ECON 208 Chapter Notes - Chapter 2: Equation, Profit Maximization, Scatter Plot

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Published on 16 Apr 2013
School
McGill University
Department
Economics (Arts)
Course
ECON 208
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of 5
Chapter 2 Economic Theories, Data, and Graphs
2.1 Positive and Normative Advice
Normative Statement: A statement about what ought to be as opposed to what actually is
o govt ought to try harder to reduce unemployment
o making judgements about the value of the various things that the govt could do with its
limited resources and about the costs and benefits of reducing unemployment
o depend on value judgements and cant be evaluated solely by a recourse to facts
o inclusion of a value judgement in a statement doesn’t necessarily make the statement
normative
Positive Statement: A statement about what actually is (was or will be), as opposed to what
ought to be
o if the govt wants to reduce unemployment, reducing unemployment insurance benefits
is an effective way of doing so
o doesn’t rely on judgement about the value of reducing unemployment = if this is what
you want to do, this is how you do it
o don’t involve value judgements, statements about matters of fact and so disagreements
about them are appropriately dealt with by an appeal to evidence
o don’t need to be true
Distinguishing what is actually true from what we would like to be true requires distinguishing
between positive and normative statements
2 tests:
o Is the statement only about actual or alleged facts -> positive
o Are value judgements necessary to assess the truth of the statement ->normative
Disagreements Among Economists
Due to
o Poor communication: don’t define their terms or point of reference clearly
o Failure to acknowledge the full state of their ignorance (when evidence is far from
conclusive)
o Positive/normative distinction: different values for each economist
Agreement on aspects of how the economy works and what happens when govts intervene to
alter its workings ( and on mostly positive rather than normative statements)
2.2 Economic Theories
Theories
Constructed to explain things; theories of demand and supply, distinguished by their variables,
assumptions, and predictions
Variables
Variable: any well defined item, such as the price or the quantity of a commodity, that can take
on various specific values
Endogenous variable: a variable that is explained within a theory. Sometimes called an induced
variable or a dependent variable
o Price of eggs and quantity of eggs
Exogenous Variable: a variable that is determined outside the theory. (influences the
endogenous variables) Sometimes called an autonomous variable or an independent variable.
o The state of weather (affects the # of eggs consumers demand or producers supply)
Assumptions
Concern
o Motives: assumes everyone pursues his or her self-interest when making economic
decisions; assumed to strive to maximize their utility and firms are assumed to try to
maximize their profits and know how to get it
o Direction of causation: assume that there’s a causal link when one variable is related to
another ( producers supply more eggs because price of chicken feed fell, not vice versa)
o Conditions of application: to specify the conditions under which a theory is meant to
hold. Firms want profit maximization assumption, but sometimes firms want to protect
the environment, but profits are still a sufficiently important consideration.
All theory is an abstraction from reality. If it weren’t, it would merely duplicate the world in all
its complexity and would add little to our understanding of it.
Predictions
The propositions that can be deducted from it: hypothesis
Models
Economic Model: a term used in several related ways:
o sometimes for an abstraction designed to illustrate some point (to help us organize our
thinking and gain crucial insights) but not designed to generate testable hypotheses
(because lacks the detail or precision necessary) (ex: circular flow of income and
expenditure and the PPB)
o sometimes as a synonym for theory, or to refer to a specific quantitative version of a
theory-> more precise predictions
2.3 Testing Theories
theory tested by confronting its predictions with evidence
a theory ceases to be useful when it cannot predict better than an alternative theory, and when
it consistently fails to predict better than an available alternative, it’s modified/replaced
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
P.30 figure - Theory and observation are in continuous interaction: assumptions of a theory and
the definitions of relevant terms lead theorists to deduce by logical analysis everything that is
implied by the assumptions, which are the predictions or the hypotheses of the theory, which is
tested by confronting its predictions with evidence. If the theory is in conflict with facts, its
amended to make it consistent with those facts, improving the theory, or will be replaced by a
superior theory. And process restarts
Rejection Vs. Confirmation
Important to create a theory that will explain some observation X that will typically generate a
prediction about some other observable variables, Y and Z, which can be tested and may be
rejected by the data, in which case the value of the theory is brought into question
Alternative: create a theory and then look for confirming evidence. The problem here is tho that
some confirming evidence can be found for any theory even though systematic, objective
evidence is failed to be discovered
Statistical Analysis
Used to test predictions (like if X increases, Y increases; or, if X falls, Z rises) and to estimate the
numerical values of the function that describes the relationship
Economists must use uncontrolled “experiments” in the everyday marketplace
Mass of data from: households deciding what to purchase given changing prices and incomes,
firms deciding what to produce and how, govts involved thru taxes, subsidies, and regulations
Variables economists interested in (level of employment, price of DVD) influenced by many
forces that vary simultaneously
If economists are to test their theories about relations among specific variables, they must use
statistical techniques where other things cannot be held constant
Correlation Vs. Causation
Test if X ^ Y^; causal because change in X, causes change in Y; positively correlated when X^,
Y^ but doesn’t mean causal relationship because may be from Y to X or third variable Z
^education^income. Reverse causality: income causes education
Most economic predictions involve causality. Economics 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 to test their theories using data collected by others
(govt statisticians)
Division of labour
o Collecting data
o Using it to test theories
Don’t waste a lot of time collecting data used, but not as well informed about the limitations of
the data collected by others that they use
Index numbers
Index Number: 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
Comparing the time paths of 2 data series us hard when absolute numbers are used
How to build an index number
Take the value of the variable at some point in time as the “base” to which the values in other
periods will be compared = base period

Document Summary

Distinguishing what is actually true from what we would like to be true requires distinguishing between positive and normative statements. Is the statement only about actual or alleged facts -> positive: are value judgements necessary to assess the truth of the statement ->normative. Due to: poor communication: don"t define their terms or point of reference clearly, failure to acknowledge the full state of their ignorance (when evidence is far from conclusive, positive/normative distinction: different values for each economist. Agreement on aspects of how the economy works and what happens when govts intervene to alter its workings ( and on mostly positive rather than normative statements) Constructed to explain things; theories of demand and supply, distinguished by their variables, assumptions, and predictions. Variable: any well defined item, such as the price or the quantity of a commodity, that can take on various specific values. Endogenous variable: a variable that is explained within a theory.