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2.1 Positive and Normative Advice Normative Statement: A statement about what ought to be as opposed to what actually is.

- depend on value judgements and cannot be evaluated solely by a recourse to facts - i.e people should be encouraged to save; Unemployment is a more important social problem than inflation - the inclusion of a value judgement does not make the statement itself normative Positive Statement: A statement about what actually is (was or will be), as opposed to what ought to be - do not involve value judgements; statements about matters of fact and so disagreements about them are dealt with by an appeal to evidence - i.e Raising interest rates encourage people to save; the majority of the population would prefer a policy that reduced unemployment to one that reduced inflation - need not be true - about actual or alleged facts Much of success of modern science depends on the ability of scientists to separate what does happen in the world from their views on what they would like to happen Distinguishing what is actually true from what we would like to be true requires distinguishing between positive and normative statements Disagreements Among Economists Stems from 1) poor communication (not defining their points of reference clearly--arguing past each other) 2) failure to acknowledge the full state of their ignorance 3) distinction between positive/normative statements Many economists agree on positive statements 2.2 Economic Theories

Theories Economists develop theories and models to explain things that have been seen and to predict things that will be seen Constructed to explain things Theories (i.e those of demand and supply) are distinguished by their variables, assumptions and predictions Variables Variable- a well-defined item, such as the price or quantity of a commodity, that can take on various specific values - i.e price and quantity variables Endogenous Variables- A variable that is explained within a theory. Sometimes called an induced variable or a dependent variable - i.e the state of the weather Exogenous Variables- A variable that is determined outside the theory. Sometimes called an autonomous variable or an independent variable - influences endogenous variables - i.e price and quantity Assumptions 1) Motives - we assume that everyone pursues his own self-interest when making economic decisions - individuals want to maximize utility, firms want to maximize profits 2) Direction of Causation - when economists assume that one variable is related to the other they are usually assuming some causal link between the two

3) Conditions of the Application - Assumptions are often used to specify the condition under which a theory is meant to hold - i.e assumption of no government means the government isnt significantly influencing the situation being studied - some assumptions are unrealistic - to make successful predictions the theory doesnt require that managers be solely and unwaveringly motivated by the desire to maximize profits at all times; they only require that profits be a sufficiently important consideration that a theory based on profit maximization will lead to explanations and predictions that are substantially correct - cant criticize a theory just because assumptions seem unrealistic - a good theory abstracts in a useful way All theory is an abstraction form reality. If it were not, it would merely duplicate the world in all its complexity and would add little to our understanding of it Predictions A theories predictions are the propositions that can be deduced from it (hypotheses) Models Economic Model: A term used in several related ways- sometimes for an abstraction designed to illustrate some point but not designed to generate testable hypotheses, and sometimes as a synonym for theory sense one: PPB, circular flows of income etc. Like political caricatures- their value is in the insights they provide sense two: demand and supply model; specific numbers are attached to the mathematical relationships embodied in the theory so the predictions are more precise 2.3 Testing Theories A theory is tested by confronting its predictions with evidence

A theory ceases to be useful when it cant predict better than an alternative theory; it is then modified or replaced Observation preceded economic theories; we can now see that theories and evidence interact The scientific approach is central to the study of economics: Empirical observation leads to the construction of theories, theories generate specific predictions, and the predictions are tested by more detailed empirical observation Rejection Versus Confirmation A theory designed to explain observation X will typically generate a prediction about some other observable variables, Y and Z - the predictions of Y and Z can be tested and may be rejected by the data: question the theory Hazardous approach: creates a theory and look for confirming evidence (some confirming evidence can be found for everything) Statistical Analysis if x falls, y will fall- Can be used to test such predictions and to estimate the numerical values of the function that describes the relationship - same data can be used to test whether a relationship exists and to provide an estimate of the magnitude of that relationship Economists must use uncontrolled experiments The variables that interest economists are generally influenced by many forced that vary simultaneously- if they want to test theories about relations among specific variables they must use statistical techniques designed for situation in which other things cannot be held constant - such techniques do exist but their application is not simple

Correlation Versus Causation A change in X causes a change in Y - correlated Positive: X and Y move together Negative: X falls when Y rises Even if we prove that X and Y move together it does not prove causation (may be in opposite direction i.e from Y to X, or Y may be jointly caused by some variable Z Most economic predictions involve causality. Economists must take care when testing predictions to distinguish between correlation and causality, Correlation can establish that the data are consistent with the theory; establishing the likelihood of causality usually requires advanced statistical techniques 2.4 Economic Data Economists use real-world observations, data typically collected by others There is a division of labour between collecting the data and using it to test theories They save time, but often arent as well informed about the limitations of the data Index Numbers It is easier to compare two paths of units that are measured differently if we focus on relative rather than absolute changes Index Numbers- An average that measures change over time of such variables as the price level and industrial production; conventionally expressed as a percentage relative to a base period, which is assigned the value 100 How to Build an Index Number Take a base period (the absolute value of some variable at one point in time)

- take the absolute value of output in a subsequent year (given year) and divide it by the output in the base year, and then multiply the result by 100.

An index number expressed the value of some series in any given year as a percentage of its value in the base year It allows us to compare relative fluctuations/growth When comparing an index number across non-base years, the percentage change in the index number is not given by the absolute difference in the values of the index number (must still divide and treat it as though its a base year) More Complex Index Numbers The CPI is the most famous- price index of the average price paid by consumers for the typical basket of goods that they buy (average makes it complex) Must be a weighted average where the weight on each price index reflects the relative importance of that goods in the typical consumers basket of goofs and services - slight swing in the higher weighted things will have more effect on CPI than huge swings in lower weighted things (i.e housing and sardines) They allow us to compare the time paths of different variables Graphing Economic Data Cross-Sectional and Time-Series Data Cross-Sectional Data: a set of observations made at the same time across several different units (such as households, firms or countries) Time-Series Data: a set of observations made at successive periods of time - useful in economics because we often want to know how specific economic numbers are changing over time

Scatter Diagrams Scatter Diagram: A graph of statistical observations of paired values of two variables, one measured on the horizontal and the other on the vertical axis, Each point on the coordinate grid represents the values of the variables for a particular unit of observation The data plotted can be either cross-sectional or time-series data 2.5 Graphing Economic Theories Theories are built on assumptions about relationships between variables Functions When one variable X is related to another variable Ym in such a way that to every value of X there is only one possible value of U, we say that Y is a functions of X. (functional relationship) Verbal Statement When income is zero, the person will spend $800 a year and for every extra $1 the person will increase expenditure by 80 cents Schedule Shows the relationship laid out Mathematical Equation C = 800 + 0.8Y Graph Scatterplot showing the relationship More Detail About Functions

To state the expression in general form, detached form the specific numerical example above we use a symbol to express the dependence of one variable on the other C = y(Y) --> C is a function of Y The variable on the left hand side is the dependent variable, since its value depends on the value of the variable on the right hand side The variable on the right hand side is independent, as it can take on any value Functional relationship- a knowledge of the value of the variable within the parentheses on the right hand side allows us to determine a unique value of the variable on the left hand side. Functional Forms The symbol f says that C is a function of Y, but doesnt tell us what the form of the function is. Functional form refers to the specific nature of the relation between the variables in the function The assumptions dont need to be true, but we need a price statement of a particular assumption in each equation The Slope of a Straight Line Slopes show how much of one variable changes as the others change- the amount of change in the variable measured on the vertical axis per unit change in the variable measured on the horizontal axis If we let X stand for whatever variable is measured on the horizontal axis and Y for whatever variable is measured on the vertical axis, the slope of a straight line is ~Y/~X

When E = 0 the amount of remaining pollution is 6. The line thus meets the vertical axis (E = 0) when P equals 6. The slope ~P / ~ E is equal to -0.5, so for every one-unit increase in E, P falls by 0.5 units ---> P = 6 + (0.5)E Non-Linear Functions Much more common than linear Change in pollution isnt linear- tough to remove more pollution when there is little left --> a bit more or less is spent on cleanup = marginal change Diminishing marginal response- payoff diminishes as more is spent on clean up - the amount of pollution reduced per dollar on expenditure gets less and less as the total expenditure rises Increasing Marginal Cost- when firms get near capacity it costs more to produce an extra unit of good To measure the slope of a non-linear line we use the slope of a straight line tangent to that curve at the point that interests us - if we want to know the slope at point Z, we draw a straight line that touches the curve only at point Z (tangent line) The slope of the curve changes as X changes, therefore the marginal response of Y to a change in X depends on the value of X Functions With a Minimum or Maximum Some curves change directions as the independent variable increases Maximum: This happens as firms unit costs rise. The firm may find that extra output will actually cost so much that profits are reduced. - When profits are maximized the slope is zero (because a tangent to the curve at point A is horizontal) and so the marginal response of profits to output is zero

Minimum: when you drive your car at 95 kph the least fuel is used- any faster or slower is inefficient. At point A the slope of the curve is zero (because a tangent to the curve at point A is horizontal) so the marginal response of fuel consumption to speed is zero At either a minimum or a maximum of a function, the slope of the curve is zero. Therefore, at the minimum or maximum, the marginal response of Y to a change in X is zero

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