Chapter

Two
Observing
and
Explaining
the Economy

Economics, an Overview
Now that we know what economics is from
Chapter 1, we need to understand the
usefulness of economics by
understanding the economic way of
thinking.

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Economics, an Overview (contd)

Economics entails:
1) accurately describing economic events
2) explaining why the events occur
3) predicting under what circumstances
such events might take place in the
future
4) recommending appropriate courses of
action
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Economics, an Overview (contd)

Economic challenges
and opportunities

Improved present
and future outcomes

Economic knowledge
Description
Explanation
Prediction
Recommendation
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Economics, an Overview (contd)

To understand the economic way of
thinking in more detail, we focus on two
observations or questions on healthcare
and the US economy.

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Health-Care and the Economy

Observation 1: Health-care spending has
increased faster than the rest of the U.S.
economy since 1990.
Question 1: Why did health-care spending
increase faster than the rest of the US economy?
To understand how we ended up with the
observation and answer the question, we need a
measure of health care spending and a measure
of the overall size of the U.S. economy.

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Health-Care and the Economy (contd)

Gross Domestic Product (GDP): a
measure of the value of all goods (cars,
trucks, houses, TVs, etc.) and services
(education, rock concerts, health-care,
etc.) newly produced in an economy
during a specified period of time.
How large is the US GDP? See Table 2.1
(column (1)) and Figure 2.1.
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Health-Care and the Economy (contd)

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Health-Care and the Economy (contd)

Figure 2.1

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Health-Care and the Economy (contd)

Health-care spending includes
payments for hospital services, lab tests,
nursing homes, visits to doctors and
dentists, prescription and non-prescription
drugs, hearing aids, eyeglasses, and
more.
How much have we been spending on
health-care? See column (2) on Table 2.1.
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Health-Care and the Economy (contd)

One way to assess health-care spending
compared to the spending of all goods and
services is to look at health spending as a share
of GDP, or:
Health-care spending
as
a share of GDP

Health-care spending
as
a share of GDP, 2000

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Health-Care and the Economy (contd)

From column (3) in Table 2.1, the share of
health-care spending to GDP has
gradually increased from 9.6 percent in
1990 to 11.9 percent in 2004.
Figure 2.3 shows the share of health-care
spending to GDP from 1990-2004.

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Health-Care and the Economy (contd)

Figure 2.3

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Health-Care and the Economy (contd)

Observation 2: The price of health care
has risen compared with the price of other
goods in the economy.
Relative Price the price of a particular
good compared to the price of other
things.

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Health-Care and the Economy (contd)

The relative price of health-care is shown in Table 2.2.

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Health-Care and
the Economy (contd)

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Health-Care and the Economy (contd)

Figure 2.2

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Correlation Between
Economic Variables
Economic Variables any economic
measure that can vary over a range of
values.
Examples:
GDP,
health care spending,
health-care spending share of GDP,
relative price of health-care, etc.
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Correlation Between
Economic Variables (contd)
Correlation Two economic variables are
correlated if they tend to move up or down
in the same direction.
positive correlation - both variables move in
the same direction (i.e., one goes up when
the other also goes up).
negative correlation - both variables move in
the opposite directions (i.e., one goes up
when the other goes down).
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Correlation Between
Economic Variables (contd)
Correlation vs. Causation
Just because variables are correlated
(they move together) does not imply that
one variable caused the other.

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Correlation: Storks Delivering Babies

In a recent issue of the Teaching Statistics (Vol. 22-2,
Summer 2002), Robert Matthews shows that there is a
high correlation between stork populations and the human
birth rates across Europe.
Given the finding described above, can we use this as
supporting evidence that storks deliver babies, as
described in Hans Christian Andersens story The Stork
(1938)?

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The Lack of Controlled Experiments

in Economics
In other fields, such as medicine, biology
and psychology, controlled experiments
are conducted to determine causation
between variables. Unfortunately for
economics, such controlled experiments
are not possible simply because we
cannot redo policy over and see what the
effects could have been.
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The Lack of Controlled Experiments

in Economics (contd)
There is a growing trend in economics
where controlled laboratory experiments
are conducted. This area in economics is
called Experimental Economics.
Experimental Economics - A branch of
economics that uses laboratory
experiments to analyze economic
behavior.
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The Circular Flow Diagram

Circular flow diagram: a diagram that
illustrates the flow of funds and goods and
services through the economy as people
(households and firms) buy and sell in
markets.

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The Circular Flow Diagram

in Health Care

In the circular flow diagram, what people

buy and sell are classified into three
groups:
1) Goods and services such as flu shots,
gauzes and bandages, etc.
2) Labor such as doctors services, nursing
services, etc.
3) Capital such as x-ray machines, hospital
beds, etc.

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The Circular Flow Diagram

in Health Care (contd)

Three markets in a circular flow diagram

in health-care:
1) the goods and services market
2) the labor market
3) the capital market

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The Circular Flow Diagram

in Health Care (contd)
Two Major Players
1) Households who buy goods and
services and sell their labor services to
firms in the labor market. Households
also supply capital to firms in the capital
market.

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The Circular Flow Diagram

in Health Care (contd)
2) Firms sell goods and services in the
goods market and buy the labor services
that households sell in the labor market.
Firms also demand (or borrow with
interest) capital from households in the
capital market.

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The Circular Flow Diagram

in Health Care (contd)
Figure 2.6

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Economic Models
Economic Model
An explanation (or representation) of how
the economy or part of the economy
works.
Abstractions or simplifications of the real
world.

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Economic Models (contd)

Positively Related: a situation in which an
increase in one variable is associated with an
increase in another variable (a.k.a. directly
related).
Negatively Related: a situation in which an
increase in one variable is associated with a
decrease in another variable (a.k.a. inversely
related).

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Economic Models (contd)

Constants: a situation in which an
increase in one variable is not associated
with any change in another variable.
Figure 2.7 and Figure 2.8 graphically
illustrate positively related and negatively
related variables.

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Economic Models (contd)

Figures 2.7 and 2.8

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Economic Models: an Example

A Model with Two Variables:

Figure 2.9 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.
2.
3.
4.

with words,
with a numerical value,
with a graph, and
with algebra or an equation.

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Economic Models: an Example (contd)

Figure 2.9

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Microeconomic vs.
Macroeconomic 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.
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Impacts of Economics on Public Policy

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:
Explaining why health care spending slowed
down in the mid-1990s.
Explaining why governments increase or
decrease tax rates.
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Impacts of Economics on
Public Policy (contd)
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:
Recommend policies that will prevent the rise of
healthcare expenditures in the future.
Recommend that the government increase tax rates
to prevent a budget deficit.

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Positive or Normative Economics?

Are the statements below positive or normative
statements?
Countries with high population growth rates usually
have low income per capita.
Countries should have population control as part of its
growth strategy.
The best policy to discourage population growth is to
tax families with more than 4 children.
A $1000 tax per child levied on families with more
than 4 children in the US could generate revenues of
more than $40 million dollars.
Answer: Positive, Normative, Normative, Positive.

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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 more than just about the stock
market.
3) The study of economics is an intellectually
fascinating adventure.

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Key Terms and Phrases

Gross domestic product (GDP)

Relative price
Economic variable
Circular flow diagram
Economic model
Positively and negatively related
Microeconomics and macroeconomics
Positive economics
Normative economics

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