CHAPTER 2

Tools 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