantiallycorrect
o Notalwaysappropriatetocriticizeatheorybecauseofunrealistic
assumptions
Alltheoryisanabstractionfromreality.Ifitwerenot,itwouldmerelyduplicatethe
worldinallitscomplexityandwouldaddlittletoourunderstandingofit
Predictions
Atheoryspredictionsarethepropositionsthatcanbededucedfromit,often
calledhypotheses

Ex:apredictionfromatheoryoftheoilmarketisthatariseintheworldpricefor
oilwillleadCanadianoilproducerstoproduceandsupplymoreoil
Ex:apredictioninthesamemarketisthatadecisionbymembersoftheOPEC
carteltoreducetheirannualoutputofoilwillleadtoanincreaseintheworld
price

TestingTheories

Atheoryistestedbyconfrontingitspredictionswithevidence
Ex:isanincreaseintheworldpriceofoilactuallyfollowedbyanincreaseinoil
productionbyCanadianproducers?
Atheoryceasestobeusefulwhenitcannotpredictbetterthananalternative
theory
Whenatheoryconsistentlyfailstopredictbetterthananavailablealternative,itis
eithermodifiedorreplaced

Thescientificapproachiscentraltothestudyofeconomics:Empiricalobservation
leadstotheconstructionoftheories,theoriesgeneratespecificpredictions,andthe
predictionsaretestedbymoredetailedempiricalobservation
RejectionVersesConfirmation
Importantpartofscientificapproachconsistsofcreatingatheorythatwillexplain
someobservation
AtheorydesignedtoexplainobservationXwilltypicallygenerateaprediction
aboutsomeotherobservablevariablesYandZ
PredictionaboutYandZcanbetestedandmayberejectedbythedata
Ifpredictionisrejected,thevalueofthetheoryisbroughtintoquestionthenwe
createatheoryandlookforconfirmingevidence
Ex:flyingsaucers,fortunetellingandastrologyhavetheirdevoteeswhocanquote
confirmingevidenceinspiteofthefailureofmanyattemptstodiscoversystematic,
objectiveevidenceofthesethings
StatisticalAnalysis
MosttheoriesgenerateapredictionintheformofifXincreases;thenYwillalso
increase
Ex:Ifnationalincomerises,thelevelofemploymentwillrise
Statisticalanalysiscanbeusedtotestsuchpredictionsandtoestimatethe
numericalvaluesofthefunctionthatdescriestherelationship
Thesamedatacanbeusedsimultaneouslytotestwhetherarelationshipexists
andtoprovideanestimateofthemagnitudeofthatrelationshipifitdoesexist
Economicslacksthecontrolledexperimentscentraltosuchsciencessuchas
physicsandchemicalsinceitisanonlaboratoryscience,soeconomistsmustuse

millionsofuncontrolledexperimentsthataregoingoneverydayinthe
marketplace

Ex:householdsaredecidingwhattopurchasegivenchangingprices/incomes
Firmsaredecidingwhattoproduceandhow,governmentsareinvolvedinthe
economythroughtheirvarioustaxes,subsidies,andregulationsbecauseall
theseactivitiescanbeobservedandrecorded,amassofdataiscontinuallybeing
producedbytheeconomy

Variables(levelofemployment,priceofaDVD,andoutputofautomobiles)that
interestseconomistsaregenerallyinfluencedbymanyforcesthatvary
Economistsmustusestatisticaltechniquesdesignedforsituationsinwhichthings
cannotbeheldconstantiftheywanttotesttheirtheoriesaboutrelationsamong
specificvariables

CorrelationvsCausation
IfXincreases,Ywillalsoincrease
YouarelookingforacausalrelationshipfromXtoYbecauseachangeinXis
predictedtocauseachangeinY
SupposethedatashowsXandYarebothpositivelycorrelatedwhenXrises,Y
alsotendstorise
AfindingthatXandYarepositivelycorrelatedmeansonlythatXandYtendto
movetogether
ThiscorrelationisconsistentwiththetheorythatXcausesYbutitisnotdirect
evidenceofthiscausalrelationship
ThecausalitymaybeintheoppositedirectionfromYtoXormaybetheyhaveno
directcausalconnectionsbecausetheyarejointcausedbyathirdvariable,Z

Ex:Individualswhogetmoreeducationwillearnhigherincomesasaresult
causalityinthistheoryrunsfromeducationtoincome
Inthedata,educationandincomearepositivelycorrelated
Thisshouldntbetakenasadirectevidenceforcausalprediction
Dataareconsistentwiththattheorybuttheyarealsoconsistentwithothers
becauseindividualswhogrowupinhigherincomehouseholdsmaybuymore
education,clothes,andentertainmentthereforeincomecauseseducationrather
thantheotherwayaround
Anotherpossibilityisthateducationandincomearepositivelycorrelatedbecause
thepersonalcharacteristicsthatleadpeopletobecomemoreeducated(abilityand
motivation)arethesamecharacteristicsthatleadtohighincomes
Inconclusionthecausalrelationshiprunsfrompersonalcharacteristicstoboth
incomeandeducation

Mosteconomicpredictionsinvolvecausality.Economistsmusttakecarewhen
testingpredictionstodistinguishbetweencorrelationandcausality.Correlationcan

establishthatthedataareconsistentwiththetheory;establishingthelikelihoodof
causalityusuallyrequiresadvancedstatisticaltechniques.

2.3EconomicData

Economistsuserealworldobservationstotesttheirtheories
Ex:Didtheamountthatpeoplesavedlastyearriseasthetheorypredictsit
shouldhavewhenalargetaxcutincreasedtheiraftertaxincomes?
Totestthispredictionweneedreliabledataforpeoplesincomeandsavings
Economistsusedatacollectedbyothers,oftengovernmentstats
Advantage:donotneedtospendmuchoftheirtimereaching
Disadvantage:oftennotaswellinformedaboutthelimitationsofthedata
collectedbyothersastheywouldbeiftheyhadcollectedthedatathemselves
Afterdataarecollected,theycanbedisplayedinvariouswayssuchastables,
graphs,etc.
Itcanalsobeexpressedinindexnumberswhenweareinterestedinrelative
movementsratherthanabsoluteones

IndexNumbers
Economistslookatdataonpricesorquantitiesandexplorehowspecificvariableschange
overtime
Ex:theymaybeinterestedincomparingthetimepathsofoutputintwoindustries:steel
andnewsprint
Theproblemisthatitmaybedifficulttocomparethetimepathsofthetwodifferent
variablesifwejustlookattherawdata
Sincethetwovariablesaremeasuredindifferentunits,itisnotimmediatelyclearwhich
ofthetwovariablesismorevolatileorwhichhasanupwardordownwardtrend
Itsmucheasiertocomparethetwopathsifwefocusonrelativethanabsolutechanges
onewaytodothisistoconstructindexnumbers
HowtobuildanIndexNumber
Takethevalueofthevariableatsomepointintimeasthebasewithwhichthevalues
inotherperiodswillbecompared(baseperiod)
Ex:wechoose2004asthebaseyearforbothseries.Wethentaketheoutputineach
subsequentyear(givenyear),divideitbytheoutputinthebaseyearthenmultiplythe
resultby100.
Index=(outputinyear/outputinbaseyear)x100
Indexnumbersareexpressedasapercentageofvalue
Ex:Indexof100.0in2004and122.5in2013showsa22.5%greateroutput
ConsumerPriceIndex(CPI)

Mostfamousindexnumberusedbyeconomistsforindexofaverageprices
Averagepricepaidbyconsumersfortypicalbasketofgoodstheybuy
GraphicEconomicData
Asingleeconomicvariablesuchasunemployment,nationalincome,ortheaverageprice
ofahousecancomeintwobasicforms
CrossSectionalandTimeseriesData
Asetofobservationsononevariablealltakenatthesametimeacrossseveraldifferent
units(suchashouseholds,firms,orcountries)
TimeSeriesData
Asetofobservationsmadeatsuccessiveperiodsoftime
Usefulineconomicsbecauseweoftenwanttoknowhowspecificeconomicnumbersare
changingovertime
ScatterDiagramsagraphshowingtwovariables,onemeasuredonthehorizontaland
theotherontheverticalaxis.Eachpointrepresentsthevaluesofthevariablesfora
particularunitofobservation
Toplotascatterdiagram,valuesofonevariablearemeasuredonthehorizontalaxisand
valuesofthesecondvariablearemeasuredontheverticalaxis
Anypointonthediagramrelatesaspecificvalueofonevariabletoacorresponding
specificvalueoftheother
Dataplottedonascatterdiagrammaybeeithercrosssectionaldataortimeseriesdata

GraphingEconomicTheories

WhenXisrelatedtoYthenwesaythatYisafunctionofX.
Weareexpressingafunctionalrelationbetweenthetwovariableswhenwewritethis
relationdown
Ex:considertherelationbetweenanindividualsannualincome(variableY)andthe
amountthatpersonspendsongoods/servicesduringtheyear(variableCfor
consumption).AnyparticularexampleoftherelationbetweenCandYcanbeexpressed
severalways:inwords,table,schedule,mathequationorgraph
VerbalStatement
Whenincomeis0,personwillspend$800ayear(byloanorusingpastsavings),for
every$1ofincome,thepersonwillincreaseexpenditureby80cents

Schedule
Tableshowsselectedvaluesofthepersonsincomeandconsumption
AnnualIncome
$0
$2,500
$5,000
$7,500
$10,000

Consumption
$800
$2,800
$4,800
$6,800
$8,800

ReferenceLetter
P
Q
R
S
T

MathEquation
C=$800+0.8Y
Graph
Comparisonofthevaluesonthegraphwiththevaluesinthescheduleandvaluesderived
fromtheequationjuststatedshowsthatthesearealternativeexpressionsofthesame
relationbetweenCandY

GraphingFunctions

You might also like