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What Do Chapter 2 Observing and Economists Do? Explaining the Economy What Do Economists Do? Economists try to answer questions such as: • Why is college tuition so high? • Why are there so many different types of toothpaste? • Why is the price of gasoline more than $3 a gallon? • Why has health-care spending increased faster than the rest of the U.S. economy? What Do Economists Do? • Why is the average income of people in the United States 35 times higher than that of people in China? • Why is unemployment higher in Europe than in the United States? • Why have the wages of college graduates increased much more rapidly than the wages of non-graduates? What Do Economists Do? Understanding Gasoline Prices in the United States Observation: The price of gasoline has risen sharply in the past five years compared to the previous decade. Figure 1: Retail Price of Gasoline in the United States, 1991–2006 What Do Economists Do? Relative Price of Gasoline: the price of gasoline compared to the average price of all other goods and services in the economy. Relative price of gasoline = Price of Gasoline _____________________________________ Average Price of All Other Goods and Services Figure 2: Relative Price of Gasoline Explaining an Economic Event Economic Variable: any economic measure that can vary over a range of values. Economic Variables: Examples a) GDP b) Health-care spending c) Health-care spending share of GDP d) Relative price of health care Explaining an Economic Event Positive Correlation: occurs when two variables move in the same direction; when one goes up, the other goes up. Negative Correlation: occurs when two variables move in different directions; when one goes up, the other goes down. Figure 4: Price of Gasoline versus Price of Crude Oil Explaining an Economic Event Correlation versus Causation Correlation: means that one event is usually observed to occur along with another. Causation: means that one event brings about another event. Note: Correlation does not imply causation. Explaining an Economic Event Controlled Experiments: empirical tests of theories in a controlled setting in which particular effects can be isolated. Experimental Economics: a branch of economics that uses laboratory experiments to analyze economic behavior. Economic Models Economic Model: an explanation of how the economy or part of the economy works; an abstraction or simplification of the real world. Economic Models Microeconomics: the branch of economics that examines individual decision-making at firms and households and the way they interact in specific industries and markets. Macroeconomics: the branch of economics that examines the workings and problems of the economy as a whole; focuses on variables such as GDP growth and unemployment. Economic Models Positively Related: a situation in which an increase in one variable is associated with an increase in another variable (also called directly related). Negatively Related: a situation in which an increase in one variable is associated with a decrease in another variable (also called inversely related). Economic Models: An Example A Model with Two Variables: Figure 6 illustrates four different ways to model the economic relationship between the number of doctors employed at an HMO and the number of physical examinations given. The four ways are: (1) with words; (2) with a numerical value; (3) with a graph; and (4) with algebra or an equation. Figure 7: Economic Models in Four Ways The Ceteris Paribus Assumption Ceteris Paribus: “all other things equal”; refers to holding all other variables constant or keeping all other things the same when one variable is changed. Recommending Appropriate Policies • Capitalism: an economic system in which capital is individually owned and production and employment decisions are decentralized. • Socialism: an economic system in which the government owns and controls all the capital and makes decisions about prices and quantities. • Mixed Economy: a market economy in which the government plays a very large role. Positive versus Normative Economics Positive Economics: economic analysis that explains what happens in the economy and why, without making recommendations about economic policy. Examples of the scope of positive economics: a) Explaining why health-care spending slowed down in the mid-1990s b) Explaining why gasoline prices went up sharply in 2005 Positive versus Normative Economics Normative Economics: economic analysis that makes recommendations about economic policy; aims to develop and recommend policies about what the government should do. Examples of the scope of normative economics: a) Recommending policies that will prevent the rise of health-care expenditures in the future b) Recommending that the government increase tax rates to prevent a budget deficit Positive versus Normative Economics Council of Economic Advisers: a three-member group of economists appointed by the president of the United States to analyze the economy and make recommendations about economic policy. Conclusion • Three important points to remember as we study more economic models: 1. Economics requires a mixture of verbal and quantitative skills. 2. Economics is a wide-ranging discipline; it is more than just about the stock market. 3. The study of economics is an intellectually fascinating adventure. Key Terms • • • • • • • • • relative price economic variable controlled experiments experimental economics economic model microeconomics macroeconomics gross domestic product (GDP) positively related • • • • • • • • negatively related ceteris paribus capitalism socialism mixed economy positive economics normative economics Council of Economic Advisers