This is an appropriate point at which to return to the definition of economics in Introduction to key ideas that we borrowed from Nobel Laureate Christopher Sims: economics is a set of ideas and methods for the betterment of society.
If economics is concerned about the betterment of society, clearly there are ethical as well as efficiency considerations at play. And given the philosophical differences among scientists (including economists), can we define an approach to economics that is shared by most of the economics profession? Most economists would answer that the profession shares a set of beliefs, and that differences refer to the extent to which one consideration may collide with another.
First of all we believe that markets are critical because they facilitate exchange and therefore encourage efficiency. Before the arrival of Man Friday, Robinson Crusoe had to hunt, cook, make fire, and sustain shelter. The arrival of Man Friday enabled Crusoe to specialize in the tasks where he was relatively more productive. More generally, trade creates benefits for the trading parties. For example, Canada has not the appropriate climate for growing coffee beans, and Colombia has not the terrain for wheat. If Canada had to be self-sufficient, we might have to grow coffee beans in green-houses—a costly proposition. But with trade we can simply exchange some of our wheat for Colombian coffee. Similar benefits arise for the Colombians.
A frequent complaint against globalization is that it does not benefit the poor. For example, workers in the Philippines may earn only a few dollars per day manufacturing clothing for Western markets. What these voices are really trying to say is that, in their opinion, most of the gains from trade go to the Western consumers, and a lesser part to the Asian worker.
A corollary of the centrality of markets is that incentives matter. If the price of business class seats on your favourite airline is reduced, you may consider upgrading. Economists believe strongly that the price mechanism influences behaviour, and therefore favour the use of price incentives in the marketplace and public policy more generally. Environmental economists, for example, frequently advocate the use of tradable pollution permits—a type of permission slip that can be traded (at a price) between users, or carbon taxes on the emission of greenhouse gases such as carbon dioxide. We will develop such ideas in Microeconomics Welfare economics and externalities more fully.
In saying that economists believe in incentives, we are not proposing that human beings are purely mercenary. People have many motivations: a sense of public duty, kindness, noblesse oblige, etc. Acting out of a sense of self-interest does not imply that people are morally empty or have no sense of altruism. It is just recognition of one important motivating factor in an individual’s life.
Whether conservative or liberal, economists believe universally in the importance of the rule of law, and a set of legal institutions that govern contracts. If goods and services are to be supplied in a market economy, the suppliers must be guaranteed that they will be remunerated. And this requires a developed legal structure with penalties imposed on individuals or groups who violate contracts. Markets alone will not function efficiently.
The development of markets in less developed economies was viewed as essential by many development economists in the nineteen eighties. The focus on ‘freeing up’ productive resources from the hand of the state was a central idea in what became known as the ‘Washington Consensus’. This emphasis represented a turning point in development philosophy – away from believing in the efficacy of the mega project, protectionism and state-led development. While the latter approach rarely produced the desired result on account of the missing incentives, the Washington Consensus did not produce the hoped-for results either. This was because the supposed ‘free markets’ were not always accompanied by property rights, or enforceable contracts – markets and contracts do not work well in a legal vacuum. Oxford economist Marcel Fafchamps has described these supposed ‘free markets’ as ‘flea markets’.
Not surprisingly, economists have found a high correlation between economic growth and national wealth on the one hand and the rule of law on the other. The consequence on the world stage is fascinating: numerous ‘economic’ development projects now focus upon training jurists, police officers and bureaucrats in the rule of law!
Finally economists believe in the importance of government policy. Governments can solve a number of problems that arise in market economies that cannot be addressed by the private market place. For example, governments can best address the potential abuses of monopoly power. Monopoly power, as we shall see in Microeconomics Monopoly, not only has equity impacts it may also reduce economic efficiency. Governments are best positioned to deal with what economists term externalities – the impact of economic activity on sectors of the economy that re not directly involved in the activity under consideration. A good example is environmental policy. Governments may also wish to impose standards on products – consumers might not know if a bicycle helmet is effective unless safety standards are put in place.
In summary, governments have a variety of roles to play in the economy. These roles apply not only to making the economy a more equitable place (which governments achieve by their tax and redistribution policies), governments can also make the marketplace more efficient.
KEY TERMS
Variables: measures that can take on different sizes.
Data: recorded values of variables.
Time series data: a set of measurements made sequentially at different points in time.
High (low) frequency data series have short (long) intervals between observations.
Cross-section data: values for different variables recorded at a point in time.
Longitudinal data follow the same units of observation through time.
Index number: value for a variable, or an average of a set of variables, expressed relative to a given base value. 
Percentage change 
Consumer price index: the average price level for consumer goods and services.
Inflation rate: the annual percentage increase in the consumer price index.
Deflation rate: the annual percentage decrease in the consumer price index.
Real price index: a nominal price index divided by the consumer price index, scaled by 100.
Nominal price index: the current dollar price of a good or service.
Nominal earnings: earnings measured in current dollars.
Real earnings: earnings measure in constant dollars to adjust for changes in the general price level.
Scatter diagram plots pairs of values simultaneously observed for two variables.
Econometrics is the science of examining and quantifying relationships between economic variables.
Regression line represents the average relationship between two variables in a scatter diagram.
Positive economics studies objective or scientific explanations of how the economy functions.
Normative economics offers recommendations that incorporate value judgments.
Economic equity is concerned with the distribution of well-being among members of the economy.
EXERCISES
- An examination of a country’s recent international trade flows yields the data in the table below.
Year National Income ($b) Imports ($b) 2011 1,500 550 2012 1,575 573 2013 1,701 610 2014 1,531 560 2015 1,638 591 - Based on an examination of these data do you think the national income and imports are not related, positively related, or negatively related?
- Draw a simple two dimensional line diagram to illustrate your view of the import/income relationship. Measure income on the horizontal axis and imports on the vertical axis.
- The average price of a medium coffee at Wakeup Coffee Shop in each of the past ten years is given in the table below.
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 $1.05 $1.10 $1.14 $1.20 $1.25 $1.25 $1.33 $1.35 $1.45 $1.49 - Construct an annual ‘coffee price index’ for the 2005 time period using 2006 as the base year.
- Based on your price index, what was the percentage change in the price of a medium coffee from 2006 to 2013?
- The table below gives unemployment rates for big cities and the rest of the country. Twothirds of the population lives in the big cities,
and one-third in other areas. Construct a national unemployment index, using the year 2000 as the base.
Unemployment (%)YearBig CitiesOther Area2007572008710200989201010122011911
- The prices in the following table below are for three components in a typical consumer’s budget: transportation, rent, and food. You must
construct an aggregate price index based on these three components on the assumption that rent accounts for 55 percent of the weight in this index, food for 35 percent, and transport for 10
percent. You should start by computing an index for each component, using year 1 as the base period.
Year 1 Year2 Year3 Year4 Year5 Transport $ 70 70 75 75 75 Rent $ 1000 1000 1100 1120 1150 Food $ 600 620 610 640 660 - The price of carrots per kilogram is given in the table below for several years, as is the corresponding CPI.
2000 20002 2004 2006 2008 2010 Nominal Carrot Price $ 2.60 2.90 3.30 3.30 3.10 3.00 CPI 110 112 115 117 120 124 - Compute a nominal price index for carrots using 2000 as the base period.
- Re-compute the CPI using 2000 as the base year.
- Construct a real price index for carrots.
- The following table shows hypothetical consumption spending by households and income of households in billions of dollars.
Year Income Consumption 2006 476 434 2007 482 447 2008 495 454 2009 505 471 2010 525 489 2011 539 509 2012 550 530 2013 567 548 - Plot the scatter diagram with consumption on the vertical axis and income on the horizontal axis.
- Fit a line through these points.
- Does the line indicate that these two variables are related to each other?
- How would you describe the causal relationship between income and consumption?
- Using the data from the preceding question, compute the percentage change in consumption and the percentage change in income for each pair of adjoining years between 2006 and 2013.
- You are told that the relationship between two variables, X and Y, has the form Y = 10+2X. By trying different values for X you can obtain the corresponding predicted value for Y (e.g., if X =3, then Y =10+2X3=16). For values of X between 0 and 12, compute the matching value of Y and plot the scatter diagram.
- Perform the same exercise as in the preceding question, but use the formula Y = 10X0.5X. What do you notice about the slope of the relationship?
- For the data below, plot a scatter diagram with variable Y on the vertical axis and variable X on the horizontal axis.
Y 40 33 29 56 81 19 20 X 5 7 9 3 1 11 10 - Is the relationship between the variables positive or negative?
- Do you think that a linear or non-linear line better describes the relationship?
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