Economic Theories, Data, and Graphs 2.1 Positive and Normative Statements Normative Statement → A statement about what ought to be; it is based on a value judgment. Positive Statement → A statement about matters of fact; it is not based on a value judgment. ⤷ “If this is what you want to do, here is a way to do it.” Distinguishing what is actually true from what we would like to be true requires distinguishing between positive and normative statements. 2.2 Building and Testing Economic Theories Theories are used to both explain events that have already happened and to help predict events that might happen in the future. What Are Theories? Theories are constructed to explain things. Economists have developed theories of demand and supply. These and all other theories are distinguished by their variables, assumptions, and predictions. Variables Variable → Any well-defined item, such as a price or a quantity, that can take on different possible values. ⤷ Endogenous variable → A variable that is explained within a theory. (e.g., wheat and it’s price) ⤷ Exogenous variable → A variable that is determined outside the theory. (e.g., better weather) Assumptions A theory’s assumptions concern motives, directions of causation, and the conditions under which the theory is meant to apply. ⤷ Motives ○ Assumes that everyone pursues their own self-interest when making economic decisions ⤷ Direction of Causation ○ Assumes there is some link between variables (e.g., better weather results in increased wheat; not vice versa) ⤷ Conditions of Application ○ Assumes the conditions under which a theory is meant to hold. “All theory is an abstraction from reality. If it were not, it would merely duplicate the world in all its complexity and would add little to our understanding of it.” Predictions Predictions/Hypotheses → The propositions that can be deduced from a theory’s predictions. Testing Theories ⤷ A theory is tested by confronting its predictions with factual evidence. A theory ceases to be useful when it cannot predict better than an alternative theory and is replaced or discarded. ⤷ Economists make use of statistical analysis when testing their theories. They must take care to make the distinction between correlation and causation. Statistical Analysis → Investigating trends, patterns, and relationships using real data. Correlation Versus Causation “Most economic predictions involve causality. Correlation can establish that the data are consistent with the theory; establishing causation usually requires more advanced statistical techniques.” 2.3 Economic Data Economists use real-world observations to test their theories and mainly use data collected by others. In economics, there is a division of labour between collecting data and using them to test theories. 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 had collected the data themselves. Index Numbers Index Number → A measure of some variable, conventionally expressed relative to a base period, which is assigned the value 100. → The value of some variable in any given year as a percentage of its value in the base year. How to Build an Index Number Base Period → The value of the variable at some point in time. 1. Take the value of the variable at some point in time as the “base”. 2. Divide the value in the given year by the value in the base year and multiply the result by 100. The index number always tells you the percentage change compared with the base year, but when comparing an index number across non-base years, the percentage change in the index number is not given by the absolute difference in the values of the index number. More Complex Index Numbers Consumer Price Index (CPI) → Price index of the average price paid by consumers for the typical collection of goods and services that they buy. Graphing Economic Data Cross-Sectional → A set of observations of a variable across different units at the same point in time. Time-Series Data → A set of observations of a variable made at successive periods of time. Scatter Diagrams → A graph designed to show the relation between two different variables. Each point represents the values of the variables for a particular unit of observation. 2.4 Graphing Economic Theories Functions A functional relation can be expressed in words, in a table giving specific values, in a mathematical equation, or in a graph. The Slope of a Straight Line Slope → Shows how much one variable changes as the other changes. ⤷ Positive Slope → When the variables both increase or decrease together. ⤷ Negative Slope → When the variables move in opposite directions. Non-linear Functions “For non-linear functions, the slope of the curve changes as X changes. Therefore, the marginal response of Y to a change in X depends on the value of X.” Marginal Change → The amount a variable changes in response to a change in a second variable. Diminishing Marginal Response → Adding an additional factor of production results in smaller increases in output. (e.g., The amount of pollution reduced per dollar of expenditure gets less and less as the total expenditure rises.) Increasing Marginal Cost → Increase in cost that accompanies a unit increase in output. (e.g., As more and more hockey sticks are produced, the extra amount that the firm must pay to produce each extra stick rises.) Functions with a Minimum or a Maximum Slope of a Straight Line Tangent - used to measure the slope of a curved line at any specific point At either a minimum or a maximum of a function, the slope of the curve is zero. Therefore the marginal response is zero. Learning Objectives (LO) 1. Distinguish between positive and normative statements. 2. Explain why and how economists use theories to help them understand the economy. 3. Understand the interaction between economic theories and empirical observation. 4. Identify several types of economic data, including index numbers, time-series and cross-sectional data, and scatter diagrams. 5. Recognize the slope of a line on a graph relating two variables as the “marginal response” of one variable to a change in the other.
