Chapter 2

Economic Theories, Data, and Graphs

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2.1 Positive and Normative Advice

Normative statements depend on value judgments and opinions -- cannot be settled by recourse to facts.

Positive statements do not involve value judgments. They are statements about what is, was, or will be.

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Disagreements Among Economists

Economists often disagree with each other in public discussions -- often because of poor communication. Disagreement also stems from economists failure to acknowledge the full state of their ignorance. Perhaps the biggest source of public disagreement is based on the positive/normative distinction. Economists must differentiate normative proffered advice from positive facts.
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2.2 Economic Theories

Theories
A theory consists of: a set of definitions about variables;
a set of assumptions; a set of predictions (or hypotheses).

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Models
The term model is used in several different ways:

as a synonym for a theory;

applied to a specific quantitative formulation of a theory; as a specific application of a general theory; and as an illustrative abstraction which helps to organize our thoughts about a particular issue.
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2.3 Testing Theories

Rejection Versus Confirmation
A hypothesis can be tested and may be rejected by the data. This rejection brings the value of the theory into question.

An alternative is to search for confirming evidence for a theory.

But no matter how unlikely the theory is, some confirming evidence can generally be found.
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Statistical Analysis
Statistical analysis is used to test a hypothesis such as if X increases, then Y will also increase. Economists are compelled to use millions of uncontrolled experiments going on every day in the economy. These activities can be observed and recorded continuously, producing a mass of data. The analysis of such data requires the use of appropriate -and often quite complex -- statistical techniques.
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Correlation Versus Causation

Positive correlation means only that X and Y move together. Negative correlation means that X and Y move in opposite directions. But X and Y may not be causally related. Or they may be related in the opposite way to what is expected -- reverse causality.

Most economic predictions attempt to establish causality. Statistical tests often attempt to distinguish between correlation and causality.
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Definitions and assumptions about behaviour A process of logical deduction Predictions (often called hypotheses) A process of empirical observation

The Interaction Between Theory and Empirical Observation

The existing theory is amended or a new theory is proposed in light of the new acquired empirical knowledge

Conclusion: The theory does or does not provide a better explanation of the facts than alternative competing theories If the theory passes the test, no consequent action is necessary, but it should be subjected to continued scrutiny

If the theory is in conflict with the evidence

either

or

The theory is discarded in favour of a superior competing theory

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2.4 Economic Data

Index Numbers
Used to compare changes in some variable relative to some base period.

Value of index in given period

absolute value in given period

absolute value in base period

X 100

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Index Numbers: An Example

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Graphing Economic Data

Economic variables usually come in two basic forms:

Cross-sectional data

Time-series data
A scatter diagram is a useful and common way of looking at the relationship between two variables.

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A Cross-Sectional Graph

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2.5 Graphing Economic Theories

A functional relation can be expressed:
in a verbal statement in a numerical schedule (a table) in a mathematical equation in a graph

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Functions
Consider a relationship between a households annual income, Y, and its total consumption, C.

We use a symbol to express the dependence of one variable on another. C = f(Y)

C is a function of Y -- we also say the amount of consumption expenditure depends upon the households income.

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Graphing Functional Relations

The relationship between two variables may be positive or negative.

If the graphs of these relationships are straight lines, the variables are linearly related to each other.

Otherwise, variables are said to be non-linearly related.

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Four Linear Relationships

Let X be the variable measured on the horizontal axis and Y the variable measured on the vertical axis.
The slope of a straight line is then Y/X.
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Four Non-Linear Relationships

A maximum

A minimum

In general, non-linear relations are much more common than linear ones.
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A Final Word
We have discussed why economists use theory and how they build economic models. We have discussed how there is a continual back-andforth process between empirical testing of predictions and refining the theoretical models.

We have explored the many ways data can be displayed in graphs and how economists use graphs to illustrate their theories.

Copyright 2011 Pearson Canada Inc.

Copyright 2011 Pearson Canada Inc.