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Economics 3rd ch02


By John B. Taylor
Stanford University

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Chapter 2
Observing and
Explaining the
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• 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

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Teaching Objectives
• Discuss how economics makes use of data and
• 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
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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)

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Figure 2.1
Gross Domestic Product (GDP) in the United States, 1990-1999

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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.

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Figure 2.2
Spending on Health Care in the United States, 1990-1999

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Figure 2.3
Health-Care Spending as a Percentage of GDP

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Figure 2.4
Relative Price of Health Care

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• Two series of data may be related. Correlation
(positive and negative) measures the potential
• What can you say about the correlation
between good grades on economic tests and
time spent partying?

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Figure 2.5
Relative Price of Health Care
versus Health-Care Spending

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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.

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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.

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Figure 2.6
A Circular Flow

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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.

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Figure 2.7
A Model with Two Positively Related Variables

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Figure 2.8
A Model with Two Negatively Related Variables

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Figure 2.9
Economic Models in
Four Ways

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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).
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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.

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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.

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