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50 Chapter 1 Economic Questions and Data

If we want to reduce smoking by a certain amount, say 20%, by raising taxes, then
we need to know the price elasticity of demand to calculate the price increase
necessary to achieve this reduction in consumption. But what is the price elasticity
of demand for cigarettes?

Although economic theory provides us with the concepts that help us answer
this question, it does not tell us the numerical value of the price elasticity of
demand. To learn the elasticity, we must examine empirical evidence about the
behavior of smokers and potential smokers; in other words, we need to analyze
data on cigarette consumption and prices.

The data we examine are cigarette sales, prices, taxes, and personal income
for U.S. states in the 1980s and 1990s. In these data, states with low taxes, and thus
low cigarette prices, have high smoking rates, and states with high prices have low
smoking rates. However, the analysis of these data is complicated because causal-
ity runs both ways: Low taxes lead to high demand, but if there are many smokers
in the state, then local politicians might try to keep cigarette taxes low to satisfy
their smoking constituents. In Chapter 12, we study methods for handling this
“simultaneous causality” and use those methods to estimate the price elasticity of
cigarette demand.

Question #4: By How Much Will U.S. GDP
Grow Next Year?

It seems that people always want a sneak preview of the future. What will sales be
next year at a firm that is considering investing in new equipment? Will the stock
market go up next month, and, if it does, by how much? Will city tax receipts next
year cover planned expenditures on city services? Will your microeconomics
exam next week focus on externalities or monopolies? Will Saturday be a nice day
to go to the beach?

One aspect of the future in which macroeconomists are particularly interested
is the growth of real economic activity, as measured by real gross domestic product
(GDP), during the next year. A management consulting firm might advise a man-
ufacturing client to expand its capacity based on an upbeat forecast of economic
growth. Economists at the Federal Reserve Board in Washington, D.C., are man-
dated to set policy to keep real GDP near its potential in order to maximize
employment. If they forecast anemic GDP growth over the next year, they might
expand liquidity in the economy by reducing interest rates or other measures, in
an attempt to boost economic activity.

Professional economists who rely on precise numerical forecasts use econo-
metric models to make those forecasts. A forecaster’s job is to predict the future