Microeconomics - Chapter 2: Economic Theories, Data, and Graphs

Chapter Outline/Learning Objectives

  • After studying this chapter, you will be able to:

    • Distinguish between positive and normative statements.

    • Explain why and how economists use theories to understand the economy.

    • Understand the interaction between economic theories and empirical observation.

    • Identify several types of economic data.

    • Including index numbers, time-series and cross-sectional data, and scatter diagrams.

    • Recognize the slope of a line on a graph as the "marginal response" of one variable to a change in another.

2.1 Positive and Normative Statements

  • Normative Statements:

    • Depend on value judgments.

    • Cannot be evaluated solely based on facts.

    • Definition: A normative statement is about what ought to be.

  • Positive Statements:

    • Do not involve value judgments.

    • Statements about matters of fact.

    • Definition: A positive statement is about what is, was, or will be.

Disagreements Among Economists

  • Economists often engage in public disagreements.

  • Many disagreements stem from the positive/normative distinction.

  • A responsible economist clearly states the normative and positive aspects of their advice.

Applying Economic Concepts 2-1: Where Economists Work

  • Economists’ skills are demanded by:

    • Governments

    • Private businesses

    • Crown corporations

    • Non-profit organizations

    • Post-secondary institutions

  • Economists analyze/evaluate government policies and examine risks to economic growth, etc.

2.2 Building and Testing Economic Theories

  • What Are Theories?

    • Theories are abstractions from reality.

    • Consist of:

    • Variables:

      • Can take various specific values.

      • Endogenous/Dependent Variables: Explained within a theory.

      • Exogenous/Independent Variables: Outside the theory.

    • Assumptions

    • Predictions

Testing Theories

  • A theory is tested by comparing its predictions against evidence.

  • If a theory contradicts the facts:

    • It will be amended to align with the facts, or

    • Discarded in favor of a superior theory.

  • The scientific approach is essential in economics.

Statistical Analysis

  • Used to test hypotheses such as: "if X occurs, then Y will also happen."

  • Economists rely on millions of uncontrolled experiments taking place daily in the marketplace.

  • Numerous simultaneous forces influence the variables of interest, requiring:

    • Appropriate, complex statistical techniques for analysis.

Correlation versus Causation

  • Positive Correlation:

    • Indicates that X and Y move together in the same direction.

  • Negative Correlation:

    • Indicates that X and Y move in opposite directions.

  • Causal Relationship:

    • Correlation does not directly indicate causality.

    • Most economic predictions involve establishing causation, often requiring advanced statistical techniques.

Applying Economic Concepts 2-2: Can Economists Design Controlled Experiments to Test Their Theories?

  • Economists are typically interested in causal relationships.

  • They often lack the means to set up controlled experiments.

  • Recent trends show the adoption of:

    • Randomized Controlled Trials (RCT):

    • Techniques utilized in medicine to ascertain underlying causality among economic variables.

2.3 Economic Data

  • Index Numbers:

    • Definition: An index number is a measure of a variable compared to a base period assigned the value of 100.

    • Example: The Consumer Price Index (CPI) reflects the average price consumers pay for a typical basket of goods and services.

    • Calculation Formula:
      ext{Index Number} = rac{ ext{Absolute Value in Given Period}}{ ext{Absolute Value in Base Period}} imes 100

Constructing Index Numbers

  • Example:

    • Steel and Newsprint Index Calculations for Various Years (Base Year = 2014):

    • 2014: Steel Index = 100.0; Newsprint Index = 100.0

    • 2015: Steel Index = 105.0; Newsprint Index = 96.9

    • 2016: Steel Index = 112.5; Newsprint Index = 93.8

    • 2017: Steel Index = 107.5; Newsprint Index = 100.0

    • 2018: Steel Index = 125.0; Newsprint Index = 96.9

    • 2019: Steel Index = 110.0; Newsprint Index = 103.1

    • 2020: Steel Index = 132.5; Newsprint Index = 96.9

    • 2021: Steel Index = 112.5; Newsprint Index = 103.1

    • 2022: Steel Index = 127.5; Newsprint Index = 96.9

    • 2023: Steel Index = 115.0; Newsprint Index = 100.0

    • 2024: Steel Index = 122.5; Newsprint Index = 93.8

  • Interpreting Results:

    • The 2024 index for steel indicates a 22.5% increase relative to the base year.

    • The 2024 index for newsprint reflects that output is at 93.8% of the base year.

2.4 Graphing Economic Data

  • Economic variables can be represented through:

    • Cross-sectional Data

    • Time-series Data

  • Scatter Diagrams:

    • Represent two variables (one on each axis); each point reflects the values for a particular observation.

Graphing Economic Theories

  • Function Definition:

    • When variable X relates to variable Y (one possible Y for each X), Y is a function of X:
      Y = f(X)

  • Function expressions:

    • Can take the form of:

    • Verbal statements

    • Numerical schedules (tables)

    • Mathematical equations

    • Graphs

  • Example:

    • Consumption function: When wage income (W) is zero, consumption (C) is $800, and for every extra $1 of wage, consumption increases by $0.80:
      C = f(W) = 800 + 0.8W

Graphing Functions

  • Positive Relationship:

    • Both variables move together in the same direction.

  • Negative Relationship:

    • Variables move in opposite directions.

  • Linear Relationships:

    • Represented by straight lines.

  • Non-linear Functions:

    • Not graphed as straight lines.

The Slope of a Straight Line

  • The slope is defined as:

    • ext{Slope} = rac{ ext{Change in Vertical Axis}}{ ext{Change in Horizontal Axis}} = rac{ ext{ΔP}}{ ext{ΔE}}

  • Example Calculation:

    • Between points A and B, cost to reduce pollution (ΔE) is $2000 for a reduction of 1000 tonnes of pollution (ΔP), yielding a slope of -0.5.

Non-Linear Functions

  • Marginal Response:

    • In non-linear functions, the slope changes as X changes, affecting the marginal response of Y based on the value of X.

    • Illustrates diminishing marginal response with changes in output (Figures 2-8, 2-9).

A Final Word

  • The discussion centers on the significance of economists developing theories to help comprehend economic events.

  • Understanding the cycle of empirical testing and theory refinement is crucial.

  • Various graphing methods help economists illustrate their theories effectively.