1. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 1 Economics THIRD EDITION By John B. Taylor Stanford University

2. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 2 Chapter 2 Observing and Explaining the Economy

3. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 3 OVERVIEW This chapter describes the tools needed to begin forming an economic analysis The foundation of all economic analysis is the use of economic data, graphs, and models. These topics are introduced and discussed with the issue of health care

4. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 4 Teaching Objectives Discuss how economics makes use of data and graphs Discuss negative and positive correlation between variables. Differentiate between correlation and causation Introduce economic models Explain normative versus positive economics Discuss the role of economics in designing government policies

5. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 5 1. Observations: What Economist Endeavor to Explain Virtually all the questions economists seek to answer come from observing the economy. They document and quantify their observations by collecting and examining data A standard measure of the size and activity of an economy is gross domestic product (GDP)

6. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 6 Figure 2.1 Gross Domestic Product (GDP) in the United States, 1990-1999

7. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 7 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.

8. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 8 Figure 2.2 Spending on Health Care in the United States, 1990-1999

9. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 9 Figure 2.3 Health-Care Spending as a Percentage of GDP

10. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 10 Figure 2.4 Relative Price of Health Care

11. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 11 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?

12. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 12 Figure 2.5 Relative Price of Health Care versus Health-Care Spending Share

13. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 13 Correlation and Causation Correlation and causation are not the same. To say that two series are correlated does not mean that once causes (leads) another. Correlation between two series may be caused by a third series.

14. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 14 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.

15. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 15 Figure 2.6 A Circular Flow Diagram

16. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 16 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.

17. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 17 Figure 2.7 A Model with Two Positively Related Variables

18. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 18 Figure 2.8 A Model with Two Negatively Related Variables

19. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 19 Figure 2.9 Economic Models in Four Ways

20. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 20 More on Economic Modeling Scarcity is a common element in all economic models: to do something, something else must be given up. Scarcity forces individuals to make choices A standard economic model that includes scarcity is supply and demand Models are simplifications of (complex) reality. Many other factors must be held constant (ceteris paribus).

21. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 21 More on Economic Modeling Economic models may be classified according to whether they seek to explain an economy (macroeconomics) or seek to explain aspects of individual behavior (microeconomics). Theories and models are not stagnant. New models and theories evolve often.

22. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 22 3. Using Economics for Public Economic Policy Ever since the Wealth of Nations by Adam Smith (1776), economists have been motivated by a desire to improve government policy. Positive economics simply explains the results of policy (What it is) Normative economics attempts to develop and recommend policy (What it should be). Economics is independent of political parties. It has a set of tools that aid in thinking.