Application of theories by economists

1. Economists use theories to

a. abstract from the complexities of the world.

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b. understand economic behavior.

c. explain and help predict human behavior.

d. do all of the above.

e. do none of the above.

2. The importance of the ceteris paribus assumption is that it

a. allows one to separate normative economic issues from positive economic ones.

b. allows one to generalize from the whole to the individual.

c. allows one to analyze the relationship between two variables apart from the influence of other variables.

d. allows one to hold all variables constant so the economy can be carefully observed in a suspended state.

(continued)

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S E C T I O N Q U I Z (Cont.)

3. When we look at a particular segment of the economy, such as a given industry, we are studying

a. macroeconomics.

b. microeconomics.

c. normative economics.

d. positive economics.

4. Which of the following is most likely a topic of discussion in macroeconomics?

a. an increase in the price of a pizza

b. a decrease in the production of stereos by a consumer electronics company

c. an increase in the wage rate paid to automobile workers

d. a decrease in the unemployment rate

e. the entry of new firms into the software industry

1. What are economic theories?

2. What is the purpose of a theory?

3. Why must economic theories be abstract?

4. What is a hypothesis? how do we determine whether it is tentatively accepted?

5. Why do economists hold other things constant (ceteris paribus)?

6. Why are observation and prediction more difficult in the social sciences?

7. Why do economic predictions refer to the behavior of groups of people rather than individuals?

8. Why is revealed preference preferred to declared preference?

9. Why is the market for running shoes considered a microeconomic topic?

10. Why is inflation considered a macroeconomic topic?

Answers: 1. d 2. c 3. b 4. d

If two events usually occur together, does it mean one event caused the other to happen?

What is the fallacy of composition?

Pitfalls to Avoid in Scientific Thinking

In our discussion of economic theory we have not yet mentioned that there are certain pitfalls to avoid that may hinder scientific and logical thinking: confusing correlation and causation, and the fallacy of composition.

Confusing Correlation and Causation Without a theory of causation, no scientist could sort out and understand the enormous complexity of the real world. But one must always be careful not to confuse correlation with causation. In other words, the fact that two events usually occur together (correlation) does not necessarily mean that one caused the other to occur (causation). For example, say a

correlation when two events occur together

causation when one event brings about another event

1.4

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groundhog awakes after a long winter of hibernation, climbs out of his hole, and sees his shadowthen six weeks of bad weather ensue. Did the groundhog cause the bad weather?

Perhaps the causality runs in the opposite direction. A rooster may always crow before the sun rises, but it does not cause the sunrise; rather, the early light from the sunrise causes the rooster tocrow.

Why Is the Correlation between Ice Cream Sales and Property Crime Positive? Did you know that when ice cream sales rise, so do prop- erty crime rates? What do you think causes the two events to occur together? The explanation is that property crime

in the Sex on Television and Teenage Pregnancy

When it comes to television programming, sex sellsmaybe too well. According to a Rand corporation study authored by Anita chandra, there is a link between teenagers exposure to sexual content on Tv and teen pregnancies. Specifically, the study found that teens exposed to high levels of sexual content on television were twice as likely to be involved in a pregnancy in the following three years compared to teens with limited exposure. The results were published in the November 2008 edition of the journal Pediatrics.

The studys author is quick to point out that the factors leading to teen pregnancies are varied and complexbut warns it is important for parents, teachers, and pediatricians to understand that tele- vision can be one of them.

consider this: While sex on television may lead to increases in teen preg- nancy, isnt it possible the causality runs in the opposite directionteenagers who are more susceptible to teen preg- nancy watch shows with more sexual content? In addition, there are a host of other variables that could be much more statistically significant, such as low self-esteem, single- parent households, household income, years of schooling, heavy drug and alcohol use, GPA, child abuse, peer pressure, and so on.

In fact, more women of all ages, not just teenagers, are having children out of wedlock. Actually, the teen birth rate was much higher in 1957 than it is today. The growing

concern is over the rise in unwed teenage mothers. However, births to single teens actually account for a smaller percent- age of all non-marital births than 20 years agoso is televi- sion to blame? Heed the authors warning: The reasons for the rise in teen pregnancies are varied and complex.

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peaks in the summer because of warmer weather, more people on vacations (leaving their homes vacant), teenagers out of school, and so on. It just happens that ice cream sales also peak in those months because of the weather. It is the case of a third variable causing both to occur. Or what if there were a positive correlation between sales of cigarette lighters and the incidence of cancer? The suspect might well turn out to be the omitted variable (the so- called smoking gun): the cigarette. Or what if research revealed that parents who bought parenting books were better parents. Does that prove the books work? Or is it possible that people who would buy books on parenting tend to be better parents? That is, it might be about the parents, not the book. Causality is tricky stuff. Be careful.

The Fallacy of Composition Economic thinking requires us to be aware of the problems associated with aggregation (adding up all the parts). One of the biggest problems is the fallacy of composition. This fal- lacy states that even if something is true for an individual, it is not necessarily true for many individuals as a group. For example, say you are at a football game and you decide to stand up to get a better view of the playing field. This works as long as the people seated around you dont stand up. But what happens if everyone stands up at the same time? Then your standing up does nothing to improve your view. Thus, what is true for an individual does not always hold true in the aggregate. The same can be said of getting to school early to get a better parking placewhat if everyone arrived early? Or studying harder to get a better grade in a class that is graded on a curvewhat if everyone studied harder? Or what if you are a wheat farmer and you decide to clear some additional land to plant even more wheat to get more income from the additional wheat that is sold. Sounds good if you were the only one. But what if all wheat farmers do the same thing? There would be so much additional wheat produced that the price would come down and you might be worse off. These are all examples of the fallacy of composition.

fallacy of composition the incorrect view that what is true for the individual is always true for the group

S E C T I O N Q U I Z

1. Which of the following statements can explain why correlation between Event A and Event B may not imply causality from A to B?

a. The observed correlation may be coincidental.

b. A third variable may be responsible for causing both events.

c. causality may run from Event B to Event A instead of in the opposite direction.

d. All of the above can explain why the correlation may not imply causality.

2. Ten-year-old Tommy observes that people who play football are larger than average and tells his mom that hes going to play football because it will make him big and strong. Tommy is

a. committing the fallacy of composition.

b. violating the ceteris paribus assumption.

c. mistaking correlation for causation.

d. committing the fallacy of decomposition.

3. The fallacy of composition

a. is a problem associated with aggregation.

b. assumes that if something is true for an individual, then it is necessarily true for a group of individuals.

c. is illustrated in the following statement: If I stand up at a football game, I will be able to see better; therefore, if we all stood up, we would all see better.

d. all of the above are true.

(continued)

If there is a correlation between more sex on television and increased teenage pregnancy, does that necessarily mean that television is responsible for the rise in teenage pregnancy?

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S E C T I O N Q U I Z (Cont.)

1. What is the relationship between correlation and causation?

2. What types of misinterpretation result from confusing correlation and causation?

3. What is the fallacy of composition?

4. If you can sometimes get a high grade on an exam without studying, does it mean that additional studying does not lead to higher grades? Explain your answer.

Answers: 1. d 2. c 3. d

Positive Statement Most economists view themselves as scientists seeking the truth about the way people behave. They make speculations about economic behavior, and then, ideally, they assess the validity of those predictions based on human experience. Their work emphasizes how people do behave, rather than how people should behave. In the role of scientist, an economist tries to observe patterns of behavior objectively, without reference to the appropriateness or inappropriateness of that behavior. This objective, value-free approach, based on the scientific method, is called positive analysis. In positive analysis, we want to know the impact of variable A on variableB. We want to be able to test a hypothesis. For example, the following is a positive statement: If rent controls are imposed, vacancy rates will fall. This statement is testable. A positive state- ment does not have to be a true statement, but it does have to be a testable statement.

Keep in mind, however, that it is doubtful that even the most objective scientist can be totally value free in his or her analysis. An economist may well emphasize data or evidence that supports a hypothesis, putting less weight on other evidence that might be contradictory. This tendency, alas, is human nature. But a good economist/scientist strives to be as fair and objective as possible in evaluating evidence and in stating conclusions based on the evidence. In some sense, economists are like engineers; they try to figure out how things work and then describe what would happen if you changed something.

Normative Statement Economists, like anyone else, have opinions and make value judgments. And when econo- mists, or anyone else for that matter, express opinions about an economic policy or statement, they are indicating in part how they believe things should be, not stating facts about the way things are. In other words, they are performing normative analysis. Normative statements involve judgments about what should be or what ought to happen. For example, norma- tive questions might include: Should the government raise the minimum wage? Should the government increase spending in the space program? Should the government give free prescription drugs to senior citizens?

positive statement an objective, testable statement that describes what happens and why it happen

normative statement a subjective, contestable statement that attempts to describe what should be done

What is a positive statement?

What is a normative statement?

Why do economists disagree?

Positive Statements and Normative Statements

1.5

What is the difference between positive statements and normative statements?

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Positive versus Normative Analysis The distinction between positive and normative analysis is important. It is one thing to say that everyone should have universal health care, an untestable normative statement, and quite anoth- er to say that universal health care would lead to greater worker productivity, a testable posi- tive statement. It is important to distinguish between positive and normative analysis because many controversies in economics revolve around policy considerations that contain both. For example, what impact would a 3 percent reduction in income taxes across the board have on the economy? This question requires positive analysis. Whether we should have a 3 percent reduction in income taxes requires normative analysis as well. When economists are trying to explain the way the world works, they are scientists. When economists start talking about how the economy should work rather than how it does work, they have entered the normative world of the policy maker. In short, positive statements are attempts to describe what happens and why it happens, while normative statements are attempts to prescribe what should be done. Positive analysis can demonstrate the consequences of a particular policy but cannot prove that a par- ticular policy is good or bad. However, it is also important to remember that a good understand- ing of positive analysis is crucial to making effective policy prescriptionsnormative analysis.

Disagreement Is Common in Most Disciplines Although economists do frequently have opposing views on economic policy questions, they probably disagree less than the media would have you believe. Disagreement is common in most disciplines: Seismologists differ over predictions of earthquakes or volcanic eruption; historians can be at odds over the interpretation of historical events; psychologists disagree on proper ways to raise children; and nutritionists debate the efficacy of particular vitamins and the quantities that should be taken.

The majority of disagreements in economics stem from normative issues; differences in values or policy beliefs result in conflict. For example, a policy might increase efficiency at the expense of a sense of fairness or equity, or it might help a current generation at the expense of a future generation. Because policy decisions involve trade-offs, they will always involve the potential for conflict.

Freedom versus Fairness Some economists are concerned about individual freedom and liberty, thinking that any encroach- ment on individual decision making is bad, other things being equal. People with this philosophic bent are inclined to be skeptical of any increased government involvement in the economy.

On the other hand, some economists are concerned with what they consider an unequal, unfair, or unfortunate distribution of income, wealth, or power, and view governmental intervention as desirable in righting injustices that they believe exist in a market economy. To these persons, the threat to individual liberty alone is not sufficient to reject governmental intervention in the face of perceived economic injustice.

The Validity of an Economic Theory Aside from philosophic differences, a second reason helps explain why economists may dif- fer on any given policy question. Specifically, they may disagree about the validity of a given economic theory for the policy in questionthat is, they disagree over the positive analysis. Why would they disagree over positive analysis? For at least two reasons. One, a particular model may yield mixed results: some empirical evidence supporting it and some not. Two, the information available may be insufficient to make a compelling theory.

Often Economists Do Agree Although you may not believe it after reading the previous discussion, economists dont always disagree. In fact, according to a survey among members of the American Economic

Does positive analysis prove a policy is good?

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Association, most economists agree on a wide range of issues, including the effects of rent control, import tariffs, export restrictions, the use of wage and price controls to curb infla- tion, and the minimum wage.

According to studies, most economists agree that these statements are correct:

1. A ceiling on rents (rent control) reduces the quantity and quality of rental housing available (93 percent agree).

2. Tariffs and import quotas usually reduce general economic welfare (93 percent agree). 3. The United States should not restrict employers from outsourcing work to foreign

countries (90 percent agree). 4. Fiscal policy (e.g., tax cuts and/or increases in government expenditure) has significant

stimulative impact on an economy that is less than fully employed (90 percent agree). 5. Flexible and floating exchange rates offer an effective international monetary arrange-

ment (90 percent agree). 6. The gap between Social Security funds and expenditures will become unsustainably large

within the next 50 years if the current policies remain unchanged (85 percent agree). 7. The United States should eliminate agricultural subsidies (85 percent agree). 8. Local and state governments in the United States should eliminate subsidies to profes-

sional sport franchises (85 percent agree). 9. A large budget deficit has an adverse effect on the economy (83 percent agree). 10. A minimum wage increases unemployment among young and unskilled (79 percent agree). 11. Effluent taxes and marketable pollution permits represent a better approach to pollu-

tion control than imposition of pollution ceilings (78 percent agree). 12. Economists favor expanding competition and market forces in education (67 percent

agree).1

Steps on How to Do Well in This (or any other) Course

1. Are you motivated to learn? Link your motivation to goals. I want an A in this class. I want to graduate. I want to go to medical school or law school. I want a college degree. Setting goals demonstrates an intention to achieve and activates learning. School is really about learning to learn and hopefully, learning to enjoy learning. Students must find satisfaction in learning based on the understanding that the goals are useful to them. Put yourself in the right mind set. In short, learning is most effective when an individual is ready to learn. If you are not ready for Step 1, the other nine steps are less useful.

2. Do you attend class and take good notes? Listen activelythink before you write but be careful not to fall behind. Try to capture the main points of the lecture. You cannot take down everything. Leave space in your notebook so you can fill in with greater clarity when reading or re-reading text. This is also a good time to edit your notes. Review your notes within 24 hours of lecture. This way you will be reviewing rather than relearning!

3. Do you read before class? Stay current. If you are studying Chapter 3 when the lecture is on Chapter 6, it will harm your performance. While perfection is not necessary, do the best you can to read the material before it is covered in lecture.

4. Do you just highlight when you read? Dont. It is too passive. Finish a section and sum- marize it in your own words. Afterward, compare it with the section checks and summary at the end of the chapter to see if you caught all the main points. Do NOT read something without learning anything. Thats a waste of time. Train your mind to learnquestioning, reciting, reviewing while you read will make you an active reader and a better student.

It seems like economists always disagree on impor- tant issues. Is that true?

1 Richard M. Alston, J. R. Kearl, and Michael B. Vaughn, Is there Consensus among Economists in the 1990s? American Economic Review (May 1992): 203-09; Robert Whaples, Do Economists Agree on Anything? Yes! Economists Voice (November 2006): 16.

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5. When do you study? Break up your study time, to keep it fresh. Dont study when you are tired. Know when you function best. To many people, an hour of studying in the day is worth two at night! That is, reading in the morning after a good nights sleep may be much more productive than when you are tired late at night. Study in 20- to 50-minute chunks with 5- to 10-minute breaks. This has proven to be the most effective way to study.

6. How do you study? Study actively. Study by doing. Work problems, like in physics, chem- istry, or engineering. Go back and forth between problems, examples, and text. That is, practice, practice, and practice. There are many problems throughout the text and on the website. Do them. The late John Wooden (famous basketball coach at UCLA) would often quote Ben Franklin, Failing to prepare is preparing to fail. Have you worked on your self-confidence? Before you look up the answer to a question, assign a confidence factor to your work. On a scale of 1-10, how confident are you that you are right? Be honest with yourself. The more often you prove yourself right, the less test anxiety you will have.

7. Do you work for understanding? Can you explain the concepts to others? If you can explain it to others, perhaps in a study group, you will really know it. There is no bet- ter way to learn something than by teaching it to others.

8. Do you find a quiet place to study with few distractions? Music and TV are not con- ducive to quality study time. This will only impair concentration. If you find your mind wandering, get up and walk around for a couple of minutes. Try to relax before you start studying, and associate reading with relaxation, not anxiety. Set a goal of how much you want to accomplish in each session and try to increase it gradually.

9. Do you apply your reading and lectures to your daily life? Retention is always greater when you can make the connection between the course and your life. Read the In the News features and the real world examples throughout the text and see how the eco- nomic principles apply to your everyday life. Economics should also help you better understand the events you read about in the newspaper and on the internet.

10. Do you cram for tests? Dont. It will not work well in economics and perhaps not in any analytical field. Study regularly, with greater review being the only difference in your study habits prior to a test. Try to have all your material read two days prior to exam so the remaining time can be devoted to review. Cramming for tests leads to fatigue, test anxiety, and careless mistakes. Get plenty of sleep. Treat being in school as having a full-time job put in your time regularly and you wont need or want to cram. In short, dont procrastinate!

S E C T I O N Q U I Z

1. Which of the following is a positive statement?

a. New tax laws are needed to help the poor.

b. Teenage unemployment should be reduced.

c. We should increase Social Security payments to the elderly.

d. An increase in tax rates will reduce unemployment.

e. It is only fair that firms protected from competition by government-granted monopolies pay higher corporate taxes.

2. Positive statements

a. are testable.

b. are attempts to describe what happens and why it happens.

c. do not have to be a true statement.

d. All of the above are true.

(continued)

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S E C T I O N Q U I Z (Cont.)

3. Normative statements

a. attempt to describe what happens and why it happens.

b. are objective and testable.

c. attempt to describe the way the world works.

d. are subjective and attempt to prescribe what should be done.

4. The statement the government should increase spending for the space program is

a. objective and testable.

b. a positive statement.

c. subjective, prescriptive, and normative.

d. a fact and very important for the defense of our country.

5. Which of the following statements is (are) true?

a. Economists disagree but most often over normative issues.

b. Economists do agree over a wide range of issues.

c. Disagreement is also common in other disciplines.

d. All of the above statements are true.

1. What is a positive statement? Must positive statements be testable?

2. What is a normative statement? Is a normative statement testable?

3. Why is the positive/normative distinction important?

4. Why do policy disagreements arise among economists? Answers: 1. d 2. d 3. d 4. c 5. d

Fill in the blanks:

1. Economics is the study of the choices we make among our many wants and desires given our _____________ resources.

2. _____________ occurs because our unlimited wants exceed our limited resources.

3. Resources are _____________ used to produce goods and services.

4. The economic problem is that _____________ forces us to choose, and choices are costly because we must give up other opportunities that we _____________.

5. Living in a world of scarcity means _____________.

6. _____________ deals with the aggregate (the forest), or total economy, while _____________ deals with the smaller units (the trees) within the economy.

7. Economists assume that individuals act as if they are motivated by _____________ and respond in _____________ ways to changing circumstances.

8. Economists believe that it is _____________ for people to anticipate the likely future consequences of their behavior.

9. Actions have _____________.

10. Rational self-interest implies that people do not make _____________ mistakes.

11. Economic _____________ are statements or proposi- tions used to _____________ and _____________ patterns of human economic behavior.

12. Because of the complexity of human behavior, economists must _____________ to focus on the most important components of a particular problem.

Interactive Summary

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13. A(n) _____________ in economic theory is a testable prediction about how people will behave or react to a change in economic circumstances.

14. _____________ analysis is the use of data to test a hypothesis.

15. In order to isolate the effects of one variable on another, we use the _____________ assumption.

16. When two events usually occur together, it is called _____________.

17. When one event brings on another event, it is called _____________.

18. The _____________ is the incorrect view that what is true for an individual is always true for the group.

19. The objective, value-free approach to econom- ics, based on the scientific method, is called _____________ analysis.

20. _____________ analysis involves judgments about what should be or what ought to happen.

21. _____________ analysis is descriptive; normative analysis is _____________.

22. A tax increase will lead to a lower rate of inflation is a(n) _____________ economic statement.

Answers: 1. limited; unlimited 2. Scarcity 3. inputs 4. scarcity; value 5. trade-offs 6. Macroeconomics; microeconomics 7. self-interest; predictable 8. rational 9. consequences 10. systematic 11. theories; explain; predict 12. abstract 13. hypothesis 14. Empirical 15. ceteris paribus 16. correlation 17. causation 18. fallacy of composition 19. positive 20. Normative 21. Positive; prescriptive 22. positive

key Terms and concepts

Section Quiz Answers

economics 3 resources 3 scarcity 3 the economic problem 3 rational behavior 7 theory 9

hypothesis 10 empirical analysis 10 ceteris paribus 11 microeconomics 13 macroeconomics 13 aggregate 13

correlation 14 causation 14 fallacy of composition 16 positive statement 17 normative statement 17

1.1 Economics: A Brief Introduction

1. What is the definition of economics? Economics is the study of the choices we make among our many wants and desires given our limited resources.

2. Why does scarcity force us to make choices? Scarcitythe fact that our wants exceed what our resources can producemeans that we are forced to make choices on how best to use these limited resources.

3. Why are choices costly? In a world of scarcity, whenever we choose one option, we also choose to do without something else that we also desire. The want that we choose not to satisfy is the opportunity cost of that choice.

4. What is the economic problem? Scarcity forces us to choose, and choices are costly because we must give up other opportunities that

we value. This is the economic problem. Every indi- vidual, business, social, religious, and governmental organization faces the economic problem. Every society, whether it is capitalistic, socialistic, or totalitarian, must also face the economic problem of scarcity, choices, and costs.

5. Why do even non-economic issues have an economic dimension? Even apparently non-economic issues have an eco- nomic dimension because economics concerns any- thing worthwhile to some human being (including love, friendship, charity, etc.) and the choices we make among those things we value.

1.2 Economic Behavior 1. What do economists mean by self-interest?

By self-interest, economists simply mean that people try to improve their own situation (as they see it, not necessarily as others see it). Self-interest can also include benevolence.

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2. What does rational self-interest involve? Economists consider individuals to be acting in their rational self-interest if they are striving to do their best to achieve their goals with their limited income, time, and knowledge, and given their expectations of the likely future consequences (both benefits and costs) of their behavior.

3. How are self-interest and selfishness different? Self-interest means people are striving to do their best to achieve their goals, which may or may not be selfish. Parents working more hours to give more to their children or a favorite charity can be self- interested but are not selfish.

4. What is rational behavior? Rational behavior is when people do the best they can based on their values and information, under current and anticipated future consequences. Rational individuals weigh the benefits and costs of their actions and they only pursue actions if they perceive their benefits to be greater than the costs.

1.3 Economic Theory 1. What are economic theories?

A theory is an established explanation that accounts for known facts or phenomena. Economic theories are statements or propositions about patterns of human behavior that are expected to take place under certain circumstances.

2. What is the purpose of a theory? The purpose of a theory is primarily to explain and predict well. Theories are necessary because the facts of a complex world do not organize themselves.

3. Why must economic theories be abstract? Economic theories must be abstract because they could not possibly include every possible event, circumstance, or factor that might affect behavior. Like a road map, an economic theory abstracts from some issues to focus more clearly and precisely on the central questions it is designed to understand.

4. What is a hypothesis? How do we determine whether it is tentatively accepted? A hypothesis is a testable proposal that makes some type of prediction about behavior in response to certain changed conditions. An economic hypothesis is a testable proposal about how people will behave or react to a change in economic circumstances. It is tentatively accepted if its predictions are consistent with what actually happens. In economics, test- ing involves empirical analysis to see whether the hypothesis is supported by the facts.

5. Why do economists hold other things constant (ceteris paribus)? The hold other things constant, or ceteris paribus, assumption is used in economics because in trying to assess the effect of one variable on another, we must isolate their relationship from other important events or variables that might also influence the situ- ation the theory tries to explain or predict.

6. Why are observation and prediction more difficult in the social sciences? Observation and prediction are more difficult in the social sciences than in physical sciences because social sciences are concerned with human behavior, which is more variable and often less readily pre- dictable than the behavior of experiments observed in a laboratory. Social scientists can seldom run truly controlled experiments like those of the bio- logical scientists.

7. Why do economic predictions refer to the behavior of groups of people rather than individuals? Economists predictions usually refer to the collec- tive behavior of large groups rather than individuals because looking at the behaviors of a large group of individuals allows economists to discern general patterns of actions and therefore make more reliable generalizations.

8. Why is revealed preference preferred to declared preference? Researchers find that their results are more accurate when they observe what people do (revealed prefer- ences) rather that what they say they do (declared preferences).

9. Why is the market for running shoes consid- ered a microeconomic topic? Because a single industry is small relative to the economy as a whole, the market for running shoes (or the running-shoe industry) is a microeconomic topic.

10. Why is inflation considered a macroeconomic topic? Inflationa change in the overall price levelhas effects throughout the entire economy, rather than just in certain small areas of the economy, which makes it a macroeconomic topic.

1.4 Pitfalls to Avoid in Scientific Thinking

1. What is the relationship between correlation and causation? Correlation means that two things are related; causation means that one thing caused the other to occur. Even though causation implies correlation, correlation does not necessarily imply causation.

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2. What types of misinterpretation result from confusing correlation and causation? Confusing correlation between variables with causa- tion can lead to misinterpretation where a person sees causation between two variables or events where none exists or where a third variable or event is responsible for causing both of them.

3. What is the fallacy of composition? The fallacy of composition is the incorrect idea that if something is true for an individual, it must also be true for many individuals as a group.

4. If you can sometimes get a high grade on an exam without studying, does it mean that additional studying does not lead to higher grades? Explain your answer. In some instances a student can get a high grade on an exam without studying. However, because additional studying increases mastery of the material, additional studying would typically increase test performance and grades. That is, even though added studying would not raise grades in some unusual situations, as a general- ization, additional studying does lead to higher grades.

1.5 Positive Statements and Normative Statements

1. What is a positive statements? Must positive statements be testable? Positive statements focus on how people actually behave, rather than on how people should behave.

They deal with how variable A impacts variable B. Positive statements must be testable to determine whether their predictions are borne out by the evidence.

2. What is a normative statement? Is a norma- tive statement testable? Normative statements focus on what should be or what ought to happen; they involve opinions about the desirability of various actions or results. Normative statements are not testable, because it is not scientifically possible to establish whether one value judgment is better than another value judgment.

3. Why is the positive/normative distinction important? It is important to distinguish between positive and normative statements because many controversies in economics revolve around policy considerations that contain both. Deciding whether a policy is good requires both positive analysis (what will happen) and normative analysis (is what happens good orbad).

4. Why do policy disagreements arise among economists? As with most disciplines, economists do disagree. However, the majority of those disagreements stem from differences in normative analysis, because the evidence cannot establish whether one set of value judgments is better or more appropriate than other sets of value judgments.

Problems

1. In most countries the birth rate has fallen as incomes and the economic opportunities for women have increased. Use economics to explain this pattern.

2. Write your own definition of economics. What are the main elements of the definition?

3. Are the following topics ones that would be covered in microeconomics or macroeconomics? a. the effects of an increase in the supply of lumber on the home-building industry b. changes in the national unemployment rate c. changes in the inflation rate d. changes in the countrys economic growth rate e. the price of concert tickets

4. Identify which of the following headlines represents a microeconomic topic and which represents a macroeconomictopic.

a. U.S. Unemployment Rate Reaches Historic Lows b. General Motors Closes Auto Plant in St. Louis c. OPEC Action Results in a General Increase in Prices d. Companies Increase the Cost of Health Care for Employees e. Lawmakers Worry about the Possibility of a U.S. Recession f. Colorado Rockies Make Outfielder Highest Paid Ballplayer

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5. The Environmental Protection Agency asks you to help it understand the causes of urban pollution. Air pollution problems are worse the higher the Air Quality Index. You develop the following two hypotheses. HypothesisI: Air pollution will be a greater problem as the average temperature increases in the urban area. Hypothesis II: Air pollu- tion will be a greater problem as the population increases in the urban area.

Test each hypothesis with the facts given in the following table. Which hypothesis fits the facts better? Have you developed a theory?

Metropolitan Statistical Area Days with Polluted Air* Average Maximum Temperature Population (thousands)

Cincinnati, OH 30 64.0 1,979 El Paso, TX 13 77.1 680 Milwaukee, WI 12 55.9 1,690 Atlanta, GA 24 72.0 4,112 Philadelphia, PA 33 63.2 5,101 Albany, NY 8 57.6 876 San Diego, CA 20 70.8 2,814 Los Angeles, CA 80 70.6 9,519

*Air Quality Index greater than 100 (2002) Source: U.S. Dept. of Commerce, Bureau of Census, 2002 Statistical Abstract of the United States, Tables Nos. 30 and 363; U.S. EPA, Air Trends Report, 2002, EPA.Gov/airtrends/factbook.

6. Do any of the following statements involve fallacies? If so, which ones do they involve? a. Because sitting in the back of classrooms is correlated with getting lower grades in the class, students should

always sit closer to the front of the classroom. b. Historically, the stock market rises in years the NFC team wins the Super Bowl and falls when the AFC wins

the Super Bowl; I am rooting for the NFC team to win for the sake of my investment portfolio. c. When a basketball team spends more to get better players, it is more successful, which proves that all the

teams should spend more to get better players. d. Gasoline prices were higher last year than in 1970, yet people purchased more gas, which contradicts the law

of demand. e. An increase in the amount of money I have will make me better off, but an increase in the supply of money in

the economy will not make Americans as a group better off.

7. In the 1940s, Dr. Melvin Page conducted a national campaign to stop people other than infants from drinking milk. According to Page, milk was a dangerous food and a leading cause of cancer. He pointed to the fact that more people died of cancer in Wisconsin, the nations leading milk producer, than any other state as proof of his claim. How would you evaluate Dr. Pages claim?

8. Are the following statements normative or positive, or do they contain elements of both normative and positive statements?

a. A higher income-tax rate would generate increased tax revenues. Those extra revenues should be used to give more government aid to the poor.

b. The study of physics is more valuable than the study of sociology, but both should be studied by all college students.

c. An increase in the price of corn will decrease the amount of corn purchased. However, it will increase the amount of wheat purchased.

d. A decrease in the price of butter will increase the amount of butter purchased, but that would be bad because it would increase Americans cholesterol levels.

e. The birth rate is reduced as economies urbanize, but it also leads to a decreased average age of developing countries populations.

9. In the debate about clean air standards we have often heard the statement, A nation as rich as the United States should have no pollution. Why is this a normative statement? Would it help you make a decision on national air quality standards? Describe two positive statements that might be useful in determining the air quality standards.

10. Answer the following questions: a. What is the difference between self-interest and selfishness? b. Why does inaction have consequences? c. Why are observation and prediction more difficult in economics than in chemistry? d. Why do economists look at group behavior rather than individual behavior?

11. Using the map analogy from the chapter, talk about the importance of abstraction. How do you abstract when tak- ing notes in class?

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Graphs Are an Important Economic Tool Sometimes the use of visual aids, such as graphs, greatly enhances our understanding of a theory. It is much the same as finding your way to a friends house with the aid of a map rather than with detailed verbal or written instructions. Graphs are important tools for economists. They allow us to understand better the workings of the economy. To economists, a graph can be worth a thousand words. This textbook will use graphs throughout to enhance the understanding of important economic relationships. This appendix provides a guide on how to read and create your own graphs.

The most useful graph for our purposes is one that merely connects a vertical line (the y-axis) with a horizontal line (the x-axis), as seen in Exhibit 1.

The intersection of the two lines occurs at the origin, which is where the value of both vari- ables is equal to zero. In Exhibit 1, the graph has

four quadrants, or boxes. In this textbook, we will be primarily concerned with the shaded box in the upper- right corner. This portion of the graph deals exclusively with positive numbers. Always keep in mind that mov- ing to the right on the horizontal axis and moving up along the vertical axis both lead to higher values.

Using Graphs and Charts Exhibit 2 presents three common types of graphs. The pie chart in Exhibit 2(a) shows the revenues received from various taxes levied on households and cor- porations. Each slice in the pie chart represents the percentage of finances that are derived from different sourcesfor example, personal income taxes account for 43 percent of the federal governments tax revenues. Therefore, pie charts are used to show the relative size of various quantities that add up to 100 percent.

Exhibit 2(b) is a bar graph that shows the unem- ployment rate by age and sex in the United States. The height of the line repre- sents the unemployment rate. Bar graphs are used to show a comparison of quantities.

Exhibit 2(c) is a time-series graph. This type of graph shows changes in the value of a variable over time. This visual tool allows us to observe impor- tant trends over a certain time period. In Exhibit 2(c) we see a graph that shows trends in the inflation rate over time. The horizontal axis shows us the passage of time, and the vertical axis shows us the inflation rate (annual percent change). From the graph, we can see the trends in the inflation rate from 1961 to 2005.

Using Graphs to Show the Relationship between Two Variables Even though the graphs and chart in Exhibit 2 are im portant, they do not allow us to show the relationship between two variables (a variable is something that is

Appendix Working with Graphs

appendix exhibit 1 Plotting a Graph

40 30 20 10 10 20 30 40

10 0

In the upper-right corner, we see that the graph includes a positive figure for the y-axis and the x-axis. As we move to the right along the horizontal axis, the numerical values increase. As we move up along the vertical axis, the numerical values increase.

e n g a g e l

e a rn

in g 2

01 3

y-axis the vertical axis on a graph

x-axis the horizontal axis on a graph

pie chart visual display showing the relative size of various quantities that add up to 100percent

bar graph visual display showing the comparison of quantities

time-series graph visual tool to show changes ina variables value over time

variable something that is measured by a number, such as your height

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appendix exhibit 2 Pie chart, Bar Graph, and Time-Series Graph

a. Pie ChartTax RevenuesFederal Government b. Bar GraphU.S. Unemployment, by Sex and Age

Personal Income Taxes 44%

Other Taxes 7%

Corporate Income Taxes 11%

Social Security Tax (Payroll Tax)

38%

24%

22%

20%

18%

16%

14%

12%

10%

Total Population Men Women Teenagers (1619 years)

U n

em p

lo ym

en t

R at

c. Time-Series GraphInflation Rate

12.5

7.5

2.5

In fl

a ti

o n

R a te

(a n

n u

a l p

e rc

e n

t c h

a n

g e )

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

SOuRcE: Economic Report of the President and Bureau of Economic

Analysis, 2009.

SOuRcE: Bureau of labor Statistics, August 2009.

SOuRcE: Bureau of labor Statistics, 2009.

measured by a number, such as your height). To more closely examine the structures and functions of graphs, lets consider the story of Josh, an avid skateboarder who has aspirations of winning the Z Games next year. He knows that to get there, hell need to put in many hours of practice. But how many hours? In search of information about the practice habits of other skateboarders, he searches the Internet, where he finds the results of a study that looked at the score of each Z Games competitor in relation to the amount of practice time per week spent by each skateboarder. As Exhibit 3 shows, the results of the study indicate that skateboarders had to practice 10 hours per week to receive a score of 4, 20 hours per week to receive a

score of 6, 30 hours per week to get a score of 8, and 40 hours per week to get a perfect score of 10. How does this information help Josh? By using a graph, he can more clearly understand the relationship between practice time and overall score.

A Positive Relationship The study on scores and practice times reveals what is called a direct relationship, also called a positive relationship. A positive relationship means that the variables change in the same direc- tion. That is, an increase

positive relationship when two variables change in the same direction

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in one variable (practice time) is accompanied by an increase in the other variable (overall score), or a decrease in one variable (practice time) is accompanied by a decrease in the other variable (overall score). In short, the variables change in the same direction.

A Negative Relationship When two variables change in opposite directions, they have an inverse relationship, also called a negative relationship. That is, when one variable rises, the other

variable falls, or when one variable decreas- es, the other variable increases.

The Graph of a Demand Curve Lets now examine one of the most important graphs in economicsthe demand curve. In Exhibit 4, we see Emilys individual demand curve for DVDs. It shows the price of DVDs on the vertical axis and the quantity of DVDs purchased per month on the horizontal axis. Every point in the space shown

represents a price and quantity combination. The downward-sloping line, labeled Demand curve, shows the different combinations of price and quan- tity purchased. Note that the higher the price of the DVDs, as shown on the vertical axis, the smaller the quantity purchased, as shown on the horizontal axis, and the lower the price shown on the vertical axis, the greater the quantity purchased shown on the horizontal axis.

In Exhibit 4, we see that moving up the vertical price axis from the origin, the price of DVDs increases from $5 to $25 in increments of $5. Moving out along the horizontal quantity axis, the quantity purchased increases from zero to five DVDs per month. Point A represents a price of $25 and a quantity of one DVD, point B represents a price of $20 and a quantity of two DVDs, point C a price of $15 and a quantity of three DVDs, and so on. When we connect all the points, we have what economists call a curve. As you can see, curves are sometimes drawn as straight lines for ease of illustration. Moving down along the curve, we see that as the price falls, a greater quantity is demanded; moving up the curve to higher prices, a smaller quantity is demanded. That is, when DVDs become less expensive, Emily buys more DVDs. When

appendix exhibit 3 A Positive Relationship

10 9 8 7 6 5 4 3 2 1

100 20 30 40

S co

re s

at Z

G am

Practice Time per Week

(10, 4)

(20, 6)

(30, 8)

(40, 10)

The skateboarders practice times and scores in the competition are plotted on the graph. Each participant is represented by a point. The graph shows that those skateboarders who practiced the most scored the high- est, which indicates a positive, or direct, relationship.

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01 3

negative relationship when two variables change in opposite directions

appendix exhibit 4 A Negative Relationship

$25

0 21 3 4 5 6

P ri

c e o

f D

V D

Quantity of DVDs Purchased

(1, $25)

(2, $20)

(3, $15)

(4, $10)

(5, $5)

Demand curve

The downward slope of the curve means that price and quantity purchased are inversely, or negatively, related: When one increases, the other decreases. That is, moving down along the demand curve from point A to point E, we see that as the price falls, the quantity purchased increases. Moving up along the demand curve from point E to point A, we see that as the price increases, the quantity pur- chased falls.

e n g a g e l

e a rn

in g 2

01 3

28 APPENDIX Working with Graphs

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DVDs become more expensive, Emily buys fewer DVDs, perhaps choosing to go to the movies or buy a pizza instead.

Using Graphs to Show the Relationship among Three Variables Although only two variables are shown on the axes, graphs can be used to show the relationship among three variables. For example, say we add a third variableincometo our earlier example. Our three variables are now income, price, and quantity pur- chased. If Emilys income risessay she gets a raise at workshe is now able and willing to buy more DVDs than before at each possible price. As a result, the whole demand curve shifts outward (to the right) compared with the old curve. That is, the new income gives her more money to use buying more DVDs. This

shift is seen in the graph in Exhibit 5(a). On the other hand, if her income fallssay she quits her job to go back to schoolshe would have less income to buy DVDs. A decrease in this variable causes the whole demand curve to shift inward (to the left) compared with the old curve. This shift is seen in the graph in Exhibit 5(b).

The Difference between a Movement along and a Shift in the Curve It is important to remember the difference between a movement between one point and another along a curve and a shift in the whole curve. A change in one of the variables on the graph, like price or quantity purchased, will cause a movement along the curve, say from point A to point B, as shown in Exhibit 6. A change in one of the variables not shown (held constant in order to show only the relationship between price and quantity), such as income in our example, will cause the whole curve to shift. The change from D

1 to

D 2 in Exhibit 6 shows such a shift.

Slope In economics, we some- times refer to the steep- ness of a line or curve on a graph as the slope. A slope can be either posi- tive (upward sloping) or negative (downward sloping). A curve that is downward sloping represents an inverse, or negative, relationship between the two variables and slants downward from left to right, as seen in Exhibit 7(a). A curve that is upward sloping represents a direct, or positive, relationship between the two variables and

appendix exhibit 5 Shifting a curve

a. Demand Curve with Higher Income

D (with higher income)

P ri

c e o

f D

V D

Quantity of DVDs Purchased 0

b. Demand Curve with Lower Income

D (with lower income)

P ri

c e o

f D

V D

Quantity of DVDs Purchased 0

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01 3

slope the ratio of rise (change in the y variable) over run (change in the x variable)

appendix exhibit 6 Shifts versus Movements

D1 D2

P ri

c e o

f D

V D

Quantity of DVDs Purchased 0

e n g a g e l

e a rn

in g 2

01 3

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slants upward from left to right, as seen in Exhibit 7(b). The numeric value of the slope shows the number of units of change of the y-axis variable for each unit of change in the x-axis variable. Slope provides the direc- tion (positive or negative) as well as the magnitude of the relationship between the two variables.

Measuring the Slope of a Linear Curve A straight-line curve is called a linear curve. The slope of a linear curve between two points measures the rela- tive rates of change of two variables. Specifically, the slope of a linear curve can be defined as the ratio of the change in the Y value to the change in the X value. The slope can also be expressed as the ratio of the rise over the run, where the rise is the vertical change and the run is the horizontal change.

Exhibit 8 shows two linear curves, one with a positive slope and one with a negative slope. In

Exhibit 8(a), the slope of the positively sloped linear curve from point A to B is 1/2, because the rise is 1 (from 2 to 3) and the run is 2 (from 1 to 3). In Exhibit 8(b), the negatively sloped linear curve has a slope of 4: a rise of 8 (a fall of 8, from 10 to 2) and a run of 2 (from 2 to 4) gives us a slope of 8/2, or 4. Notice the appropriate signs on the slopes: the negatively sloped line carries a minus sign and the positively sloped line, a plus sign.

Finding the Slope of a Nonlinear Curve In Exhibit 9, we show the slope of a nonlinear curve. A nonlinear curve is a line that actually curves. Here the slope varies from point to point along the curve. However, we can find the slope of this curve at any given point by drawing a straight line tangent to that point on the curve. A tangency is when a straight line just touches the curve without actually crossing it. At

appendix exhibit 7

Downward- and upward-Sloping linear curves

a. Downward-Sloping Linear Curve

5 10 15 20 25

Downward sloping

b. Upward-Sloping Linear Curve

5 10 15 20 25

Upward sloping

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01 3

appendix exhibit 8

Slopes of Positive and Negative curves

a. Positive Slope b. Negative Slope

y -a

x is

x-axis

10 9 8 7 6 5 4 3 2 1

1 2 3 4 5 60

A B

2 Run

1 Rise

Positive slope 1/2

y -a

x is

x-axis

10 9 8 7 6 5 4 3 2 1

1 2 3 4 5 60

B +2 Run

Negative slope

8 Rise

A k

u B

c E

J P

E k

/S h

u T

T E

R S T

O c

k .c

O M

l O

R ID

A S T

O c

k /S

h u

T T

E R

S T

O c

k .c

O M

appendix exhibit 9 Slopes of a Nonlinear curve

y -a

x is

x-axis

1 2 3 4 5 760

A C

Slope 0

h O

T O

G l

/S h

u T

T E

R S T

O c

k .c

O M

30 APPENDIX Working with Graphs

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y-axis 26 x-axis 26 pie chart 26

bar graph 26 time-series graph 26 variable 26

positive relationship 27 negative relationship 28 slope 29

1. The following table gives the prices and quantity demanded of oranges (pounds) for the week of December 1016.

Price ($/lb.) Quantity Demanded (lbs.)

$0.80 0 0.70 3 0.60 4 0.50 5 0.40 7

a. Plot the data from the table into a graph. b. Is it a positive or negative relationship? Explain.

Answer

We have created a negatively sloped demand curve. That is, the price and quantity demanded of oranges are inversely related:

P Q D and P Q

Individual demand curve of a customer for oranges of a certain grade, Week of December 1016. The demand curve records the pounds of oranges a consumer desires at various prices in a given week, holding all other

factors fixed. Because the individual desires more oranges at lower prices, the demand curve slopes downward.

0.80

0.70

0.60

Demand curve

P ri

c e (

$ )

0.50

0.40

0 2 4 5

Quantity Demanded (lbs.)

6 8 10 Q

key Terms and concepts

Problems

point A, we see that the positively sloped line that is tangent to the curve has a slope of 1: the line rises 1 and runs 1. At point B, the line is horizontal, so it has zero slope. At point C, we see a slope of 2, because the negatively sloped line has a rise of 2 (a fall of 2) for every run of 1.

Remember, many students have problems with eco- nomics simply because they fail to understand graphs, so make sure that you understand this material before going on to Chapter 2.

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2. Which of the following will lead to a positive relationship? A negative relationship? a. hours studied and grade in a course b. the price of ice cream and the amount of ice cream purchased c. the amount of seasonal snowfall and the sale of snow shovels

Answer a. positive b. negative c. positive

3. Below is Emilys demand curve for pizza. How do we add income, a third variable, to price and quantity purchased on our graph? Using a graph, explain what would happen if Emily had an increase in income. What would happen if Emily has a decrease in income?

Answer

Quantity of Pizzas (per week)

P ri

c e o

f P

iz za

D1D3 D2

Quantity of Pizzas (per week)

P ri

c e o

f P

iz za

When income increases, Emily can purchase more pizzas at each and every pricea rightward shift from D 1 to D

2 . If

Emilys income falls, her demand will shift leftward from D 1 to D

3 .

4. Use the information in the following table to plot a graph. Is it a positive or negative relationship? What is the slope?

x y 1 2 2 4 3 6 4 8 5 10

Answer

y -a

x is

x-axis 1 2 3 4 5

1 Run

2 Rise

Positive Slope = = = + 2 Rise Run

2 1

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5. What is a pie chart? Bar graph? Time-series graph?

Answer

Pie charts are used to show the relative size of various quantities that add up to 100 percent. Bar graphs are used to show a comparison of quantities of similar items. Time-series graphs allow us to see important trends over a period of time.

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2c h a p t e r t w oEconomics: Eight Powerful Ideas2.1 IDEA 1: People Face Scarcity and Costly Trade-offs2.2 IDEA 2: People Engage in Rational Decision Making and Marginal Thinking2.3 IDEA 3: People Respond Predictably to Changes in Incentives2.4 IDEA 4: Specialization and Trade Can Make Everyone Better Off

2.5 IDEA 5: Markets Can Improve Economic Efficiency 2.6 IDEA 6: Appropriate Government Policies Can Improve

Market Outcomes 2.7 IDEA 7: Government Policies May Help Stabilize the

Economy 2.8 IDEA 8: Higher Productivity Leads to Economic Growth

You’re thinking about cutting class and going to the beach? Is the expected marginal ben- efit greater than the expected marginal cost? What if it is expected to be windy and rainy? What if you have a final next class period, and today is the review? Do these scenarios affect your decision? Studying economics may teach you how to think better, because economics helps develop a disciplined method of

COuRTESY OF ROBERT SExTOn

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thinking about problems. A student of economics becomes aware that, at a basic level, much of economic life involves choosing one course of action rather than anothermaking choices among our conflicting wants and desires in a world of scarcity. Economics provides insights about how to intelligently evaluate these options and determine the most appropriate choices in given situations.

This chapter presents eight powerful ideas that will help you understand the economic way of thinking. The economic way of thinking provides a logical framework for organizing and analyzing your understanding of a broad set of issues, many of which do not even seem directly related to economics as you now know it.

The basic ideas that you learn in this chapter will occur repeatedly throughout the text. If you develop a good understanding of these principles and master the problem-solving skills inherent in them, they will serve you well for the rest of your life. Learning to think like an economist takes time. Like most disciplines, economics has its own specialized vocabulary, including such terms as elasticity, comparative advantage, supply and demand, deadweight loss, and consumer surplus. Learning economics requires more than picking up this new terminolo- gy; however, it also involves using its powerful tools to improve your understanding of a whole host of issues in the world around you.

Introduction This chapter presents eight powerful ideas that serve as the foundation of economics. Most of economics is really knowing certain principles well and knowing how and when to apply them. These few basic ideas will occur repeatedly throughout the text and are presented in this chapter as a preview of what is to come. if you develop a good understanding of these principles and master the problem-solving skills inherent in them, they will serve you well for the rest of your life.

The first three ideas focus on individual behavior: people face scarcity and costly trade-offs; people are rational decision makers and engage in marginal thinking; and people respond predictably to incentives. The next three ideas emphasize the interaction of people: specialization and trade makes people better off; markets can improve economic efficiency; and appropriate government policies can improve economic outcomes. The final two ideas are about how the economy as a whole interacts: government policies may help stabilize the econ- omy, and increased productivity leads to economic growth.

Human Wants Exceed Available Resources Eonomics is concerned primarily with scarcityhow we satisfy our unlimited wants in a world of limited resources. We may want essential items such as food, clothing, schooling, and health care.

scarcity exists when human wants (material and nonmaterial) exceed available resources

What are goods and services?

What are tangible and intangible goods?

What are economic goods?

Why do we have to make choices?

What do we give up when we have to

choose?

IDEA 1: People Face Scarcity and Costly Trade-offs

2.1

C O

u R

T E

S Y

O F

R O

B E

R T

L . S E

x T

O n

All the things you see heregrass, trees, rocks, animalsare considered land to economists.

chapter 2 Economics: Eight Powerful Ideas 35

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We may want many other items, such as vacations, cars, computers, and concert tickets. We may want more friendship, love, knowledge, and so on. We also may have many goalsper- haps an A in this class, a college education, and a great job. Unfortunately, people are not able to fulfill all their wants and desires, material and nonmaterial. Or, in the words of Mick Jagger, You cant always get what you want. And as long as human wants exceed available resources, scarcity will exist.

Scarcity and Resources Our desires and wants could all be met if we had unlimited resources. Unfortunately, resources are scarce: they are desirable and limited. Consequently, people have to make choices.

As we learned in the last chapter, a resource is anything that can be used to produce something else. Resources are costly because they have alternative uses. When we use land for a new football stadium that same land cannot be used for something else that is valuable like an office building or a hotel.

The scarce resources used in the production of goods and services can be grouped into four categories: labor, land, capital, and entrepreneurship.

Labor is the total of both physical and mental effort expended by people in the produc- tion of goods and services. The services of a teacher, nurse, cosmetic surgeon, professional golfer, and an electrician all fall under the general category of labor.

Land includes the gifts of nature or the natural resources used in the production of goods and services. Economists consider land to include trees, animals, water, minerals, and so on, along with the physical space we normally think of as land.

Capital is the equipment and structures used to produce goods and services. Office buildings, tools, machines, and factories are all considered capital goods. When we invest in factories, machines, research and development, or education, we increase the potential to create more goods and services in the future. Capital also includes human capitalthe pro- ductive knowledge and skill people receive from education and on-the-job training.

Entrepreneurship is the process of combining labor, land, and capital to produce goods and services. Entrepreneurs make the tough and risky decisions about what and how to produce goods and services. Entrepreneurs are always looking for new ways to improve production techniques or to create new products. They are lured by the chance of making a profit. It is this opportunity to make a profit that leads entrepreneurs to take risks.

Profits provide the financial incentive and income for entrepreneurs for their effort and risk if they are successful. Losses provide the financial incentive to let entrepreneurs know that resources are not being used efficiently.

Entrepreneurship is not just about new technology. Its also about the introduction of new goods, new production methods, new markets, new sources of raw materials, and new organizational structures.

However, not every entrepreneur is a Bill Gates or a Henry Ford. In some sense, we are all entrepreneurs when we try new products or when we find better ways to manage our households or our study time. Rather than money, then, our profits might take the form of greater enjoyment, additional time for recreation, or better grades.

What Are Goods and Services? Goods are the items that we value or desire to satisfy our wants. Goods tend to be tangible objects that can be seen, held, tasted, or smelled, such as shirts, pizzas, and perfume.

Goods that we cannot reach out and touch are called intangible goods, which includes fairness for all, friendship, leisure, knowledge, security, prestige, respect, and health.

Services are intangible acts for which people are willing to pay, such as legal counsel, medical care, and education. Services are intangible because they are less overtly visible, but they are certainly no less valuable than goods.

labor the physical and human effort used in the production of goods and services

land the natural resources used in the production of goods and services

capital the equipment and structures used to produce goods and services

human capital the productive knowledge and skill people receive from education, on-the- job training, health, and other factors that increase productivity

entrepreneurship the process of combining labor, land, and capital to produce goods and services

goods items we value or desire

tangible goods items we value or desire that we can reach out and touch

intangible goods goods that we cannot reach out and touch, such as friendship and knowledge

services intangible items of value provided to consumers, such as education

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All goods and services, whether tangible or intangible, are produced from scarce resources and can be subjected to economic analysis. Scarce goods created from scarce resources are called economic goods. These goods are desirable but limited in amount.

Oxygen to breathe is not scarce because it is desirable and abundant. Garbage is not scarce because it is abundant but not desirable. However, freedom, books, vacations, com- puters, cell phones, cars, houses, drinkable water, clean air, health, and sunlight in December in Anchorage, Alaska, are all scarce. That is, for most people, all of these things are desirable but limited in amountthat is, scarce.

Without enough economic goods for all of us, we are forced to compete. That is, scarcity ultimately leads to competition for the available goods and services, a subject we will return to often in the text.

What Are Bads? In contrast to goods, bads are those items that we do not desire or want. For most people, garbage, pollution, weeds, and crime are bads. People tend to eliminate or minimize bads, so they will often pay to have bads, like garbage, removed. The elimination of the badgarbage removal, for exampleis a good.

Does Everyone Face Scarcity? We all face scarcity because we cannot have all the goods and services we desire. However, because we all have different wants and desires, scarcity affects everyone differently. For example, a child in a developing country may face a scarcity of food and clean drinking water, while a rich man may face a scarcity of garage space for his growing antique car collection. Likewise, a harried middle-class working mother may find time for exercise particularly scarce, while a pharmaceutical company may be concerned with the scarcity of the natural resources it uses in its production process. Its effects may vary, but no one can escape scarcity.

We often hear it said of rich people that He has everything, or She can buy anything she wants. Actually, even the richest person must live with scarcity and must, at some point, choose one want or desire over another. That is, even rich people have finite income. And of course, we all have only 24 hours in a day! The problem is that as we get more affluent, we learn of new luxuries to provide us with satisfaction. Wealth, then, creates a new set of wants to be satisfied. No evidence indicates that people would not find a valuable use for additional income, no matter how rich they became. Even the wealthy individual who decides to donate all her money to charity faces the constraints of scarcity. If she had greater resources, she could do still more for others.

Not even millionaire lottery winners can escape scarcity. They may become less content as the excitement wears off and they begin looking for new satisfactions. After winning his second $1 million scratch-off lottery, a 78-year-old man from Michigan said, I am now going for three.

Will Scarcity Ever Be Eradicated? It is probably clear by now that scarcity never has and never will be eradicated. The same creativity that develops new methods to produce goods and services in greater quantities also reveals new wants. Fashions are always changing. Clothes and shoes that are

economic goods scarce goods created from scarce resourcesgoods that are desirable but limited in supply

bads items that we do not desire or want, where less is preferred to more, like terrorism, smog, or poison oak

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in one year will likely be out the next. New wants quickly replace old ones. It is also quite possible that over a period of time, a rising quantity of goods and services will not increase human happiness. Why? Because our wants may grow as fastif not fasterthan our ability to meet those wants.

Wants versus Needs To an economist, the terms wants and needs are very different. In fact, it is difficult to objec- tively define a need. To most, a need is something you must have and dont currently pos- sess. But it can be used to describe a trivial wish, a want, or something that is essential for survival. A need can be more or less urgent, depending on the circumstances. Whenever you hear somebody say, I need a new car, I need a vacation, or I need new clothes, always be sure to ask: What does the person really mean?

During rush hour, freeways can get very congested. Perhaps we should have an express lane for people who have urgent needs. What do you think of this idea? Imagine the number of people who would develop what they felt were urgent needs if the urgent need lane was much shorter than the other lanes. It would be inevitable that the system would fall apart. In fact, it would be fun to guess what might be defined as an urgent need when you are stopped by the urgent need police. It might include: I am really in a hurry be cause I have to get home to clean my apartment, or I need to get back to the dorm to type a term paper that is overdue. Oh, shoot, I left the dog in the house. Many people would perceive their needs as more urgent than other peoples urgent needs. This is a reason that the concept of need falls apart as a means of explain ing behavior. It is impossible to make the concept of need useful when it is so hard to define or compare those needs among people.

Need as a concept ignores scarcity and the fact that choices may change with circumstances and trade-offs. In a world of scarcity, we have unlimited wants in the face of limited resources. That is, we all must make choices because we have competing wants and limited resources. Whenever we choose, we can satisfy one want but we leave other wants not satisfied. We might satisfy our want for a new car but it may leave other wants, like a trip to Hawaii, tuition, or paying rent, unfilled. That is, every want that is satisfied leaves other wants that are unsatisfied.

Scarcity Forces Us to Choose Each of us might want a nice home, two luxury cars, wholesome and good-tasting food, a personal trainer, and a therapist, all enjoyed in a pristine environment with zero pollution. If we had unlimited resources, and thus an ability to produce all the goods and services everyone wants, we would not have to choose among those desires. However, we all face scarcity, and as a consequence, we must make choices. If we did not have to make meaning- ful economic choices, the study of economics would not be necessary. The essence of eco- nomics is to understand fully the implications that scarcity has for wise decision making.

Trade-Offs In a world of scarcity, we all face trade-offs. If you spend more time at work you might give up an opportunity to go shopping at the mall or watch your favorite television show. Time spent exercising means giving up something else that is valuableperhaps relaxing with friends or studying for an upcoming exam. Or when you decide how to spend your income, buying a new car may mean you have to forgo a summer vacation. Businesses have trade- offs, too. If a farmer chooses to plant his land in cotton this year, he gives up the opportunity to plant his land in wheat. If a firm decides to produce only cars, it gives up the opportunity to use those resources to produce refrigerators or something else that people value. Society,

What is the difference between a want and aneed?

Doesnt the fact that we face scarcity mean we have to compete for the limited resources?

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too, must make trade-offs. For example, the federal government faces trade-offs when it comes to spending tax revenues; additional resources used to enhance the environment may come at the expense of additional resources to provide health, education, or national defense.

To Choose Is to Lose Every choice involves a cost. Anytime you are doing something, you could be doing some- thing else. The highest or best forgone opportunity resulting from a decision is called the opportunity cost. Another way to put it is that to choose is to lose, or, An opportunity cost is the highest valued opportunity lost. It is important to remember that the opportunity cost involves the next highest valued alternative, not all alternatives not chosen. For exam- ple, what would you have been doing with your time if you were not reading this book? That alternative is what you give up, not all the things you could have been doing. To get more of anything that is desirable, you must accept less of something else that you also value.

Every choice you make has a cost, an opportunity cost. All productive resources have alternative uses regardless of who owns themindividuals, firms, or government. For example, if a city uses land for a new school, the cost is the next-best alternative use of that landperhaps, a park. To have a meaningful understanding of cost, you must be able to compare the alternative opportunities that are sacrificed in that choice.

Bill Gates, Tiger Woods, and Oprah Winfrey all quit college to pursue their dreams. Tiger Woods dropped out of Stanford (an economics major) to join the PGA golf tour. Bill Gates dropped out of Harvard to start a software company. Oprah Winfrey dropped out of Tennessee State to pursue a career in broadcasting. At the early age of 19, she became the co-anchor of the evening news. LeBron James (Miami Heat), Kobe Bryant (LA Lakers), and Alex Rodriguez (New York Yankees) understood opportunity cost; they didnt even start college, and it worked out well for them. Staying in, or starting, college would have cost each of them millions of dollars. Wecannot say it would have been the wrong decision to stay in or never start college, but it would have been costly. Their opportunity cost of staying in or going to or starting college was high.

Money Costs and Nonmoney Costs If you go to the store to buy groceries, you have to pay for the items you bought. This money cost is an opportunity cost, because you could have used that money to purchase other goods or services. However, additional oppor- tunity costs include the nonprice costs incurred to acquire the groceriestime spent getting to the grocery store, finding a parking place, actual shopping, and waiting in the checkout line. The nonprice costs are measured by assess- ing the sacrifice involvedthe value you place on what you would have done with that time if you had not gone shopping. So the cost of grocery shopping is the price paid for the goods, plus the nonprice costs incurred. Or your con- cert ticket may have only been $50. But what if you had to wait in line for six hours in the freezing cold? Waiting and enduring the cold are costs, too. Seldom are costs just dollars and cents. Shopping at a large discount store may save you on the money price, but cost you time waiting in long checkout lines. Also, buying food in bulk quantities may be less expensive per ounce, but cost inventory space in your pantry, or the food may spoil before it is eaten.

Remember that many costs do not involve money but are still costs. Do I major in economics or engineering? Do I go to Billy Madison University or Tech State University? Should I get an MBA now or work and wait a few years to go back to school?

Choices have present and future consequences. What if I decide not to study for my final exams? What future consequences will I bear? Flunk out of school? Not get into graduate school?

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The famous poet, Robert Frost, understood that choices have costs. In his poem, The Road Not Taken, he writes, two roads diverged in a yellow wood, and sorry I could not travel both.

opportunity cost the value of the best forgone alternative that was not chosen

Is an opportunity cost all the things you give up when you make a choice?

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Policy makers are unavoidably faced with opportunity costs, too. Consider airline safety. Both money costs and time costs affect airline safety. New airline safety devices cost money (lug- gage inspection devices, smoke detectors, fuel tank safeguards, new radar equipment, and so on), and time costs are quite evident with the new security checks. Time waiting in line costs time doing something else that is valuable. New airline safety requirements could also actually cost lives. If the new safety equipment costs are passed on in the form of higher airline ticket prices, people may choose to travel by car, which is far more dangerous per mile traveled than by air. Opportunity costs are everywhere! And the real cost of anything is what you have to give up to get it.

The Opportunity Cost of Going to College or Having a Child The average person often does not correctly calculate opportu- nity costs. For example, the (opportunity) cost of going to college includes not just the direct expenses of tuition and books. Of

course, those expenses do involve an opportunity cost because the money used for books and tuition could be used to buy other things that you value. But what about the nonmoney costs? That is, going to college also includes the opportunity cost of your time. Specifically, the time spent going to school is time that could have been spent on a job earning, say, $30,000 over the course of an academic year. What about room and board? That aspect is a little tricky because you would presumably have to pay room and board whether you went to college or not. The relevant question may be how much more it costs you to live at school rather than at home (and living at home may have substantial nonmoney costs). Even if you stayed at home, your parents would sacrifice something; they could rent your room out or use the room for some other purpose such as storage, guest room, home office, a siblings room, and so on.

How often do people consider the full opportunity of raising a child to age 18? The obvious money costs include food, visits to the doctor, clothes, piano lessons, time spent at

Economic questions are all around you. Take for instance the people who lined up to buy the latest Apple iPhone. Not only did it cost them money to purchase the item, but it also cost them time waiting in linetime that they might have spent doing other things. Choices like this one are all around us. By studying economics, we can better understand these choices and hopefully make better ones.

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Is That Really a Free Lunch, a Freeway, or a Free Beach?

what youve learned

The expression, Theres no such thing as a free lunch, clarifies the relationship between scarcity and opportunity cost. Suppose the school cafete- ria is offering free lunches today. Although the lunch is free to you, is it really free from societys perspective? The answer is no, because some of societys scarce resources will have been used in the preparation of the lunch. The issue is whether the resources that went into creating that lunch could have been used to produce something else of value. Clearly, the scarce resources that went into the production of the lunchthe labor and materials (food-service workers, lettuce, meat, plows, tractors,

fertilizer, and so forth)could have been used in other ways. They had an opportunity cost and thus were not free.

Do not confuse free with a zero monetary price. A number of goodsfreeways, free beaches, and free libraries, for instancedo not cost consumers money, but they are still scarce. Few things are free in the sense that they use none of societys scarce resourc- es. So what does a free lunch really mean? It is, tech- nically speaking, a subsidized luncha lunch using societys scarce resources, but one that the person receiving it does not have to pay for personally.

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soccer practices, and so on. According to the Department of Agriculture, a middle-income family with a child born in 2011 can expect to spend about $300,000 for food, shelter, and other necessities to raise that child through age 17. And that does not include college. Other substantial opportunity costs are incurred in raising a child as well. Consider the opportunity cost of one parent choosing to give up his or her job to stay at home. For a parent who makes that choice, the time spent in child raising is time that could have been used earning money and pursuing a career.

S E C T I O N Q U I Z

1. Scarcity occurs because our _________ wants exceed our _________ resources.

a. limited; unlimited

b. unlimited; limited

c. limited; unlimited

d unlimited; unlimited

2. Scarcity and rarity are

a. the same because both words means the good is limited in supply.

b. different because something might be rare, but if it is not desirable, it is not scarce.

c. different because scarcity only affects poor people and rarity only affects rich people.

d. All of the above are true.

3. Scarce resources include

a. laborthe human effort used in producing goods and services.

b. landthe natural resources used in the production of goods and services.

c. capitalthe equipment and structures used to produce goods and services.

d. entrepreneurshipthe process of combining labor, land, and capital to produce goods and services.

e. all of the above.

4. To economists, needs

a. are difficult to define.

b. can be more or less urgent, depending on the circumstances.

c. are hard to compare among people.

d. ignore scarcity and the fact that choices may change with circumstances and trade-offs.

e. all of the above.

5. Which of the following statements is true?

a. The opportunity cost of a decision is always expressed in monetary terms.

b. The opportunity cost of a decision is the value of the best forgone alternative.

c. Some economic decisions have zero opportunity cost.

d. The opportunity cost of attending college is the same for all students at the same university but may differ amongstudents at different universities.

e. none of the above statements is true.

6. Money costs

a. are not opportunity costs, since they involve money.

b. are opportunity costs, because you could have used that money to buy other goods and services.

c. are always the only relevant opportunity costs.

d. both (a) and (c). (continued)

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S E C T I O N Q U I Z (Cont.)

7. Which of the following involve an opportunity cost?

a. choosing to go to law school rather than business school

b. the money I used to pay for my new laptop

c. new airline safety regulations

d. all of the above

8. Which of the following are the opportunity costs of going to college?

a. tuition

b. books needed for classes

c. the job I was going to take if I did not go to school

d. all of the above

1. What must be true for something to be an economic good?

2. Why does scarcity affect everyone?

3. How and why does scarcity affect each of us differently?

4. Why might daylight be scarce in Anchorage, Alaska, in the winter but not in the summer?

5 Would we have to make choices if we had unlimited resources?

6 What do we mean by opportunity cost?

7 Why was the opportunity cost of going to college higher for LeBron James (Miami Heat star) than for most undergraduates?

8. Why is the opportunity cost of time spent getting an MBA typically lower for a 22-year-old straight out of college

thanfor a 45-year-old experienced manager?

Answers: 1. b 2. b 3. e 4. e 5. b 6. b 7. d 8. d

What is rational decision making?

What do we mean by marginal thinking?

What is the rule of rational choice?

Why do we use the word expected with

marginal benefits and costs?

IDEA 2: People Engage in RationalDecision Making and Marginal Thinking

Do People Engage in Rational Decision Making? Recall from Chapter 1 that economists assume that people, for the most part, engage in rational, or purposeful, behavior. That is, people systematically and purposefully do the best they can, based on their values and information, under current and anticipated future circumstances. In short, as rational individuals, we are influenced by an array of incentives, social norms, and past experiences. We act the way we do because we do not want to make

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ourselves worse off. Even if everyone does not behave rationally all the time, the assumption of rational decision making is still very useful in explaining most of the choices that individu- als make.

Many Choices We Face Involve Marginal Thinking Some decisions are all or nothing, like whether to start a new business or go to work for someone else, or whether to attend graduate school or take a job. But rational people know that many decisions are not black and white. Many choices we face involve how much of something to do rather than whether to do something. It is not whether you eat but how much will you eat? Or how many caffe lattes will I buy this week? Or how often do I change the oil in my car? Or how much of my check do I spend, and how much do I save? Your instructors hope that the question is not whether you study this semester but how much you study. You might think to yourself, If I studied a little more, I might be able to improve my grade, or, If I had a little better concentration when I was studying, I could improve my grade. That is, spending more time has an additional expected benefit (a higher grade) and an additional expected cost (giving up time to do something else that is valuable, such as watching TV or sleeping). These examples reflect what economists call marginal thinking because the focus is on the additional, or marginal, choices available to you. Or think of marginal as the edgemarginal decisions are made around the edge of what you are currently doing. Marginal choices involve the effects of adding or subtracting from the current situation. In short, they are the small (or large) incremental changes to a plan of action.

Businesses are constantly engaged in marginal thinking. For example, firms have to decide whether the additional (marginal) revenue received from increasing production is greater than the marginal cost of that production.

Always watch out for the difference between average and marginal costs. Suppose an airline had 10 unoccupied seats on a flight from Los Angeles to New York, and the aver- age cost was $400 per seat (the total cost divided by the number of seats$100,000/250). If 10 people are waiting on standby, each willing to pay $300, should the airline sell them the tickets? Yes! The unoccupied seats earn nothing for the airline. What are the additional (marginal) costs of a few more passengers? The marginal costs are minimalslight wear and tear on the airplane, handling some extra baggage, and 10 extra in-flight meals. In this case, thinking at the margin can increase total profits, even if it means selling at less than the average cost of production.

Another good example of marginal thinking is an auction. Prices are bid up marginally as the auctioneer calls out one price after another. When bidders view the new price (the mar- ginal cost) to be greater than the value they place on the good (the marginal benefit), they withdraw from further bidding.

In trying to make themselves better off, people alter their behavior if the expected marginal benefits from doing so outweigh the expected marginal costs, which is the rule of rational choice. Economic theory is often called marginal analysis because it assumes that people are always weighing the expected marginal benefits against the expected marginal costs. The term expected is used with marginal bene- fits and marginal costs because the world is uncertain in many important respects, so the actual result of changing behavior may not always make people better off. However, as a matter of rationality, people are assumed to engage only in behavior that they think ahead of time will make them better off. That is, individuals will only pursue an activity if their expected

rational decision making people do the best they can, based on their values and information, under current and anticipated future circumstances.

marginal thinking focusing on the additional, or marginal, choices; marginal choices involve the effects of adding or subtracting, from the current situation, the small (or large) incremental changes to a plan of action

rule of rational choice individuals will pursue an activity if the expected marginal benefits are greater than the expected marginal costs

Effective decision making requires comparing the additional costs of alterna- tives with the additional benefits. Most choices involve doing a little more or a little less of some- thing: few choices are all or nothing decisions.

ECS economic content standards

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During rush hour some drivers will switch into and out of lanes if they perceive one lane is moving faster that another. This is a marginal adjustment. The same is true of lines in a supermarket. People are constantly weigh- ing the marginal benefits and marginal costs of changing lanes and/or lines.

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marginal benefits are greater than their expected marginal costs of pursuing that activity one step further, E(MB) > E(MC).

This fairly unrestrictive and realistic view of individuals seeking self-betterment can be used to analyze a variety of social phenomena.

Suppose that you have to get up for an 8 a.m. class but have been up very late. When the alarm goes off at 7a.m. you are weighing the marginal benefits and marginal costs of an extra 15 minutes of sleep. If you perceive the marginal benefits of 15 additional minutes of sleep to be greater than the marginal costs of those extra minutes, you may choose to hit the snooze button. Or perhaps you may decide to blow off class completely. But its unlikely that you will choose that action if its the day of the final exambecause it is now likely that the net benefits (the difference between the expected marginal benefits and the expected marginal costs) of skipping class have changed. When people have opportunities to make themselves better off they usually take them. And they will continue to seek those opportuni- ties as long as they expect a net benefit from doing so.

To determine the optimal or best public policy program, voters and government offi- cials must compare the expected marginal benefits against the expected marginal costs of providing a little more or a little less of the programs services.

Rational decision makers will follow the rule of rational choice. This is simply the rule of being sensible, and most economists believe that individuals act as if they are sensible and apply the rule of rational choice to their daily lives. It is a rule that can help us understand our decisions to study, walk, shop, exercise, clean house, cook, and perform just about every other action.

It is also a rule that we will continue to use throughout the text. Because whether it is consumers, producers, or policy makers, they all must compare the expected marginal benefits and the expected marginal cost to determine the best level to consume, produce, or provide public programs.

Zero Pollution Would Be Too Costly Lets use the concept of marginal thinking to evaluate pollution levels. We all know the benefits of a cleaner environment, but what would we have to give upthat is, what mar- ginal costs would we have to incurto achieve zero pollution? A lot! You could not drive a car, fly in a plane, or even ride a bicycle, especially if everybody else were riding bikes, too (because congestion is a form of pollution). How would you get to school or work, or go to the movies or the grocery store? Everyone would have to grow their own food because transporting, storing, and producing food uses machinery and equipment that pollute. And even growing your own food would be a problem because many plants emit natural pol- lutants. We could go on and on. The point is not that we shouldnt be concerned about

the environment; rather, we have to weigh the expected marginal benefits of a cleaner environment against the expected marginal costs of a cleaner envi- ronment. This discussion is not meant to say the environment should not be cleaner, only that zero pollution levels would be far too costly in terms of what we would have to give up.

Optimal (Best) Levels of Safety Like pollution, crime and safety can have optimal (or best) levels that are greater than zero. Take crime. What would it cost society to have zero crime? It would be prohibitively costly to divert a tremendous amount of our valu- able resources toward the complete elimination of crime. In fact, it would be impossible to eliminate crime totally. Even reducing crime significantly would be costly. Because lower crime rates are costly, society must decide how much it is willing to give up. The additional resources for crime prevention can only come from limited resources, which could be used to produce something else that people may value even more.

net benefit the difference between the expected marginal benefits and the expected marginal costs

Do government policy makers have to weigh their expected marginal benefits against their expected marginal costs?

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If you decide to buy a more expensive diamond ring for your fiancee, what are the expected marginal benefits? What are the expected marginal costs? What did you give up part of a down payment for a house, a nicer honeymoon?

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The same is true for safer products. Nobody wants defective tires on their cars, or cars that are unsafe and roll over at low speeds. The optimal amount of risk may not be zero. The issue is not safe versus unsafe products but rather, how much safety we want. It is not risk versus no-risk but rather, how much risk we are willing to take. Additional safety can only come at higher costs. To make all products perfectly safe would be impossible, so we must weigh the benefits and costs of safer products. In fact, according to one study by Sam Peltzman, a University of Chicago economist, additional safety regulations in cars (manda- tory safety belts and padded dashboards) in the late 1960s may have had little impact on highway fatalities. Peltzman found that making cars safer led to more reckless driving and more accidents. The safety regulations did result in fewer deaths per automobile accident, but the total number of deaths remained unchanged because more accidents occurred.

Reckless driving has a benefit in the form of getting somewhere more quickly, but it can also have a costan accident or even a fatality. Most people will compare the marginal benefits and marginal costs of safer driving and make the choices that they believe will get them to their destination safely.

Shouldnt all products be perfectly safe?

S E C T I O N Q U I Z

1. Which of the following demonstrates marginal thinking?

a. deciding to never eat meat

b. deciding to spend one more hour studying economics tonight because you think the improvement on your next test will be large enough to make it worthwhile to you

c. working out an extra hour per week

d. both (b) and (c)

2. Which of the following best reflects rational decision-making behavior?

a. analyzing the total costs of a decision

b. analyzing the total benefits of a decision

c. undertaking an activity as long as the total benefits exceed the total costs

d. undertaking an activity whenever the marginal benefit exceeds the marginal cost

e. undertaking activities as long as the marginal benefit exceeds zero

3. Individual gallons of milk at a local grocery story are priced at $4, but two gallons purchased at the same time are priced at $6 for two. The marginal cost of buying a second gallon of milk on a shopping trip is

a. $6.

b. $4.

c. $3.

d. $2.

e. none of the above.

4. The results of which of the following activities would marginal thinking help improve?

a. studying

b. driving

c. shopping

d. looking for a place to park your car

e. all of the above

1. What are marginal choices? Why does economics focus on them?

2. What is the rule of rational choice?

(continued)

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Answers: 1. d 2. d 3. d 4. e

S E C T I O N Q U I Z (Cont.)

3. How could the rule of rational choice be expressed in terms of net benefits?

4. Why does rational choice involve expectations?

5. What is rational decision making?

6. Why do students often stop taking lecture notes when a professor announces that the next few minutes of material will not be on any future test or assignment?

7. If you decide to speed to get to a doctors appointment and then get in an accident due to speeding, does your decision to speed invalidate the rule of rational choice? Why or why not?

8. If pedestrians felt far safer using crosswalks to cross the street, how could adding crosswalks increase the number of pedestrian accidents?

9. Imagine driving a car with daggers sticking out of the steering wheelpointing directly at your chest. Would you drive more safely? Why?

Can we predict how people will respond to

changes in incentives?

What are positive incentives?

What are negative incentives?

IDEA 3: People Respond Predictably to Changes in Incentives

Changes in Incentives Change Individual Behavior Because most people are seeking opportunities to make them- selves better off, they respond to changes in incentives. If you can figure out what peoples incentives are, there is a good chance you can predict their behavior. That is, they are react- ing to changes in expected marginal benefits and expected marginal costs. In fact, much of human behavior can be explained and predicted as a response to changing incentives. That is, changes in incentives cause people to change their behavior in predictable ways.

Positive and Negative Incentives Almost all of economics can be reduced to incentive stories, where consumers and producers are driven by incentives that

affect expected costs or benefits. An incentive induces people to respond to a reward or a punishment. We just discussed that most rational people predictably respond to changes in incentives by weighing the expected marginal benefits against the expected marginal cost. Prices, wages, profits, taxes, and subsidies are all examples of economic incentives. Incentives can be classified into two types: positive and negative. Positive incentives are those that either

positive incentive an incentive that either reduces costs or increases benefits, resulting in an increase in an activity or behavior

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A subsidy on hybrid electric vehicles would be a positive incentive that would encourage greater production and consumption of these vehicles. A wide variety of incen- tives are offered at the federal, state, and local levels to encourage the expanded use of alternative-fuel vehicles.

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increase benefits or reduce costs and thus result in an increased level of the related activity or behavior. Negative incentives, on the other hand, either reduce benefits or increase costs, resulting in a decreased level of the related activity or behavior. For example, a tax on cars that emit lots of pollution (an increase in costs) would be a negative incentive that would lead to a reduction in emitted pollution. On the other hand, a subsidy (the opposite of a tax) on hybrid carspart electric, part internal combustionwould be a positive incentive that would encourage greater production and consumption of hybrid cars. Human behavior is influenced in predictable ways by such changes in economic incentives, and economists use this information to predict what will happen when the benefits and costs of any choice are changed. In short, economists study the incentives and consequences of particular actions.

Because most people seek opportunities that make them better off, we can predict what will happen when incentives are changed. If salaries increase for engineers and decrease for MBAs, we would predict fewer people would go to graduate school in business and more would go into engineering. A permanent change to a much higher price of gasoline would lead us to expect fewer gas guzzlers on the highway. People who work on commission tend to work harder. If the price of downtown parking increased, we would predict that com- muters would look for alternative methods to get to work that would save money. If house- holds were taxed to conserve water, economists would expect people to use less waterand substantially less water than if they were simply asked to conserve water. Some people are charitable and some people are stingy, but if you change the tax code to give even greater deductions for charitable contributions, we can predict more people will be charitable, even some of those who are stingy. Incentives matter.

negative incentive an incentive that either increases costs or reduces benefits, resulting in a decrease in the activity or behavior

People respond predictably to positive and negative incentives.

ECS economic content standards

S E C T I O N Q U I Z

1. Positive incentives make actions _____________ likely; negative incentives make actions

_____________ likely.

a. more; more

b. more; less

c. less; more

d. less; less

2. A higher price is a _____________ incentive to buyers and a _____________ incentive to sellers.

a. positive; positive

b. positive; negative

c. negative; positive

d. negative; negative

3. Because most people seek opportunities that make people better off,

a. it makes it more difficult to predict behavior.

b. we can predict what will happen when incentives are changed.

c. we cannot predict as well as we could if their behavior was random and chaotic.

d. none of the above is true.

4. If households, water usage was taxed, economists would expect

a. people to use less water.

b. people to use less water, but they would not reduce their consumption by as much as they would if they were asked to conserve water.

c. they would not reduce their water consumption because people need water.

d. none of the above. (continued)

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S E C T I O N Q U I Z (Cont.)

5. Who would be most likely to drop out of college before graduation?

a. an economics major who wishes to go to graduate school

b. a math major with a B+ average

c. a chemistry major who has been reading about the great jobs available for people with chemistry degrees

d. a star baseball player who has just received a multi-million dollar contract offer after his junior year

1. What is the difference between positive incentives and negative incentives?

2. According to the rule of rational choice, would you do more or less of something if its expected marginal benefits

increased? Why?

3. According to the rule of rational choice, would you do more or less of something if its expected marginal costs

increased? Why?

4. How does the rule of rational choice imply that young children are typically more likely to misbehave at a

supermarket checkout counter than at home?

5. Why do many parents refuse to let their children have dessert before they eat the rest of their dinner?

Answers: 1. b 2. c 3. b 4. a 5. d

Why Do People Specialize? As you look around, you can see that people specialize in what they produce. They tend to dedicate their resources to one primary activity, whether it be performing brain surgery, driving a cab, or making bagels. Why? The answer, short and simple, is opportunity costs. By concentrating their energies on only one, or a few, activities, individuals are specializing. This focus allows them to make the best use of (and thus gain the most benefit from) their limited resources. A person, a region, or a country can gain by specializing in the production of the good in which they have a comparative advantage. That is, if they can produce a good or service at a lower opportunity cost than others, we say that they have a comparative advantage in the production of that good or service. Comparative advan- tage changes over time for many reasons, including changes in resources, prices, and events that occur in other countries. For example, the United States once had a comparative advantage in producing shoes, but now imports most of its shoes from foreign countries.

specializing concentrating in the produc- tion of one, or a few, goods

comparative advantage occurs when a person or country can produce a good or service at a lower oppor- tunity cost than others

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Without specialization and division of labor, this car and crew would not be as competitive. Imagine how much time would be lost if one person was changing four tires.

What is the relationship between

opportunity cost and specialization?

What are the advantages of specialization

in production?

IDEA 4: Specialization and Trade Can Make Everyone Better Off

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We All Specialize We all specialize to some extent and rely on others to produce most of the goods and services we want. The work that we choose to do reflects our specialization. For example, we may specialize in selling or fixing automobiles. The wages from that work can then be used to buy goods from a farmer who has chosen to specialize in the production of food. Likewise, the farmer can use the money earned from selling his produce to get his tractor fixed by someone who specializes in that activity.

Specialization is evident not only among individuals but among regions and countries as well. In fact, the story of the economic development of the United States and the rest of the world involves specialization. Within the United States, the Midwest with its wheat, the coastal waters of the Northeast with its fishing fleets, and the Northwest with its timber are each examples of regional specialization.

The Advantages of Specialization In a small business, every employee usually performs a wide variety of tasksfrom hiring to word processing to market- ing. As the size of the company increases, each employee can perform a more specialized job, with a consequent increase in output per worker. The primary advantages of specialization are that employees acquire greater skill from repetition, they avoid wasted time in shifting from one task to another, and they do the types of work for which they are best suitedand specializa- tion promotes the use of specialized equipment for specialized tasks.

The advantages of specialization are seen throughout the workplace. For example, in larger firms, specialists conduct personnel relations, and accounting is in the hands of full- time accountants instead of someone with half a dozen other tasks. Owners of small retail stores select the locations for their stores primarily through guesswork, placing them where they believe sales will be high or where empty low-rent buildings are available. In contrast, larger chains have store sites selected by experts who have experience in analyzing the fac- tors that make different locations relatively more desirable, such as traffic patterns, income levels, demographics, and so on. In short, workers will earn more by specializing in doing the things that they do relatively well because that entails the least sacrifice in opportunities forgone. It also important to remember that even if everyone had similar skills and resources, specialization could still lead to greater production because the concentration of production of some goods and services in one location can sometimes reduce the costs of production.

Specialization and Trade Lead toGreater Wealth and Prosperity Trade, or voluntary exchange, directly increases wealth by mak- ing both parties better off (or they wouldnt trade). It is the prospect of wealth-increasing exchange that leads to produc- tive specialization. That is, trade increases wealth by allowing a person, a region, or a nation to specialize in those products that it produces at a lower opportunity cost and to trade them

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Bangladesh exports low-cost garments to mass-market retailers like Walmart. U.S. workers are a lot more produc- tive in building airplanes and a little more productive in producing clothes than Bangladeshi workers. If the two countries divide the work according to comparative advan- tage, then the U.S. workers would specialize in the tasks at which they are most productive, airplanes. And the the Bangladeshi workers would concentrate on the tasks where their productivity is only slightly less, clothing.

The entrepreneurs at Apple have learned how to com- bine almost 500 generic parts to make something of much greater value. The whole is greater than the sum of the parts. There is not one person at Apple or in the world who could put together an iPhone all alone. It takes many people, making many parts, living all over the world. In other words, specialization and exchange has given us the ability to do things we do not even understand.

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for products that others produce at a lower opportunity cost. That is, we trade with others because it frees up time and resources to do other things that we do better.

In short, if we divide tasks and produce what we do relatively best and trade for the rest, we will be better off than if we were self-sufficientthat is, without trade. Imagine life with- out trade, where you were completely self-sufficientgrowing your own food, making your own clothes, working on your own car, building your own housedo you think you would be better off? For example, say the United States is better at producing wheat than is Brazil, and Brazil is better at producing coffee than is the United States. The United States and Brazil would each benefit if the United States produces wheat and trades some of it to Brazil for coffee. Coffee growers in the United States could grow coffee in expensive greenhouses, but it would result in higher coffee costs and prices, while leaving fewer resources available for employment in more beneficial jobs, such as wheat production.

In the words of growth theorist, Paul Romer, There are huge potential gains from trade. Poor countries can supply their natural and human resources. Rich countries can supply their know-how. When these are combined, everyone can be better off. The chal- lenge is for a country to arrange its laws and institutions so that both sides can profitably engage in trade. Standards of living can be increased through trade and exchange. In fact, the economy as a whole can create more wealth when each person specializes in a task that he or she does relatively best. And through specialization and trade, a country can gain a greater variety of goods and services at a lower cost. So while counties may be competitors in the global market, they are also partners.

When individuals, regions, and nations specialize in what they can produce at lower costs and then trade with others, both produc- tion and consumption increase.

ECS economic content standards

Comparative Advantagewhat youve learned

Q Should an attorney who types 100 words per minute hire an administrative assistant to type her legal documents, even though he can only type 50 words per minute? If the attorney does the job, she can do it in five hours; if the administrative assistant does the job, it takes him 10 hours. The attorney makes $100 an hour, and the administra- tive assistant earns $10 an hour. Which one has the comparative advantage (the lowest opportunity cost) in typing documents?

A If the attorney types her own documents, it will cost $500 ($100 per hour 5 hours). If she has the administrative assistant type her documents, it will cost $100 ($10 per hour 10 hours). Clearly, then, the lawyer should hire the administrative assistant to type her documents, because the admin- istrative assistant has the comparative advantage (lowest opportunity cost) in this case, despite being half as good in absolute terms.

S E C T I O N Q U I Z

1. The person, region, or country that can produce a good or service at a ________ opportunity cost

than other producers has a ________ advantage in the production of that good or service.

a. higher; comparative

b. lower; absolute

c. lower; comparative

d. higher; absolute

(continued)

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S E C T I O N Q U I Z (Cont.)

2. Specialization is important for

a. individuals.

b. businesses.

c. regions.

d. nations.

e. all of the above.

3. People can gain by specializing in the production of a good in which

a. they have a comparative advantage.

b. they have an absolute advantage.

c. they have a lower opportunity cost.

d. they have a higher opportunity cost.

e. both (a) and (c).

4. If a country wants to maximize the value of its output, each job should be carried out by the person who

a. has the highest opportunity cost.

b. has a comparative advantage in that activity.

c. can complete the particular job most rapidly.

d. enjoys that job the least.

5. If resources and goods are free to move across states, and if Florida producers choose to specialize in growing

grapefruit and Georgia producers choose to specialize in growing peaches, then we could reasonably conclude that

a. Georgia has a comparative advantage in producing peaches.

b. Florida has a comparative advantage in producing peaches.

c. the opportunity cost of growing peaches is lower in Georgia than in Florida.

d. the opportunity cost of growing grapefruit is lower in Florida than in Georgia.

e. all of the above except (b) are true.

6. kelly is an attorney and also an excellent typist. She can type 120 words per minute, but she is pressed for time

because she has all the legal work she can handle at $75.00 per hour. kellys friend Todd works as a waiter and

would like some typing work (provided that he can make at least his wage as a waiter, which is $25.00 per hour).

Todd can type only 60 words per minute.

a. kelly should do all the typing because she is faster.

b. Todd should do the typing as long as his earnings are more than $25.00 and less than $37.50 per hour.

c. unless Todd can match kellys typing speed, he should remain a waiter.

d. Todd should do the typing, and kelly should pay him $20.00 per hour.

e. Both a and c are correct.

1. Why do people specialize?

2. What do we mean by comparative advantage?

3. Why does the combination of specialization and trade make us better off?

4. If you can mow your lawn in half the time it takes your spouse or housemate to do it, do you have a compara-

tive advantage in mowing the lawn?

5. If you have a current comparative advantage in doing the dishes, and you then become far more productive than

before in completing yard chores, could that eliminate your comparative advantage? Why or why not?

6. Could a student who gets a C in one class but a D or worse in everything else have a comparative advantage

over someone who gets a B in that class but an A in everything else? Explain this concept using opportunity cost.

Answers: 1. c 2. e 3. e 4. b 5. e 6. b

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How Does the Market Work to Allocate Resources? In a world of scarcity, competition is inescapable, and one method of allocating resources among competing uses is the market economy. The market economy provides a way for mil- lions of producers and consumers to allocate scarce resources. For the most part, markets are efficient. To an economist, efficiency is achieved when the economy gets the most out of its scarce resources. In short, efficiency makes the economic pie as large as possible.

Competitive markets are powerfulthey can make existing products better and/or less expensive, they can improve production processes, and they can create new products, from video games to life-saving drugs. Buyers and sellers indicate their wants through their action and inaction in the marketplace, and it is this collective voice that determines how resources are allocated. But how is this information communicated? Market prices serve as the language of the market system. By understanding what these market prices mean, you can get a better understanding of the vital function that the market economy performs.

Markets may not always lead to your desired tastes and preferences. You may think that markets produce too many pet rocks, chia pets, breast enhancements, and face lifts. Some markets are illegalthe market for cocaine, the market for stolen body parts, the market for child pornography, and the market for indecent radio announcers. Markets do not come with a moral compass; they simply provide what buyers are willing and able to pay for and what sellers are willing and able to produce.

Market Prices Provide Important Information Market prices send signals and provide incentives to both buyers and sellers. These prices communicate information about the relative availability of products to buyers, and they pro- vide sellers with critical information about the relative value that consumers place on those products. In short, buyers look at the price and decide how much they are willing and able to demand and sellers look at the price and decide how much they are able and willing to supply. The market price reflects the value a buyer places on a good and the cost to society of producing that good. Thus, market prices provide a way for both buyers and sellers to communicate about the relative value of resources. To paraphrase Adam Smith, prices adjust like an invisible hand to direct buyers and sellers to an outcome that is socially desirable. We will see how this works beginning in Chapter 4.

The basis of a market economy is voluntary exchange and the price system that guides peoples choices and produces solutions to the questions of what goods to produce and how to produce and distribute them.

Take something as simple as the production of a pencil. Where did the wood come from? Perhaps the Northwest or Georgia. The graphite may have come from the mines in Michigan and the rubber may be from Malaysia. The paint, the glue, the metal piece that holds the eraserwho knows? The point is that market forces coordinated this production activity among literally thousands of people, some of whom live in different countries and speak dif- ferent languages. The market brought these people together to make a pencil that sells for 25 cents at your bookstore. It all happened because the market economy provided the incentive

efficiency when an economy gets the most out of its scarce resources

ECS economic content standards

Markets exist when and where buyervs and sellers interact. This interaction determines market prices and thereby allocates goods and services.

Prices provide incen- tives for buyers and sellers. Higher prices for a good or service provide incentives for buyers to purchase less of that good or service and for producers to make or sell more of it. Lower prices for a good or service pro- vide incentives for buyers to purchase more of that good or service and for producers to make or sell less of it.

What is the invisible hand?

How does a market economy allocate

scarce resources?

What are the important signals that

market prices communicate?

What are the effects of price controls?

IDEA 5: Markets Can Improve Economic Efficiency

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for people to pursue activities that benefit others. This same process produces millions of goods and services around the world, from automobiles and computers to pencils and paper clips.

What Effect Do Price Controls Have on the Market System? Government policies called price controls sometimes force prices above or below what they would be in a market economy. Unfortunately, these controls often impose harm on the same people they are trying to help, in large part by short-circuiting the markets information- transmission function. That is, price controls effectively strip the market price of its mean- ing for both buyers and sellers (as we will see in Chapter 5). A sales tax also distorts price signals, leading to a misallocation of resources (as we will see in Chapter 6).

price controls government-mandated minimum or maximum prices

S E C T I O N Q U I Z

1. Markets

a. for the most part are efficient.

b. provides a way for millions of of producers and consumers to allocate scarce resources.

c. may not always lead to your desired tastes and preferences.

d. All of the above statements are true.

2. Efficiency

a. makes the size of the economic pie as large as possible.

b. is achieved when the economy gets the most of of its resources.

c. Both (a) and (b) are true.

d. none of the above is true.

3. Which of the following is (are) true statement(s)?

a. Prices provide incentives for buyers and sellers.

b. Higher prices for a good or service provide incentives for buyers to purchase less of that good or service and for producers to make or sell more of it.

c. Lower prices for a good or service provide incentives for buyers to purchase more of that good or service and for producers to make or sell less of it.

d. All of the above statements are correct.

4. Price controls

a. assure that society distributes its resources fairly.

b. distort price signals.

c. prevent the natural system of supply and demand from working.

d. Both (b) and (c) are true.

1. Why must every society choose some manner in which to allocate its scarce resources?

2. How does a market system allocate resources?

3. What do market prices communicate to others in society?

4. How do price controls undermine the market as a communication device?

Answers: 1. d 2. c 3. d 4. d

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Property Rights and the Legal System In a market economy, private individuals and firms own most of the resources. For example, when consumers buy houses, cars, or pizzas, they have purchased the right to use these goods in ways they, not someone else, see fit. These rights are called property rights. Property rights are the rules of our economic game. If well-defined, property rights give individuals the incentive to use their property efficiently. That is, owners with property rights have a greater incentive to maintain, improve, and conserve their property to preserve or increase its value.

The market system can only work if the government enforces the rules. That is, one of the key functions of government is to provide a legal framework that protects and enforces property rights and contracts. Markets, like baseball games, need umpires. It is the govern- ment that plays this role when it defines and protects the rights of people and their property through the legal system and police protection. That is, by providing rules and regulations, government can make markets work more efficiently. Private enforcement is possible, but as economic life becomes more complex, political institutions have become the major instru- ment for defining and enforcing property rights.

The government defines and protects property rights through the legal system and public policy. The legal system ensures the rights of private ownership, the enforcement of contracts and the legal status for businesses. The legal system serves as the referee, imposing penalties on violators of our legal rules. Property rights also include intellectual propertythe prop- erty rights that an owner receives through patents, copyrights and trademarks. These rights give the owner long-term protection that encourages individuals to write books, music and software programs and invent new products. In short, well-defined property rights encour- age investment, innovation, exchange, conservation, and economic growth.

Market Failure The market mechanism is a simple but effective and efficient general means of allocating resources among alternative uses. When the economy fails to allocate resources efficiently on its own, however, it is known as market failure. For example, a steel mill might put soot and other forms of crud into the air as a byproduct of making steel. When it does, it imposes costs on others not connected with using or producing steel from the steel mill. The soot may require homeowners to paint their homes more often, entailing a cost. And studies show that respiratory diseases are greater in areas with more severe air pollution, imposing costs that may even include life itself. In addition, the steel mill might discharge chemicals into a stream, thus killing wildlife and spoiling recreational activities for the local

market failure when the economy fails to allocate resources efficiently on its own

An important role for gov- ernment in the economy is to define, establish, and enforce property rights. A property right to a good or service includes the right to exclude others from using the good or service and the right to transfer the ownership or use of the resource to others.

ECS economic content standards

Why is it so important that the government

protect our property rights?

Why cant we rely exclusively on the

invisible hand of the market to

determine economic decisions?

What are market failures?

Does the market distribute income fairly?

IDEA 6: Appropriate Government Policies Can Improve Market Outcomes

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population. In this case, the steel factory does not bear the costs of its polluting actions, and it continues to emit too much pollution. In other words, by transferring the pollution costs onto society, the firm lowers its costs of production and so produces more than the ideal outputwhich is inefficient because it is an overallocation of resources.

Markets sometimes produce too little of a goodresearch, for example. Therefore, the government might decide to subsidize promising scientific research that could benefit many peoplesuch as cancer research. When one party prevents other parties from participating in

in the Song Swapping on the Net

If you were a rock star, would you want to put a stop to bootlegged music on the Internet?

Yes, it violates copyright laws and cheats the artist.

Yes, but unlicensed music sharing is inevitable.

no, it will only increase the size of my audience.

no, it hurts only record companies, which charge too much anyway.

Song swapping on the net allows you to search for almost any song you can think of, find the song on a fellow enthusiasts hard drive, and then download it for yourself, right nowfor the unbeatable cost of zero, free, nada, gratis.

music piracy costs American workers significant losses in jobs and earnings, and lost tax revenues to the government.

Incentives play an important part in this story, too. If the price is zero, the probability of being caught is close to zero, and people do not view it as illegal, then you would expect many to download music illegally rather than purchase. However, the flipside of the story is that when talented producers and artists do not get royalties for their artistic work, you will see a lot less of itespecially quality music. Incentives matter.

consider this: Song swapping on the Net has set the stage for an inter esting battle over copyright laws and intellectual property rights. Is sharing songs with others on the Internet under ground piracy, or is it sharing someones purchased posses sion? Is it a personal use right to share music onlinelike sharing a CD with a friend?

Napster and Grokster may be gone, but free music and videos are alive and well. The network is still wide open. It is a tough war to win, and the people trading music illegally online have little chance of being caught. Also, many young music lovers do not see downloading music without paying the copyright as a crime. The industry must innovate its way out. One reason that illegal downloading took off was because the industry did not keep up with the technology. The music industry continued to sell CDs and tapes when buyers had the technology to download songs.

A recent survey by the Institute for Policy Innovation concludes that the piracy of recorded music costs the U.S. recording industries billions of dollars annually in lost reve nue and profits. In addition, the study states that recorded

SOuRCE: From newsweek, June 5, 2000, The noisy War Over napster

reserved. used by permission and protected by the Copyright Laws of the

united States. The printing, copying, redistribution, or retransmission of the

Material without express written permission is prohibited.

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Am I sharing or stealing if I download a song from a site like Limewire or The Pirate Bay?

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mutually beneficial exchange, it also causes a market failure. This situation occurs in a monopoly, with its single seller of goods. Because the monopolist can raise its end price above the competi- tive price, some potential consumers are kept from buying the goods they would have bought at the lower price, and inefficiency occurs. Whether the market economy has produced too little (underallocation) or too much (overallocation), the government can improve societys well-being by intervening. The case of market failure will be taken up in more detail in Chapter 8.

We cannot depend on the market economy to always communicate accurately. Some firms may have market power to distort prices in their favor. For example, the only regional cement company in the area has the ability to charge a higher price and provide lower- quality services than if the company were in a highly competitive market. In this case, the lack of competition can lead to higher prices and reduced product quality. And without adequate information, unscrupulous producers may be able to misrepresent their products to the disadvantage of unwary consumers.

When such conditions of restricted competition arise, the communication system of the marketplace is disrupted, causing the market to function inefficiently, to the detriment of consumers. For this reason, since 1890, the federal government has engaged in anti- trust activities designed to encourage competition and discourage monopoly conditions. Specifically, the Antitrust Division of the Department of Justice and the Federal Trade Commission attempt to increase competition by attacking monopolistic practices.

In sum, government can help promote efficiency when there is a market failuremaking the economic pie larger.

Does the Market Distribute Income Fairly? Sometimes a painful trade-off exists between how much an economy can produce efficiently and how that output is distributedthe degree of equality. An efficient market rewards

those that produce goods and services that others are willing and able to buy. But this does not guarantee a fair or equal distribu- tion of income. That is, how the economic pie is divided up. A market economy cannot guarantee everyone adequate amounts of food, shelter, and health care. That is, not only does the mar- ket determine what goods are going to be produced and in what quantities, but it also determines the distribution of output among members of society.

As with other aspects of government intervention, the degree- of-equity argument can generate some sharp disagreements. What is fair for one person may seem highly unfair to someone else. One person may find it terribly unfair for some individuals to earn many times the amount earned by other individuals who work equally hard, and another person may find it highly unfair to ask one group, the relatively rich, to pay a much higher proportion of their income in taxes than another group pays.

Government Is Not Always the Solution However, just because the government could improve the situation does not mean it will. After all, the political process has its own set of problems, such as special interests, shortsightedness, and imper- fect information. For example, government may reduce competition

through tariffs and quotas, or it may impose inefficient regulations that restrict entry. Consequently, government, like markets, has shortcomings and imperfections; the cost of government policies can exceed the benefits. Citizens failing to understand the difference between actual and ideal government performance will find it dif- ficult to to decide the appropriate role for government.

Even though designating these parking spaces for disabled drivers may not be an efficient use of scarce parking spaces (because they are often not used), many believe it is fair to give these drivers a convenient spot. The debate between efficiency and equity is often heated.

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S E C T I O N Q U I Z

1. The government defines and protects property rights through

a. the legal system.

b. police protection.

c. the military.

d. all of the above.

2. Well-defined property rights encourage

a. investment.

b. innovation.

c. conservation.

d. exchange.

e. economic growth.

f. all of the above.

3. A market failure is said to occur

a. when costs are imposed on some people without their consent.

b. when the market economy fails to allocate resources efficiently.

c. when one party prevents others from participating in mutually beneficial exchange.

d. All of the above are examples of market failure.

4. The government redistributes income through

a. taxes.

b. subsidies.

c. transfer payments.

d. all of the above.

1. Why do owners with clear property rights have incentives to use their property efficiently?

2. How does the government use taxes, subsidies, and transfer payments to redistribute income toward lower-income groups?

3. Why would the government want to prevent market conditions of insufficient competition?

4. Why can markets sometimes fail to allocate resources efficiently?

Answers: 1. d 2. f 3. d 4. d

The market mechanism does not always assure fulfillment of macroeconomic goals, most notably full employment and stable prices. Sometimes total spending is insufficient, and unemployment occurs; sometimes total spending is excessive, and inflation occurs. Both inflation and unemployment affect economic growth and standards of living. Almost every- one is affected directly or indirectly by high rates of unemployment or inflation.

What can happen when total spending is insufficient?

What can happen when total spending is excessive?

What is inflation, and what causes it?

Why is a stable monetary environment important?

How can the government policies help stabilize the economy?

Can government policies used to stabilize the economy be counterproductive?

IDEA 7: Government Policies May Help Stabilize the Economy

2.7

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Inflation What is inflation, and what causes it? Inflation is an increase in the overall price level in the economy. Sustained inflation is usually caused by government printing too much money. When the government prints too much money, money loses its value. In its extreme form, inflation can lead to complete erosion in faith in the value of money. In Germany after both World Wars, prices increased so rapidly that people in some cases finally refused to take paper money, insisting instead on payment in goods or metals with some intrinsic worth.

A stable monetary environment can lead to price stability and enable producers and con- sumers to better coordinate their plans and decisions through the market. An increase in the overall price level increases burdens on people with fixed incomes when the inflation is not anticipated. It hurts savers, but helps those who have borrowed at a fixed rate. Moreover, inflation can raise one nations prices relative to prices in other countries, which will either lead to difficulties in financing purchases of foreign goods or to a decline in the value of the national currency relative to that of other countries. Also, inflation imposes costs on people who devote resources to protecting themselves from expected inflation. The redistributional impact of inflation need not be the result of conscious public policy; it just happens.

Both inflation and unemployment affect economic growth and standards of the living. Almost everyone is affected directly or indirectly by high rates of unemployment and inflation.

Unemployment When the economy is producing at less than its capacity, there will be some unemployment. Unemployment will vary by age, sex, and race. It will also vary by work experience, years of schooling, and skill level.

Unemployment statistics do not always give us an accurate picture of the economy. There are discouraged workers who are so disillusioned by the economy they stop looking for work and are no longer counted as unemployed. There are also workers who take part- time jobs when they are looking for full-time jobs.

What causes unemployment? Some of it results from a downswing in a business cycle, the unpredictable fluctuations in the economy. Other unemployment occurs because people are changing jobs, different skills needed by employers, or there are seasonal fluctuations in demand.

During the 1930s, the unemployment rate rose to more than 20 percent of the labor force, and among some groups, such as women and minority workers, unemployment rates were even higher. The concern over unemployment manifested itself in the passage of the Employment Act of 1946, committing the government to promote maximum employ- ment, production, and purchasing power. The act also implied that the government should respond to fluctuations in the economy through the use of stabilization policies.

More recently, as a result of a severe global recession, unemployment in many countries has remained high with many workers remaining unemployed for long periods of time. In 2009, 45 percent of unemployed workers had been without a job for at least 27 weeks. This is the longest downturn since World War II. The financial and psychological damage to the unemployed will last for years.

Government policies called fiscal policy, use taxes, and government spending to try to help stabilize the economy. If there is an unemployment problem, policy makers may lower taxes and/or increase government spending to stimulate demand. Alternatively, if there is a problem with persistent inflation, policy makers may raise taxes and/or reduce government spending.

Also, the Federal Reserve can use monetary policy to change the money supply and interest rates in an effort to achieve price stability, high employment, and economic growth. Many economists believe that these government policies play an important role in stabilizing the economy.

However, other economists believe the government policies are not effective and can be counterproductive. Because some government spending occurs for reasons other than

Federal government bud- getary policy (fiscal policy) and the Federal Reserve Systems monetary policy influence the overall levels of employment, output, and prices.

ECS economic content standards

Unemployment imposes costs on individuals and the overall economy. Inflation, both expected and unexpected, also imposes costs on indi- viduals and the overall economy. Unemployment increases during reces- sions and decreases during recoveries.

ECS economic content standards

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S E C T I O N Q U I Z

1. When total spending is insufficient, it can lead to

a. economic growth.

b. inflation.

c. unemployment.

d. none of the above.

2. When total spending is excessive it can lead to

a. budget surpluses.

b. inflation.

c. unemployment.

d. all of the above.

3. Inflation

a. is when there is an increase in the overall price level in the economy.

b. can be caused by the government printing too much money.

c. can cause people to lose faith in the value of money.

d. All of the above are true.

4. A stable monetary environment

a. can lead to price stability.

b. enables producers and consumers to better coordinate their plans and decisions.

c. Both (a) and (b) are true.

d. none of the above is true.

5. unanticipated inflation

a. redistributes income.

b. increases burdens on people with fixed incomes when the inflation is not anticipated.

c. hurts savers, but helps those who have borrowed at a fixed rate.

d. can raise one nations prices relative to prices in other countries.

e. can cause all of the above.

6. The government may help stabilize the economy

a. by providing a stable monetary environment.

b. by using changes in government spending.

c. by using changes in taxes.

d. using any of the above.

1. What is inflation?

2. What causes inflation?

3. Why is a stable monetary environment so important?

4. What was the Employment Act of 1946?

Answers: 1. c 2. b 3. d 4. c 5. e 6. d macroeconomic stabilizationlike money spent on defense and health caregovernment programs may have counterproductive effects on employment and inflation. And there are problems of time lags and the higher interest rate effect of expansionary fiscal policy, which can crowd out private investment and spending. This debate is important and will be dis- cussed in the macroeconomic portion of the text.

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Defining Economic Growth Economic growth is usually measured by the annual percentage change in real (indexed for inflation) output of goods and services per capita (real GDP per capita), reflecting the expansion of the economy over time. We focus on per capita measures because we want to adjust for the effect of increased population on economic well-being. An increase in population, ceteris paribus, will lower the standard of living because more people will be sharing a fixed real GDP. Long-run economic growth is a sustained increase in real output per capita. However, economic growth rates do not reveal anything about the distribution of output and income. For example, a country could have extraordinary growth in per capita output, and yet the poor might achieve little or no improvement in their standard of living.

In Exhibit 1, we see that most of the increase in world GDP per capita has occurred in the last 200 years. Over the past millennium, world population rose twenty-two fold. Per capita income increased thirteen fold, world GDP nearly three-hundred fold. This contrasts sharply with the preceding millennium, when world population grew by only a sixth, and there was no advance in per capita income. From the year 1000 to 1820, the advance in per capita income was a slow crawlthe world average rose about 50 percent. Most of the growth went to accommodate a fourfold increase in populationstagnant economic growth rates mean little changes in the standard of living. The average Englishman was probably no better off in 1800 than he was in 1500. Life expectancy in England was less than 40 years in 1800. The effects of the Industrial Revolution had a huge impact beginning in the mid- 1800s. Since then, world development has been much more dynamic. Per capita income rose more than eightfold, population more than fivefold.

Because of increased economic growth, the people of the world are better fed, better sheltered, and better protected against diseases. Global life expectancies have risen despite increases in population. This is not to say that millions of people do not still live in poverty. Admittedly, averages conceal a lot, but even the poorest countries of the world are better off than they were 60 years ago.

According to Stanford economist Paul Romer, Economic growth springs from bet- ter recipes, not just from more cooking. Better recipes lead to permanent and continuing change. It is these better recipes that lead us down the path of innovation, the path of breakthroughsorganizational, intellectual, and technological. These are the ideas that can transform societies.

Small Differences in Growth Rates Matter If Nation A and Nation B start off with the same population and the same level of real GDP, will a slight difference in their growth rates over a long period of time make much of a dif- ference? Yes. In the first year or two, the difference will be small. However, after a decade the difference will be large, and after 50 or 100 years, it will be huge. In the words of Nobel laureate Robert Lucas, Once one starts to think about differences in growth rates among countries, it is hard to think about anything else.

Economic growth the economys abilities to produce more goods and services

Was the standard of living higher two hundred years ago, when we had fewer people?

What is economic growth?

Do differences in growth rates matter?

What is productivity?

IDEA 8: Higher ProductivityGrowth Leads to Greater Long-Run EconomicGrowth

2.8

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in the Rockefeller and Carnegie

Are you richer than they were? John D. Rockefeller (left) and Andrew Carnegie (right) were the wealthi- est Americans who ever lived. John D. Rockefeller had wealth valued at $200 billion in todays dollars (Bill Gates estimated worth is about $50 billion), and Andrew Carnegie had wealth valued at $100 billion in todays dollars. But were they richer than you? Look what long-run economic growth has done for you. Rockefeller and Carnegie could not travel by air, ride in a car, turn on an air conditioner on a hot and humid day, watch HDTv, text message their friends, down- load music, or use Facebook, Skype, or Twitter. And medicine was far less advanced. Improvements in

medical technology and sanitation have increased life expectancies about 50 percent since their day.

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Because of differences in growth rates, some countries will become richer than oth- ers over time. If they achieve relatively slower rates of economic growth, todays richest countries will not remain the richest over time. And with even slight improvements in eco- nomic growth, todays poorest countries will not remain poor for long. China and India have both experienced spectacular economic growth over the past 20 years. Because of this economic growth, much of the world is now poorer than these two heavily populated countries. Other countries, such as Ireland, once one of the poorest countries in Western Europe, is now one of the richest. Because of past economic growth, the richest or most-developed countries today have many times the market output of the poorest or least-developed countries.

Economic Growth, Productivity, and the Standard of Living The only way an economy can increase its rate of consumption in the long run is by increasing the amount it produces. Whether a countrys standard of living rises, levels off, or declines over time depends for the most part on productivity growth. Productivity is the amount of goods and services a worker can produce per hour. Sustained economic growth occurs when workers productivity rises. For example, slow growth of capital investment can lead to slower growth in labor productivity and, consequently, slower growth rates in real wages. On the other hand, increases in productivity and the associated higher real wages can be the result of carefully crafted economic policies, such as tax policies that stimulate investment or programs that encourage research and development. The only way an economy can increase its rate of consumption in the long run is by increasing the amount it produces.

Saving and investment are critical components of long-run economic growth and liv- ing standards. Families save for many things, including housing, medical expenses, taxes, retirement, childrens education, vacations, automobiles, and so on. When money is saved in a bank or other financial institution, this money will earn interest because those savings are loaned to firms. An interest rate is the price of money that is borrowed or saved and is determined by the interaction of supply and demand. Higher real (that is, adjusted for infla- tion) interest rates provide an incentive for people to save more and borrow less. Lower real interest rates provide an incentive for people to borrow more and save less. Thus, higher (real) interest rates reduce investment spending by firms and household spending on housing cars and other major purchases.

Productivity output per worker

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When firms invest in new production techniques, new capital (machines and factories), and new technology, it makes labor more productive, which in turn leads to increases in incomes and living standards. Of course, investing in new physical or human capital involves a trade-offgiving up consumption today in anticipation of greater future production and consumption. For example, college is expensive but you hope the future payoff from this investment in human capital will lead to greater consumption and production in the future.

What Factors Contribute to Increases in Productivity? There are a number of major factors that contribute to productivity growth. These include physical capital, human capital, natural resources, technological change as well as improvements in economic institutions and incentives. Todays workers generally produce more output than workers in the past. And workers in some countries, like the United States, generally produce more output than workers in most other countries. Workers with higher productivity usually have more physical capital to work with, like buildings and computers, are more educated, and have benefited from tremendous technological advancements.

Rate of productivity growth will be higher in countries that provide incentives for innovation, investment in research and development, and physical and human capital. These incentives can be in the form of copyrights or patents.

in the Results of Long-Run Economic Growth

The American economy is in a rough patch. But the long-term trends are goodand there is a price to economic pessimism. When a presidential election year collides with iffy economic times, the publics view of the u.S. economy turns gloomy. Perspective shrinks in favor of short-term assessments that focus on such unpleasant realities as falling job counts, sluggish GDP growth, uncertain incomes, subprime mortgage woes, and wobbly financial markets.

Taken together, its enough to shake our faith in American progress. The best path to reviving that faith lies in gaining some perspectivegetting out of the short-term rutcasting off the blinders that focus us on what will turn out to be mere footnotes in a longer-term march of progress. . . . In the exhibit you can see what many goods Americans can now afford because of long-run economic growth.

SOuRCE: W. Michael Cox and Richard Alm, How Are We Doing? The American, July/August 2008.

The Results of Long-Run Economic Growth

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S E C T I O N Q U I Z

1. Economic growth is measured by

a. the percentage change in nominal GDP.

b. the percentage change in nominal GDP per capita.

c. the percentage change in real GDP.

d. the percentage change in real GDP per capita.

2. Growth in real per capita output

a. says nothing about the distribution of output.

b. has been far more common in the last 200 years than before.

c. can make poorer countries richer over time.

d. All of the above are true.

3. Productivity growth

a. is a primary determinant of a countrys standard of living.

b. is a primary cause of growth in real wages.

c. is the only way in the long run for an economy to increase its potential real consumption per capita over time.

d. is crucially affected by saving and investment over time.

e. All of the above are true.

4. Which of the following can add to productivity growth?

a. physical capital

b. human capital

c. discovery of new natural resources

d. technological advances

e. All of the above can add to productivity growth.

1. What is long-run economic growth, and why do we use a per capita measure?

2. Why is economic growth important?

3. Do small differences in growth rates matter?

4. What is labor productivity?

5. What role do saving and investment have in economic growth?

6. What factors lead to increases in labor productivity?

Answers: 1. d 2. d 3. e 4. e

Interactive Summary

Fill in the blanks:

1. As long as human _____________ exceed available _____________, scarcity will exist.

2. Something may be rare, but if it is not _____________it is not scarce.

3. The scarce resources that are used in the produc- tion of goods and services can be grouped into four categories: _____________, _____________, _____________, and _____________.

4. Capital includes human capital, the _____________ people receive from _____________.

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5. Entrepreneurs are always looking for new ways to improve _____________ or _____________. They are lured by the chance of making a(n) _____________.

6. _____________ goods include fairness, friendship, knowledge, security, and health.

7. _____________ are intangible items of value, such as education, provided to consumers.

8. Scarce goods created from scarce resources are called _____________ goods.

9. Scarcity ultimately leads to _____________ for the available goods and services.

10. Because we all have different _____________, scarcity affects everyone differently.

11. Economics is the study of the choices we make among our many _____________ and _____________.

12. In a world of scarcity, we all face _____________.

13. The highest or best forgone alternative resulting from a decision is called the _____________.

14. The cost of grocery shopping is the _______________ paid for the goods plus the _______________ costs incurred.

15. Many choices involve _____________ of something to do rather than whether to do something.

16. Economists emphasize _____________ thinking because the focus is on additional, or _____________, choices, which involve the effects of _____________ or _____________ the current situation.

17. The rule of rational choice is that in trying to make themselves better off, people alter their behavior if the _____________ to them from doing so outweigh the _____________ they will bear.

18. In acting rationally, people respond to _____________.

19. If the benefits of some activity _____________ and/ or if the costs _____________, economists expect the amount of that activity to rise. Economists call these _____________ incentives. Likewise, if the benefits of some activity _____________ and/or if the costs _____________, economists expect the amount of that activity to fall. Economists call these _____________ incentives.

20. Because most people seek opportunities that make them better off, we can _____________ what will happen when incentives are _____________.

21. People _____________ by concentrating their energies on the activity to which they are best suited because individuals incur _____________ opportunity costs as a result.

22. If a person, a region, or a country can produce a good or service at a lower opportunity cost than oth- ers can, we say that they have a(n) _____________ in the production of that good or service.

23. The primary advantages of specialization are that employees acquire greater _____________ from repetition, they avoid _____________ time in shift- ing from one task to another, and they do the types of work for which they are _____________ suited.

24. We trade with others because it frees up time and resources to do other things we do _____________.

25. Produce what we do _____________ best and _____________ for the _____________.

26. Market prices serve as the _____________ of the market system. They communicate information about the _____________ to buyers, and they provide sellers with critical information about the _____________ that buyers place on those products. This commu- nication results in a shifting of resources from those uses that are _____________ valued to those that are _____________ valued.

27. The basis of a market economy is _____________ exchange and the _____________ system that guides peoples choices regarding what goods to produce and how to produce those goods and distribute them.

28. _____________ can lead the economy to fail to allo- cate resources efficiently, as in the cases of pollution and scientific research.

29. Sometimes a painful trade-off exists between how much an economy can produce _____________ and how that output is _____________.

30. In the case of market _____________, appropriate gov- ernment policies could improve on market outcomes.

31. Sometimes total spending is insufficient, and _____________ occurs.

32. Sometimes total spending is excessive, and _____________ occurs.

33. A stable _____________ environment can lead to price stability

34. Government policies called _____________ policy use taxes and government spending to try to help sta- bilize the economy.

35. The Federal Reserve can use _____________ policy to change the money supply and interest rates in an effort to achieve price stability, high employment, and economic growth.

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Section Quiz Answers

key Terms and Concepts

2.1 IDEA 1: People Face Scarcity and Costly Trade-offs

1. What must be true for something to be an economic good? An economic good, tangible or intangible, is any good or service that we value or desire. This defi- nition includes the reduction of things we dont wantbadsas a good.

2. Why does scarcity affect everyone? Because no one can have all the goods and services that he or she desires, we all face scarcity as a fact of life.

3. How and why does scarcity affect each of us differently? Because our desires and the extent of the resources we have available to meet those desires vary, scar- city affects each of us differently.

4. Why might daylight be scarce in Anchorage, Alaska, in the winter but not in the summer? For a good to be scarce means we want more of it than we are able to have. Residents of Anchorage typically have all the daylight they wish in the summer, when the sun sets just before midnight, but they have only a few hours of daylight during the winter months. If daylight is desirable, it is limited in the winter.

scarcity 35 labor 36 land 36 capital 36 human capital 36 entrepreneurship 36 goods 36 tangible goods 36 intangible goods 36

services 36 economic goods 37 bads 37 opportunity cost 39 rational decision making 43 marginal thinking 43 rule of rational choice 43 net benefit 44 positive incentive 46

negative incentive 47 specializing 48 comparative advantage 48 efficiency 52 price controls 53 market failure 54 economic growth 60 productivity 61

36. The only way an economy can increase its rate of consumption in the long run is by increasing the amount it _____________.

37. Whether a countrys living standard of living rises, levels off, or declines over time depends for the most part on _____________ growth.

38. _____________ is the amount of goods and servicesa worker can produce per hour and _____________ economic growth occurs when workers productivity rises.

Answers: 1. wants; resources 2. desirable 3. land; labor; capital; entrepreneurship 4. knowledge and skill; education and on-the-job

training 5. production techniques; products; profit 6. Intangible 7. Services 8. economic 9. competition 10. wants and desires

11. wants; desires 12. trade-offs 13. opportunity cost 14. price; nonprice 15. how much 16. marginal; marginal; adding to;

subtracting from 17. expected marginal benefits; expected marginal costs 18. incentives 19. rise; fall; positive; fall; rise; negative

20. predict; changed 21. specialize; lower 22. comparative advantage 23. skill; wasted; best 24. better 25. relatively; trade; rest

26. language; relative availability of products; relative value; less; more 27. voluntary; price 28. Market failure 29. efficiently;

distributed 30. failure 31. unemployment 32. inflation 33. monetary 34. fiscal 35. monetary 36. produces 37. productivity

38. productivity; sustained

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5. Would we have to make choices if we had unlimited resources? We would not have to make choices if we had unlimited resources, because we would then be able to produce all the goods and services anyone want- ed, and having more of one thing would not require having less of other goods or services.

6. What do we mean by opportunity cost? The opportunity cost of a choice is the highest val- ued forgone opportunity resulting from a decision. It can usefully be thought of as the value of the opportunity a person would have chosen if his most preferred option was taken away from him.

7. Why was the opportunity cost of going to college higher for LeBron James (Miami Heat star) than for most undergraduates? The forgone alternative to LeBron James of going to collegestarting a highly paid professional basketball career sooner than he could otherwise was far more lucrative than the alternatives facing most undergraduates. Because his forgone alter- native was more valuable for LeBron James, his opportunity cost of going to college was higher than for most.

8. Why is the opportunity cost of time spent getting an MBA typically lower for a 22-year- old straight out of college than for a 45-year- old experienced manager? The opportunity cost of time for a 45-year-old experienced managerthe earnings he would have to give up to spend a given period getting an MBAis higher than that of a 22-year-old straight out of college, whose income earning alternatives are far less.

2.2 IDEA 2: People Engage in Rational Decision Making and Marginal Thinking

1. What are marginal choices? Why does eco- nomics focus on them? Marginal choices are choices of how much of some- thing to do, rather than whether to do something. Economics focuses on marginal choices because those are the sorts of choices we usually face: Should I do a little more of this or a little less of that?

2. What is the rule of rational choice? The rule of rational choice is that in trying to make themselves better off, people alter their behavior if the expected marginal benefits from doing so out- weigh the expected marginal costs they will bear. If

the expected marginal benefits of an action exceed the expected marginal costs, a person will do more of that action; if the expected marginal benefits of an action are less than the expected marginal costs, a person will do less of that action.

3. How could the rule of rational choice be expressed in terms of net benefits? Because net benefits are expected to be positive when expected marginal benefits exceed expected marginal cost to the decision maker, the rule of rational choice could be restated as: People will make choices for which net benefits are expected to be positive.

4. Why does rational choice involve expectations? Because the world is uncertain in many important respects, we can seldom know for certain whether the marginal benefits of an action will in fact exceed the marginal costs. Therefore, the rule of rational choice deals with expectations decision makers hold at the time they make their decisions, recognizing that mistakes can be made.

5. What is rational decision making? Rational decision making is when people do the best they can based on their values and information, under current and anticipated future consequences. Rational individuals weigh the marginal benefits and marginal costs of their actions and they only pursue actions if they perceive the marginal benefits to be greater than the marginal costs.

6. Why do students often stop taking lecture notes when a professor announces that the next few minutes of material will not be on any future test or assignment? The benefit, in terms of grades, from taking notes in class falls when the material discussed will not be tested or rewarded, and when the benefits of lecture note taking are smaller in this situation, stu- dents do less of it.

7. If you decide to speed to get to a doctors appointment and then get in an accident due to speeding, does your decision to speed invalidate the rule of rational choice? Why or why not? No. Remember, the rule of rational choice deals with expectations at the time decisions were made. If you thought you would get in an accident due to speeding in this situation, you would not have decided to speed. The fact that you got in an acci- dent doesnt invalidate the rule of rational choice; it only means your expectations at the time you decided to speed were incorrect.

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8. If pedestrians felt far safer using crosswalks to cross the street, how could adding cross- walks increase the number of pedestrian accidents? Just like safer cars can lead people to drive less safe- ly, if pedestrians felt safer in crosswalks, they might cross less safely, such as taking less care to look both ways. The result of pedestrians taking less care may well be an increase in the number of pedestrian accidents.

9. Imagine driving a car with daggers sticking out of the steering wheelpointing directly at your chest. Would you drive more safely? Why? Because the cost to you of an accident would be so much higher in this case, you would drive far more safely as a result.

2.3 IDEA 3: People Respond Predictably to Changes in Incentives

1. What is the difference between positive incentives and negative incentives? Positive incentives are those that either increase benefits or decrease costs of an action, encouraging the action; negative incentives are those that either decrease benefits or increase costs of an action, dis- couraging the action.

2. According to the rule of rational choice, would you do more or less of something if its expected marginal benefits increased? Why? You would do more of something if its expected marginal benefits increased, because then the mar- ginal expected benefits would exceed the marginal expected costs for more units of the relevant action.

3. According to the rule of rational choice, would you do more or less of something if its expected marginal costs increased? Why? You would do less of something if its expected marginal costs increased, because then the marginal expected benefits would exceed the marginal expect- ed costs for fewer units of the relevant action.

4. How does the rule of rational choice imply that young children are typically more likely to misbehave at a supermarket checkout counter than at home? When a young child is at a supermarket checkout counter, the benefit of misbehavingthe potential

payoff to pestering Mom or Dad for candyis greater. Also, because his parents are less likely to punish him, or to punish him as severely, in public as in private when he pesters them, the costs are lower as well. The benefits of misbehavior are higher and the costs are lower at a supermarket checkout coun- ter, so more child misbehavior is to be expected there.

5. Why do many parents refuse to let their chil- dren have dessert before they eat the rest of their dinner? Children often find that the costs of eating many foods at dinner exceed the benefits (e.g., If its green, it must be disgusting.), but that is seldom so of dessert. If parents let their children eat dessert first, children would often not eat the food that was good for them. But by adding the benefit of getting dessert to the choice of eating their other food, parents can often get their children to eat the rest of their dinner, too.

2.4 IDEA 4: Specialization and Trade Can Make Everyone Better Off

1. Why do people specialize? People specialize because by concentrating their energies on the activities to which they are best suit- ed, individuals incur lower opportunity costs. That is, they specialize in doing those things they can do at lower opportunity costs than others, and let oth- ers who can do other things at lower opportunity costs than they can specialize in doing them.

2. What do we mean by comparative advantage? A person, region, or country has a comparative advantage in producing a good or service when it can produce it at a lower opportunity cost than other persons, regions, or countries.

3. Why does the combination of specialization and trade make us better off? Trade increases wealth by allowing a person, region, or a nation to specialize in those products that it produces relatively better than others and to trade for those products that others produce relatively bet- ter than they do. Exploiting our comparative advan- tages, and then trading, allows us to produce, and therefore consume, more than we could otherwise from our scarce resources.

4. If you can mow your lawn in half the time it takes your spouse or housemate to do it, do you have a comparative advantage in mow- ing the lawn? Your faster speed at mowing the lawn does not establish that you have a comparative advantage in

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mowing. That can only be established relative to other tasks. The person with a comparative advan- tage in mowing lawns is the one with the lowest opportunity cost, and that could be your spouse or housemate in this case. For instance, if you could earn $12 an hour, mowing the lawn in half an hour implies an opportunity cost of $6 of forgone output elsewhere. If your spouse or housemate could only earn $5 per hour (because he or she was less than half as productive doing other things compared to you), the opportunity cost of that person mowing the lawn in an hour is $5. In this case, your spouse or housemate has a comparative advantage in mow- ing the lawn.

5. If you have a current comparative advantage in doing the dishes, and you then become far more productive than before in completing yard chores, could that eliminate your com- parative advantage? Why or why not? The opportunity cost of you doing the dishes is the value of other chores you must give up to do the dishes. Therefore, an increase in your productivity doing yard chores would increase the opportunity cost of doing the dishes, and could well eliminate your current comparative advantage in doing the dishes compared to other members of your family.

6. Could a student who gets a C in one class but a D or worse in everything else have a comparative advantage over someone who gets a B in that class but an A in eve- rything else? Explain this concept using opportunity cost. A student who gets a C in a class is less good, in an absolute sense, at that class than a student who gets a B in it. But if the C student gets Ds in other classes, he is relatively, or comparatively, better at the C class, while if the B student gets As in other classes, she is relatively, or comparatively, worse at that class.

2.5 IDEA 5: Markets Can Improve Economic Efficiency

1. Why must every society choose some manner in which to allocate its scarce resources? Every society must choose some manner in which to allocate its scarce resources because the col- lective wants of its members always far outweigh what the scarce resources nature has provided can produce.

2. How does a market system allocate resources? A market system allows individuals, both as pro- ducers and consumers, to indicate their wants and desires through their actionshow much they are willing to buy or sell at various prices. The market then acts to bring about that level of prices that allows buyers and sellers to coordinate their plans.

3. What do market prices communicate to others in society? The prices charged by suppliers communicate the relative availability of products to consumers; the prices consumers are willing to pay communicate the relative value consumers place on products to producers. That is, market prices provide a way for both consumers and suppliers to communicate about the relative value of resources.

4. How do price controls undermine the market as a communication device? Price controlsboth price floors and price ceilings prevent the market from communicating relevant information between consumers and suppliers. A price floor set above the market price prevents sup- pliers from communicating their willingness to sell for less to consumers. A price ceiling set below the market price prevents consumers from indicating their willingness to pay more to suppliers.

5. Why can markets sometimes fail to allocate resources efficiently? Markets can sometimes fail to allocate resources efficiently. Such situations, called market failures, represent situations such as externalities, where costs can be imposed on some individuals without their consent (e.g., from dumping crud in their air or water), where information in the market may not be communicated honestly and accurately, and where firms may have market power to distort prices in their favor (against consumers interests).

2.6 IDEA 6: Appropriate Government Policies Can Improve Market Outcomes

1. Why must every society choose some manner in which to allocate its scarce resources? Every society must choose some manner in which to allocate its scarce resources because the collec- tive wants of its members always far outweigh what the scarce resources that nature has provided can produce.

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2.7 IDEA 7: Government Policies May Help Stabilize the Economy

1. What is inflation? Inflation is an increase in the overall price level in the economy.

2. What causes inflation? Sustained inflation is usually caused by government printing too much money. When the government prints too much money; money loses its value. The high inflation of the 1970s was associated with rapid growth in the quantity of money and the recent low inflation rates have been associated with slow growth in the quantity of money.

3. Why is a stable monetary environment so important? A stable monetary environment can lead to price stability and enable producers and consumers to better coordinate their plans and decisions through the market. Inflation can redistribute income ran- domly. An increase in the overall price level increases burdens on people with fixed incomes when the inflation is not anticipated. Unanticipated inflation hurts savers, but helps those who have borrowed at a fixed rate. Also, inflation can raise one nations prices relative to prices in other countries, which will either lead to difficulties in financing purchase of foreign goods or to a decline in the value of the national currency relative to that of other countries.

4. What was the Employment Act of 1946? Answer: The passage of the Employment Act of 1946 committed the government to promote

maximum employment, production, and purchas- ing power. The act also implied that the govern- ment should respond to fluctuations in the economy through the use of stabilization policies.

5. What government policy changes might be effective in increasing employment in recessions? Government policies to stimulate the economy, such as decreasing taxes or increasing government pur- chases, could potentially increase employment in recessions.

6. What government policy changes might be effective in controlling inflation? Government policies to control inflation can include increasing taxes, decreasing government purchases, and reducing the growth in the money supply through the banking system.

2.8 IDEA 8: Higher Productivity Growth Leads to Greater Long- Run Economic Growth

1. What is long-run economic growth and why do we use a per capita measure? Economic growth is usually measured by the annual percentage change in real output of goods and services per capita (real GDP per capita), reflecting the expansion of the economy over time. We focus on per capita because we want to isolate the effect of increased population on economic growth.

2. Why is economic growth important? Because of increases in economic growth, the people of the world are better fed, better sheltered, and bet- ter protected against disease. Global life expectan- cies have risen despite increases in population.

3. Do small differences in growth rates matter? Because of differences in growth rates, over time some countries will become richer than others. With relatively slower economic growth, todays richest countries will not be the richest for very long. On the other hand, with even slight improvements in economic growth, todays poorest countries will not remain poor for long.

4. What is labor productivity? Whether a countrys living standard rises, levels off, or declines over time depends for the most part on

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productivity growth. For example, slow growth of capital investment can lead to lower labor produc- tivity and, consequently, lower wages. On the other hand, increases in productivity and higher wages can occur as a result of carefully crafted economic poli- cies, such as tax policies that stimulate investment or programs that encourage research and development. The only way an economy can increase its rate of consumption in the long run is by increasing the amount it produces.

5. What role do saving and investment have in economic growth? Saving and investment are critical components of long-run economic growth and living standards. When money is put in a savings account in a bank or other financial institution, that money will earn interest because those savings are loaned to firms. An interest rate is the price of money that is bor- rowed or saved and I determined by the interac- tion of supply and demand. Higher real (that is, adjusted for inflation) rates provide an incentive

for people to save more and borrow less. Lower real interest rates provide an incentive for people to borrow more and save less. Thus, higher (real) interest rates reduce investment spending by firms and household spending on housing cars and other major purchases.

6. What factors lead to increases in labor productivity? Labor productivity increases as firms invest in new production techniques, acquire new capital (machines and factories), and incorporate new tech- nology. This makes labor more productive leading to increases in incomes and living standards. Of course, investing in new physical or human capital involves a trade-offgiving up consumption today in anticipation of greater future production and con- sumption. There are five major factors that contrib- ute to growth in productivity. These include physical capital, human capital, natural resources, techno- logical change, and improvements in economic insti- tutions and incentives.

1. Which of the following goods are scarce? a. garbage b. salt water in the ocean c. clothes d. clean air in a big city e. dirty air in a big city f. a public library

2. Explain the difference between poverty and scarcity.

3. The automotive revolution after World War II reduced the time involved for travel and shipping goods. This inno- vation allowed the U.S. economy to produce more goods and services since it freed resources involved in transporta- tion for other uses. The transportation revolution also increased wants. Identify two ways the car and truck revealed new wants.

4. The price of a one-way bus trip from Los Angeles to New York City is $150.00. Sarah, a school teacher, pays the same price in February (during the school year) as in July (during her vacation), so the cost is the same in February as in July. Do you agree?

5. McDonalds once ran a promotion that whenever St. Louis Cardinals slugger Mark McGwire hit a home run into the upper deck at Busch Stadium, McDonalds gave anyone with a ticket to that days game a free Big Mac. If hold- ers of ticket stubs have to stand in line for 10 minutes, is the Big Mac really free?

6. List some things that you need. Then ask yourself if you would still want some of those things if the price were five times higher. Would you still want them if the price were 10 times higher?

7. List the opportunity costs of the following: a. going to college b. missing a lecture c. withdrawing and spending $100 from your savings account, which earns 5 percent interest annually d. going snowboarding on the weekend before final examinations

Problems

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8. Which of the following activities require marginal thinking, and why? a. studying b. eating c. driving d. shopping e. getting ready for a night out

9. Should you go to the movies this Friday? List the factors that affect the possible benefits and costs of this decision. Explain where uncertainty affects the benefits and costs.

10. Explain why following the rule of rational choice makes a person better off.

11. Which of the following are positive incentives? Negative incentives? Why? a. a fine for not cleaning up after your dog defecates in the park b. a trip to Hawaii paid for by your parents or significant other for earning an A in your economics course c. a higher tax on cigarettes and alcohol d. a subsidy for installing solar panels on your house

12. Modern medicine has made organ transplants a common occurrence, yet the number of organs that people want far exceeds the available supply. According to CNN, 10 people die each day because of a lack of transplantable organs like kidneys and livers. Some economists have recommended that an organ market be established through which doctors and others could pay people for the right to use their organs when they die. The law currently forbids the sale of organs. What do you think of such a proposal? What kind of incentives would an organ market provide for people to allow others to use their organs? What would happen to the supply of organs if, instead of relying on donated kidneys, livers, and retinas, doctors and hospitals could bid for them? What drawbacks would a free mar- ket in organs have? Have you made arrangements to leave your organs to your local organ bank? Would you do so if you could receive $50,000 for them?

13. Throughout history, many countries have chosen the path of autarky, choosing to not trade with other countries. Explain why this path would make a country poorer.

14. Farmer Fran can grow soybeans and corn. She can grow 50 bushels of soybeans or 100 bushels of corn on an acre of her land for the same cost. The price of soybeans is $1.50 per bushel and the price of corn is $0.60 per bushel. Show the benefits to Fran of specialization. What should she specialize in?

15. Which region has a comparative advantage in the following goods: a. wheat: Colombia or the United States? b. coffee: Colombia or the United States? d. timber: Iowa or Washington? e. corn: Iowa or Washington?

16. Why is it important that the country or region with the lower opportunity cost produce the good? How would you use the concept of comparative advantage to argue for reducing restrictions on trade between countries?

17. People communicate with each other in the market through the effect their decisions to buy or sell have on prices. Indicate how each of the following would affect prices by putting a check in the appropriate space.

a. People who see an energetic and lovable Jack Russell Terrier in a popular TV series want Jack Russell Terriers as pets. The price of Jack Russell Terriers _____________ Rises _____________ Falls

b. Aging retirees flock to Tampa, Florida, to live. The price of housing in Tampa _____________ Rises _____________ Falls

c. Weather-related crop failures in Colombia and Costa Rica reduce coffee supplies. The price of coffee _____________ Rises _____________ Falls

d. Sugarcane fields in Hawaii and Louisiana are replaced with housing. The price of sugar _____________ Rises _____________ Falls

e. More and more students graduate from U.S. medical schools. The wages of U.S. doctors _____________ Rise _____________ Fall

f. Americans are driving more, and they are driving bigger, gas-guzzling cars like sport utility vehicles. The price of gasoline _____________ Rises _____________ Falls

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18. Prices communicate information about the relative value of resources. Which of the following would cause the relative value and, hence, the price of potatoes to rise?

a. Fungus infestation wipes out half the Idaho potato crop. b. The price of potato chips rises. c. Scientists find that eating potato chips makes you better looking. d. The prices of wheat, rice, and other potato substitutes fall dramatically.

19. Imagine that you are trying to decide whether to cross a street without using the designated crosswalk at the traffic signal. What are the expected marginal benefits of crossing? The expected marginal costs? How would the following conditions change your benefitcost equation?

a. The street was busy. b. The street was empty, and it was 3 a.m. c. You were in a huge hurry. d. A police officer was standing 100 feet away. e. The closest crosswalk was a mile away. f. The closest crosswalk was 10 feet away.

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3 ViViane Moos/Corbis

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Goods and services can be distributed many different ways: prices, first come/first served, random selection (like a lottery), majority rule, according to need, equal shares, and so on. Each method has advantages and disadvantages. What are the benefits and costs of different allocative systems?

Some methods of resource allocation might seem bad and counterproduc- tive; physical violence has been used since the beginning of time, as people, regions, and countries attacked one another to gain control over resources.

We could argue that government should allocate scarce resources on the basis of equal shares or according to need. However, this approach

Scarcity, Trade-Offs, and Production Possibilities 3.1 The Three Economic Questions

Every Society Faces

3.2 The Circular Flow Model

3.3 The Production Possibilities Curve

3.4 Economic Growth and the Production Possibilities Curve

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

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poses problems because of diverse individual preferences, the difficulty of ascertaining needs, and the negative work and investment incentives involved. In command economies, resource allocation is determined by central planners rather than in the market. Consequently, the plan- ners do not get markets signals regarding consumers preferences and producers costs, and shortages and surpluses ensue. When prices are used to allocate resources, the seller produces something a consumer wants and takes the money from the sale and buys what she wants. If something other than price is used, say force, what incentive does a producer have to produce the good, if she knows it can be taken from her? People will not produce as much in this kind of world. Incentives matter. For many goods and services, consumers wait in linecalled queu- ing. This is another way to distribute goods and services. People routinely queue at concerts or sporting events, to purchase groceries, to mail a parcel at the post office, to use a public toilet at a ball game, or to enter a congested highway. What are the costs of waiting in line?

Most queuing problems can be resolved by the market if people are willing to pay a higher price. For example, what if your grocery store charged you 5 percent to use the express lane, donating the express fee to charity? Or what if a store had a discount line that gave you coupons for waiting longer in line? However, the question remains, how do you create a system that simultaneously satisfies concerns about efficiency, time, money, and fairness?

This chapter builds on the foundations of the preceding chapters. We have learned that we have unlimited wants and limited resourcesthat is, we all face scarcity. And scarcity forces us to choose. To get one thing we like, we usually have to give up something else we wantthat is, people face trade-offs. Recognizing these trade-offs will allow us to make better decisions.

Every economy must transform the resources that nature provides into goods and services. Economics is the study of that process. This chapter begins with a discussion of how every economy must respond to three fundamental questions: What goods and services will be pro- duced? How will the goods and services be produced? Who will get the goods and services?

In this chapter, we introduce our first economic models: the circular flow model and the production possibilities curve. In the circular flow model, we show how decisions made by households and firms interact with each other. Our second model, the production possibili- ties curve, illustrates many of the most important concepts in economics: scarcity, trade-offs, increasing opportunity costs, efficiency, investment in capital goods, and economic growth.

What goods and services will be produced?

How will the goods and services be produced?

Who will get the goods and services?

The Three Economic Questions Every Society Faces

The Three Economic Questions Because of scarcity, certain economic questions must be answered, regardless of a societys level of affluence or its political structure. We will consider three fundamental questions that every society inevitably faces: (1) What goods and services will be produced? (2) How will the goods and services be produced? (3) Who will get the goods and services produced? These questions are unavoidable in a world of scarcity.

If producers decide what to produce in a market economy, why do we describe it as consumer sovereignty?

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What Goods and Services WillBeProduced? How do individuals control production decisions in market- oriented economies? Questions arise such as whether society should produce more baseball stadiums or more schools. Should Apple produce more iPhones or laptops? The government has a limited budget, too, and must make choices on how much to spend on defense, health care, highways, and education. In short, consumers, firms, and governments must all make choices about what goods and services will be produced and each one of those decisions has an opportunity costthe highest valued alternative forgone. In the marketplace, the answer to these and other similar questions is that people vote in economic affairs with their dollars (or pounds or yen). This concept is called consumer sovereignty. Consumer sovereignty explains how individual consumers in market economies determine what continues to be produced.

High-definition televisions, DVD players, cell phones, iPods, camcorders, and computers, for example, became part of our lives because consumers voted hundreds of dollars apiece on these goods. Consumers voted fewer dollars on regular color televisions and more on high definition televisions. Similarly, vinyl record albums gave way to tapes, CDs to downloadable music, as consumers voted for these items with their dollars. If consumers vote for more fuel effi- cient cars and healthier foods, then firms that wish to remain profitable must listen and respond.

How Different Types of Economic Systems Answer the Question What Goods and Services Will Be Produced? Economies are organized in different ways to answer the question of what is to be produced. The dispute over the best way to answer this question has inflamed passions for centuries. Should a central planning board make the decisions, as in North Korea and Cuba? Sometimes this highly centralized economic system is referred to as a command economy. Under this type of regime, decisions about how many tractors or automobiles to produce are largely deter- mined by a government official or committee associated with the central planning organiza- tion. That same group decides on the number and size of school buildings, refrigerators, shoes, and so on. Other countries, including the United States, much of Europe, and increasingly, Asia and elsewhere have largely adopted a decentralized deci- sion-making process where literally millions of individual producers and consumers of goods and services determine what goods, and how many of them, will be produced. A country that uses such a decentralized decision-making process is often said to have a market economy. Actually, no nation has a pure market economy. The United States, along with most countries, is said to have a mixed economy. In such an economy, the government and the private sector together determine the allocation of resources.

How Will the Goods and Services Be Produced? All economies, regardless of their political structure, must decide how to produce the goods and services that they wantbecause of scarcity. Goods and services can

consumer sovereignty consumers vote with their dollars in a market economy; this accounts for what is produced

command economy an economy in which the government uses central planning to coordinate mosteconomic activities

market economy an economy that allocates goods and services through the private decisions of consumers, input suppliers, and firms

mixed economy an economy where govern- ment and the private sector determine the allocation of resources

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Consumers say no to some new products. If consumers do not like a product, like the Ford Edsel above, it becomes unprofitable and will eventually disappear. Sometimes they become collectors items years later.

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generally be produced in several ways. Firms may face a trade-off between using more machines or more workers. For example, a company might decide to move its production to a plant in another country that uses more workers and fewer machines.

A ditch can be dug by many workers using their hands, by a few workers with shovels, or by one person with a backhoe. Someone must decide which method is most appropriate. From this example, you might be tempted to conclude that it is desirable to use the biggest, most elaborate form of capital. But would you really want to plant your spring flowers with huge earthmoving machinery? That is, the most capital-intensive method of production may not always be the best. The best method is the least-cost method.

What Is the Best Form of Production? The best or optimal form of production will usually vary from one economy to the next. For example, earthmoving machinery is used in digging large ditches in the United States and Europe, while in developing countries, shovels are often

used. Why do these optimal forms of production vary? Compared with capital, labor is relatively inexpensive and plentiful in developing countries but relatively scarce and expensive in the United States. In contrast, capital (machines and tools, mainly) is comparatively plentiful and relatively inexpensive in the United States but scarcer and more costly in developing countries. That is, in developing countries, production tends to be more labor intensive, or labor driven. In the

United States, production tends to be more capital intensive, or capital driven. Each nation tends to use the production processes that conserve its relatively scarce (and thus relatively more expensive) resources and use more of its relatively abundant resources.

Who Will Get the Goods and Services Produced? In every society, some mechanism must exist to determine how goods and services are to be distributed among the population. Who gets what? Why do some people get to consume or use far more goods and services than others? This question of distribution is so important

labor intensive production that uses a large amount of labor

capital intensive production that uses a large amount of capital

Market Signalswhat youve learned

Q Adam was a college graduate with a major in art. A few years ago, Adam decided that he wanted to pursue a vocation that utilized his talent. In response, he shut himself up in his studio and created a watercolor collection. With high hopes, Adam put his collection on display for buyers. After several years of displaying his art, however, the only one interested in the collection was his 18-year- old sister, who wanted the picture frames for her room. Recognizing that Adam was having trouble pursuing his chosen occupation, Adams friend Karl told him that the market had failed. In the mean- time, Adam turned to house painting (interior and

exterior) and business was booming. Adam hired five workers and would often be painting all day and into the evenings and weekends. Do you think the market has failed?

A no. Markets provide important signals, and the signal being sent in this situation is that Adam should look for some other means of support something that society values. Remember the function of consumer sovereignty in the marketplace. Clearly, consumers were not voting for Adams art. The mar- ket seems to be telling Adam: less painting on canvas and more painting on walls, doors, and trim.

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Which transplant patient should receive the available kidney? What are benefits and costs of different allocative systems?

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that wars and revolutions have been fought over it. Both the French and Russian revolutions were concerned fundamentally with the distribution of goods and services. Even in societies where political questions are usually settled peacefully, the question of the distribution of income is an issue that always arouses strong emotional responses. As we will see, in a market economy with private ownership and control of the means of production, the amounts of goods and services an individual can obtain depend on her or his income. Income, in turn, will depend on the quantity and quality of the scarce resources the individual controls. Income is also determined by the price others are willing and able to pay for what you have to sell. If you are a medical doctor and make $300,000 a year, that is income you will have available to buy goods and ser- vices. If you also own a condominium you rent out in Aspen, Colorado, you will have an even greater amount of income to spend on goods and services. Markets reward education, hard work, and training. Education (years of schooling) and earnings are highly (positively) correlated. Oprah Winfrey made a lot of money because she had unique and marketable skills as a talk show host. This basis for distribution may or may not be viewed as fair, an issue we will look at in detail later in this book.

Castaway and Resource Allocation In the movie Cast Away, a plane crash leaves Chuck Noland (Tom Hanks) stranded on a deserted island, as in the classic 18th century novel Robinson Crusoe. In this simple island economy, Noland had to find a way to survive. His behavior was restricted by the resources that he salvaged from the crash and what he could find on the island. He was by himself, so property rights were not an issue. However, he still had to answer the what, how, and for whom questions. In this chapter, you will discover these are the three ques- tions that every society must faceeven the simplest island economy. To Noland, the for whom question, who get the goods and services produced, was pretty easy: He was the only one on the island; he got what was pro- duced. The what question, what goods and services would be produced, was pretty easy, too: He was trying to survive, so he was looking to produce food, shelter, and clothing. The how question, how will the goods and services be produced, was where this scene becomes interesting. How to best use his scarce resources? Noland salvaged several boxes from the plane crash. After a failed attempt to leave the island, he decided to open the boxes to see whether they contain anything useful. He first found a pair of ice skates. He uses the blade of the skate as a knife to open coconuts, to cut a dress to convert into a fishing net, and to sharpen a stick to use as a spear for catching fish. He uses the laces from the skate and the bubble wrap in the package to dress an injury. He uses the raft as a lean-to for his shelter. He builds a fire and even makes a friend out of a volleyball Wilson. In short, Noland uses his entrepreneurial talents to try to make the best use of the scarce resources in order to survive on the island.

In a market economy, whodecides what and howmuch to produce?

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Chuck Noland (Tom Hanks) had to make the best use of his scarce resources to survive on the island.

Singer Beyonce gets paid a lot of money because she controls scarce resources: her talent and her name recognition. As we will see in Chapter 5, peo- ples talents and other goods and services in limited supply relative to demand will com- mand high prices.

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S E C T I O N Q U I Z

1. Which of the following is not a question that all societies must answer?

a. How can scarcity be eliminated?

b. What goods and services will be produced?

c. Who will get the goods and services?

d. How will the goods and services be produced?

e. All of the above are questions that all societies must answer.

2. Economic disputes over the distribution of income are generally associated with which economic question?

a. Who should produce the goods?

b. What goods and services will be produced?

c. Who will get the goods and services?

d. How will the goods and services be produced?

3. The private ownership of property and the use of the market system to direct and coordinate economic activity are most characteristic of

a. a command economy.

b. a mixed economy.

c. a market economy.

d. a traditional economy.

4. The degree of government involvement in the economy is greatest in

a. a command economy.

b. a mixed economy.

c. a market economy.

d. a traditional economy.

5. The best method of production is

a. the capital-intensive method.

b. the labor-intensive method.

c. the same under all circumstances.

d. the lowest cost method.

6. When _____________ is relatively scarce, _____________ methods of production will be relatively less expensive.

a. capital; capital-intensive

b. capital; labor-intensive

c. labor; capital-intensive

d. labor; labor-intensive

e. both (b) and (c) are true.

1. Why does scarcity force us to decide what to produce?

2. How is a command economy different from a market economy?

3. How does consumer sovereignty determine production decisions in a market economy?

4. Do you think that what and how much an economy produces depends on who will get the goods and services produced in that economy? Why or why not?

5. Why do consumers have to vote for a product with their dollars for it to be a success?

6. Why must we choose among multiple ways of producing the goods and services we want?

7. Why might production be labor intensive in one economy but be capital intensive in another?

8. If a tourist from the united States on an overseas trip notices that other countries dont produce crops like they do back home, would he be right to conclude that farmers in the other countries produce crops less efficiently than u.S. farmers?

9. In what way does scarcity determine income?

10. What are the most important functions of the market system?

Answers: 1. a 2. c 3. c 4. a 5. d 6. e

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How do we explain how the millions of people in an economy interact when it comes to buy- ing, selling, producing, working, hiring, and so on? A continuous flow of goods and services is bought and sold between the producers of goods and services (which we call firms) and the buyers of goods and services (which we call households). A continuous flow of income also moves from firms to households as firms buy inputs to produce the goods and services they sell. In our simple economy, these exchanges take place in product markets and factor markets.

Product Markets Product markets are the markets for consumer goods and services. In the product market, households are buyers and firms are sellers. Households buy the goods and services that firms produce and sell. The payments from the households to the firms, for the purchases of goods and services, flow to the firms at the same time as goods and services flow to the households.

Factor Markets Factor or input markets are where households sell the use of their inputs (capital, land, labor, and entrepreneurship) to firms. In the factor market, households are the sellers and firms are the buyers. Households receive money payments from firms as compensation for the labor, land, capital, and entrepreneurship needed to produce goods and services. These payments take the form of wages (salaries), rent, interest payments, and profit.

The Simple Circular Flow Model The simple circular flow model is illustrated in Exhibit 1. In the top half of the exhibit, the product markets, households purchase goods and services that firms have produced. In the lower half of the exhibit, the factor (or input) markets, households sell the inputs that firms use to produce goods and services. Households receive income (wages, rent, interest, and profit) from firms for the inputs used in production (capital, land, labor, and entre- preneurship).

So we see that in the simple circular flow model, income flows from firms to households (factor markets), and spending flows from households to firms (product markets). The simple circular flow model shows how households and firms interact in product markets and factor markets and how the two markets are interrelated.

product markets markets where households are buyers and firms are sellers of goods and services

factor (or input) markets markets where households sell the use of their inputs (capital, land, labor, and entrepreneurship) to firms

simple circular flow model an illustration of the continuous flow of goods, services, inputs, and payments between firms and households

What are product markets?

What are factor markets?

What is the circular flow model?

The Circular Flow Model

A teachers supply of labor gener- ates personal income in the form of wages in the factor market, which she can use to buy automobiles, vacations, food, and other goods in the product market. Suppose she buys an automobile in the product market; the automobile dealer now has revenue to pay for his inputs in the factor marketwages to workers, payment for new cars to replenish his inventory, rent for his building, and so on.

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section 3.2 exhibit 1 The Circular Flow Diagram

Consumption Spending

Goods and Services

Purchased

Goods and Services

Sold

Revenue

Capital, Land, Labor, and Entrepreneurship

Inputs for Production

Money Income Wages, Rent, Interest, and Profit

Factor Markets Households Sell Firms Buy

Product Markets Households Buy Firms Sell

Households Buy Goods and Services Sell Inputs

Firms Sell Goods and Services Buy Inputs

The circular flow diagram is a visual model of the economy. Households and firms interact with each other in product markets (where households buy and firms sell) and factor markets (where households sell and firms buy). For example, households receive income from firms in exchange for working and providing other inputs. Households then recycle that income to firms in exchange for goods and services. Dollars flow clockwise, and goods and services flow counterclockwise.

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Are households always buyers and firms always sellers?

S E C T I O N Q U I Z

1. In a circular flow diagram,

a. goods and services flow in a clockwise direction.

b. goods and services flow in a counterclockwise direction.

c. product markets appear at the top of the diagram.

d. factor markets appear at the left of the diagram.

e. both (b) and (c) are true.

2. Which of the following is true?

a. In the product markets, firms are buyers and households are sellers.

b. In the factor markets, firms are sellers and households are buyers.

c. Firms receive money payments from households for capital, land, labor, and entrepreneurship.

d. All of the above are true.

e. none of the above is true.

(continued)

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The Production Possibilities Curve The economic concepts of scarcity, choice, and trade-offs can be illustrated visually by means of a simple graph called a pro- duction possibilities curve. The production possibilities curve represents the potential total output combinations of any two goods for an economy, given the available factors of pro- duction and the available production technology that firms use to turn their inputs into outputs. That is, it illustrates an economys potential for allocating its limited resources in producing various combinations of goods, in a given time period.

The Production Possibilities Curve for Grades in Economics and History What would the production possibilities curve look like if you were producing grades in two of your classessay, economics and history? Exhibit 1 shows a hypothetical production possibilities curve for your expected grade in economics (on the vertical axis), and your expected grade in

production possibilities curve the potential total output combinations of any two goods for an economy given the available factors of production and the available production technology that firms use to turn their inputs into outputs.

Because Tia and Tamera only have so many hours a week to study, studying more for economics and less for history might hurt their grade in history, ceteris paribus. Life is full of trade-offs.

What is a production possibilities curve?

What are unemployed resources?

What are underemployed resources?

What is efficiency?

What is the law of increasing opportunity costs?

The Production Possibilities Curve

S E C T I O N Q U I Z (Cont.)

3. In the circular flow model,

a. firms supply both products and resources.

b. firms demand both products and resources.

c. firms demand resources and supply products.

d. firms supply resources and demand products.

4. The circular flow model

a. traces the flow of goods and services among firms and households.

b. traces the flow of payments among firms and households.

c. includes both product markets and factor markets.

d. All of the above are true.

1. Why does the circular flow of money move in the opposite direction from the flow of goods and services?

2. What is bought and sold in factor markets?

3. What is bought and sold in product markets?

Answers: 1. b 2. e 3. c 4. d

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history (on the horizontal axis). Suppose you have a part-time restaurant job, so you choose to study 10 hours a week. You like both courses and are equally adept at studying for both.

We see in Exhibit 1 that the production possibilities curve is a straight line. For example, if you spend the full 10 hours studying economics, your expected grade in economics is 95 percent (an A), and your expected grade in history is 55 percent (an F). Of course, this outcome assumes you can study zero hours a week and still get a 55 percent average or study the full 10 hours a week and get a 95 percent average. Moving down the production possibilities curve, we see that as you spend more of your time studying history and less on economics, you can raise your expected grade in history but only at the expense of lowering your expected grade in economics. Specifically, moving down along the straight-line production possibilities curve, the trade-off is one lower per- centage point in economics for one higher percentage point in history. That is, with a straight-line production possibili- ties curve, the opportunity costs are constant.

Of course, if you were to increase your overall study time, you would expect higher grades in both courses. But that would be on a different production possibilities curve. Along the production possibilities curve shown in Exhibit 1, we assume that technology and the number of study hours are given.

The Production Possibilities Curve for Food and Shelter

To illustrate the production possibilities curve more clearly, imagine living in an economy that produces just two goods, food and shelter. The fact that we have many goods in the real world makes actual decision making more complicated, but it does not alter the basic prin- ciples being illustrated. Each point on the production possibilities curve shown in Exhibit 2 represents the potential amounts of food and shelter that we can produce in a given period, with a given quantity and quality of resources in the economy available for production.

section 3.3 exhibit 1

Production Possibilities Curve: Producing Grades in Economics and History

75% 65% 55% 55%

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10 Hours Economics 0 Hours History

7.5 Hours Economics 2.5 Hours History

5 Hours Economics 5 Hours History

2.5 Hours Economics 7.5 Hours History

0 Hours Economics 10 Hours History

The production possibilities curve highlights the concept of trade-offs. Assuming you choose to study a total of 10 hours a week, moving down the production possibilities curve shows that if you use your time to study history instead of economics, you can raise your expected grade in history but only at the expense of lowering your expected grade in economics. note that, with a straight-line production possibilities curve, the opportunity costs are constant.

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section 3.3 exhibit 2 Production Possibilities Curve: The Trade-Off between Food and Shelter

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