Using Units of Analysis in Economics

Introduction

Understanding units is critical in economics. For example, who is richer?

  • David Zaslav of Discovery Communications had income of over $150,000,000 in 2014
  • Bill Gates had over $79,000,000,000 wealth in 2014
  • Carlos Slim had over 110,000,000,000 Mexican peso wealth in 2014

To compare these three men, economists need to understand the difference between units.

  • millions vs. billions
  • a flow of income vs. a stock of wealth
  • US dollars vs. the Mexican peso

Making sense of large numbers

  • A million has 6 zeros -- 1,000,000
  • A billion has 9 zeros -- 1,000,000,000 or 1,000 million.
  • A trillion has 12 zeros -- 1,000,000,000,000 or 1,000 billion

How to deal with all those zeros?

  • When using a calculator, leave off 6 zeros and remember you are in millions. Leave off 9 zeros and you are in billions.
  • When dividing, cross off an equal number of zeros in the numerator and denominator. For example, divide 500 billion by 100 million.

    $\require{cancel}500{,}000{,}000{,}000 / 100{,}000{,}000 = $ $500{,}0\cancel{00{,}000{,}000} / 1\cancel{00{,}000{,}000} = 5{,}000$

Per capita

Large numbers are easier to understand if measured per person, also called per capita.

For example, US spending on the military was about $600,000,000,000 in 2015 --- the largest in the world. That works out to around $2,600 per capita --- also the largest in the world.

Chinese spending on the military was about $140,000,000,000 in 2015 --- the second largest in the world. Per capita, that was around $100 --- the 30th-largest in the world.

Stock versus Flow

Large numbers also are easier to understand if they are measured by their impact over time. For example, $10 billion in wealth (called a stock variable --- like a "stockpile" of money) that earns interest at 5% per year would return $500 million per year in interest income (called a flow variable)

Exchange rates

An exchange rate is the price of one country's currency as compared to another country's currency.

  • For example, in 2015, the exchange rate between the US Dollar and the Chinese Yuan (¥) was $1 = ¥6.21
  • Another way of looking at this exchange rate is ¥1 = $0.16 (16¢)

You might be tempted to conclude that this exchange rate implies that the Chinese currency is "cheap". But the yuan is simply a measurement tool. We could measure the US economy in pennies, making all numbers look one hundred time larger. Of course that wouldn't change the value of anything.

Index numbers

For comparing combinations of numbers over time, economists rely on index numbers.

  • Consumer Price Index --- how all prices vary over time
  • Stock market indexes (or indices) such as the Dow Jones Industrial Average --- how overall stock prices vary over time
  • Trade weighted index --- how a currency such as the US dollar varies over time compared to other currencies

Base

An index picks a starting year with a base number that is easy to calculate, usually 100.

For example, the US Consumer Price Index (CPI) currently uses the years 1982-1984 as a base, set at 100. In 2015 the CPI was about 240, meaning that prices were a bit more than double, at 140% higher than in 1982-1984.

Weighting

The index is a combination of values, but not all the values are equally important. So most indexes weight the values depending on their importance.

For example, the trade weighted index for a currency value takes into account changes in a currency compared to currency in other countries with which it trades. The changes for a country are counted more if there is more trade (weighted heavily), or counted less if there is less trade (weighted less heavily). The US dollar trade-weighted index in 2015 was 114, with a base of 100 set in 1997.

What units of analysis are used in Macroeconomics?

Macroeconomics --- the study of the entire economy --- uses very large numbers like GDP (in trillions of dollars), and index numbers such as the Consumer Price Index.

  • Measures of the entire economy --- Gross Domestic Product (GDP)
    Measured in billions or trillions, economists usually omit most of the zeros. US GDP in 2015 was over $17,000 B (billion) or $17 T (trillion).
    • Per capita GDP, or GDP per person

    • Comparison across countries --- requires the use of one country's currency, corrected for the purchasing power of each currency, or Purchasing Power Parity.

    • Real versus Nominal --- Usually it is important to correct measurements (called nominal numbers) for the effect of inflation. These corrected numbers are called real values.

  • Federal budget
    Measured in billions, usually omitting the zeros. It is important to separate truly large expenditures --- such as US social security, over $700 billion in 2015 --- from politically-sensitive expenditures that are in the billions, but which actually are small compared to the larger expenditures --- such as international economic assistance, $31 billion in 2015.
  • Unemployment
    The number of US unemployed typically is in the millions --- over 9,000,000 in 2015. Usually, it is measured as a percentage of the labor force. For example, the unemployment rate was 5.6% in May 2015.
  • Prices and Inflation
    • Prices are measured with an index number, often the Consumer Price Index (CPI). CPI is an average of the prices of a wide array of consumer goods and services, weighted by consumer spending on each good or service.


    • Inflation is the percentage change in the overall price index over time.

What units of analysis are used in Microeconomics?

Microeconomics is the study of the choices and behaviors of individual consumers, businesses and governments.

  • Size of corporations
    • Large corporations have sales and assets in billions of US dollars

    • Flow versus stock. Corporate income is a flow over time; corporate assets are a stock.


  • Stock indices
    • There are many measures of the overall stock market, including the Dow Jones Industrial Average ("the Dow"), Standard and Poor's Index ("S&P" or "S&P 500"), and the NASDAQ composite index ("the NASDAQ").
    • Indices have different base years, so what matters most is the percent change in the index --- not its total.

    • Most indices weight stocks so that larger corporations count more in the index than smaller corporations.
  • Income versus wealth Measures of inequality distinguish between incomes, a flow over time (versus wealth), a stock of assets (not necessarily corporate "stock") accumulated over time.

  • Individuals, households, and families Economic studies can look at individual people, households (single individuals or people sharing their incomes), or families (households with more than one person)

  • Currency values
    • The Japanese Yen (¥) is valued at about $0.01 US (1¢). Such differences are only the units of measurement, and they do not indicate an economy's strength. To understand "strength", the currencies must be converted to a common measure.

    • Measuring the value of a currency against all other currencies requires a Trade Weighted Index (TWI) showing how a currency has changed, taking into account how much trade is done with each other country's currency.

    • Weighting in TWI

✓ Final thoughts on units of analysis

As shown above, economic variables can be measured different ways. The way a variable is measured can greatly affect its meaning, so be sure to understand the units that you are using for your economic analysis!

A good rule of thumb is to always include the units as you work out your problems, to make sure you don't get confused.

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