Observing and Explaining the Economy What Do Economists Do? Chapter 2 Observing and Explaining the Economy

What Do Economists Do? Economists try to answer questions such as: Why is college tuition so high? Why are there so many different types of toothpaste? Why is the price of gasoline more than $3 a gallon? Why has health-care spending increased faster than the rest of the U.S. economy?

What Do Economists Do? Why is the average income of people in the United States 35 times higher than that of people in China? Why is unemployment higher in Europe than in the United States? Why have the wages of college graduates increased much more rapidly than the wages of non-graduates?

What Do Economists Do? Understanding Gasoline Prices in the United States Observation: The price of gasoline has risen sharply in the past five years compared to the previous decade.

Figure 1: Retail Price of Gasoline in the United States, 1991–2006

What Do Economists Do? Relative Price of Gasoline: the price of gasoline compared to the average price of all other goods and services in the economy. Relative price of gasoline Price of Gasoline _____________________________________ = Average Price of All Other Goods and Services

Figure 2: Relative Price of Gasoline

Explaining an Economic Event Economic Variable: any economic measure that can vary over a range of values. Economic Variables: Examples GDP Health-care spending Health-care spending share of GDP Relative price of health care

Explaining an Economic Event Positive Correlation: occurs when two variables move in the same direction; when one goes up, the other goes up. Negative Correlation: occurs when two variables move in different directions; when one goes up, the other goes down.

Figure 4: Price of Gasoline versus Price of Crude Oil

Explaining an Economic Event Correlation versus Causation Correlation: means that one event is usually observed to occur along with another. Causation: means that one event brings about another event. Note: Correlation does not imply causation.

Explaining an Economic Event Controlled Experiments: empirical tests of theories in a controlled setting in which particular effects can be isolated. Experimental Economics: a branch of economics that uses laboratory experiments to analyze economic behavior.

Economic Models Economic Model: an explanation of how the economy or part of the economy works; an abstraction or simplification of the real world.

Economic Models Microeconomics: the branch of economics that examines individual decision-making at firms and households and the way they interact in specific industries and markets. Macroeconomics: the branch of economics that examines the workings and problems of the economy as a whole; focuses on variables such as GDP growth and unemployment.

Economic Models Positively Related: a situation in which an increase in one variable is associated with an increase in another variable (also called directly related). Negatively Related: a situation in which an increase in one variable is associated with a decrease in another variable (also called inversely related).

Economic Models: An Example A Model with Two Variables: Figure 6 illustrates four different ways to model the economic relationship between the number of doctors employed at an HMO and the number of physical examinations given. The four ways are: (1) with words; (2) with a numerical value; (3) with a graph; and (4) with algebra or an equation.

Figure 7: Economic Models in Four Ways

The Ceteris Paribus Assumption Ceteris Paribus: “all other things equal”; refers to holding all other variables constant or keeping all other things the same when one variable is changed.

Recommending Appropriate Policies Capitalism: an economic system in which capital is individually owned and production and employment decisions are decentralized. Socialism: an economic system in which the government owns and controls all the capital and makes decisions about prices and quantities. Mixed Economy: a market economy in which the government plays a very large role.

Positive versus Normative Economics Positive Economics: economic analysis that explains what happens in the economy and why, without making recommendations about economic policy. Examples of the scope of positive economics: Explaining why health-care spending slowed down in the mid-1990s Explaining why gasoline prices went up sharply in 2005

Positive versus Normative Economics Normative Economics: economic analysis that makes recommendations about economic policy; aims to develop and recommend policies about what the government should do. Examples of the scope of normative economics: Recommending policies that will prevent the rise of health-care expenditures in the future Recommending that the government increase tax rates to prevent a budget deficit

Positive versus Normative Economics Council of Economic Advisers: a three-member group of economists appointed by the president of the United States to analyze the economy and make recommendations about economic policy.

Conclusion Three important points to remember as we study more economic models: Economics requires a mixture of verbal and quantitative skills. Economics is a wide-ranging discipline; it is more than just about the stock market. The study of economics is an intellectually fascinating adventure.

Key Terms relative price economic variable controlled experiments experimental economics economic model microeconomics macroeconomics gross domestic product (GDP) positively related negatively related ceteris paribus capitalism socialism mixed economy positive economics normative economics Council of Economic Advisers