Web Appendix 1.

1
Some Techniques of Economic Analysis
Tools of the economist’s trade

As you will see if you flick through the pages of the book, there are many diagrams and
tables and several equations. But this does not mean that there are many mathematical
techniques that you will have to master in order to study this book. In fact there are relatively
few techniques, but ones which we use many times in many different contexts. You will find
that if you are new to the subject, you will very quickly become familiar with these
techniques.

Diagrams as pictures
On many occasions, we use diagrams simply to provide a picture of a relationship. Just as a
photograph in a newspaper can often depict an event much more vividly than any verbal
account, so too a diagram in economics can often picture a relationship with a vividness and
clarity that could never be achieved by words alone.
For example, we may observe that as people’s incomes rise, they spend a lot more on
entertainment and only a little more on food. We can picture this relationship very nicely by
the use of a simple graph.

In Figure 1, an individual’s income is measured along the horizontal axis and

expenditure on food and entertainment is measured up the vertical axis. There are just two
lines on this diagram: one showing how the expenditure on entertainment rises as income
rises, the other how the expenditure on food rises as income rises. We could use a diagram
like this to plot actual data, but if we simply use it as a sketch – as a picture – we do not need
to put figures on the two axes. We are simply showing the relative shapes of the two curves.
These shapes tell us that the person’s expenditure on entertainment rises more quickly than
that on food, and that above a certain level of income the expenditure on entertainment
becomes greater than that on food. If you tried to describe in words all the information that
this sketch graph depicts, they would fill several lines.

Question
What else is the diagram telling us?

Representing real-life statistics

In many cases, we will want to depict real-world data. We may want to show, for example,
how unemployment has changed over the years in a particular country, or how income is
distributed between different groups in the population. In the first we will need to look at
time-series data. In the second we will look at cross-section data.
Table 1 Unemployment Rate, % of Workforce, 1990–2017

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
7.1 8.9 9.9 10.4 9.5 8.6 8.1 6.9 6.2 6.0 5.4 5.1 5.2 5.0

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
4.8 4.8 5.4 5.3 5.7 7.6 7.9 8.1 8.0 7.6 6.2 5.4 4.9 4.4
Source: Time-series data, series LF2Q (National Statistics)

Time-series data
Table 1 shows the rate of UK unemployment between 1991 and Time-series data
2014. A table like this is a common way of representing time-series Information
data. It has the advantage of giving the precise figures, and is thus a depicting how a
useful reference if we want to test any theory and see if it predicts variable (e.g. the
accurately. price of eggs)
Notice that in this particular table the figures are given changes over time.
annually. Depending on the period of time over which we want to
see the movement of a variable, it may be more appropriate to use a different interval of time.
For example, if we wanted to see how unemployment had changed over the past 5 years, we
might use quarterly or monthly figures.
Time-series data can also be shown graphically. In fact the data from a table can be
plotted directly on to a graph. Figure 2 plots the data from Table 1. Each dot on the graph
corresponds to one figure from the table. The dots are then joined up to form a single line.
Thus if you wanted to find the level of unemployment at any time between 1991 and 2012,
you would simply find the appropriate date on the horizontal axis, read vertically upward to
the line you have drawn, then read across to find the rate of unemployment.
Although a graph like this cannot give you quite such an accurate measurement of
each point as a table does, it gives a much more obvious picture of how the figures have
moved over time and whether the changes are getting bigger (the curve getting steeper) or
smaller (the curve getting shallower). We can also read off what the likely figure would be
for some point between two observations.

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All developed countries publish time-series data for the major macroeconomic variables such
as national income, prices, employment and unemployment, interest rates, and imports and
exports. In the UK, the figures are published by the Office for National Statistics.
Microeconomic data on the distribution of income, the performance of particular
industries, the distribution of household expenditure and so on also appear in the official
government statistics. Firms, consumers’ associations, charities and other organisations also
publish microeconomic statistics.
There are also several sources of data freely available on the Internet. Section B of the
Web Appendix at the end of the book gives a number of websites containing data sets. These
websites can be accessed directly from the Hotlinks section of this book’s own website
(www.pearsoned.co.uk/sloman).

Cross-section data
Cross-section data show different observations made at the same
point in time. For example, they could show the quantities of food Cross-section data
and clothing purchased at various levels of household income, or Information showing
the costs to a firm or industry of producing various quantities of a how a variable (e.g.
the consumption of
product.
eggs) differs between
Table 2 gives an example of cross-section data. It shows different groups or
the distribution of household income in the UK before the different individuals
deduction of taxes and the addition of benefits. It puts households at a given time.
into five equal-sized groups (or ‘quintiles’) according to their
income. Thus the poorest 20 per cent of households are in one group, the next poorest 20 per
cent are in the next and so on. Looking just at the 2016/17 figures, they show that the poorest
20 per cent earned just 3 per cent of total household incomes, whereas the richest 20 per cent
earned 50 per cent.

3
Table 2 Income before taxes and benefits (original income)
1977 1987 1997/8 2007/8 2010/11 2013/14 2016/17
Lowest 20% 3 2 2 3 3 3 4
Next 20% 10 7 7 7 7 8 8
Middle 20% 18 16 14 14 14 15 15
Next 20% 26 26 26 25 24 24 24
Highest
42 50 51 51 51 50 49
20%
All 100 100 100 100 100 100 100
Note: Columns do not necessarily sum to 100 because of rounding of decimals to nearest whole number
Source: Effects of Taxes and Benefits on Household Income (National Statistics, 2018)

Cross-section data like these are often represented in the form of a chart. Figure 3(a)
shows the data for 1977 and 2016/17 as a bar chart, and Figure 3(b) as a pie chart.

4
 It is possible to represent cross-section data at two or more different points in time,
thereby presenting the figures as a time series. In Figure 3, figures are given for just two time

5
periods. With a more complete time series we could graph the movement of the shares of
each of the five groups over time.

Getting a true picture from the statistics

‘There are lies, damned lies and statistics.’ This well-known saying highlights the abuse of
statistics – abuse, unfortunately, that is commonplace. Have you noticed how politicians
always seem to be able to produce statistics to ‘prove’ that they are right and that their
opponents are wrong? And it’s not just politicians. Newspapers frequently present statistics in
the most ‘newsworthy’ way; companies try to show their performance in the most flattering
way; pressure groups fighting for a cause (such as the protection of the environment) again
present statistics in the way that best supports their case.
It is not difficult to present data in such a way as to give a grossly distorted picture of
a situation. Let us have a look at some of the most common examples.

Selective use of data

This occurs where people select only those statistics that support their case and ignore those
that do not. For example, assume that unemployment has risen but inflation has fallen. The
government highlights the inflation statistics to show how successful its policies have been.
The opposition parties do the opposite: they concentrate on the unemployment statistics to
demonstrate the failure of government policy.

Graphical presentation of data

Table 3 Annual purchases per person of a particular foodstuff

Consumer income (£ per year) 0 5000 10 000 15 000 20 000

Foodstuff purchased per person (kg per year) 10 25 45 70 100

Two graphs may present exactly the same data and yet convey a quite different
impression about them. Figure 4 shows how the amount that people buy of a particular
foodstuff varies with their income. It is based on the information in Table 3.

Figure 4 Graphs depicting the same data

Diagram (a) shows exactly the same information as diagram (b), and yet at a glance it would
seem from diagram (a) that people buy a lot more as their incomes rise, whereas from

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diagram (b) it would seem that people only buy a little more. Clearly the choice of scales for
the two axes will determine the shape of the graph.

Questions
1. If the vertical scale for Figure 2 (the unemployment rate) ran from 0 to 20 per cent,
how would this alter your impression of the degree to which unemployment had
changed?
2. What are the advantages and disadvantages of presenting data graphically with the
axes starting from zero?

Use of absolute or proportionate values

‘People are paying more taxes now than they did when the government came to office,’
claims the opposition.
‘Since coming into office we have cut taxes substantially,’ claims the government.
So who is right? Do we pay more or less tax? Quite possibly they are both right. If incomes
have risen, we probably do pay more tax in total. After all, the more we earn, the greater the
sum of money we will be paying in income tax; and the more we spend, the more we will be
paying out in VAT. Thus in absolute terms we probably are paying more in taxes.
On the other hand, if the government has cut the rates of tax, we may be paying a
smaller proportion of our income. In other words, a smaller proportion of a larger total can
still represent an absolute increase.

Ignoring questions of distribution

‘The average person has become better off under this government,’ claims a minister.
‘Poverty has increased steeply under this government,’ claims the opposition. ‘More than half
the population are worse off now than when the government came to office.’
Surely, this time one of the claims must be wrong? But
again, both could be right. The term ‘average’ normally Mean (or arithmetic mean)
refers to the mean. The mean income is simply the total The sum of the values of
national income divided by the number in the population: each of the members of the
i.e. income per head. If this is what is meant by the sample divided by the total
average, then the government may well be correct. Income number in the sample.
per head may have risen.
If, however, a relatively few people have got a lot
Median
richer and the rest have got a little poorer, the median
The value of the middle
income will have fallen. The median income is the income
member of the sample.
of the middle person. For example, if the population were
50 million, the median income would be the income of the twenty-five millionth richest
person. This person’s income may have fallen.

Real or nominal values

‘Incomes have risen by 5 per cent this last year’, claims the government.
‘The standard of living has fallen’, claims the opposition.
One of the most common abuses of statistics is
Nominal values
deliberately switching between real and nominal figures,
Money values measured at
depending on what message you want to give your
current prices.

7
audience. Nominal figures are the simple monetary values at the prices ruling at the time. For
example, if you earned a wage of £100 per week last year and are earning £105 per week this
year, then in nominal terms your wage has risen by 5 per cent.
But what if prices have risen by 8 per cent? Your 5 Real values
per cent increase in wages will in fact buy you 3 per cent less Money values corrected
goods. Your real wages have gone down by 3 per cent. In for inflation.
other words, to show how much better or worse off a person
or nation is, the nominal figure must be corrected for inflation. Thus:
Real growth = Nominal growth – Inflation

Questions
1. If a bank paid its depositors 3 per cent interest and inflation was 5 per cent, what would
be the real rate of interest?

2. Has your real income gone up or down this last year?

The time chosen for comparison

‘Between 1982 and 1990, Britain’s real growth rate averaged 3.5 per cent per year’, boasted
the Conservative government of the time.
‘Between 1979 and 1993, Britain could only manage a real growth rate of 1.6 per cent per
year’, chided the opposition.
Again both were correct, but they had chosen either to include or to ignore the periods from
1979 to 1982 and from 1990 to 1993 when the real growth rate was negative.

Index numbers
Table 4 UK manufacturing output (2016 = 100)

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
97.0 92.2 92.1 93.4 97.8 99.3 100.1 101.8 102.2 102.7

2000 2001 2001 2003 2004 2005 2006 2007 2008 2009
105.0 103.4 101.2 100.7 102.5 102.5 104.7 105.3 102.4 92.8

2010 2011 2012 2013 2014 2015 2016 2017

97.1 99.2 97.8 96.8 99.6 99.6 100.0 102.5

Source: UK Manufacturing Index, series L2KX (National Statistics)

Time-series data are often expressed in terms of index Index number

numbers. Consider the data in Table 4. It shows index The value of a variable
numbers of manufacturing output in the UK from 1990 to expressed as 100 plus or
2017. minus its percentage
One year is selected as the base year and this is given deviation from a base year.
the value of 100. In our example this is 2016. The output for
Base year
other years is then shown by their percentage variation from
The year whose index
100. For 1992 the index number is 92.1. This means that
number is set at 100.

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manufacturing output was 7.9 per cent lower in 1990 than in 2016. The index number for
2007 is 105.3. This means that manufacturing output was 5.3 per cent higher in 2007 than in
2016.

Question
Does this mean that the value of manufacturing output in 2007 was 5.3 per cent higher in
money terms?

The use of index numbers allows us to see clearly any upward and downward movements and
to make an easy comparison of one year with another. For example, Table 4 shows quite
clearly that manufacturing output fell from 2007 to 2009 and still had not regained its 2007
level by 2017.

Using index numbers to measure percentage changes

To find the annual percentage growth rate in any one year we simply look at the percentage
change in the index from the previous year. To work this out we use the following formula:

( )
I t −I t−1
I t−1
×10 0

where It is the index in the year in question and It–1 is the index in the previous year. Thus to
find the growth rate in manufacturing output from 2009 to 2010 we first see how much the
index has risen (It – It–1). The answer is 97.1 – 92.8 = 4.3. But this does not mean that the
growth rate is 4.3 per cent. According to our formula, the growth rate is equal to:
97.1−92.8 4.3
×100= ×100=4.63 %
92.8 92.8

Question
What was the growth rate in manufacturing output from (a) 1993 to 1994; (b) 2008 to 2009?

The price index

Perhaps the best known of all price indices is the
consumer prices index (CPI). It is an index of the prices Consumer prices index
of goods and services purchased by the average An index of the prices of goods
household. Movements in this index, therefore, show bought by a typical household.
how the cost of living has changed. Annual percentage
increases in the CPI are the commonest definition of the rate of inflation. Thus if the CPI
went up from 100 to 110 over a twelve-month period, we would say that the rate of inflation
was 10 per cent.

Question
If the CPI went up from 150 to 162 over 12 months, what would be the rate of inflation?

The use of weighted averages

Weighted average
The average of several items
where each item is ascribed a
weight according to its
9 importance. The weights must
add up to 1.
The CPI is a weighted average of the prices of many items. The index of manufacturing
output that we looked at previously was also a weighted average, an average of the output of
many individual products.
To illustrate how a weighted average works, consider the case of a weighted average
of the output of just three industries, A, B and C. Let us assume that in the base year (year 1)
the output of A was £7 million, of B £2 million and of C £1 million, giving a total output of
the three industries of £10 million. We now attach weights to the output of each industry to
reflect its proportion of total output. Industry A is given a weight of 0.7 because it produces
seven-tenths of total output. Industry B is given a weight of 0.2 and industry C a weight of
0.1. We then simply multiply each industry’s index by its weight and add up all these figures
to give the overall industry index.

Table 5 Constructing a weighted average index

Year 1 Year 2
Industry Weight Index Index times Index Index times
weight weight
A 0.7 100 70 90 63
B 0.2 100 20 110 22
C 0.1 100 10 130 13
Total 1.0 100 98

The index for each industry in year 1 (the base year) is 100. This means that the
weighted average index is also 100. Table 5 shows what happens to output in year 2. Industry
A’s output falls by 10 per cent, giving it an index of 90 in year 2. Industry B’s output rises by
10 per cent and industry C’s output rises by 30 per cent, giving indices of 110 and 130,
respectively. But as you can see from the table, despite the fact that two of the three
industries have had a rise in output, the total industry index has fallen from 100 to 98. The
reason is that industry A is so much larger than the other two that its decline in output
outweighs their increase.
The consumer prices index is a little more complicated. This is because it is calculated
in two stages. First, products are grouped into categories such as food, clothing and services.
A weighted average index is worked out for each group. Thus the index for food would be the
weighted average of the indices for bread, potatoes, cooking oil, etc. Second, a weight is
attached to each of the groups in order to work out an overall index.

Functional relationships
Throughout economics we examine how one economic variable affects another: how the
purchases of cars are affected by their price; how consumer expenditure is affected by taxes,
or by incomes; how the cost of producing washing machines is affected by the price of steel;
how the rate of unemployment is affected by the level of government expenditure. These
relationships are called functional relationships. We will need to express these relationships
in a precise way, preferably in the form of a table or a graph
or an equation. Functional relationships
The mathematical
Simple linear functions relationships showing how
one variable is affected by
These are relationships which produce a straight line when
one or more others.
plotted on a graph. Let us take an imaginary example of the
relationship between total value added tax receipts in an

10
economy (V ) and the level of consumer expenditure (C). This functional relationship can be
written as:
V = ƒ(C)
This is simply shorthand for saying that VAT receipts are a function of (i.e. depend on) the
level of consumer expenditure.
If we want to know just how much VAT revenue will be at any given level of
consumer expenditure, we will need to spell out this functional relationship. Let us do this in
each of the three ways.

Table 6 A VAT function

Consumer expenditure (£bn per year) VAT receipts (£bn per year)
0 0
10 2
20 4
30 6
40 8
50 10

As a table. Table 6 gives a selection of values of C and the corresponding level of V. It is easy
to read off from the table the level of VAT receipts at one of the levels of consumer
expenditure listed. It is clearly more difficult to work out the level of VAT receipts if
consumer expenditure is £23.4 billion or £47.6 billion.

As a graph. Figure 5 plots the data from Table 6. Each of the dots corresponds to one of the
points in the table. By joining the dots up into a single line we can easily read off the value for
VAT receipts at some level of consumption other than those listed in the table. A graph also
has the advantage of allowing us to see the relationship at a glance.
It is usual to plot the independent variable (i.e. the one that does not depend on the
other) on the horizontal or x-axis, and the dependent variable on the vertical or y-axis. In our
example, VAT receipts depend on consumer expenditure. Thus VAT receipts are the
dependent variable and consumer expenditure is the independent variable.

As an equation. The data in the table can be expressed in the equation:

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 V = 0.2C
This would be the equation if the VAT rate were 20 per cent on all goods and services.
An equation has the major advantage of being precise. We could work out exactly
how much would be paid in VAT at any given level of consumption.
This particular function starts at the origin of the graph (i.e. the bottom left-hand
corner). This means that when the value of the independent variable is zero, so too is the
value of the dependent variable.
When a graph does not pass through the origin its equation will have the form:
y = a + bx
where y stands for the dependent variable and x for the independent variable, and a and b will
have numbers assigned in an actual equation. For example, the equation might be:
y = 4 + 2x
This would give Table 7 and Figure 6.

Table 7 y = 4 + 2x
x y
0 4
1 6
2 8
3 10
4 12
5 14
. .

Notice two things about the relationship between the equation and the graph:
 The point where the line crosses the vertical axis (at a value of 4) is given by the constant (a)
term. If the a term is negative, the line will cross the vertical axis below the horizontal axis.
 The slope of the line is given by the b term. The slope is 2/1: for every 1 unit increase in x
there is a 2 unit increase in y.

Question
On a diagram like Figure 6 draw the graphs for the following equations.
y = –3 + 4x

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 y = 15 – 3x

Note that in the second equation of the question, the x term is negative. This means that y and
x are inversely related. As x increases, y decreases.

Non-linear functions
With these functions the equation involves a squared term (or other power terms). Such
functions will give a curved line when plotted on a graph. As an example, consider the
following equation:
y = 4 + 10x – x 2
Table 8 and Figure 7 are based on it.

Table 8 y = 4 + 10x – x 2

x y
0 4
1 13
2 20
3 25
4 28
5 29
6 28
7 25
. .

As you can see, y rises at a decelerating rate and eventually begins to fall. This is because the
negative x 2 term is becoming more and more influential as x rises and eventually begins to
outweigh the 10x term.

Question
What shaped graph would you get from the equations?
y = –6 + 3x + 2x 2
y = 10 – 4x + x 2

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(If you cannot work out the answer, construct a table like Table 8 and then plot the figures on
a graph.)

APPENDIX SUMMARY
 Diagrams in economics can be used as pictures: to sketch a relationship so that its
essentials can be perceived at a glance.
 Tables, graphs and charts are also used to portray real-life data. These can be time-series
data or cross-section data or both.
 In order to get a true picture from economic data it is important to be aware of various
ways that statistics can be abused: these include a selective use of data, a choice of axes
on a graph to make trends seem more or less exaggerated or to make a curve more or less
steep, confusing absolute and relative values, ignoring questions of distribution,
confusing nominal and real values, and selecting the time period to make the statistics
look the most favourable or unfavourable.
 Presenting time-series data as index numbers gives a clear impression of trends and is a
good way of comparing how two or more series (perhaps originally measured in different
units) have changed over the same time period. A base year is chosen and the index for
that year is set at 100. The percentage change in the value of a variable is given by the
percentage change in the index (I). The formula is:


( )
I t −I t−1
I t−1
×10 0

 Several items can be included in one index by using a weighted value for each of the
items. The weights must add up to 1, and each weight will reflect the relative importance
of that particular item in the index.
 Functional relationships can be expressed as an equation, a table or a graph. In the linear
(straight-line) equation y = a + bx, the a term gives the vertical intercept (the point where
the graph crosses the vertical axis) and the b term gives the slope. When there is a power
term (e.g. y = a + bx + cx 2), the graph will be a curve.

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