CHAPTER 1

Observing and
Explaining the Economy

CHAPTER OVERVIEW

What is economics? If you are tempted to answer, "everything," you would be at least partly correct. Economics is a way of thinking. It entails describing economic events, explaining why they occur, predicting whether they might occur in the future, and recommending appropriate courses of action to policymakers. When you listen to your professor in class, read the text, or work through the study guide, you should be learning to actively analyze economic events. This chapter introduces some of the tools of analysis. We consider the timely issue of health-care spending, and see what economists attempt to explain and how to interpret what they find. We look at economic models, and learn how economists abstract reality in order to make it manageable. We see how economics is used for public policy, and consider some of its limitations. Finally, we introduce some tools that economists use in their analysis. Using both graphs and algebra, we begin to learn how to document and quantify observations about the economy.

CHAPTER REVIEW

1. Economists divide people into broad categories. Households are either individuals or a group of individuals who share the same living quarters. Organizations are producers of goods and services. Firms are private organizations that produce goods and services. Governments also produce goods and services, such as national defense and education.

2. A market is an arrangement through which exchanges of goods or services between people take place. Households supply their labor to the firms that employ them. The resources used by firms to produce goods and services are called capital. Labor and capital are called factors of production.

3. An economic model is an explanation of how the economy or a part of the economy works. Economic models, like models in other sciences, are always simplifications of reality. Economic models can be described with words, with numbers, with graphs, or with algebra, and you will use all four as you work through the text and study guide. The study of economic events of the past is called economic history.

4. An economic variable is any economic measure that can vary over a range of values. Correlation means that two variables move together, either in the same direction or in opposite directions. There is a positive correlation if the two variables move in the same direction: one increases when the other increases. There is a negative correlation if the two variables move in opposite directions: one decreases when the other increases. Causation means that the movements in one variable bring about, or cause, the movements in another variable. Correlation does not imply causation. Just because two variables move together does not mean that the movements of one caused the movements of the other.

5. Scarcity is a central theme in economics. If people could have everything they wanted, there would be no economic problems. Economic models describe situations in which people must choose between one thing and another. Economists assume that people, when confronting scarcity, make purposeful choices to improve their well-being.

6. According to the law of demand, when the price of a good increases, people will choose to purchase less of that good and more of other goods. According to the law of supply, when the price of a good increases, people will provide more of that good. The law of supply and the law of demand are part of the same economic model, the supply and demand model.

7. The assumption of ceteris paribus, which means "all other things equal," is often used by economists for prediction. The idea of ceteris paribus is easiest to explain through an example. Suppose that you wanted to predict the effect of cold weather on football attendance. In making your prediction you would want to hold other things, such as the team's won-lost record, equal.

8. Keeping other things equal is not easy in economics. In many sciences, such as physics, researchers perform controlled experiments to determine whether one event causes another. In economics, as in astronomy, controlled experiments are rare. If you want to study the causes of the Great Depression of the 1930s, you cannot ask the government to go back and change policy. In experimental economics, a new and growing area of economics, researchers have begun to conduct economic experiments in laboratory settings.

9. The two main branches of economics are microeconomics and macroeconomics. Microeconomics studies the behavior of individual firms, households, and markets. Questions such as how much milk consumption would fall if the price of milk rises or how much a college education increases an individual's lifetime earnings are part of microeconomics. Macroeconomics focuses on the whole national, or even world, economy. Questions such as what were the effects of lowering inflation in the early 1980s in the United States or what are the prospects for economic reform in the former Soviet Union are part of macroeconomics.

10. There are two basic types of economic systems' market economies, where the vast majority of prices are free to vary, and command economies, where the vast majority of prices are determined by the government. Command economies are also called centrally planned economies. In modern market economies, the government plays a large role, and such economies are sometimes called mixed economies.

11. Economics is an important part of public policy making. Positive economics describes or explains what the government does. Normative economics makes recommendations about what the government should do. For example, interest rates in the United States were increased in the spring and summer of 1994. Positive economics describes the effects of the higher interest rates and explains why interest rates were raised. Normative economics is concerned with recommending whether they should be raised further. The work of the Council of Economic Advisors, which gives policy advice to the president, is an example of normative economics.

ZEROING IN

1. Health-care reform has been the major domestic issue since the election of President Clinton in 1992. Although Congress adjourned in the fall of 1994 without passing a bill, health care provides a good introduction to thinking about economics.

a. Two facts about health-care spending stand out. First, health-care spending has grown more rapidly than the rest of the US economy during the last twenty-five years. Second, the price of health care has increased faster than most other prices. It is the task of economics to quantify, document, and explain these observations.

b. Let's look at the first observation, that health-care spending has grown more rapidly than the rest of the US economy. In order to evaluate this assertion, we need to measure both health-care spending and the economy as a whole. Gross domestic product (GDP) is the most comprehensive measure of the size of an economy. GDP for the United States is the total value of all goods and services made in the United States during a specified period of time, usually one year. In 1993, GDP for the United States was $6,378 billion, or about $6.4 trillion.

c. We can measure health-care spending the same way we measure GDP, by adding up what we spend on all categories of health care. That number was $681 billion in 1993. If you doubt that health-care spending is important, you probably don't realize that $681 billion is three times as large as the entire automobile industry.

d. Health-care spending as a share of GDP (in percentage terms) can be calculated by dividing health-care spending by GDP and multiplying by 100:

Health-care spending as a share of GDP = health-care spending
GDP

In 1993, health-care spending as a share of GDP was 681/6,378 ¥ 100 = 10.7 percent. [If we did not multiply by 100, the share would have been .107 (out of 1) instead of 10.7 (out of 100). While we will usually represent shares in percentage terms, you should understand that the two numbers represent the same thing).

e. Now let's turn to prices. The overall price level is a measure of the average price of all the goods and services in GDP. Real GDP equals GDP divided by the overall price level. Inflation is the general increase in prices over time, and the inflation rate is the percentage increase in the overall price level from one year to the next. The price of health care is a measure of the average price of all the items included in the measure of health-care spending. The relative price of health care can be calculated by dividing the price of health care by the overall price level:

Relative price of health care = health care price
overall price level

 
1. Health-care spending and GDP for all years from 1970 to 1993 are reported in the text. Although both health-care spending and GDP have been rising, health-care spending has been increasing more quickly. The share of health-care spending as a percent of GDP has therefore been rising. The overall price level and the price of health care for the same years are also reported in the text. The relative price of health care has increased since 1970 because the price of health care has risen more rapidly than the overall price level.

2. Graphs and diagrams are used extensively in economics. They are useful both for uncovering correlations in economic variables and for understanding economic models.

a. In a Cartesian coordinate system, pairs of observations on variables can be represented in a plane by designating one axis for one variable and the other axis for the other variable. Each point on the plane corresponds to a pair of observations. In economics, the axes are usually designated the vertical axis and the horizontal axis.

b. A time-series graph plots a series' several values of the variable--over time. Figure 1.1 plots two variables, called x and y, over time. The value of the variable is depicted on the vertical axis, and time is on the horizontal axis. More than one variable can be plotted on the same graph. If the scales of measurement of the variables are very different, a dual scale can be used.

 

 

 

 

 

 

 

 

 

 

 

 

ACTIVE REVIEW

Fill-in Questions

1. ___________________ are individuals or a group of individuals who share the same living quarters.

2. Private organizations that produce goods and services are called ________________________.

3. A(n) ___________________ is an arrangement through which exchanges of goods or services between people take place.

4. Two factors of production are ___________________ and ___________________.

5. A(n) ___________________ is an explanation of how the economy or a part of the economy works.

6. Two variables have a ___________________ if they move in the same direction.

7. According to the ___________________, when the price of a good increases, people will choose to purchase less of that good and more of other goods.

8. The assumption of ___________________ means "all other things equal."

9. The two main branches of economics are ___________________ and ___________________.

10. ___________________ economics makes recommendations about what the government should do.

11. The most comprehensive measure of the size of an economy is ___________________.

12. ___________________ is the general increase in prices over time.

13. In a(n) ___________________, pairs of observations on variables can be represented in a plane by designating one axis for one variable and the other axis for the other variable.

14. A(n) ___________________ plots a series over time.

15. In a(n) ___________________, the vertical axis is used for one variable and the horizontal axis is used for the other variable.

True-False Questions

T F 1. Governments produce goods and services.

T F 2. Money and capital are called factors of production.

T F 3. It is desirable to make economic models as realistic as possible.

T F 4. If two economic variables have a positive correlation, one must cause the other.

T F 5. According to the law of supply, when the price of a good increases, people will choose to purchase less of that good.

T F 6. The question of by how much a college education increases an individual's lifetime earnings is part of microeconomics.

 

T F 7. The question of what were the effects of lowering inflation in the early 1980s in the United States is part of macroeconomics.

T F 8. Gross domestic product (GDP) is measured for a specified time period.

T F 9. Health-care spending is over 10 percent of GDP in the United States.

T F 10. In the United States, we spend more for automobiles than for health care.

T F 11. Health-care spending as a share of GDP has been rising during the last twenty-five years.

T F 12. The relative price of health care has increased since 1970.

T F 13. In a time-series graph, the value of the variable is depicted on the horizontal axis, and time is on the vertical axis.

T F 14. If the curve depicting two variables in a scatter plot is linear, the two variables are positive related.

T F 15. When the value of one of the variables on the two axes changes, it causes a shift in the curve.

Short-Answer Questions

1. What is a market?

2. What is the difference between labor and capital?

3. What is the difference between correlation and causation?

4. Why is scarcity a central theme in economics?

5. What is the assumption of ceteris paribus?

6. What is experimental economics?

7. In the context of public policy making, what is the difference between positive and normative economics?

8. What are two important facts about health-care spending during the last twenty-five years?

9. How do economists calculate health-care spending as a share of GDP?

10. What is the overall price level?

11. What is the difference between inflation and the inflation rate?

12. How do economists calculate the relative price of health care?

13. What is the use of a dual scale?

14. What is the relation between the slope of the curve in a scatter plot and the correlation between the variables on the axes?

 
1. What types of changes cause movements along a curve, and what causes shifts in the curve?

WORKING IT OUT

1. We have studied how to calculate health-care spending as a share of GDP and how to compute the relative price of health care. These techniques are applicable to any category of spending. Let's consider housing spending for a fictional economy, starting in the year 2000.

a. Suppose you are given the following data on GDP and housing spending:

 

Year	GDP	Housing Spending
2000	1,000	50
2010	2,000	120
2020	4,000	280
2030	8,000	640

GDP and housing spending are in billions of dollars. You can calculate housing spending as a share of GDP (in percentage terms) by dividing housing spending by GDP and multiplying by 100.

 

 

Housing spending as a share of GDP has increased from 5 percent to 8 percent over this thirty-year period.

b. Now suppose you are given data for the same time period on the overall price level and the price of housing:

 

Year	Overall Price	Housing Price
2000	1.00	.80
2010	1.10	.99
2020	1.21	1.21
2030	1.33	1.46

You can calculate the relative price of housing by dividing the price of housing by the overall price level:

 

Year	Relative Price of Housing
2000	.80
2010	.90
2020	1.00
2030	1.10

The relative price of housing has increased over this period.

2. We have learned that economic variables can be depicted by using either time-series graphs or scatter plots. We will use both to uncover the correlation between housing spending as a share of GDP and the relative price of housing in the fictional economy described above.

a. The movements in housing spending as a share of GDP and the relative price of housing can be shown by using time-series plots. In the first panel of Figure 1.4, the housing spending share is on the vertical axis and time (the year) is on the horizontal axis. The curve is upward-sloping, indicating that housing spending as a share of GDP has increased over this period. The second panel of Figure 1.4 depicts the relative price of housing on the vertical axis and the year on the horizontal axis. This curve is also upward-sloping, indicating that the relative price of housing has also increased over this period.

 

 

 

 

 

 

 

 

 

 

 

 

Worked Problems

1. Consider the following data for a fictional economy, starting in the year 2000:

 

Year	GDP	Food Spending	Overall Price	Food Price
2000	1,000	100	1.00	1.00
2010	2,000	180	1.20	1.32
2020	4,000	320	1.40	1.68
2030	8,000	560	1.60	2.08

GDP and food spending are in billions of dollars.

a. Calculate food spending as a share of GDP (in percentage terms) and the relative price of food.

b. What has happened to the food spending share and the relative price of food over this period?

Answers

a. Food spending as a share of GDP equals food spending divided by GDP multiplied by 100. The relative price of food equals the price of food divided by the overall price level.

 

Year	Food Spending Share	Relative Price of Food
2000	10 percent	1.00
2010	9 percent	1.10
2020	8 percent	1.20
2030	7 percent	1.30

b. The food spending share has decreased and the relative price of food has increased during this period.

2. Using the data for the economy in Worked Problem 1:

a. Draw a scatter plot to illustrate the relation between food spending as a share of GDP and the relative price of food. Are the two variables positively or negatively related?

b. Suppose that the relative price of food rises from 1.1 to 1.2. Is this a movement along the curve or a shift in the curve? Illustrate your answer.

 
1. Suppose that something causes the food spending share to decrease by 1 percent at each relative price of food. Is this a movement along the curve or a shift in the curve? Illustrate your answer.

Answers

a. The scatter plot, with the relative price of food on the vertical axis and the food spending share on the horizontal axis, is shown in Figure 1.7. The curve is downward-sloping, indicating that the two variables are negatively related.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Practice Problems

1. Consider the following data for a fictional economy, starting in the year 2000:

 

GDP and automobile spending are in billions of dollars.

a. Calculate automobile spending as a share of GDP (in percentage terms) and the relative price of automobiles.

b. What has happened to the automobile spending share and the relative price of automobiles over this period?

2. Consider the following data for a fictional economy, starting in the year 2000:

 

GDP and clothing spending are in billions of dollars.

a. Calculate clothing spending as a share of GDP (in percentage terms) and the relative price of clothing.

b. What has happened to the clothing spending share and the relative price of clothing over this period?

3. Using the data for the economy in Practice Problem 1:

a. Draw a scatter plot to illustrate the relation between automobile spending as a share of GDP and the relative price of automobiles. Are the two variables positively or negatively related?

 
1. Suppose the relative price of automobiles falls from .92 to .84. Is this a movement along the curve or a shift in the curve? Illustrate your answer.

4. Using the data for the economy in Practice Problem 2:

a. Draw a scatter plot to illustrate the relation between clothing spending as a share of GDP and the relative price of clothing. Are the two variables positively or negatively related?

 
1. Suppose that something causes the clothing spending share to increase by 1/2 percent at each relative price of clothing. Is this a movement along the curve or a shift in the curve? Illustrate your answer.

CHAPTER TEST

1. Individuals or a group of individuals who share the same living quarters are called

a. firms.

b. households.

c. governments.

d. groups.

2. Private organizations that produce goods and services are called

a. firms.

b. households.

c. governments.

d. groups.

3. An arrangement through which exchanges of goods or services between people take place is called

a. a firm.

b. an industry.

c. a market.

d. an economic model.

4. When the movements in one variable bring about the movements in another variable, this is called

a. causation.

b. correlation.

c. relationship.

d. connection.

5. Two variables have a positive correlation if

a. they move in opposite directions.

b. they move in the same direction.

c. one decreases when the other increases.

d. one increases when the other decreases.

6. Which of the following is a central theme in economics?

a. Causation

b. Abundance

c. Scarcity

d. Ceteris paribus

7. According to the law of demand, when the price of a good increases,

a. people will choose to purchase less of that good and more of other goods.

b. people will provide more of that good.

c. people will choose to purchase more of that good and less of other goods.

d. people will provide less of that good.

8. According to the law of supply, when the price of a good increases,

a. people will choose to purchase less of that good and more of other goods.

b. people will provide more of that good.

c. people will choose to purchase more of that good and less of other goods.

d. people will provide less of that good.

9. Macroeconomics focuses on

a. the whole national economy.

b. the behavior of individual firms.

c. the behavior of households.

d. markets.

10. Which of the following is most likely to be studied by a microeconomist?

a. Inflation of the general price level

b. Unemployment in the economy

c. Employment of labor in furniture production

d. The growth rate of aggregate output

11. Which of the following makes recommendations about what the government should do?

a. Positive economics

b. Negative economics

c. Experimental economics

d. Normative economics

12. The total value of all goods and services made in a country during a specified period of time is called

a. supply.

b. gross domestic product.

c. demand.

d. net domestic product.

13. The general increase in prices over time is called

a. inflation.

b. the inflation rate.

c. the overall price level.

d. the relative price level.

14. If a curve has a positive slope, then

a. the two variables are negatively related.

b. the two variables are positively related.

c. one variable increases when the other decreases.

1. the curve slopes down from left to right.

Use the following table for questions 15, 16, and 17.

 

GDP and food spending are in billions of dollars.

15. What is food spending as a share of GDP (in percentage terms) in the year 2010?

a. 3 percent

b. 6 percent

c. 10 percent

d. 5 percent

16. What is food spending as a share of GDP (in percentage terms) in the year 2030?

a. 4 percent

b. 5 percent

c. 10 percent

d. 8 percent

17. What is the relative price of food in the year 2010?

a. 1.00

b. 1.10

c. 1.20

d. 1.30

 

Use Figure 1.9 for questions 18 and 19.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1. a downward shift in the curve.

ANSWERS TO THE REVIEW QUESTIONS

Fill-in Questions

1. Households 2. firms 3. market 4. labor, capital 5. economic model 6. positive correlation 7. law of demand 8. ceteris paribus

9. microeconomics, macroeconomics 10. Normative 11. gross domestic product 12. Inflation 13. Cartesian coordinate system 14. time-series graph 15. scatter plot

True-False Questions

1. True. They produce goods and services such as national defense and education.

2. False. Labor and capital are called factors of production.

3. False. Economic models are always simplifications of reality.

4. False. Correlation does not imply causation.

5. False. According to the law of supply, when the price of a good increases, people will provide more of that good.

6. True. Microeconomics studies the behavior of individual firms, households, and markets.

7. True. Macroeconomics focuses on the whole national, or even world, economy.

8. True. GDP is usually specified for one year.

9. True. Health-care spending was 10.7 percent of US GDP for 1993.

Short-Answer Questions

1. A market is an arrangement through which exchange of goods and services between people take place.

2. Households supply their labor to the firms that employ them. The resources used by firms to produce goods and services are called capital.

3. Correlation means that two variables move together, either in the same direction or in opposite directions. Causation means that the movements in one variable bring about, or cause, the movements in another variable.

4. Scarcity is a central theme in economics because if people could have everything they wanted, there would be no economic problems.

5. The ceteris paribus assumption is that, when making a prediction of the effect of one variable on another, all other variables are unchanged.

6. Experimental economics is a new and growing area of economics, in which researchers have begun to conduct economic experiments in laboratory settings.

7. Positive economics describes or explains what the government does. Normative economics makes recommendations about what the government should do.

8. Health-care spending has grown more rapidly than the rest of the US economy, and the price of health care has increased more than most other prices.

9. Health-care spending as a share of GDP can be calculated by dividing health-care spending by GDP and multiplying by 100.

10. The overall price level is a measure of the average price of all the goods and services in GDP.

11. Inflation is the general increase in prices over time. The inflation rate is the percentage increase in the overall price level from one year to the next.

12. The relative price of health care is calculated by dividing the price of health care by the overall price level.

13. A dual scale can be used to plot more than one variable on the same graph when the scales of measurement of the variables are very different.

14. The two variables are positively related if the slope is positive and negatively related if the slope is negative.

1. Changes in the values of variables that are depicted on the axes cause movements along a curve, whereas changes in the values of other variables cause shifts in the curve.

SOLUTIONS TO THE PRACTICE PROBLEMS

1. a. The automobile spending share and the relative price of automobiles are:

 

Year	Automobile Spending Share	Relative Price of Automobiles
2000	3.0 percent	1.00
2010	3.5 percent	.92
2020	4.0 percent	.84
2030	4.5 percent	.77

b. The automobile spending share has increased and the relative price of automobiles has decreased over this period.

2. a. The clothing spending share and the relative price of clothing are:

 

Year	Clothing Spending Share	Relative Price of Clothing
2000	3.0 percent	.90
2010	3.5 percent	.95
2020	4.0 percent	1.00
2030	4.5 percent	1.05

b. The clothing spending share and the relative price of clothing have both increased during this period.

3. a. The scatter plot is drawn in Figure 1.11. The curve is downward-sloping, indicating that the two variables are negatively related.