Chapter 2 The Tools of Economic Analysis ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Models and data A Model or Theory a framework based on simplifying assumptions helps to organize our economic thinking Data help us to test our models. Like all careful scientists, economists must check that their theories square with the relevant facts the economist’s link with the real world time series cross section ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Real and nominal Many economic variables are measured in money terms Nominal values measured in current prices Real values adjusted for price changes compared with a base year measured in constant prices ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Time series data A time series is a sequence of measurements of the same variable at different points in time. ©McGraw-Hill Companies, 2010

Cross section data: Unemployment (% of labour force), March, 2010 Cross-section data record at a point in time the way an economic variable differs across different individuals or groups of individuals, or in this case countries. Source OECD/ and IMF ©McGraw-Hill Companies, 2010

Panel data combines both time series and cross section data Panel data record observations over multiple time periods for the same individuals or groups of individuals ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Economic models To organise our thinking we need a simplified picture of reality, focusing on key elements. An example comes from analysing tube fares and revenue. ©McGraw-Hill Companies, 2010

Economic models: an example Tube revenue = tube fare  number of passengers Number of passengers = f (tube fare, taxi fare, petrol price, bus fare, passenger incomes …) Tube revenue = tube fare  f (tube fare, taxi fare, petrol price, bus fare, incomes …)    ©McGraw-Hill Companies, 2010

We do indeed see a positive relationship between fares and revenue Scatter diagrams show the relationship between two variables plotted in the diagram. By fitting a line through these points we summarize the average relationship between the two variables. ©McGraw-Hill Companies, 2010

The other things being equal assumption Other things equal, higher fares reduce the number of tube journeys, but if quantity demanded falls only a little, overall revenue may rise when fares are increased. But other things were not equal. In this period Britain’s national income, adjusted for inflation, grew substantially Even if tube fares had been constant, rising incomes should have led to (and did lead to) rising tube use and rising tube revenues. ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Econometrics Analytical diagrams are often useful in building a model. They show relationships between two variables holding other things equal. But if we wish to change one of these other things, we have to resort to econometrics. Econometrics uses computers to fit average relationships between many variables simultaneously. In principle this allows us to get round the ‘other things equal’ problem, which always applies in two dimensions. ©McGraw-Hill Companies, 2010

But it is not an exact science Economics is only rarely an experimental science. It is prohibitively costly to make half of the population unemployed just to find out how the economy then works. Without controlled experiments, we have to disentangle different influences in past data to overcome the problem of other things not being equal. Using data over many years makes it easier to do this unraveling but introduces a new problem. Since attitudes and institutions are slowly changing, data from many years ago may no longer be relevant to current behaviour. The problems we confront are difficult ones and we have to do the best we can. ©McGraw-Hill Companies, 2010