How Economists Work

Chapter 2

LIPSEY & CHRYSTAL

ECONOMICS 12e
 Introduction
• Economics seeks to understand many
important issues in the world around us and
ask the following questions, amongst others:
• What makes some countries grow richer when others
seem to get poorer?
• Why do we sometimes have recessions?
• When should the government try to influence markets?
What are the costs and benefits of globalization?
• Will some new technology eliminate many jobs?
• In order to get a handle on such big issues,
economists have developed ways of setting
out and testing their theories
• They also seek to use what they have
learned in order to provide advice on how
things could be improved.
 Learning outcomes
• By the end of the lecture you should have a
good understanding of:
– The difference between positive and normative
statements
– How economists set out their theories
– How economic data are handled and graphed
– How economic relationships are represented in
diagrams.
 Positive and normative statements
• Economists give advice on a wide variety of
topics. Advice comes in two broad types:
• Normative
• Positive
 Normative advice
• Normative advice depends upon a value
judgement and it tells others what they ought
to do.
 Positive advice
• Positive advice is where the adviser is saying,
‘If this is what you want to do, then here are
ways of doing it.’
Positive and Normative statements
• It is difficult to have a rational discussion of
issues if positive and normative issues are
confused.
• Much of the success of modern science
depends on the ability of scientists to
separate their views on what does, or might,
happen in the world, from their views on what
they would like to happen.
 Note!

Distinguishing what is true from what we

would like to be, or what we feel ought to
be, depends to a great extent on being
able to distinguish between positive and
normative statements.
 To clarify
• Normative statements depend on value
judgments. They involve issues of personal
opinion, which cannot be settled by recourse
to facts.
• In contrast, positive statements do not
involve value judgments. They are
statements about what is, was, or will be; that
is, statements that are about matters of fact.
 Economic theorizing
• In order to address the problems that we face
economists have developed an approach that
involves developing theories and building
models.
• These help the economist to understand
problems and find realistic and practical
solutions where possible!
 Theories
• Theories are constructed to explain things!
• These theories are built around definitions,
assumptions, and predictions.
• They simplify the problem in hand and allow
the economist to observe the problem first
hand.
 Definitions
• The basic elements of any theory are its
variables.
• A variable is a magnitude that can take on
different possible values.
 Endogenous and exogenous
variables
• An endogenous variable is a variable that
is explained within a theory.
• An exogenous variable influences
endogenous variables but is itself determined
by forces outside the theory.
 Assumptions
• A theory’s assumptions concern motives,
physical relationships, lines of causation, and
the conditions under which the theory is
meant to apply, as well as the direction of
causation!
• The variable that does the causing is called
the independent variable and the variable that
is caused is called the dependent variable.
 Predictions
• A theory’s predictions are the propositions
that can be deduced from it.
• These propositions are then taken as
predictions about real-world events.
 Models
• Economists often proceed by constructing
what they call economic models.
• More often, a model means a specific
quantitative formulation of a theory.
• The term ‘model’ is often used to refer to an
application of a general theory in a specific
context.
 Evidence
• Economists make much use of evidence, or,
as they usually call it, empirical observation.
• Such observations can be used to test a
specific prediction of some theory and to
provide observations to be explained by
theories.
 Testing the evidence
• A theory is tested by confronting its
predictions with evidence.
• Are events of the type contained in the theory
followed by the consequences predicted by
the theory?
 Note!

Generally, theories tend to be abandoned when

they are no longer useful. A theory ceases to
be useful when it cannot predict better than
an alternative theory. When a theory
consistently fails to predict better than an
available alternative, it is either modified or
replaced.
 Theories about human behaviour
• So far we have talked about theories in
general.
• But what about theories that purport to
explain and predict human behaviour?
• A scientific study of human behaviour is only
possible if humans respond in predictable
ways to things that affect them.
• Is it reasonable to expect such stability?
 Think about this!
• We humans have free will and can behave in
capricious ways if the spirit moves us.
• This thus implies human behaviour really is
unpredictable!
• How is it that human behaviour can show
stable responses even though we can never
be quite sure what one individual will do?
• Successful predictions about the behaviour of
large groups are made possible by the
statistical ‘law’ of large numbers.
• Very roughly, this ‘law’ asserts that (under a
carefully specified set of conditions) random
movements of a large number of items tend
to offset one another.
 Note!
• Individuals may do peculiar things that, as far
as we can see, are inexplicable. But the
group’s behaviour will nonetheless be
predictable, precisely because the odd things
that one individual does will tend to cancel
out the odd things that some other individual
does.
 Why do economists often disagree?
• When all their theories have been
constructed and all their evidence has been
collected, economists still disagree with each
other on many issues.
 Sources of disagreement?
• There are five possible sources that results in
economists disagreeing:
– Different benchmarking.
– Different time frames being used.
– Lack of knowledge.
– Different values held by economists.
– Both sides of the problem are justified.
 Economic data
• Economists seek to explain observations
made of the real world.
• Real-world observations are also needed to
test the predictions of economic theories.
 Collecting data
• Political scientists, sociologists,
anthropologists, and psychologists all tend to
collect much of the data they use to formulate
and test their theories.
• Economists are unusual among social
scientists in mainly using data collected by
others, often government statisticians.
• In economics there is a division of labour
between collecting data and using it to
generate and test theories.
– The advantage is that economists do not need to
spend much of their scarce research time
collecting the data they use.
– The disadvantage is that they are often not as well
informed about the limitations of the data collected
by others, as they would be if they collected the
data themselves.
 Index Numbers
• Once data are collected they can be
displayed in various ways.
• Where we are interested in relative
movements rather than absolute ones, the
data can be expressed in index numbers.
• Comparisons of relative changes can be
made by expressing each price series as a
set of index numbers.
• To do this we take the price at some point of
time as the base to which prices in other
periods will be compared.
• We call this the base period.
• The formula of any index number is:

Value of index in period t = (value in period

t/value in base period) × 100
 Index numbers – An example
Price of cocoa and coffee
(average price in each quarter; US cents per kg)
Period Cocoa Coffee

2001 (Q1) 100.4 146.7

2001 (Q2) 104.5 146.4

2001 (Q3 100.8 129.7

2001 (Q4) 121.8 126.4

2002 (Q4) 149.0 136.6

Calculation of an index of coffee
prices

Period Coffee Coffee Index

2001 (Q1) (146.7/146.7)x100 100

2001 (Q2) (146.4/146.7)x100 99.8
2001 (Q3 (129.7/146.7)x100 88.4
2001 (Q4) (126.4/146.7)x100 86.2
2002 (Q4) (136.6/146.7)x100 93.1
Index of cocoa and coffee prices

Period Cocoa Index Coffee Index

2001 (Q1) 100 100

2001 (Q2) 104.1 99.8
2001 (Q3 100.4 88.4
2001 (Q4) 121.3 86.2
2002 (Q4) 148.4 93.1
 Index numbers as averages
• Index numbers are particularly useful if we
wish to combine several different series into
some average. This can be done by:
– An un-weighted index
– An output-weighted index
 Note!

An index that averages changes in several

series is the weighted average of the
indexes for the separate series, the
weights reflecting the relative importance
of each series.
 Price indexes
• Economists make frequent use of indexes of
the price level that cover a broad group of
prices across the whole economy.
• One of the most important of these is the
retail price index, RPI, which covers goods
and services that individuals buy.
• All price indexes are calculated using the
same procedure.
• First, the relevant prices are collected. Then a
base year is chosen. Then each price series
is converted into index numbers.
• Finally, the index numbers are combined to
create a weighted average index series
where the weights indicate the relative
importance of each price series.
Index of cocoa and coffee prices

Period Equal weights Coffee = 0.9;

Cocoa = 0.1
2001 (Q1) 100 100
2001 (Q2) 101.9 100.2
2001 (Q3 94.2 89.6
2001 (Q4) 103.7 89.7
2002 (Q4) 120.7 98.6
 Graphing economic data
• A single economic variable such as
unemployment or GDP can come in two basic
forms:
• Cross-section
• Time-series
 Scatter diagrams
• Another way in which data can be presented
is in a scatter diagram.
• This type of chart is more analytical than
those shown previously.
• It is designed to show the relationship
between two different variables.
• To plot a scatter diagram, values of one
variable are measured on the horizontal axis
and values of the second variable are
measured on the vertical axis.
• Any point on the diagram relates a specific
value of one variable to a corresponding
specific value of the other.
Households Annual income (£) Annual savings
1 70,000 10,000
2 30,000 2,500
3 100,000 12,000
4 60,000 3,000
5 80,000 8,000
6 10,000 500
7 20,000 2,000
8 50,000 2,000
9 40,000 4,200
10 90,000 8,000
 Graphing economic relationships
• Theories are built on assumptions about
relationships between variables.
• How can such relationships be expressed?
• When one variable is related to another in
such a way that to every value of one variable
there is only one possible value of the second
variable, we say that the second variable is a
function of the first.
• When we write this relationship down, we are
expressing a functional relationship between
the two variables.
 Note!
• A functional relationship can be expressed in
words, in a numerical schedule, in an
equation, or in a graph.
Annual Income Consumption Reference letter
0 800 p
2,500 2,800 q
5,000 4,800 r
7,500 6,800 s
10,000 8,800 t
 Functions
• Let us look in a little more detail at the
algebraic expression of this relationship
between income and consumption spending.
• To state the expression in general form,
detached from the specific numerical example
shown previously, we use a symbol to
express the dependence of one variable on
another.
• Using ‘f’ for this purpose, we write C = f(Y).
• This is read ‘C is a function of Y’. Spelling this
out more fully, it reads ‘The amount of
consumption spending depends upon the
household’s income.’
• The variable on the left-hand side is the
dependent variable, since its value depends
on the value of the variable on the right-hand
side.
• The variable on the right-hand side is the
independent variable, since it can take on any
value.
 Graphing relationships
• Different functional forms have different
graphs - When income goes up consumption
goes up.
• In such a relationship the two variables are
positively related to each other.
 The slope of a straight line
• Slopes are important in economics.
• They show you how fast one variable is
changing as the other changes.
• The slope is defined as the amount of change
in the variable measured on the vertical or y-
axis per unit change in the variable measured
on the horizontal or x-axis.
 Maxima and minima
• So far, all the graphs we have shown have
had either a positive or negative slope over
their entire range.
• But many relationships change direction as
the independent variable increases.