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CHAPTER 2Tools of economic analysis
©McGraw-Hill Education, 2014
Economic models
• Help us to organize our thinking we need a simplified picture of reality
• Help us to focus on key elements• are developed so that understanding of
how the economy functions can be improved.
• Allow us to generate hypotheses that can be tested against the facts.
©McGraw-Hill Education, 2014
Economic models: an example
Tube revenue = tube fare number of passengers
Number of passengers = f (tube fare, taxi fare, petrol price, bus fare, passenger incomes …)
Tube revenue = tube fare f (tube fare, taxi fare, petrol price, bus fare, passenger incomes …)
©McGraw-Hill Education, 2014
We do indeed see a positive relationship between fares and
revenue
Scatter diagrams show the relationship between two variables plotted in the diagram. By fitting a ‘line of best fit’ through these points we summarize the average relationship between the two variables.
©McGraw-Hill Education, 2014
The other things being equal or ceteris paribus assumption
• Other things equal, higher fares reduce the number of tube journeys, but if the number of journeys made falls only a little, overall revenue may actually rise when fares are increased.
©McGraw-Hill Education, 2014
The other things being equal or ceteris paribus assumption
• Other things equal, higher fares reduce the number of tube journeys, but if the number of journeys made falls only a little, overall revenue may actually rise when fares are increased.
• But other things were not equal over the period. In this period Britain’s national income, adjusted for inflation, grew substantially
©McGraw-Hill Education, 2014
The other things being equal, or ceteris paribus, assumption
• Even if tube fares had been constant, rising incomes should have led to (and did lead to) rising tube use and rising tube revenues.
©McGraw-Hill Education, 2014
Econometrics (1)
• Analytical diagrams are often useful in building a model. They show relationships between two variables holding other things equal.
• Econometrics uses computers to fit average relationships between many variables simultaneously. In principle this allows us to get round the ‘other things equal’ problem, which always applies in two dimensions
©McGraw-Hill Education, 2014
Econometrics (2)
•Once relationships have been established, they are useful as a test of our hypotheses they can be use to make predictions about the likely impact of a change in one variable (e.g. price) on another (e.g. demand).
©McGraw-Hill Education, 2014
Concluding comments (1)
• A model is a simplified framework to organize how we think about a problem.
• Data are important as they suggest relationships which we should aim to explain and they allow us to test our hypotheses and to quantify the effects that they imply.
• Time-series data are values of a given variable at different points in time.
• Cross-section data refer to the same point in time but to different values of the same variable across different people.
©McGraw-Hill Education, 2014
Concluding comments (2)
• Panel data are a mix between time-series and cross-section data.
• Index numbers express data relative to some given base value.
• The consumer price index summarizes changes in the prices of all goods bought by households.
• The annual percentage change in the retail price index is the usual measure of inflation.
• Real or constant price variables adjust nominal variables for changes in the general level of prices.
©McGraw-Hill Education, 2014
