Chapter 2 Observing and
Explaining the Economy.
Key points
• Economists try to explain facts & observations about the
economy
• Tables & graphs help organize the info
• GDP is a measure of all the goods and services produced in a
country during a period of time
• Correlation does not imply causation
• Establishing causation is more difficult in econ because
controlled experiments are rare.
• Recent advances improve this situation
• Economic observations not always accurate; e.g. quality of
service difficult to measure
Economic models (p.35)
• Economists use economic models to explain
economic observations. Models are
simplifications of reality & have variables &
constants. Types of representation: verbal,
with numerical tables, with graphs, with
algebra.
• New models are developed because existing
models cannot explain facts or observations.
Gross Domestic Product (GDP) in the
United States, 1990-1999
4
Time-Series Graphs
• Any series of data that is measured over
time is called a time-series. A series that is
plotted over time is called a time-series
graph.
• We use a time-series graph to describe the
behavior of a series over time. Economic
models are used to explain the behavior.
5
Spending on Health Care in the United
States, 1990-1999
6
Health-Care Spending as a Percentage of GDP
7
positive economics:
what is or will be
normative economics:
what ought to be
ceteris paribus:
“all other things equal”
apples
$0.30
At a particular price of apples, people buy a certain quantity of apples.
apples
$0.30
$0.50
Ceteris paribus, when the price of apples increases, people buy fewer apples.
But suppose people’s incomes increase at the same time that the price of fruit goes
up. Perhaps, originally we had a little income...
... and now we have a lot more income.
apples
$0.30
$0.50
Then people may buy more
apples even though the
price of apples
has gone up. The ceteris paribus assumption (other things constant) has been
violated. Income is not constant.
Correlation
• Two series of data may be related.
Correlation (positive and negative)
measures the potential relationship.
• What can you say about the correlation
between good grades on economic tests
and time spent partying?
15
Relative Price
of Health Care
versus HealthCare Spending
Share
16
Correlation and Causation
• Correlation and causation are not the same. To
say that two series are correlated does not
mean that one causes (leads) another.
Correlation between two series may be caused
by a third series.
• Interesting perspectivehttp://www.youtube.com/watch?v=lbODqslc4
Tg
• Classroom perspectivehttp://www.youtube.com/watch?v=5zyruPbgx
yM
17
Economic Data
• Data measure the interaction of
households (consumers), firms, and
governments. Most interaction occurs in
markets.
• A market is a mechanism in which exchange
between buyers and sellers take place.
18
Gross Domestic Product
• Gross domestic product
(GDP) is the total market
value of all final goods and
services produced within a
given period by factors of
production located within a
country.
National Income
and Product Accounts
• National income and product accounts are data
collected and published by the government
describing the various components of national
income and output in the economy.
• The U.S. Department of Commerce is responsible
for producing and maintaining the “National
Income and Product Accounts” that keep track of
GDP.
Final Goods and Services
• The term final goods and services in GDP
refers to goods and services produced for
final use.
• Intermediate goods are goods produced
by one firm for use in further processing
by another firm.
Value Added
• Value added is the difference
between the value of goods as they
leave a stage of production and the
cost of the goods as they entered
that stage.
– In calculating GDP, we can either sum
up the value added at each stage of
production, or we can take the value
of final sales.
Examples of value added
• There are four major ways that value is added
to crops along the value chain:
• Product transformation
• Distribution
• Storage
• Added service
Product transformation
• Product transformation describes the process
of taking a crop from its raw or commodity
state and transforming it into a different form.
This could be as simple as tying three
ornamental corn ears together for sale at a
farmers market. Product transformation could
also be as complex as harvesting a specific
variety of wheat that is ground into flour, used
to make fresh pasta, and packaged for delivery
to retail stores.
• Distribution within the value chain involves any
transportation of crops to a more convenient
buying location. Nursery plant sales via the
Internet are one example of adding value to crop
production via distribution.
• Storage has long been utilized by grain and
oilseed growers to warehouse crops in
anticipation of future price increases or while
awaiting contract delivery dates. Storage is also a
common “next step” for producers of fruit and
vegetable crops wanting to add value to crop
production.
• Added service refers to providing information
or services that increase a crop product’s
value. Farmers market vendors or Community
Supported Agriculture (CSA) producers might
provide customers with recipes utilizing new
and unfamiliar vegetables. Nutritional
information about crops might be provided for
direct market consumers.
Value Added
Value Added in the Production of a Gallon of Gasoline
(Hypothetical Numbers)
STAGE OF PRODUCTION
VALUE OF SALES
VALUE ADDED
$ .50
$ .50
(2) Refining
.65
.15
(3) Shipping
.80
.15
1.00
.20
(1) Oil drilling
(4) Retail sale
Total value added
$1.00
What is GDP!- click the pic
Exclusions of Used Goods
and Paper Transactions
• GDP ignores all transactions
in which money or goods
change hands but in which no
new goods and services are
produced.
Exclusion of Output Produced Abroad
by Domestically Owned Factors of Production
• GDP is the value of output
produced by factors of production
located within a country. Output
produced by a country’s citizens,
regardless of where the output is
produced, is measured by gross
national product (GNP).
Calculating GDP
GDP can be computed in two ways:
• The expenditure approach: A method of
computing GDP that measures the total
amount spent on all final goods during a given
period.
• The income approach: A method of computing
GDP that measures the income—wages, rents,
interest, and profits—received by all factors of
production in producing final goods.
Calculating GDP
The Expenditure Approach
Expenditure categories:
• Personal consumption
expenditures (C)—household
spending on consumer goods.
• Gross private domestic
investment (I)—spending by firms
and households on new capital:
plant, equipment, inventory, and new
residential structures.
The Expenditure Approach
Expenditure categories:
• Government consumption and
gross investment (G)
• Net exports (EX – IM)—net
spending by the rest of the world, or
exports (EX) minus imports (IM)
The Expenditure Approach
• The expenditure approach
calculates GDP by adding together
the four components of spending.
In equation form:
GDP  C  I  G  ( EX  IM )
Components of GDP, 1999:
The Expenditure Approach
Components of GDP, 2002: The Expenditure Approach
Personal consumption expenditures (C)
Durable goods
Nondurable goods
Services
Gross private domestic investment (l)
Nonresidential
Residential
Change in business inventories
Government consumption and gross investment (G)
Federal
State and local
Net exports (EX – IM)
Exports (EX)
Imports (IM)
Total gross domestic product (GDP)
Note: Numbers may not add exactly because of rounding.
37 of 38U.S. Department of Commerce, Bureau of Economic Analysis.
Source:
BILLIONS OF
DOLLARS
PERCENTAGE
OF GDP
7303.7
871.9
2115.0
4316.8
1543.2
1117.4
471.9
3.9
1972.9
693.7
1279.2
 423.6
1014.9
1438.5
10446.2
69.9
8.3
20.2
41.3
14.8
10.7
4.5
0
18.9
6.6
12.2
 4.1
9.8
13.8
100.0
Personal Consumption Expenditures
• Personal consumption expenditures (C) are
expenditures by consumers on the following:
– Durable goods: Goods that last a relatively
long time, such as cars and appliances.
– Nondurable goods: Goods that are used up
fairly quickly, such as food and clothing.
– Services: Things that do not involve the
production of physical things, such as legal
services, medical services, and education.
Personal Consumption Expenditures
Gross Private Domestic Investment
• Investment refers to the purchase
of new capital.
• Total investment by the private
sector is called gross private
domestic investment. It includes
the purchase of new housing,
plants, equipment, and inventory
by the private sector.
Gross Private Domestic Investment
• Nonresidential investment includes
expenditures by firms for machines, tools,
plants, and so on.
• Residential investment includes expenditures
by households and firms on new houses and
apartment buildings.
• Change in inventories computes the amount
by which firms’ inventories change during a
given period. Inventories are the goods that
firms produce now but intend to sell later.
Gross Private Domestic Investment
• Remember that GDP is not the
market value of total sales during a
period—it is the market value of
total production.
• The relationship between total
production and total sales is:
GDP = final sales + change in business inventories
Gross Investment
versus Net Investment
• Gross investment is the total value of all newly
produced capital goods (plant, equipment,
housing, and inventory) produced in a given
period.
• Depreciation is the amount by which an asset’s
value falls in a given period.
• Net investment equals gross investment minus
depreciation.
capitalend of period = capitalbeginning of period + net investment
Government Consumption
and Gross Investment
• Government
consumption and gross
investment (G) counts
expenditures by federal,
state, and local
governments for final
goods and services.
Government Consumption
and Gross Investment
Net Exports
• Net exports (EX – IM) is the
difference between exports and
imports. The figure can be positive
or negative.
– Exports (EX) are sales to foreigners of
U.S.-produced goods and services.
– Imports (IM) are U.S. purchases of
goods and services from abroad).
Net Exports vs imports
The Income Approach
• National income is the total income
earned by the factors of production
owned by a country’s citizens.
• The income approach to GDP breaks
down GDP into four components:
GDP = national income + depreciation + (indirect taxes – subsidies) +
net factor payments to the rest of the world + other
From GDP to Disposable Personal Income
GDP, GNP, NNP, National Income, Personal Income, and Disposable Personal Income, 2002
GDP
Plus: receipts of factor income from the rest of the world
Less: payments of factor income to the rest of the world
Equals: GNP
Less: depreciation
Equals: net national product (NNP)
Less: indirect taxes minus subsidies plus other
Equals: national income
Less:
Less:
Plus:
Plus:
corporate profits minus dividends
social insurance payments
personal interest income received from the government and consumers
transfer payments to persons
Equals: personal income
Less: personal taxes
Equals: disposable personal income
Source: See Table 18.2.
49 of 38
DOLLARS
(BILLIONS)
10,205.6
+ 342.1
 353.2
10,194.5
 1,351.3
8,843.2
 643.3
8,199.9
 332.6
 731.2
+ 439.1
+1,148.7
8,723.9
 1,306.2
7,417.7
From GDP to Disposable Personal Income
• Net national product equals gross national
product minus depreciation; a nation’s total
product minus what is required to maintain
the value of its capital stock.
• Personal income is the income received by
households after paying social insurance taxes
but before paying personal income taxes.
Disposable Personal
Income and Personal Saving
Disposable Personal Income and Personal Saving, 2002
DOLLARS
(BILLIONS)
Disposable personal income
Less:
Personal consumption expenditures
Interest paid by consumers to business
Personal transfer payments to foreigners
Equals: personal saving
Personal savings as a percentage of disposable personal income:
Source: See Table 18.2.
7,417.7
 7063.5
 204.3
 31.3
118.6
1.6%
2. Economic Models
• A model is an explanation of how the
economy, or part of the economy, works.
• Models are built on theories and tell
economists whether variables are
negatively or positively related.
52
Economic
Models in
Four Ways
53