Chapter Two Observing and Explaining the Economy

2 | 2 Copyright © Houghton Mifflin Company. All rights reserved. Economics, an Overview Now that we know what economics is from Chapter 1, we need to understand the usefulness of economics by understanding the economic way of thinking.

2 | 3 Copyright © Houghton Mifflin Company. All rights reserved. Economics entails: 1)accurately describing economic events 2)explaining why the events occur 3)predicting under what circumstances such events might take place in the future 4)recommending appropriate courses of action Economics, an Overview (cont’d)

2 | 4 Copyright © Houghton Mifflin Company. All rights reserved. Economics, an Overview (cont’d) Economic challenges and opportunities Improved present and future outcomes Economic knowledge Description Explanation Prediction Recommendation

2 | 5 Copyright © Houghton Mifflin Company. All rights reserved. Economics, an Overview (cont’d) To understand the economic way of thinking in more detail, we focus on two observations or questions on healthcare and the US economy.

2 | 6 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy Observation 1: Health-care spending has increased faster than the rest of the U.S. economy since Question 1: Why did health-care spending increase faster than the rest of the US economy? To understand how we ended up with the observation and answer the question, we need a measure of health care spending and a measure of the overall size of the U.S. economy.

2 | 7 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy (cont’d) Gross Domestic Product (GDP): a measure of the value of all goods (cars, trucks, houses, TVs, etc.) and services (education, rock concerts, health-care, etc.) newly produced in an economy during a specified period of time. How large is the US GDP? See Table 2.1 (column (1)) and Figure 2.1.

2 | 8 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy (cont’d)

2 | 9 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy (cont’d) Figure 2.1

2 | 10 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy (cont’d) Health-care spending – includes payments for hospital services, lab tests, nursing homes, visits to doctors and dentists, prescription and non-prescription drugs, hearing aids, eyeglasses, and more. How much have we been spending on health-care? See column (2) on Table 2.1.

2 | 11 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy (cont’d) One way to assess health-care spending compared to the spending of all goods and services is to look at health spending as a share of GDP, or: Health-care spending as a share of GDP Health-care spending as a share of GDP, 2000

2 | 12 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy (cont’d) From column (3) in Table 2.1, the share of health-care spending to GDP has gradually increased from 9.6 percent in 1990 to 11.9 percent in Figure 2.3 shows the share of health-care spending to GDP from

2 | 13 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy (cont’d) Figure 2.3

2 | 14 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy (cont’d) Observation 2: The price of health care has risen compared with the price of other goods in the economy. Relative Price – the price of a particular good compared to the price of other things.

2 | 15 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy (cont’d) The relative price of health-care is shown in Table 2.2.

2 | 16 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy (cont’d)

2 | 17 Copyright © Houghton Mifflin Company. All rights reserved. Health-Care and the Economy (cont’d) Figure 2.2

2 | 18 Copyright © Houghton Mifflin Company. All rights reserved. Correlation Between Economic Variables Economic Variables – any economic measure that can vary over a range of values. Examples: –GDP, –health care spending, –health-care spending share of GDP, –relative price of health-care, etc.

2 | 19 Copyright © Houghton Mifflin Company. All rights reserved. Correlation Between Economic Variables (cont’d) Correlation – Two economic variables are correlated if they tend to move up or down in the same direction. –positive correlation - both variables move in the same direction (i.e., one goes up when the other also goes up). –negative correlation - both variables move in the opposite directions (i.e., one goes up when the other goes down).

2 | 20 Copyright © Houghton Mifflin Company. All rights reserved. Correlation Between Economic Variables (cont’d) Correlation vs. Causation Just because variables are correlated (they move together) does not imply that one variable caused the other.

2 | 21 Copyright © Houghton Mifflin Company. All rights reserved. Correlation: Storks Delivering Babies In a recent issue of the Teaching Statistics (Vol. 22-2, Summer 2002), Robert Matthews shows that there is a high correlation between stork populations and the human birth rates across Europe. Given the finding described above, can we use this as supporting evidence that storks deliver babies, as described in Hans Christian Andersen’s story “The Stork” (1938)?

2 | 22 Copyright © Houghton Mifflin Company. All rights reserved. The Lack of Controlled Experiments in Economics In other fields, such as medicine, biology and psychology, controlled experiments are conducted to determine causation between variables. Unfortunately for economics, such controlled experiments are not possible simply because we cannot redo policy over and see what the effects could have been.

2 | 23 Copyright © Houghton Mifflin Company. All rights reserved. The Lack of Controlled Experiments in Economics (cont’d) There is a growing trend in economics where controlled laboratory experiments are conducted. This area in economics is called Experimental Economics. Experimental Economics - A branch of economics that uses laboratory experiments to analyze economic behavior.

2 | 24 Copyright © Houghton Mifflin Company. All rights reserved. The Circular Flow Diagram Circular flow diagram: a diagram that illustrates the flow of funds and goods and services through the economy as people (households and firms) buy and sell in markets.

2 | 25 Copyright © Houghton Mifflin Company. All rights reserved. In the circular flow diagram, what people buy and sell are classified into three groups: 1)Goods and services – such as flu shots, gauzes and bandages, etc. 2)Labor – such as doctor’s services, nursing services, etc. 3)Capital – such as x-ray machines, hospital beds, etc. The Circular Flow Diagram in Health Care

2 | 26 Copyright © Houghton Mifflin Company. All rights reserved. Three markets in a circular flow diagram in health-care: 1)the goods and services market 2)the labor market 3)the capital market The Circular Flow Diagram in Health Care (cont’d)

2 | 27 Copyright © Houghton Mifflin Company. All rights reserved. Two Major Players 1)Households – who buy goods and services and sell their labor services to firms in the labor market. Households also supply capital to firms in the capital market. The Circular Flow Diagram in Health Care (cont’d)

2 | 28 Copyright © Houghton Mifflin Company. All rights reserved. 2)Firms – sell goods and services in the goods market and buy the labor services that households sell in the labor market. Firms also demand (or borrow with interest) capital from households in the capital market. The Circular Flow Diagram in Health Care (cont’d)

2 | 29 Copyright © Houghton Mifflin Company. All rights reserved. The Circular Flow Diagram in Health Care (cont’d) Figure 2.6

2 | 30 Copyright © Houghton Mifflin Company. All rights reserved. Economic Models Economic Model An explanation (or representation) of how the economy or part of the economy works. Abstractions or simplifications of the real world.

2 | 31 Copyright © Houghton Mifflin Company. All rights reserved. Positively Related: a situation in which an increase in one variable is associated with an increase in another variable (a.k.a. directly related). Negatively Related: a situation in which an increase in one variable is associated with a decrease in another variable (a.k.a. inversely related). Economic Models (cont’d)

2 | 32 Copyright © Houghton Mifflin Company. All rights reserved. Constants: a situation in which an increase in one variable is not associated with any change in another variable. Figure 2.7 and Figure 2.8 graphically illustrate positively related and negatively related variables. Economic Models (cont’d)

2 | 33 Copyright © Houghton Mifflin Company. All rights reserved. Economic Models (cont’d) Figures 2.7 and 2.8

2 | 34 Copyright © Houghton Mifflin Company. All rights reserved. Economic Models: an Example A Model with Two Variables: Figure 2.9 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.

2 | 35 Copyright © Houghton Mifflin Company. All rights reserved. Economic Models: an Example (cont’d) Figure 2.9

2 | 36 Copyright © Houghton Mifflin Company. All rights reserved. Microeconomic vs. Macroeconomic 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.

2 | 37 Copyright © Houghton Mifflin Company. All rights reserved. Impacts of Economics on Public Policy 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-1990’s. –Explaining why governments increase or decrease tax rates.

2 | 38 Copyright © Houghton Mifflin Company. All rights reserved. Impacts of Economics on Public Policy (cont’d) 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: –Recommend policies that will prevent the rise of healthcare expenditures in the future. –Recommend that the government increase tax rates to prevent a budget deficit.

2 | 39 Copyright © Houghton Mifflin Company. All rights reserved. Positive or Normative Economics? Are the statements below positive or normative statements? –Countries with high population growth rates usually have low income per capita. –Countries should have population control as part of its growth strategy. –The best policy to discourage population growth is to tax families with more than 4 children. –A $1000 tax per child levied on families with more than 4 children in the US could generate revenues of more than $40 million dollars. Answer: Positive, Normative, Normative, Positive.

2 | 40 Copyright © Houghton Mifflin Company. All rights reserved. Conclusion Three important points to remember as we study more economic models: 1)Economics requires a mixture of verbal and quantitative skills. 2)Economics is more than just about the stock market. 3)The study of economics is an intellectually fascinating adventure.

2 | 41 Copyright © Houghton Mifflin Company. All rights reserved. Key Terms and Phrases Gross domestic product (GDP) Relative price Economic variable Circular flow diagram Economic model Positively and negatively related Microeconomics and macroeconomics Positive economics Normative economics