Chapter Two Observing and Explaining the Economy

Figure 2.5: Relative Price of Health Care versus Health-Care Spending Share

Correlation vs. Causation  Positive Correlation: While reading a graph from LEFT TO RIGHT, one variable increases as the other increases, moving in the SAME direction (UPWARD HILL)  Negative Correlation: While reading a graph from LEFT TO RIGHT, one variable decreases as the other increases, moving in OPPOSITE directions (DOWNWARD HILL)

Figure 2.8: A Model with Two Negatively Related Variables

Figure 2.7: A Model with Two Positively Related Variables

Causation vs. Correlation, continued  IMPORTANT! – Just because there is a correlation between two variables does not mean that one CAUSED the other.  Correlation: One event is usually observed to occur along with another.  Causation: One event brings about another.  Example: When the thermometer reads 90º, does it CAUSE it to be hot out? NO – they are correlated. However, consider the reverse – when it is hot out does it CAUSE the thermometer to read 90°? YES – that is a CAUSAL relationship.  Back to health-care: We can speak of the CORRELATION, but don’t know about the CAUSATION

Reading, Understanding, and Creating Graphs  Cartesian Coordinate Plane: 2 dimensional, x and y axis  Time series graph: Plots a series (several values) of the variable over time.

Figure 2A.1: U.S. Federal Debt

Figure 2A.2: Stretching the Debt Story in Two Ways – SAME DATA

Figure 2A.9: Measuring the Slope

SLOPE  Slope = rise OR Δy run Δx run Δx  Steeper the curve = Bigger the slope  Almost flat curve = Almost zero slope  Read graphs LEFT TO RIGHT  If slope is constant, then the line is LINEAR and has no bends

Figure 2A.10: A Relationship with a Negative Slope

Figure 2A.11: Six Types of Relationships

Answers to Text Problems  macroeconomic  microeconomic  macroeconomic

Answers to Text Problems 2. A. This is a normative policy statement. It is not clear what "too high" means. It is not too high for holders of the stock but buyers may view the stock as too high. This is a statement of opinion. B. This is a normative policy statement. This statement is an opinion. There are other ways (markets for example) to control the price of health care. C. This is a positive statement. It can be tested by examining data. It explains what happened as opposed to what should have happened. D. This is a normative statement. It is an opinion.

Answers to Text Problems 3.A. Clothing spending as a share of GDP has fallen from 4.60 percent to 3.23 percent. B. The relative price of clothing has fallen from 1.88 to.89. Obviously, the price of clothing has been rising at a slower rate than the average price of all goods. As a percent of GDP, people are spending less on clothing. This suggests that there is relatively less pressure on clothing prices as people spend less of their income on clothing. During the 30- year period, there is a correlation between falling clothing spending and decreasing relative price of clothing. In future chapters we will learn whether there may be a causal relationship between these two variables. YearGDP Spend on Cloth Share of GDP

Answers to Text Problems 4.

5. Economists make ceteris paribus assumptions to focus on how a change will affect an economic outcome. A forecast cannot account for all the possible changes in all the variables that may occur. In order to make a concrete statement about what will happen, economists must focus on the change in one variable.

Answers to Text Problems 6. When more web programmers are employed, more web pages are produced. But the increase in web page production slows as more programmers are employed. When more web programmers are employed, more web pages are produced. But the increase in web page production slows as more programmers are employed.

Answers to Text Problems 7. The overall price of a good is simply the actual market price of the product at a unique point in time. The relative price of a good measures the price of a particular product relative to the general price level. A change in the relative price would be useful information if you wanted to analyze the change in spending on a particular good.

Answers to Text Problems 8.A. A positive correlation is expected. To show causation, it is necessary to argue that one of these causes the other. In this case, it would be useful to have both a theory explaining how roosters respond to sunrise and data supporting the positive relationship. B. A negative correlation would be expected. To show causation, it is necessary to have a theory showing that people go to the theater less when the price of tickets rises and supporting data. C. A positive correlation is expected. To show causation it is necessary to show that one causes the other. In this case, you would expect to find that neither causes the other.

Review 1.P rivate organizations that produce goods and services are called __________________. A.H ouseholds B.F irms C.G overnments D.I ndividuals

Review 2. Two variables have a __________________ if they move in the same direction. A.Positive correlation B.Non-correlation C.Causation D.Negative correlation

Review 3. The assumption of ____________________ means "all other things equal." A.C eteris Paribus B.S carcity C.C ausation D.C orrelation

Review 4. The two main branches of economics are ___________ and __________________. A.M icroeconomics and Normative Economics B.M icroeconomics and Positive Economics C.M icroeconomics and Macroeconomics D.N ormative Economics and Positive Economics

Review 5. ___________________ economics makes recommendations about what the government should do. A.P ositive B.N ormative C.E xperimental D.M icroeconomics

Review 6. Money and capital are called factors of production. A.True B.False

Review 7. It is desirable to make economic models as realistic as possible. A.T rue B.F alse

Review 8. Gross Domestic Product (GDP) is measured for a specific period. A.True B.False

Review 9. Health-care spending was 10.7 percent of U.S. GDP for A.T rue B.F alse

Review 10. The relative price of health care has increased since A.True B.False

Review 11. An arrangement through which exchanges of goods or services between people take place is called A.A firm. B.A n industry. C.A market. D.A n economic model.

Review 12. When the movements in one variable bring about the movements in another variable, this is called A.A causation. B.A correlation. C.A relationship. D.A connection.

Review 13. Two variables have a positive correlation if A.T hey move in opposite directions. B.T hey move in the same direction. C.O ne decreases when the other increases. D.O ne increases when the other decreases.

Review 14. Which of the following is a central theme of economics? A.Causation B.Abundance C.Scarcity D.Ceteris Paribus

Review 15. According to the law of demand, when the price of a good increases, A.p eople will choose to purchase less of that good and more of other goods. B.p eople will provide more of that good. C.p eople will choose to purchase more of that good and less of other goods. D.p eople will provide less of that good.

Review 16. According to the law of supply, when the price of a good increases, A.p eople will choose to purchase less of that good and more of the other goods B.p eople will provide more of the good. C.p eople will choose to purchase more of that good and less of other goods. D.p eople will provide less of that good.

Review 17.M acroeconomics focuses on A.T he whole national economy. B.T he behavior of individual firms. C.T he behavior of individual households. D.M arkets.

Review 18. Which of the following is most likely to be studied by a microeconomist? A.I nflation of the price level. B.U nemployment in the economy. C.E mployment of labor in furniture production. D.T he growth rate of aggregate output.

Review 19. The total value of all goods and services made in a country during a specified period of time is called A.Supply B.Gross Domestic Product C.Demand D.Net Domestic Product

Review 20. The general increase in prices over time is called A.I nflation B.T he inflation rate C.T he overall price level D.T he relative price level

Extra Problems  1. Identify whether the following issues are macroeconomic or microeconomic and explain why you categorized them in that way.  The growth rate of real GDP.  A government policy which guarantees a minimum price of agricultural goods.  A tax on restaurant meals.  A government policy to affect the increase in the overall price level.

Answer  Macroeconomic issue because it concerns the whole economy.  Microeconomic issue because this government policy affects a particular industry.  Microeconomic issue because the tax affects a particular industry.  Macroeconomic issue because the government policy affects the overall price level in the economy.

Extra Problems 2. Identify whether the following statements are positive or normative economic statements, and explain why you categorized them in that way.  "The best way to improve the economic situation would be to decrease the unemployment rate by decreasing the interest rate."  "The government increased taxes in order to decrease the budget deficit and improve economic growth."  "The tax on business decreased production in some industries in the short run."  "The government should pursue a low-inflation policy by restraining the growth of the money supply."

Answer  Normative economic statement expressing an opinion about the best economic policy.  Positive economic statement explaining government’s actions.  Positive economic statement explaining the affect of tax policy on particular industries.  Normative economic statement expressing an opinion about the best monetary policy.

Extra Problems 3. a. What has happened to spending on clothing and shoes in the U.S. over this thirty-year period? What has happened to spending on clothing and shoes in the U.S. as a share of GDP? How does this compare to the increase in health care spending as a share of GDP discussed in the text? b. What has happened to the relative price of clothing and shoes over this period? How does this compare to the increase in the relative price of health care discussed in the text?

Answer 3. A.Spending on clothing and shoes in the U.S. has increased over the 30- year period, but as a share of GDP it has been falling continuously. This is in sharp contrast to the share of spending of health care, which has been rising dramatically over the same period. B.The relative price of clothing and shoes has decreased over this period. This is in sharp contrast to the relative price of health care, which has been rising over this period of time.

Extra Problems 4. What problems would arise if economists did not make ceteris paribus assumptions when making predictions?

Answer  Without making ceteris paribus assumptions, economists would not be able to control or identify the other factors that would alter the outcome of what they are predicting.

Extra Problems 5. Consider an economic model of CD production. Show how to represent this model graphically, algebraically, and verbally.

Answer Using the information in the table, the relationship between the number of CDs(CD) and the number of workers (L) can be expressed algebraically as: CD = 10L. Verbally, the information in the table indicates a positive and linear relationship between the number of workers and the production of CDs. In other words, as the number of workers increases, the production of CDs also increases.

Extra Problems 6. What is the difference between the price of gasoline and its relative price? Which information is more useful if you are interested in the change in spending on gasoline?

Answer  The price of gasoline is the actual price a consumer pays for the good. The relative price of gasoline is a measure of gasoline price compared with the average price of all goods and services. Information on the relative price is more useful if a consumer is interested in the change in spending on that good because prices tend to change over time and therefore this relative price measure can provide information about the change in gasoline spending relative to the spending on other goods and services.

Extra Problems 7. Analyze the following statements, indicating (i) the type of correlation implied, and (ii) what would be necessary to show causation.  "The relative price of rubber and the relative price of tires vary directly."  "There is a direct relationship between the number of hours I study and the grade that I receive on the exam."  "The sales of hot cocoa vary inversely with the temperature outside."

Answer  Positive correlation. To show causation it would be necessary to show that rubber is an important input into tires, and therefore the price of the input affects the price of the output.  Positive correlation. To show causation it is necessary to theorize that more hours studying improves performance on exams.  Negative correlation. To show causation it is necessary to show that colder temperatures cause people to want warmer drinks.