Economics 1A: Lectures 2-3

How economists work

Ioana R. Moldovan
University of Glasgow
Outline

1. Positive and normative statements

2. Economic theories/models

3. Economic data

4. Graphs of economic relationships

marginal relations!
1. Positive and normative statements

Positive statements: statements of fact, whether correct or incorrect. In principle may

be resolved by appealing to facts.

There are however situations in which the facts may be agreed but diering views may
be held as to what the facts imply for policy. These dierences will not be resolved by
an appeal to the facts since these are agreed and we are thus left with dierences of
opinion.

Normative statements: involve a value judgement, depend on opinions. Frequently

include words such as should or ought implying some kind of underlying moral or
ethical issues are involved.

Examples:

Higher taxes on alcohol discourage drinking.

People should consume more.

Governments should tax rich people more.

2. Economic theories/models

Economic theories/models: essentially a set of denitions, assumptions, relationships

which help us explain various things.

Denitions of variables to be employed:

Variables: something that can take on multiple values. E.g. price, quantity, time,
income.

endogenous variables: explained within the theory or the model.

exogenous variables: determined outside the model/theory. Exogenous variables

can inuence the behaviour of endogenous variables (but not the other way around).

E.g. the quantity of a wheat produced is an endogenous variable in a theory of sup-

ply. The weather is an exogenous variable, which inuences wheat harvests. In some
models/theories, technological progress is assumed exogenous.
Assumptions about how things behave:

Assumption that rms act so as to maximize prots. Assumption that people pursue
their self-interest.

Physical relationships: e.g. the production function = shows how the amount of output
is related to the quantities of inputs used.

Conditions under which the theory is meant to apply: e.g. in studying one market,
we assume prices of all other products are held constant./ no governmentassumption
means that the theory is intended to hold when the role of the government is insignicant
for what is being studied./ short-run vs long-run.

Identifying causal relationships between variables: what causes what?

Predictions: use models to make predictions, i.e. make conditional statements of the
form "If.... something is done, then.... this and that will happen"

Test the theory: compare the theorys predictions with the evidence.
3. Economic data

Data representation:

* time series

* cross sectional

* scatter diagrams

Index Numbers: help express relative movements in a variable. First, choose the base
period. Then, compute the index as,
value in period t
index = 100
value in base period

Note that the index in the base year is 100. Also, subtracting 100 from the index gives
the percent change relative to the base year. The percent change can also be computed
using directly the raw data,
! !
Xt Xt 1 Xt
% Xt = 100 = 1 100
Xt 1 Xt 1
Example: the rst table gives the average price of cocoa and coee, while the second
table gives the two indices, when assuming that 2001:1 is the base period.

Ave. price of cocoa and coffee (US cents per kg)

Period Cocoa Coffee

2001.1 100.4 146.7
2001.2 104.5 146.4
2001.3 100.8 129.7
2001.4 121.8 126.4
2002.1 149.0 136.6

Index of cocoa and coffee prices

Period Cocoa Coffee

2001.1 100 100

2001.2 104.1 99.8

2001.3 100.4 88.4

2001.4 121.3 86.2

2002.1 148.4 93.1

Averages:

* "unweighted" (equal-weight) index: simple average of two indices

I1 + I2
= 0 :5 I1 + 0:5 I2
2

* weighted index: weighted average, with the weights reecting the relative im-
portance of the variables considered (given for example by their share of sales), for
example:
0:3 I1 + 0:7 I2

Period Cocoa Index Coffee Index Average Weighted Average

(I1) (I2) (I1+I2)/2 0.3 * I1 + 0.7 * I2

2001.1 100 100 100 100

2001.2 104.1 99.8 101.9 101.1

2001.3 100.4 88.4 94.4 92.0

2001.4 121.3 86.2 103.7 96.7

2002.1 148.4 93.1 120.8 109.7

4. Graphs of economic relationships

A function: gives the specic relationship between two variables. In an implicit form,
we can write Y = f (X ), where for each value of X we can nd a value of Y: A
functional relation can be expressed in words, in a schedule giving specic values, in a
mathematical equation, or in graphs.

Linear relationship (function). Looking at linear relationships, we can have the fol-
lowing examples, expressed as a mathematical equation:

Y = 10 + 2X
or
Y = 10 2X
or
general notation:Y = a + bX

Example 1: positive relationship. Y = 10 + 2X : X and Y move in the same direction,

as X " we have Y ", and graphically the line is upward-sloping. Example 2: negative
relationship. Y = 10 2X : X and Y move in opposite ways, as X " we have Y #,
and graphically the line is downward-sloping.
Let X take the positive values f0; 1; 2; 3; 4; 5; 6g. Find the corresponding Y values.
The pairs of (X; Y ) values can then be plotted into graphs as below.

X Y = 10 + 2X Y = 10 2X
0 10 10
1 12 8
2 14 6
3 16 4
4 18 2
5 20 0
6 22 -2
 Y Y

10

10

0 5 X 0 X

Y = 10 2 X Y = 10 + 2 X
slope = -2 slope = 2

Slope of a straight line.

The slope gives the change in Y for a one unit change in X

Y
X

Note: slope of a straight line is the same along the line.

The slope gives the marginal change in Y , i.e. the change in Y when there is a bit
more or a bit less of X . This is an important concept as most economic decisions are
decisions on the margin, e.g. we consider whether to consume a bit more or a bit less of
a certain good; rms look at how producing a bit more would aect revenues or costs,
etc.

Non-linear relationships. Linear relationships are nice and simple but not all rela-
tionships are linear. Consider the graphical representation of the following non-linear
relationships.

The slope is NOT the same at all points along a non-linear curve. The next graph
illustrates the case of diminishing marginal change: the slope becomes atter as we
move downwards long the curve. This means that, as X increases, Y keeps decreasing
but by smaller and smaller amounts.
 Diminishing marginal change
Y

y1 y2
steeper >
y1 x x

flatter
y2

X
x x
 Increasing marginal change
Y

y1 steeper y1 y2
>
x x

flatter
y2

X
x x

Try to draw a positive relationship which has a diminishing marginal changes and a
negative relationship with increasing marginal change!
Minimum and maximum values

Minimum and Maximum Values

Y Y
max.

min.

X X

slope of the tangent at the points of minimum and maximum is zero

Reading material:

Lispey & Chrystal (2011): Chapter 2.