sample contents ch2 & ch4

Part 1 INTRODUCTION

Chapter 1The Role and Method of Economics 2

Chapter 2The Economic Way of Thinking 36

Chapter 3Scarcity, Trade-Offs, and Production Possibilities 66

Part 2 SUPPLY AND DEMAND

Chapter 4Supply and Demand 92

Chapter 5Bringing Supply and Demand Together 121

Chapter 6Elasticities 151

Part 3 MARKET EFFICIENCY, MARKET FAILURE, AND THE PUBLIC SYSTEM

Chapter 7Market Efficiency and Welfare 182

Chapter 8Market Failure 209

Chapter 9Public Sector and Public Choice 233

Part 4 HOUSEHOLDS AND MARKET STRUCTURE

Chapter 10Consumer Choice Theory 256

Chapter 11The Firm: Production and Costs 287

Chapter 12Firms in Perfectly Competitive Markets 326

Chapter 13Monopoly and Antitrust 359

Chapter 14Monopolistic Competition and Product Differentiation 398

Chapter 15Oligopoly and Strategic Behavior 419

Part 5 INPUT MARKETS AND MICROECONOMIC POLICY ISSUES

Chapter 16The Markets for Labor, Capital, and Land 452

Chapter 17Income and Poverty 480

Chapter 18The Environment 511

Chapter 19Health Care 535

Part 6 MACROECONOMIC FOUNDATIONS

Chapter 20Introduction to Macroeconomics: Unemployment, Inflation, and Economic Fluctuations 558

Chapter 21Measuring Economic Performance 603

Chapter 22Economic Growth in the Global Economy 627

Chapter 23Financial Markets, Saving, and Investment 649

Part 7 THE MACROECONOMIC MODELS

Chapter 24Aggregate Demand and Aggregate Supply 684

Chapter 25The Aggregate Expenditure Model 727

Brief Contents

iv Brief Contents

52270_00_fm_pi-xxx.indd iv52270_00_fm_pi-xxx.indd iv 10/20/09 2:45:13 PM10/20/09 2:45:13 PM

Part 8 MACROECONOMIC POLICY

Chapter 26Fiscal Policy 754

Chapter 27Monetary Institutions 797

Chapter 28The Federal Reserve System and Monetary Policy 826

Chapter 29Issues in Macroeconomic Theory and Policy 869

Part 9 THE GLOBAL ECONOMY

Chapter 30International Trade 906

Chapter 31International Finance 943

vBrief Contents

52270_00_fm_pi-xxx.indd v52270_00_fm_pi-xxx.indd v 10/20/09 2:45:19 PM10/20/09 2:45:19 PM

Part 1 I N T R O D U C T I O N

C H A P T E R 1The Role and Method of Economics 21.1 Economics: A Brief Introduction 3

Economics—A Word with Many Different Meanings 3

Economics Is All Around Us 3Why Study Economics? 4

1.2 Economic Behavior 7Self-Interest 7What Is Rational Behavior? 7

1.3 Economic Theory 10Economic Theories 10Abstraction Is Important 10Developing a Testable Proposition 11Science and Stories 11The Ceteris Paribus Assumption 12Why Are Observation and Prediction Harder

in the Social Sciences? 12Why Do Economists Predict on a Group Level? 12The Two Branches of Economics: Microeconomics

and Macroeconomics 13

1.4 Pitfalls to Avoid in Scientific Thinking 14Confusing Correlation and Causation 14The Fallacy of Composition 14

1.5 Positive Statements and Normative Statements 16Positive Statement 16Normative Statement 17Positive Versus Normative Analysis 17Disagreement Is Common in Most Disciplines 17Often Economists Do Agree 19

Interactive Chapter Summary 20Key Terms and Concepts 21Section Check Answers 21Study Guide 24Appendix: Working with Graphs 28

C H A P T E R 2The Economic Way of Thinking 362.1 Scarcity 37

Scarcity 37Scarcity and Resources 37What Are Goods and Services? 38

What Are Bads? 38Are Those Who Want More Greedy? 38Does Everyone Face Scarcity? 38Will Scarcity Ever Be Eradicated? 39

2.2 Choices, Costs, and Trade-Offs 40Scarcity Forces Us to Choose 40Trade-Offs 40To Choose Is to Lose 40The Opportunity Cost of Going to College or Having

a Child 41Is That Really a Free Lunch, a Freeway, or a Free

Beach? 41

2.3 Marginal Thinking 42Many Choices We Face Involve Marginal

Thinking 42

2.4 Incentives Matter 47People Respond to Changes in Incentives 47Positive and Negative Incentives 47

2.5 Specialization and Trade 49Why Do People Specialize? 49We All Specialize 49The Advantages of Specialization 49Specialization and Trade Lead to Greater Wealth

and Prosperity 51

2.6 Markets and Improved Efficiency 52How Does the Market Work to Allocate

Resources? 52Market Prices Provide Important Information 52What Effect Do Price Controls Have on

the Market System? 53Market Failure 53

Interactive Chapter Summary 55Key Terms and Concepts 56Section Check Answers 56Study Guide 60

C H A P T E R 3Scarcity, Trade-Offs, and Production Possibilities 663.1 The Three Economic Questions Every

Society Faces 67Scarcity and the Allocation of Resources 67What Goods and Services Will Be Produced? 67How Will the Goods and Services Be Produced? 68Who Will Get the Goods and Services Produced? 68

3.2 The Circular Flow Model 71Product Markets 71

Table of Contents

Table of Contentsvi

52270_00_fm_pi-xxx.indd vi52270_00_fm_pi-xxx.indd vi 10/20/09 2:45:19 PM10/20/09 2:45:19 PM

Factor Markets 71The Simple Circular Flow Model 71

3.3 The Production Possibilities Curve 73The Production Possibilities Curve 73Using Resources Efficiently 75Inefficiency and Efficiency 76The Law of Increasing Opportunity Cost 76

3.4 Economic Growth and the Production Possibilities Curve 78Generating Economic Growth 78Growth Does Not Eliminate Scarcity 78The Effects of a Technological Change

on the Production Possibilities Curve 79Summing Up the Production Possibilities Curve 80


Part 2 SUPPLY AND DEMAND

C H A P T E R 4Supply and Demand 924.1 Markets 93

Defining a Market 93Buyers and Sellers 94

4.2 Demand 94The Law of Demand 94Individual Demand 95What Is a Market Demand Curve? 95

4.3 Shifts in the Demand Curve 97A Change in Demand Versus a Change in Quantity

Demanded 97Shifts in Demand 98The Prices of Related Goods 98Income 99Number of Buyers 101Consumer’s Preferences and Information 101Expectations 101Changes in Demand Versus Changes in Quantity

Demanded—Revisited 102

4.4 Supply 104The Law of Supply 104A Positive Relationship Between Price and Quantity

Supplied 105An Individual Supply Curve 105The Market Supply Curve 105

4.5 Shifts in the Supply Curve 106A Change in Quantity Supplied Versus a Change

in Supply 106Shifts in Supply 107Change in Supply Versus Change in Quantity

Supplied—Revisited 109


C H A P T E R 5Bringing Supply and Demand Together 1215.1 Market Equilibrium Price and Quantity 122

Equilibrium Price and Quantity 122Shortages and Surpluses 123Scarcity and Shortages 123

5.2 Changes in Equilibrium Price and Quantity 127A Change in Demand 127A Change in Supply 127Changes in Both Supply and Demand 129The Combinations of Supply and Demand Shifts 130Supply, Demand, and the Market Economy 134

5.3 Price Controls 135Price Controls 135Price Ceilings: Rent Controls 135Price Floors: The Minimum Wage 137Price Ceilings: Price Controls on Gasoline 138Unintended Consequences 139


C H A P T E R 6Elasticities 1516.1 Price Elasticity of Demand 152

Is the Demand Curve Elastic or Inelastic? 152Types of Demand Curves 152Calculating the Price Elasticity of Demand:

The Midpoint Method 154The Determinants of the Price Elasticity

of Demand 155

6.2 Total Revenue and the Price Elasticity of Demand 158How Does the Price Elasticity of Demand Impact

Total Revenue? 158Price Elasticity Changes Along a Linear Demand

Curve 159

6.3 Other Types of Demand Elasticities 163The Cross-Price Elasticity of Demand 163Cross-Price Elasticity and Sodas 163The Income Elasticity of Demand 163

6.4 Price Elasticity of Supply 165What Is the Price Elasticity of Supply? 165Elasticities and Taxes: Combining Supply and Demand

Elasticities 166

Table of Contents vii

52270_00_fm_pi-xxx.indd vii52270_00_fm_pi-xxx.indd vii 10/20/09 2:45:21 PM10/20/09 2:45:21 PM


Part 3 MARKET EFFICIENCY, MARKET FAILURE, AND THE PUBLIC SYSTEM

C H A P T E R 7Market Efficiency and Welfare 1827.1 Consumer Surplus and Producer Surplus 183

Consumer Surplus 183Marginal Willingness to Pay Falls as More

Is Consumed 183Price Changes and Changes in Consumer Surplus 184Producer Surplus 184Market Efficiency and Producer and Consumer

Surplus 185

7.2 The Welfare Effects of Taxes, Subsidies, and Price Controls 190Using Consumer and Producer Surplus to Find

the Welfare Effects of a Tax 190Elasticity and the Size of the Deadweight Loss 192The Welfare Effects of Subsidies 193Price Ceilings and Welfare Effects 193Applications of Consumer and Producer Surplus 194Price Floors 196The Welfare Effects of a Price Floor When

the Government Buys the Surplus 196Deficiency Payment Program 198


C H A P T E R 8Market Failure 2098.1 Externalities 210

Negative Externalities in Production 210What Can the Government Do to Correct for Negative

Externalities? 211Positive Externalities in Consumption 213What Can the Government Do to Correct for Positive

Externalities? 214Nongovernmental Solutions to Externalities 214

8.2 Public Goods 216Private Goods Versus Public Goods 216Public Goods and the Free-Rider Problem 217The Government and Benefit-Cost Analysis 217Common Resources and the Tragedy

of the Commons 218

8.3 Asymmetric Information 219What Is Asymmetric Information? 219What Is Moral Hazard? 222


C H A P T E R 9Public Sector and Public Choice 2339.1 Other Functions of Government 234

Property Rights and the Legal System 234Insufficient Competition in Markets 234Income Redistribution 234

9.2 Government Spending and Taxation 236Growth in Government 236Generating Government Revenue 238Financing State and Local Government Activities 239Should We Have a Flat Tax? 240Taxes: Efficiency and Equity 240

9.3 Public Choice 245What Is Public Choice Theory? 245Scarcity and the Public Sector 245The Individual Consumption-Payment Link 245Majority Rule and the Median Voters 245Voters and Rational Ignorance 246Special Interest Groups 247


Part 4 HOUSEHOLDS AND MARKET STRUCTURE

C H A P T E R 1 0Consumer Choice Theory 25610.1 Consumer Behavior 257

Wants Versus Needs 257Do We Need More Freeways? 258Utility 258Utility Is a Personal Matter 258Total Utility and Marginal Utility 259Diminishing Marginal Utility 261

10.2 The Consumer’s Choice 264What Is the “Best” Decision for Consumers? 264Consumer Equilibrium 264The Law of Demand and the Law of Diminishing

Marginal Utility 265

Interactive Chapter Summary 270Key Terms and Concepts 271Section Check Answers 271

viii Table of Contents

52270_00_fm_pi-xxx.indd viii52270_00_fm_pi-xxx.indd viii 10/20/09 2:45:21 PM10/20/09 2:45:21 PM

Study Guide 273Appendix: A More Advanced Theory

of Consumer Choice 277

C H A P T E R 1 1The Firm: Production and Costs 28711.1 Firms and Profits: Total Revenues Minus Total

Costs 288Explicit Costs 288Implicit Costs 288Profits 288Are Accounting Profits the Same as Economic

Profits? 288A Zero Economic Profit Is a Normal Profit 290Sunk Costs 290

11.2 Production in the Short Run 291The Short Run Versus the Long Run 291Production in the Short Run 291Diminishing Marginal Product 292

11.3 Costs in the Short Run 294Fixed Costs, Variable Costs, and Total Costs 294Average Total Costs 294Marginal Costs 295How Are These Costs Related? 296

11.4 The Shape of the Short-Run Cost Curves 298

The Relationship Between Marginal Costs and Marginal Product 298

The Relationship Between Marginal and Average Amounts 299

Why Is the Average Total Cost Curve U-Shaped? 299

The Relationship Between Marginal Costs and Average Variable and Average Total Costs 300

11.5 Cost Curves: Short-Run Versus Long-Run 302Why Are Long-Run Cost Curves Different from

Short-Run Cost Curves? 302What Are Economies of Scale? 304Why Do Economies and Diseconomies of Scale

Occur? 304

Interactive Chapter Summary 305Key Terms and Concepts 306Section Check Answers 306Study Guide 309Appendix: Using Isoquants and Isocosts 318

C H A P T E R 1 2Firms in Perfectly Competitive Markets 32612.1 A Perfectly Competitive Market 327

A Perfectly Competitive Market 327

12.2 An Individual Price Taker’s Demand Curve 328An Individual Firm’s Demand Curve 328A Change in Market Price and the Firm’s

Demand Curve 329

12.3 Profit Maximization 330Revenues in a Perfectly Competitive Market 330Total Revenue 331Average Revenue and Marginal Revenue 331How Do Firms Maximize Profits? 331Equating Marginal Revenue and Marginal Cost 331

12.4 Short-Run Profits and Losses 333The Three-Step Method 333Evaluating Economic Losses in the Short Run 335Deriving the Short-Run Market Supply Curve 336

12.5 Long-Run Equilibrium 339Economic Profits and Losses Disappear in the Long

Run 339The Long-Run Equilibrium for the

Competitive Firm 341

12.6 Long-Run Supply 342A Constant-Cost Industry 342An Increasing-Cost Industry 342A Decreasing-Cost Industry 344Perfect Competition and Economic Efficiency 345


C H A P T E R 1 3Monopoly and Antitrust 35913.1 Monopoly: The Price Maker 360

What Is a Monopoly? 360Pure Monopoly Is a Rarity 360Barriers to Entry 360

13.2 Demand and Marginal Revenue in Monopoly 361The Monopolist’s Price in the Elastic Portion

of the Demand Curve 364

13.3 The Monopolist’s Equilibrium 366How Does the Monopolist Determine the

Profit-Maximizing Output? 366Three-Step Method for the Monopolist 366Profits for a Monopolist 366Losses for the Monopolist 367Patents 368

13.4 Monopoly and Welfare Loss 369Does Monopoly Promote Inefficiency? 369Does Monopoly Retard Innovation? 371

13.5 Monopoly Policy 371Antitrust Policies 372Antitrust Laws 372Have Antitrust Policies Been Successful? 373

Table of Contents ix

52270_00_fm_pi-xxx.indd ix52270_00_fm_pi-xxx.indd ix 10/20/09 2:45:21 PM10/20/09 2:45:21 PM

Government Regulation 373Difficulties in Average Cost Pricing 375

13.6 Price Discrimination and Peak Load Pricing 376Price Discrimination 376Conditions for Price Discrimination 376Why Does Price Discrimination Exist? 377Examples of Price Discrimination 377The Welfare Effects of Price Discrimination 379Peak Load Pricing 383


C H A P T E R 1 4Monopolistic Competition and Product Differentiation 39814.1 Monopolistic Competition 399

What Is Monopolistic Competition? 399The Three Basic Characteristics of Monopolistic

Competition 399

14.2 Price and Output Determination in Monopolistic Competition 401The Firm’s Demand and Marginal Revenue

Curve 401Determining Short-Run Equilibrium 402Short-Run Profits and Losses in Monopolistic

Competition 403Determining Long-Run Equilibrium 404Achieving Long-Run Equilibrium 405

14.3 Monopolistic Competition Versus Perfect Competition 406The Significance of Excess Capacity 406Failing to Meet Allocative Efficiency, Too 407What Are the Real Costs of Monopolistic

Competition? 408Are the Differences Between Monopolistic

Competition and Perfect Competition Exaggerated? 408

14.4 Advertising 409Why Do Firms Advertise? 409Is Advertising “Good” or “Bad” from Society’s

Perspective? 410


C H A P T E R 1 5Oligopoly and Strategic Behavior 41915.1 Oligopoly 420

What Is Oligopoly? 420Mutual Interdependence 420Why Do Oligopolies Exist? 420

Measuring Industry Concentration 420Economies of Scale as a Barrier to Entry 421Equilibrium Price and Quantity in Oligopoly 421

15.2 Collusion and Cartels 422Uncertainty and Pricing Decisions 422Collusion 422Joint Profit Maximization 422Why Are Most Collusive Oligopolies

Short Lived? 425

15.3 Other Oligopoly Models 425The Kinked Demand Curve Model—Price Rigidity 425Price Leadership 426What Happens in the Long Run If Entry Is Easy? 427How Do Oligopolists Deter Market Entry? 427Antitrust and Mergers 428Antitrust and Pricing Strategies 428

15.4 Game Theory and Strategic Behavior 431Some Strategies for Noncollusive Oligopolies 431What Is Game Theory? 431Cooperative and Noncooperative Games 431The Prisoners’ Dilemma 432Profits Under Different Pricing Strategies 433Advertising 434Repeated Games 436Network Externalities 437


Part 5 INPUT MARKETS AND MICROECONOMIC POLICY ISSUES

C H A P T E R 1 6The Markets for Labor, Capital, and Land 45216.1 Input Markets 453

Determining the Price of a Productive Factor: Derived Demand 453

16.2 Supply and Demand in the Labor Market 454Will Hiring That Input Add More to Revenue

Than Costs? 454The Demand Curve for Labor Slopes

Downward 455How Many Workers Will an Employer Hire? 456The Market Labor Supply Curve 457

16.3 Labor Market Equilibrium 459Determining Equilibrium in the Competitive Labor

Market 459Shifts in the Labor Demand Curve 459Shifting the Labor Supply Curve 461Monopsony 462

x Table of Contents

52270_00_fm_pi-xxx.indd x52270_00_fm_pi-xxx.indd x 10/20/09 2:45:21 PM10/20/09 2:45:21 PM

16.4 Labor Unions 463Labor Unions in the United States 463Why Are There Labor Unions? 464Union Impact on Labor Supply and Wages 464Wage Differences for Similarly Skilled Workers 464Can Unions Lead to Increased Productivity? 465

16.5 The Markets for Land and Capital 466The Supply of and Demand for Land 466Supply and Demand in the Capital Market 466The Interdependence of Input Markets 467Income Distribution and Marginal Productivity 468


C H A P T E R 1 7Income and Poverty 48017.1 Income Distribution 481

Measuring Income Inequality 481The Lorenz Curve 482Are We Overstating the Disparity in the Distribution

of Income? 483Permanent Income Hypothesis 484How Much Movement Happens on the Economic

Ladder? 484Why Do Some Earn More than Others? 485Income Distribution in Other Countries 487

17.2 Income Redistribution 488Equality 489Income Redistribution Can Reduce Incentives to

Work, Invest, and Save 489Revisiting Marginal Productivity Theory 490

17.3 The Economics of Discrimination 491Job-Entry Discrimination 491Wage Discrimination 491Discrimination or Differences in Productivity? 491Why Do People Discriminate? 492The Costs of Discrimination 493

17.4 Poverty 494Defining Poverty 494An Alternative Definition of Poverty 494Income Redistribution 496


C H A P T E R 1 8The Environment 51118.1 Negative Externalities and Pollution 512

What Are Social Costs? 512Negative Externalities and Pollution 512Measuring Externalities 513

18.2 Public Policy and the Environment 514Why Is a Clean Environment Not Free? 514The Costs and Benefits of Pollution Control 515Command and Control Policies: Regulation 515Pollution (Pigovian) Taxes: A Market-Based Policy 517Transferable Pollution Rights 519What Is an Ideal Pollution Control Policy? 519

18.3 Property Rights 523Property Rights and the Environment 523The Coase Theorem 523Transaction Costs and the Coase Theorem 523


C H A P T E R 1 9Health Care 53519.1 The Rising Cost of Health Care 536

19.2 The Health Care Market 538Income 538Insurance and Third-Party Payers 539Demographic Changes 540The Supply of Health Care 540Doctors as Gatekeepers 540Technological Progress and Quality of Care 541Imperfect Competition 541Shortages 542The Market for Human Organs 543Health Saving Account (HSA) 543


Part 6 MACROECONOMIC FOUNDATIONS

C H A P T E R 2 0Introduction to Macroeconomics: Unemployment, Inflation, and Economic Fluctuations 55820.1 Macroeconomic Goals 559

Three Major Macroeconomic Goals 559Acknowledging Our Goals: The Employment

Act of 1946 559

20.2 Employment and Unemployment 560The Consequences of High

Unemployment 560What Is the Unemployment Rate? 560The Worst Case of U.S. Unemployment 561Variations in the Unemployment Rate 561

Table of Contents xi

52270_00_fm_pi-xxx.indd xi52270_00_fm_pi-xxx.indd xi 10/20/09 2:45:21 PM10/20/09 2:45:21 PM

Are Unemployment Statistics Accurate Reflections of the Labor Market? 561

Who Are the Unemployed? 562Categories of Unemployed Workers 562How Much Unemployment? 563How Long Are People Usually Unemployed? 563Labor Force Participation Rate 564

20.3 Types of Unemployment 565Frictional Unemployment 565Should We Worry About Frictional

Unemployment? 565Structural Unemployment 566Some Unemployment Is Unavoidable 566Cyclical Unemployment 566The Natural Rate of Unemployment 567

20.4 Reasons for Unemployment 569Why Does Unemployment Exist? 569Minimum Wages and Unemployment 569The Impact of Unions on the Unemployment

Rate 570Efficiency Wage 570Job Search 570Unemployment Insurance 571Does New Technology Lead to Greater

Unemployment? 571

20.5 Inflation 572Stable Price Level as a Desirable Goal 572Measuring Inflation 573The Consumer Price Index and the GDP

Deflator 574How Is a Price Index Created? 574Producer Price Index 575GDP Deflator Versus CPI 575The Price Level over the Years 575Who Loses with Inflation? 578Other Costs of Inflation 579Inflation and Interest Rates 580Do Creditors Always Lose During Inflation? 581Protecting Ourselves from Inflation 581

20.6 Economic Fluctuations 583Short-Term Fluctuations in Economic

Growth 583The Phases of a Business Cycle 583How Long Does a Business Cycle Last? 584Seasonal Fluctuations Affect Economic

Activity 585Forecasting Cyclical Changes 585


C H A P T E R 2 1Measuring Economic Performance 60321.1 National Income Accounting: A Standardized

Way to Measure Economic Performance 604What Is Gross Domestic Product? 604Production, Income, and the Circular

Flow Model 604

21.2 Measuring Total Production 606The Expenditure Approach to Measuring GDP 606Consumption (C) 606Investment (I ) 607Government Purchases in GDP (G) 608Exports (X � M) 608

21.3 Other Measures of Total Production and Total Income 609

21.4 Problems in Calculating an Accurate GDP 610Problems in Calculating an Accurate GDP 610How Do We Solve This Problem? 610A Price-Level Index 610Real GDP 610Is Real GDP Always Less Than Nominal GDP? 611Real GDP per Capita 611Why Is the Measure of per Capita GDP So

Important? 612

21.5 Problems with GDP as a Measure of Economic Welfare 613Nonmarket Transactions 613The Underground Economy 613Measuring the Value of Leisure 613GDP and Externalities 613Quality of Goods 616Other Measures of Economic Well-Being 616


C H A P T E R 2 2Economic Growth in the Global Economy 62722.1 Economic Growth 628

Defining Economic Growth 628The Rule of 70 628

22.2 Determinants of Economic Growth 630Factors That Contribute to Economic Growth 630New Growth Theory 633

xii Table of Contents

52270_00_fm_pi-xxx.indd xii52270_00_fm_pi-xxx.indd xii 10/20/09 2:45:21 PM10/20/09 2:45:21 PM

22.3 Public Policy and Economic Growth 634The Impact of Economic Growth 634Saving Rates, Investment, Capital Stock, and

Economic Growth 634Infrastructure 634Research and Development 634The Protection of Property Rights Impacts

Economic Growth 635Free Trade and Economic Growth 635Education 636

22.4 Population and Economic Growth 638Population Growth and Economic Growth 638The Malthusian Prediction 639


C H A P T E R 2 3Financial Markets, Saving, and Investment 64923.1 Financial Institutions and Intermediaries 650

Bonds 650Stocks 650Retained Earnings 651The Value of Securities 651Reading Stock Tables 652Executives, Stockholders, and the Principal-Agent

Problem 653

23.2 Saving, Investment, and the Financial System 654

The Macroeconomics of Saving and Investment 655

The Market for Loanable Funds 655Analyzing the Market for Loanable Funds 656

23.3 The Financial Crisis of 2008 663Low Interest Rates (2002–2004) Led to Aggressive

Borrowing 663Deregulation in the Housing Market and Subprime

Mortgages 663Who Bought These Risky Subprime

Mortgages? 664The Fed Raises Interest Rates and the Housing

Bust 666

Interactive Chapter Summary 669Key Terms and Concepts 670Section Check Answers 670Study Guide 673Appendix: Calculating Present Value 680

Part 7 THE MACROECONOMIC MODELS

C H A P T E R 2 4Aggregate Demand and Aggregate Supply 68424.1 The Determinants of Aggregate Demand 685

What Is Aggregate Demand? 685Consumption (C) 685Investment (I) 685Government Purchases (G) 685Net Exports (X � M) 685

24.2 The Aggregate Demand Curve 686How Is the Quantity of Real GDP Demanded

Affected by the Price Level? 686Why Is the Aggregate Demand Curve Negatively

Sloped? 687

24.3 Shifts in the Aggregate Demand Curve 688Shifts Versus Movements Along the Aggregate

Demand Curve 688Aggregate Demand Curve Shifters 688

24.4 The Aggregate Supply Curve 690What Is the Aggregate Supply Curve? 690Why Is the Short-Run Aggregate Supply Curve

Positively Sloped? 691Why Is the Long-Run Aggregate Supply Curve

Vertical? 691

24.5 Shifts in the Aggregate Supply Curve 693Shifting Short-Run and Long-Run

Supply Curves 693What Factors Shift Short-Run Aggregate Supply

Only? 694

24.6 Macroeconomic Equilibrium 696Determining Macroeconomic Equilibrium 696Recessionary and Inflationary Gaps 696Demand-Pull Inflation 697Cost-Push Inflation 697What Helped the United States Recover

in the 1980s? 698A Decrease in Aggregate Demand

and Recessions 699Adjusting to a Recessionary Gap 700Slow Adjustments to a Recessionary Gap 700What Causes Wages and Prices to Be

Sticky Downward? 700Adjusting to an Inflationary Gap 701Price Level and RGDP Over Time 702

Table of Contents xiii

52270_00_fm_pi-xxx.indd xiii52270_00_fm_pi-xxx.indd xiii 10/20/09 2:45:21 PM10/20/09 2:45:21 PM

24.7 The Classical and the Keynesian Macroeconomic Model 703The Classical School and Say’s Law 703Changes in Aggregate Demand in the Classical

Model 704The Keynesian Short-Run Aggregate Supply

Curve—Sticky Prices and Wages 705


C H A P T E R 2 5The Aggregate Expenditure Model 72725.1 Simple Aggregate Expenditure Model 728

Why Do We Assume the Price Level Is Fixed? 728The Simplest Aggregate Expenditure Model:

Autonomous Consumption Only 728What Are the Autonomous Factors That Influence

Spending? 729

25.2 Finding Equilibrium in the Aggregate Expenditure Model 730Revisiting Marginal Propensity to Consume

and Save 731Marginal Propensity to Save 731Equilibrium in the Aggregate Expenditure

Model 732Equilibrium in the Aggregate Expenditure Model 733

25.3 Adding Investment, Government Purchases, and Net Exports 735

25.4 Shifts in Aggregate Expenditure and the Multiplier 737

25.5 From Aggregate Expenditures to Aggregate Demand 740Shifts in Aggregate Demand 741Limitations of the Aggregate Expenditure Model 741


Part 8 MACROECONOMIC POLICY

C H A P T E R 2 6Fiscal Policy 75426.1 Fiscal Policy 755

Fiscal Policy 755Fiscal Stimulus Affects the Budget 755The Government and Total Spending 755

26.2 Fiscal Policy and the AD/AS Model 757Fiscal Policy and the AD/AS Model 757

26.3 The Multiplier Effect 761Government Purchases, Taxes, and Aggregate

Demand 761The Multiplier Effect 761The Multiplier Effect at Work 762Changes in the MPC Affect the Multiplier

Process 763The Multiplier and the Aggregate Demand

Curve 763Tax Cuts and the Multiplier 763Taxes and Investment Spending 764A Reduction in Government Purchases and Tax

Increases 765Time Lags, Saving, and Imports Reduce the Size of

the Multiplier 765

26.4 Supply-Side Effects of Tax Cuts 766What Is Supply-Side? 766Impact of Supply-Side Policies 766The Laffer Curve 767Research and Development and the Supply Side

of the Economy 768How Do Supply-Side Policies Affect Long-Run

Aggregate Supply? 768Critics of Supply-Side Economics 768The Supply-Side and Demand-Side Effects

of a Tax Cut 769

26.5 Possible Obstacles to Effective Fiscal Policy 774The Crowding-Out Effect 774Time Lags in Fiscal Policy Implementation 775

26.6 Automatic Stabilizers 778Automatic Stabilizers 778How Do the Tax System and Transfer Payments

Stabilize the Economy? 778

26.7 The National Debt 779Fiscal Stimulus Affects the Budget 779How Government Finances the Debt 779Why Run a Budget Deficit? 780An Increase in the Budget Deficit: Short-Run and

Long-Run Effects 781The Burden of Public Debt 782


C H A P T E R 2 7Monetary Institutions 79727.1 What Is Money? 798

The Functions of Money 798

27.2 Measuring Money 801Currency 801Currency as Legal Tender 802

xiv Table of Contents

52270_00_fm_pi-xxx.indd xiv52270_00_fm_pi-xxx.indd xiv 10/20/09 2:45:22 PM10/20/09 2:45:22 PM

Demand Deposits and Other Checkable Deposits 802

The Popularity of Demand Deposits and Other Checkable Deposits 802

Credit Cards 803Savings Accounts 803Money Market Mutual Funds 804Stocks and Bonds 804Liquidity 804The Money Supply 804How Was Money “Backed”? 804What Really Backs Our Money Now? 805

27.3 How Banks Create Money 807Financial Institutions 807The Functions of Financial Institutions 807How Do Banks Create Money? 807How Do Banks Make Profits? 807Reserve Requirements 808Fractional Reserve System 808A Balance Sheet 808The Required Reserve Ratio 809Loaning Excess Reserves 810Is More Money More Wealth? 812

27.4 The Money Multiplier 813The Multiple Expansion Effect 813New Loans and Multiple Expansions 813The Money Multiplier 813Why Is It Only “Potential” Money Creation? 814

27.5 The Collapse of America’s Banking System, 1920–1933 815What Happened to the Banking Industry? 815What Caused the Collapse? 815Bank Failures Today 816


C H A P T E R 2 8The Federal Reserve System and Monetary Policy 82628.1 The Federal Reserve System 827

The Functions of a Central Bank 827Location of the Federal Reserve System 827The Fed’s Relationship to the Federal

Government 828The Fed’s Ties to the Executive Branch 828Fed Operations 829

28.2 How Does the Federal Reserve Change the Money Supply? 830Open Market Operations 830The Reserve Requirement 831The Discount Rate 831How the Fed Reduces the Money Supply 832How the Fed Increases the Money Supply 832Difficulties in Controlling the Money Supply 833

28.3 Money, Interest Rates, and Aggregate Demand 833The Money Market 833The Demand for Money and the Nominal Interest

Rate 834Why Is the Supply of Money Relatively

Inelastic? 835The Money Market 835How Do Income Changes Affect the Equilibrium

Position? 836How Would an Increase in the Money Supply

Affect Equilibrium Interest Rates and Aggregate Demand? 836

Does the Fed Target the Money Supply or Interest Rates? 837

Which Interest Rate Does the Fed Target? 838Does the Fed Influence the Real Interest Rate in the

Short Run? 839

28.4 Expansionary and Contractionary Monetary Policy 842Expansionary Monetary Policy in a Recessionary

Gap 842Contractionary Monetary Policy in an Inflationary

Gap 842Monetary Policy in the Open Economy 843

28.5 Money and Inflation 847The Inflation Rate and the Growth in the Money

Supply 848The Equation of Exchange 848

28.6 Problems in Implementing Monetary and Fiscal Policy 850Problems in Conducting Monetary Policy 850How Do Commercial Banks Implement the Fed’s

Monetary Policies? 850Banks That Are Not Part of the Federal Reserve

System and Policy Implementation 851Fiscal and Monetary Coordination

Problems 851Alleviating Coordination Problems 851Imperfect Information 852Overall Problems with Monetary and

Fiscal Policy 852


C H A P T E R 2 9Issues in Macroeconomic Theory and Policy 86929.1 The Phillips Curve 870

Unemployment and Inflation 870The Phillips Curve 870The Slope of the Phillips Curve 870The Phillips Curve and Aggregate Supply

and Demand 871

Table of Contents xv

52270_00_fm_pi-xxx.indd xv52270_00_fm_pi-xxx.indd xv 10/20/09 2:45:22 PM10/20/09 2:45:22 PM

29.2 The Phillips Curve over Time 872The Phillips Curve—The 1960s 872Is the Phillips Curve Stable? 872The Short-Run Phillips Curve Versus the Long-Run

Phillips Curve 873Supply Shocks 875

29.3 Rational Expectations and Real Business Cycles 877Can Human Behavior Counteract Government

Policy? 877The Rational Expectations Theory 877Rational Expectations and the Consequences of

Government Macroeconomic Policies 878Anticipation of an Expansionary Monetary

Policy 878Unanticipated Expansionary Policy 879When an Anticipated Expansionary Policy Change Is

Less Than the Actual Policy Change 880Critics of Rational Expectations Theory 880New Keynesians and Rational Expectations 881What Is the Real Business Cycle Theory? 881

29.4 Controversies in Macroeconomic Policy 883Are Fiscal and Monetary Policies Effective? 883Policy Difficulties with Supply Shocks 884What Should the Central Bank Do? 885Inflation Targeting 885Indexing and Reducing the Costs of Inflation 888


Part 9 THE GLOBAL ECONOMY

C H A P T E R 3 0International Trade 90630.1 The Growth in World Trade 907

Importance of International Trade 907Trading Partners 907

30.2 Comparative Advantage and Gains from Trade 908Economic Growth and Trade 908The Principle of Comparative Advantage 908Comparative Advantage, Specialization, and the

Production Possibilities Curves 910Regional Comparative Advantage 913

30.3 Supply and Demand in International Trade 917The Importance of Trade: Producer and Consumer

Surplus 917Free Trade and Exports—Domestic Producers Gain

More Than Domestic Consumers Lose 918Free Trade and Imports—Domestic Consumers Gain

More Than Domestic Producers Lose 922

30.4 Tariffs, Import Quotas, and Subsidies 923Tariffs 923The Domestic Economic Impact of Tariffs 923Arguments for Tariffs 925Import Quotas 926The Domestic Economic Impact of an Import

Quota 926The Economic Impact of Subsidies 926

Interactive Chapter Summary 932Key Terms & Concepts 933Section Check Answers 934Study Guide 936

C H A P T E R 3 1International Finance 94331.1 The Balance of Payments 944

Balance of Payments 944The Current Account 944The Capital Account 947

31.2 Exchange Rates 948The Need for Foreign Currencies 948The Exchange Rate 948Changes in Exchange Rates Affect the Domestic

Demand for Foreign Goods 948The Demand for a Foreign Currency 948The Supply of a Foreign Currency 949Determining Exchange Rates 949The Demand Curve for a Foreign Currency 949The Supply Curve for Foreign Currency 950Equilibrium in the Foreign Exchange Market 950

31.3 Equilibrium Changes in the Foreign Exchange Market 951Determinants in the Foreign Exchange Market 951Increased Tastes for Foreign Goods 951Relative Income Increases or Reductions

in U.S. Tariffs 951European Incomes Increase, Reductions in European

Tariffs, or Changes in European Tastes 952How Do Changes in Relative Real Interest Rates

Affect Exchange Rates? 953Changes in the Relative Inflation Rate 953Expectations and Speculation 954

31.4 Flexible Exchange Rates 956The Flexible Exchange Rate System 956Are Exchange Rates Managed at All? 956When Exchange Rates Change 957The Advantages of Flexible Rates 957Fixed Exchange Rates Can Result in Currency

Shortages 957Flexible Rates Solve the Currency Shortage

Problem 958Flexible Rates Affect Macroeconomic Policies 958The Disadvantages of Flexible Rates 958


xvi Table of Contents

52270_00_fm_pi-xxx.indd xvi52270_00_fm_pi-xxx.indd xvi 10/20/09 2:45:22 PM10/20/09 2:45:22 PM

A student of economics becomes aware that, at a basic level, much of economic life involves choos-ing one course of action rather than another—making choices among our conflicting wants and desires in a world of scarcity. Economics pro-vides insights about how to intelligently evaluate these options and determine the most appropri-ate choices in given situations. Most of econom-ics really involves knowing certain principles well and knowing when and how to apply them.

This chapter presents some important tools 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, sup-ply and demand, deadweight loss, and consumer surplus. Learning economics requires more than picking up this new terminology; however, it also involves using its powerful tools to improve your understanding of a whole host of issues in the world around you. ■

Studying economics may teach you how to “think better,” because economics helps develop a disciplined method of thinking about problems.

The Economic Way of Thinking

2.1 Scarcity

2.2 Choices, Costs, and Trade-Offs

2.3 Marginal Thinking

2.4 Incentives Matter

2.5 Specialization and Trade

2.6 Markets and Improved Efficiency

2

36

s that you learn in this cthroughout the text. If you

nding of these principlesving skills inhe

for the rest of onomist

velolem

ives Ma

alization a

ets and Im ro ed Efficien

52270_02_ch02_p036-065.indd 3652270_02_ch02_p036-065.indd 36 11/6/09 5:39:52 AM11/6/09 5:39:52 AM

Scarcity

Economics is concerned primarily with scarcity—how we satisfy our unlimited wants in a world

of limited resources. We may want “essential” items such as food, clothing, schooling, and health care. 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 goals—perhaps 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. And as long as human wants exceed available resources, scarcity will exist.

Don’t confuse scarcity with rarity. Something may be rare, but if it is not desirable, it is not scarce. You won’t find many baseball cards of my son (rare)—about 10—but at the same time, few people outside of the immediate family want one. Therefore, the card is rare but not scarce. However, if he becomes a major league star, those cards could become scarce—rare and desirable.

Scarcity and Resources

The scarce resources used in the pro-duction 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 production of goods and services. The services of a teacher, nurse, cos-metic 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 struc-tures used to produce goods and ser-vices. 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

capital—the productive knowledge and skill people receive from education and on-the-job training.

Entrepreneurship is the process of combining labor, land, and capi-tal to produce goods and services. Entrepreneurs make the tough and risky decisions about what and how to pro-duce 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.

However, not every entrepreneur is a Bill Gates (Microsoft) or a Henry Ford (Ford Motor Company). In some

ScarcityS E C T I O N

2.1n What are goods and services?

n What are tangible and intangible goods?

n What are economic goods?

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

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

All the things you see here—grass, trees, rocks, animals—are considered land to economists.

CO

UR

TE

SY

OF

RO

BE

RT

L.

SE

XT

ON

Chapter 2 The Economic Way of Thinking 37


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. Goods tend to be tangible—

objects that can be seen, held, heard, tasted, or smelled. But other goods that we cannot reach out and touch are called intangible goods. Intangible

goods include 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 vis-ible, but they are certainly no less valuable than goods.

All goods and services, whether tangible or intan-gible, 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 supply. Without enough economic goods for all of us, we are forced to compete. That is, scarcity ultimately leads to competi-tion 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, pollu-

tion, weeds, and crime are bads. People tend to elimi-nate or minimize bads, so they will often pay to have bads, like garbage, removed. The elimination of the bad—garbage removal, for example—is a good.

Are Those Who Want More Greedy?

We all want more tangible and intangible goods and services. In economics, we assume that

more goods lead to greater satisfaction. However, just

because economics assumes that we want more goods does not mean that economics also assumes that we are selfish and greedy. That is, scarcity does not result from people just wanting more for themselves. Many people give much of their income and time to chari-table or religious organizations. The ways people allocate their income and time reveal their preferences. The fact that people are willing to give up their money and time for causes that they believe to be important reveals quite conclusively that charitable endeavors are a desirable good. Clearly, then, many desires, such as the desire to build new friendships or help charities, can hardly be defined as selfish; yet they are desires that many people share. In other words, self-interest is not the same as selfishness or greed. Indeed, in a world without scarcity, we would have no use for generosity.

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,

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

economic goods scarce goods created from scarce resources—goods 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.

Not even millionaire lottery winners can escape scarcity. The problem is that as we get more affluent, we learn of new luxuries to provide us with satisfaction. Even lottery winners may become less content as the excitement wears off and they begin looking for new satisfactions. A 78-year-old man from Michigan just won his second $1 million scratch-off lottery. He says, “I am now going for three.”

© S

TE

VE

DIP

AO

LA

/RE

UT

ER

S/C

OR

BIS

38 PART 1 Introduction


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 work-ing 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. 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 satisfac-tion. 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.

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 “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 fast—if not faster—than our ability to meet those wants.

S E C T I O N C H E C K

1. We all have many wants and goals.

2. Scarcity exists when our wants exceed the available resources.

3. Scarce resources can be categorized as: land (all of our natural resources), labor (the physical and mental efforts expended in the production of goods and services), capital (the equipment and structures used to pro-duce goods and services, and the productive knowledge and skill people receive from education and on-the-job training), and entrepreneurship (the process of combining land, labor, and capital into production of goods and services).

4. Goods and services are things that we value.

5. Goods can be tangible (physical) or intangible (love, compassion, and intelligence).

6. Economic goods are goods created from limited resources.

7. We all face scarcity—rich and poor alike.

8. Our wants grow over time, so scarcity will never be eliminated.

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

2. Does wanting more tangible and intangible goods and services make us selfish?

3. Why does scarcity affect everyone?

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

5. Why do you think economists often refer to training that increases the quality of workers’ skills as “adding to human capital”?

6. What are some of the ways that students act as entrepreneurs as they seek higher grades?

7. Why might sunshine be scarce in Seattle but not in Tucson?

8. Why can’t a country become so technologically advanced that its citizens won’t have to choose?



Scarcity Forces Us to Choose

Each of us may want a nice home, two luxury cars, wholesome and good-tasting food, a per-

sonal 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 scar-city, and as a consequence, we must make choices. If we did not have to make meaningful economic choices, the study of economics would not be necessary. The essence of economics is to understand fully the implica-tions 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 TV show. Or when you decide how to spend your income, buying a new car may mean you have to forgo a summer vaca-tion. 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, 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. 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 an opportunity lost.” To get more of anything

that is desirable, you must accept less of something else that you also value.

For example, time spent exercising costs time that could be spent doing something else that is valuable—perhaps relaxing with friends or studying for an upcoming exam. One of the reasons drivers talk so much on their cell phones is because they have little else to do with their time while driving—a low opportunity cost. However, drivers using cell phones should pay attention; otherwise, they are giving up safety. Trade-offs are everywhere. The famous poet, Robert Frost, understood that to live is to choose. In his poem, “The Road Not Taken,” he writes, “two roads diverged in a yellow wood, and sorry I could not travel both.”

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. Staying in school would have cost each of them millions of dollars. We cannot say it

would have been the wrong decision to stay in school; but it would have been costly. Their opportunity cost of staying in school was high.

Money Prices and CostsIf you go to the store to buy groceries you have to pay for the items you bought. This amount is called the money price. It is an opportunity cost, because you could have used that money to purchase other goods or services. However, additional opportunity costs include the nonprice costs incurred to acquire the groceries—time spent getting to the grocery store, finding a park-ing place, actual shopping, and waiting in the checkout line. The nonprice costs are measured by assessing the sacrifice involved—the 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 concert ticket may have only been $50. But what

n Why do we have to make choices?

n What do we give up when we have to choose?

n Why are “free” lunches not free?

Choices, Costs, and Trade-OffsS E C T I O N

2.2

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



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 engineer-ing? 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?

Policy makers are unavoidably faced with oppor-tunity costs too. Consider airline safety. Both money cost and time costs affect airline safety. New airline safety devices cost money (luggage 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!

The Opportunity Cost of Going to College or Having a Child

The average person often does not correctly calcu-late opportunity costs. For example, the (oppor-

tunity) 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 col-lege 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 sibling’s room, and so on.

You may think tuition, room and board are expen-sive! Now add the opportunity cost of your time—perhaps working during those nine months.

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 soccer practices, and so on. According to the Department of Agriculture, a middle-income family with a child born in 2007 can expect to spend about $270,000 for food, shelter, and other necessities to raise that child through age 17. Other substantial opportunity costs are incurred in rearing 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 rearing is time that could have been used earning money and pursuing a career.

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

The expression “there’s no such thing as a free lunch” clarifies the relationship between scarcity

and opportunity cost. Suppose the school cafeteria is offering “free” lunches today. Although the lunch is free to you, is it really free from society’s perspective?

CO

UR

TE

SY

OF

RO

BE

RT

L.

SE

XT

ON



The answer is no, because some of society’s 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 lunch—the 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 goods—freeways, free beaches, and free libraries, for instance—do not cost consumers money, but they are still scarce. Few things are free in the sense that they use none of society’s scarce resources. So what does a free lunch really mean? It is, technically speaking, a “subsidized” lunch—a lunch using soci-ety’s scarce resources, but one that the person receiving it does not have to pay for personally.


1. Scarcity means we all have to make choices.

2. When we are forced to choose, we give up the next highest-valued alternative.

3. Opportunity cost is what you give up when you make a choice.

1. Would we have to make choices if we had unlimited resources?

2. What is given up when we make a choice?

3. What do we mean by opportunity cost?

4. Why is there no such thing as a free lunch?

5. Why was the opportunity cost of staying in college higher for Tiger Woods than for most undergraduates?

6. 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?

n What do we mean by marginal thinking?

n What is the rule of rational choice?

n Why do we use the word expected with marginal benefits and costs?

Marginal ThinkingS E C T I O N

2.3

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 some-

one else, or whether to attend graduate school or take

a job. But 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 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

Is air free? How about clean air? Clean air is desirable but limited in cities—that is, it is a scarce good. How about air to a scuba diver? Or how about air to a climbing expedition on Mount Everest? What if you want to fill your tires at this gas station but you didn’t buy gas? So in many situations, air is not free; it is scarce.

CO

UR

TE

SY

OF

RO

BE

RT

L.

SE

XT

ON



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 addi-tional expected benefit (a higher grade) and an addi-tional 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 mar-ginal, choices available to you. Or think of marginal as the edge—marginal 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 wheth-er 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 average 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 minimal—slight 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 marginal cost) to be greater than the value they place on the good (the mar-ginal 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 benefits 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—but on average it will. 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, indi-viduals will only pursue an activity if their expected marginal benefits are greater than their expected mar-ginal costs of pursuing that activity one step further, E(MB) > E(MC).

This fairly unrestrictive and realistic view of indi-viduals 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 7 a.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 min-utes 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 it’s unlikely that you will choose that action if it’s the day of the final exam—because it is now likely that the net benefits (the differ-ence 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 opportunities as long as they expect a net benefit from doing so.

The rule of rational choice is sim-ply 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 per-form 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 CostlyLet’s 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 up—that is, what marginal costs would we have to incur—to achieve zero pollution? A lot! You could not drive a

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

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



With just over five minutes to play in yester-day’s game against the New York Jets, the Washington Redskins found themselves on

their own 23-yard line facing a fourth and one. The team, which was ahead by just three points, elected to do what teams normally do in such situations: They played it safe and punted rather than try to keep the drive alive.

The Jets promptly came back to kick a field goal, tying the game and sending it into overtime. While this particular story had a happy ending for Washington, which won, 23-20, it illustrated the value of an analysis by David Romer, an economist at the University of California, who has concluded that football teams are far too conservative in play calling in fourth-down situations.

You don’t have to be particularly interested in sports to find Romer’s conclusion intriguing: His hunch about human behavior in general was that although people say they have a certain goal and are willing to do everything they can to achieve it, their actual behavior regularly departs from the optimal path to reach that goal.

In his analysis of football teams, Romer spe-cifically looked at a single question -- whether teams should punt or kick the football on fourth down, or take a chance and run or throw the ball. Romer’s cal-culations don’t necessarily tell teams what to do in specific situations such as yesterday’s game. But on average, teams that take the risk seem to win more often than lose.

Data from a large number of NFL games show that coaches rarely follow what Romer’s calculations predict would give them the best chance of victory. While fans often suggest more aggressive play call-ing, even fans usually don’t go as far as the econo-mist does—his calculations show that teams should regularly be going for it on fourth down, even if it is early in the game, even if the score is tied, and even if the ball is on their own side of the field.

Romer’s calculations have been backed up by independent analyses. Coaches have not raised a serious challenge to Romer’s analysis, but they have simply ignored his finding.

New England Patriots coach Bill Belichick is among those who has said he agrees with Romer, and Belichick happens to be one of the more suc-cessful coaches in the league. Two Sundays ago, as the Patriots were piling up an astronomical score against Washington, Belichick took a chance on a fourth-down play and got his team seven points instead of the three he might have gotten had the team tried a field goal.

When asked by reporters why he took the chance, Belichick’s response was the response of someone who really means what he says about maximizing points: “What do you want us to do, kick a field goal?”

Owners and fans have been receptive to Romer’s ideas. However, in informal conversations Romer has had with the coaching staffs of various teams, the economist said he has been told to mind his own business in the ivory tower.

Indeed, since Romer wrote his paper a couple of years ago, NFL coaches seem to have gotten even more conservative in their play calling, which the economist attributes to their unwillingness to follow the advice of an academic, however useful it might be. . . .

ECONOMICS AND FOOTBALL: WEIGHING THE BENEFITS AND COSTS OF GOING FOR IT ON FOURTH DOWN

MIK

E B

LA

KE

/RE

UT

ER

S/L

AN

DO

V



Even thrill seekers would likely slow down if fines were higher and/or law enforcement were increased, because such measures would alter the driver’s cost-benefit calculation for reckless driving (as would bad brakes, bald tires, and poor visibility). On the other hand, compulsory seat belts and air-bags would also alter behavior, because they change the driver’s incentives. Seat belts and airbags make accidents less costly, by reducing the chance of seri-ous injury or death; thus they reduce the benefit to safe driving, causing some motorists to drive more recklessly.

© T

IM M

cG

UIR

E/C

OR

BIS

“It used to be that going for it on fourth down was the macho thing to do,” Romer said. But after his find-ings were widely publicized in sports circles, he said: “Now going for it on fourth down is the egghead thing to do. Would you rather be macho or an egghead?”

The interesting question raised by Romer’s research applies to a range of settings that have nothing to do with sports. Why do coaches persist in doing something that is less than optimal, when they say their only goal is to win? One theory that Romer has heard is that coaches—like generals, stock fund directors and managers in general—actually have different goals than the people they lead and the people they must answer to. Everyone wants to win, but managers are held to different standards than followers when they lose, especially when they lose after trying something that few others are doing.

SOURCE: From Shankar Vedantam, “Go for It on Fourth Down, Coach? Maybe You

Should Ask an Egghead”, ‘Washington Post’, November 5, 2007, p. A3. Copyright

© 2007 The Washington Post. All rights 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 writtten permission is prohibited.

car, fly in a plane, or even ride a bicycle, especially if everybody else were riding bikes, too (because conges-tion 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 pollutants. We could go on and on. The point is not that we shouldn’t 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 environment. 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 SafetyLike 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 valuable resources toward the com-plete elimination of crime. In fact, it would be impos-sible to eliminate crime totally. Even reducing crime

consider this:

Coaches must weigh the expected marginal benefits and

costs of “going for it” on fourth down. So why don’t coaches

go for it more often if the data suggests that teams should

take more risks? Does Coach Belichick take more risks

because he was an economics major in college and has

figured it out? Or is it because coaches tend to be more risk

averse than their fans and owners because coaches are held

to different standards when they lose? So coaches often do

what other coaches do and play it safe and punt.



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 the people may value even more.

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. However, opti-mal amounts of safety that are greater than zero are available. 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 will-ing 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 (mandatory 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 driv-ing 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 get-ting somewhere more quickly, but it can also have a cost—an 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.


1. Economists are usually interested in the effects of additional, or marginal, changes in a given situation.

2. People try to make themselves better off.

3. People make decisions based on what they expect to happen.

4. The rule of rational choice states that individuals will pursue an activity if they expect the marginal benefits to be greater than the marginal costs, or E(MB) > E(MC).

5. The optimal (best) levels of pollution, crime, and safety are greater than zero.

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

2. What is the rule of rational choice?

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

4. Why does rational choice involve expectations?

5. 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?

6. If you decide to speed to get to a doctor’s 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?

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

8. Imagine driving a car with daggers sticking out of the steering wheel—pointing directly at your chest. Would you drive more safely? Why?



People Respond to Changes in Incentives

Because most people are seeking opportunities to make themselves better off, they respond to

changes in incentives. That is, they are reacting 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 incentives.

Positive and Negative Incentives

Almost all of economics can be reduced to incen-tive [E(MB) versus E(MC)] stories, where con-

sumers and producers are driven by incentives that affect expected costs or benefits. Prices, wages, profits, taxes, and subsidies are all examples of eco-nomic incentives. Incentives can be classified into two types: positive and negative. Positive incentives are those that either 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 cars—part electric, part internal combustion—would be a positive incentive that would encour-age greater production and consump-tion of hybrid cars. Human behavior is influenced in predictable ways by such changes in economic incentives, and economists use this information to pre-dict 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 pre-dict 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 com-mission tend to work harder. If the price of downtown parking increased, we would predict that commuters 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 water and substantially less water than if they were simply asked to conserve water. Incentives matter.

n Can we predict how people will respond to changes in incentives?

n What are positive incentives?

n What are negative incentives?

Incentives MatterS E C T I O N

2.4

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

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

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 incentives are offered at the federal, state, and local levels to encourage the expanded use of alternative-fuel vehicles.

ST

EP

HE

N S

HA

VE

R/U

PI/

LA

ND

OV



Estonia’s Total Fertility Rate Increasing in Part Because of Government Program Encouraging Women to Give Birth

Estonia’s total fertility rate has increased to an average of 1.5 children per woman from an average of 1.3 children per woman in the late

1990s, which could be the result of a government initiative aimed at sustaining the nation’s popula-tion by providing women who have children with monthly stipends, the Wall Street Journal reports. The initiative, launched in 2004, was pushed after a 2001 world population report by the United Nations showed that Estonia was “one of the fastest- shrinking nations on earth,” according to the Journal. Under the program, Estonia provides employed women who have children with their monthly salary, up to $1,560 monthly, over a 15-month period and unemployed women with $200 monthly. According to the Journal, the average monthly salary in Estonia is $650. The program has helped raise the total fertility rate because many employed women in the country could not afford to take time off from work to have children and because taking time off could have a negative impact on job security, according to the Journal. Some other factors that contributed to the lower total fertility rate include advances in birth control and ideas about personal freedom and happiness, the Journal reports. Estonia’s program could serve as a model for other countries with low total fertility rates, according to the Journal. The Estonian government plans to continue formulating strategies—such as expanding preabortion counsel-ing and subsidizing child-care providers and private day care—to help improve the total fertility rate, the Journal reports. According to the Journal, Estonia needs a total fertility rate of 2.1 children per woman to maintain its current population.

in the news Incentives Matter

SOURCE: Reprinted with permission from http://www.kaisernetwork.org. You can

view the entire Kaiser Daily Health Policy Report, search the archives, or sign up for

email delivery at http://www.kaisernetwork.org/dailyreports/healthpolicy. The Kaiser

Daily Health Policy Report is published for kaisernetwork.org, a free service of The

Henry J. Kaiser Family Foundation. © 2005 Advisory Board Company and Kaiser Family

Foundation. All rights reserved.

consider this:

Estonia is using positive incentives. But what would happen

to birth rates if the tax deduction for dependents is removed?

Although it would not change everyone’s behavior, overall

we would expect birth rates to fall if the tax deduction for

dependents was eliminated, because it would then be more

expensive for couples to raise children. We would also pre-

dict that couples would choose to have fewer children if the

government imposed a birth tax on couples. Clearly, both of

these policy changes would serve as negative incentives to

having children, because both increase the costs of having

kids. In essence, what either of these policies would do is

change the benefit–cost equation, and altering this equation

typically leads to predictable results.

CO

UR

TE

SY

OF

RO

BE

RT

L.

SE

XT

ON




1. People respond to incentives in predictable ways.

2. A positive incentive decreases costs or increases benefits, thus encouraging consumption or production.

3. A negative incentive increases costs or reduces benefits, thus discouraging consumption or production.

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?

Why Do People Specialize?

As you look around, you can see that people spe-cialize in what they produce. They tend to dedi-

cate their resources to one primary activity, whether it be child rearing, driving a cab, or mak-ing bagels. Why? The answer, short and simple, is opportunity costs. By concen-trating their energies on only one, or a few, activities, individuals are special-

izing. 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 compara-tive 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 produc-tion of that good or service.

We All Specialize

We all specialize to some extent and rely on oth-ers 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 sell-ing 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 fish-

ing 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 tasks—from hiring to word process-

ing to marketing. As the size of the company increases, each employee can perform a more specialized job, with a consequent increase in output per worker. The

n What is the relationship between opportunity cost and specialization?

n What are the advantages of specialization in production?

Specialization and TradeS E C T I O N

2.5

specializing concentrating in the production of one, or a few, goods

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



primary advantages of specialization are that employ-ees 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 suited—and specialization promotes the use of special-ized 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 factors that make different locations relatively more desirable, such as traf-fic patterns, income levels, demographics, and so on.

Specialization and comparative advantage are important in sports, as they are in other fields. In baseball and softball, teams

have resources that they must place in alternative positions to increase the likelihood of a victory. The resource is labor—human effort used to produce something. We can be even more specific, and talk about the particular characteristics or skills of the labor. That is, we have strength of arms, speed, fielding, power hitting, and contact hitting. Where do we play each of these players in the field or place them in the batting line-up to increase our chances to win? The teams that specialize with their varied talent have a better chance of winning. Quicker players are usually positioned in the middle of the field—shortstop, second base, and center field. Slower (less quick) fielders are usually on the corners—third base, first base, left field, and right field. Strength of arm—pitchers, catchers, and right field (it is a long throw from right field to third base). Hitting—speed and contact in the one and two spots, power in the three, four, and five spots, and the relatively poorer contact hitters at the bottom of the line-up.

It is also easy to see the importance of com-parative advantage in this example. Suppose there are two players on your softball team, Jessica and Mariah, and you are not sure where they should play in the field. Jessica is good at infield and good at out-field. Mariah is good at infield and bad at outfield, but not as good at Jessica at either. Where should they play Mariah, since Jessica has an absolute advan-tage over Mariah in the infield and outfield? It would be best to play Mariah in the infield because she is

just a little worse than Jessica in the infield and a lot worse than Jessica in the outfield. Remember, com-parative advan-tage is a relative concept.

Finally, why did hitters put up higher bat-ting averages 100 years ago? Ted Williams was the last player to hit over 400, and that was in 1941. Over 30 hitters exceeded that mark from 1880–1930. Were hitters better back in the old days? Or are pitchers better today? It is probably that pitchers are better today. Part of the reason is training and nutrition for pitchers. But the other reason is spe-cialization. Pitchers rarely throw complete games these days. Often they are only asked to throw five innings of a nine-inning game. It is then up to the middle relievers and the closers to finish up the game. There are also specialty pitchers for differ-ent situations—if you need a ground ball you might bring in your sinker ball pitcher. If your computer records suggest that the left-handed batter coming up struggles against left-handed pitching, you might bring in a left-handed reliever. Specialization has changed the game.

SPECIALIZATION, COMPARATIVE ADVANTAGE, AND BASEBALL

MC

T/L

AN

DO

V



Specialization and Trade Lead to Greater Wealth and Prosperity

Trade, or voluntary exchange, directly increases wealth by making both parties better off (or they

wouldn’t trade). It is the prospect of wealth-increasing exchange that leads to productive 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 for prod-ucts 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-sufficient—that is, without trade. Imagine life without trade, where you were completely self-sufficient—growing your own food, making your own clothes, working on your own car, building your own house—do 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 cof-fee 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 green-houses, but it would result in higher coffee costs and prices, while leaving fewer resources available for employ-ment in more beneficial jobs, such as wheat production.

This concept is true for individuals as well. Imagine Tom had 10 pounds of tea and Katherine had 10 pounds of coffee. However, Tom preferred coffee to tea and Katherine preferred tea to coffee. So if Tom traded his tea to Katherine for her coffee, both parties would be better off. Trade simply reallocates existing goods, and volun-tary exchange increases wealth by making both parties better off—otherwise, they would not agree to trade.

In the words of growth theorist, Paul Romer, “There are huge potential gains from trade. Poor coun-tries can supply their natural and human resources. Rich countries can supply their know-how. When these are combined, everyone can be better off. The challenge 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 best. And through special-ization and trade, a country can gain a greater varietyof goods and services at a lower cost. So while counties may be competitors inn the global market they are also partners.

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 administrative 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 x 5 hours). If she has the administrative assistant type her documents, it will cost $100 ($10 per hour x 10 hours). Clearly, then, the lawyer should hire the administrative assis-tant to type her documents, because the administra-tive assistant has the comparative advantage (lowest opportunity cost) in this case, despite being half as good in absolute terms.

COMPARATIVE ADVANTAGE


1. We all specialize.

2. Specialization is important for individuals, businesses, regions, and nations.

3. Specialization and trade increase wealth.

4. The person, region, or country that can produce a good or service at a lower opportunity cost than other producers has a comparative advantage in the production of that good or service.

(continued)



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 pro-vides a way for millions 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 powerful—they 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 indi-cate their wants through their action and inaction in the marketplace, and it is this collective “voice” that deter-mines how resources are allocated. But how is this information communicated? Market prices serve as the language of the market sys-tem. 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 illegal—the 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 communicate important informa-tion to both buyers and sellers. These prices

communicate information about the relative avail-ability of products to buyers, and they provide sell-

ers 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.

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 com-parative 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.

n How does a market economy allocate scarce resources?

n What are the important signals that market prices communicate?

n What are the effects of price controls?

n What is a market failure?

Markets and Improved EfficiencyS E C T I O N

2.6

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



The basis of a market economy is voluntary exchange and the price system that guides people’s choices and produces solutions to the questions of what goods to produce and how to produce and dis-tribute 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 rub-ber may be from Malaysia. The paint, the glue, the metal piece that holds the eraser—who knows? The point is that market forces coordinated this produc-tion activity among literally thousands of people, some of whom live in different countries and speak different 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 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.

The same is true of the IPod and IPhone. The entrepreneur of Apple have learned how to combine almost 500 generic parts to make something of much greater value. The whole is greater than the sum of the parts.

What Effect Do Price Controls Have on the Market System?

Government policies called price controls some-times 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 market’s infor-mation-transmission function. That is, price controls effectively strip the mar-ket price of its meaning 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).

Market Failure

The market mechanism is a simple but effective and efficient general means of allocating resourc-

es 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 by-product of making steel. When it does,

price controls government-mandated minimum or maximum prices

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

Countries that do not rely on the market system have no clear communication between buyers and sellers. The former Soviet Union, where

quality was virtually nonexistent, experienced many shortages of quality goods and surpluses of low-qual-ity goods. For example, thousands of tractors had no spare parts and millions of pairs of shoes were left on shelves because the sizes did not match those of the population. Before the breakup of the Soviet Union, one of President Reagan’s favorite stories concerned a man who goes to the Soviet bureau of transporta-tion to order an automobile. He is informed that he will have to put down his money now, but there is a 10-year wait. The man fills out all the various forms, has them processed through the various agencies, and finally he gets to the last agency. He pays them his money and they say, “Come back in 10 years and

get your car.” He asks, “Morning or afternoon?” The man from the agency says, “We’re talking 10 years from now. What is the difference?” He replies, “The plumber is coming in the morning.”

COUNTRIES THAT DO NOT RELY ON A MARKET SYSTEM

AP

IM

AG

ES



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 pollu-tion, 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 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 pro-duces more than the ideal output—which is inefficient because it is an overallocation of resources.

Markets sometimes produce too little of a good—research, for example. Therefore, the government might decide to subsidize promising scientific research that could benefit many people—such as cancer research. When one party prevents other parties from participat-ing in 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 competitive 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 society’s 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 exam-ple, 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 pro-ducers may be able to misrepresent their products to the disadvantage of unwary consumers.

In sum, government can help promote efficiency when there is a market failure—making 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 distributed—the degree of equality. An efficient mar-ket rewards those that produce goods and services that others are willing and able to buy. But this does not guar-antee a “fair” or equal distribution 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 market 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 SolutionHowever, just because the government could improve the situation does not mean it will. After all, the politi-cal process has its own set of problems, such as special interests, shortsightedness, and imperfect information. For example, government may reduce competition through tariffs and quotas, or it may impose inefficient regulations that restrict entry. That is, there is govern-ment failure as well as market failure.

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.

CO

UR

TE

SY

OF

RO

BE

RT

L.

SE

XT

ON



In te rac t i ve Chapter 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 production of goods and services can be grouped into four categories: _____________, _____________, _____________, and _____________.

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

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

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


1. Scarcity forces us to allocate our limited resources.

2. Market prices provide important information to buyers and sellers.

3. Price controls distort market signals.

4. A market failure is said to occur when the economy fails to allocate resources efficiently.

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?

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



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 others can, we say that they have a(n) _____________ in the pro-duction of that good or service.

23. The primary advantages of specialization are that employees acquire greater _____________ from repeti-tion, they avoid _____________ time in shifting 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 mar-ket system. They communicate information about the ____________ to buyers, and they provide sellers with

critical information about the ____________ that buyers place on those products. This communication 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 people’s choices regarding what goods to produce and how to produce those goods and distribute them.

28. _____________ can lead the economy to fail to allocate resources efficiently, as in the cases of pollution and sci-entific 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.

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

scarcity 37labor 37land 37capital 37human capital 37entrepreneurship 37goods 38tangible goods 38

intangible goods 38services 38economic goods 38bads 38opportunity cost 40marginal thinking 43rule of rational choice 43net benefit 43

positive incentive 47negative incentive 47specializing 49comparative advantage 49efficiency 52price controls 53market failure 53

Key Terms and Concepts

2.1 Scarcity 1. What must be true for something to be an eco-

nomic good?An economic good, tangible or intangible, is any good or service that we value or desire. This definition includes the reduction of things we don’t want—bads—as a good.

Sect ion Check Answers

2. Does wanting more tangible and intangible goods and services make us selfish?No. Among the goods many of us want more of are helping others (charity), so to say we all want more goods and services does not imply that we are selfish.

3. 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.



4. 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, scarcity affects each of us differently.

5. Why do you think economists often refer to training that increases the quality of workers’ skills as “adding to human capital”?Training increases a worker’s ability to produce further goods, just as capital goods increase an economy’s ability to produce further goods. Because of this similarity in their effects on productive abili-ties, training is often referred to as adding to workers’ human capital.

6. What are some of the ways that students act as entrepreneurs as they seek higher grades?Students act as entrepreneurs in seeking higher grades in a wide variety of ways. They sometimes form study groups, often assigning different material to different members. They often share notes. They study harder for those questions they believe will be more likely to be tested. Sometimes they try to get hold of old tests or to cheat. All of these activities and more are part of dif-ferent students’ efforts to discover the lowest-cost way for them to get higher grades.

7. Why might sunshine be scarce in Seattle but not in Tucson?For a good to be scarce means we want more of it than we are able to have. Residents of Tucson typically have all the sunshine they wish, while rain may be something that is scarce relative to residents’ desires. For residents of Seattle, where the sun shines much less and it rains much more, the opposite might well be true.

8. Why can’t a country become so technologically advanced that its citizens won’t have to choose?No matter how productive a country becomes, citi-zens’ desires will continue to outstrip their ability to satisfy them. As we get more productive, and incomes grow, we discover new wants that we would like to satisfy, so our ability to produce never catches up with our wants.

2.2 Choices, Costs, and Trade-Offs 1. Would we have to make choices if we had

unlimited resources?We would not have to make choices if we had unlim-ited resources, because we would then be able to pro-duce all the goods and services anyone wanted, and having more of one thing would not require having less of other goods or services.

2. What is given up when we make a choice?What is given up when we make a choice is the oppor-tunity to pursue other valued alternatives with the same time or resources.

3. What do we mean by opportunity cost?The opportunity cost of a choice is the highest valued 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.

4. Why is there no such thing as a free lunch?There is no such thing as a free lunch because the pro-duction of any good uses up some of society’s resources, which are therefore no longer available to produce other goods we want.

5. Why was the opportunity cost of staying in college higher for Tiger Woods than for most undergraduates?The forgone alternative to Tiger Woods of staying in school—starting a highly paid professional golf career sooner than he could otherwise—was far more lucra-tive than the alternatives facing most undergraduates. Because his forgone alternative was more valuable for Tiger Woods, his opportunity cost of staying in school was higher than for most.

6. 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 expe-rienced manager—the earnings he would have to give up to spend a given period getting an MBA—is higher than that of a 22-year-old straight out of college, whose income earning alternatives are far less.

2.3 Marginal Thinking 1. What are marginal choices? Why does economics

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 outweigh 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

57Chapter 2 The Economic Way of Thinking


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 mis-takes can be made.

5. 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, students do less of it.

6. If you decide to speed to get to a doctor’s 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 accident doesn’t invalidate the rule of rational choice; it only means your expecta-tions at the time you decided to speed were incorrect.

7. If pedestrians felt far safer using crosswalks to cross the street, how could adding crosswalks increase the number of pedestrian accidents?Just like safer cars can lead people to drive less safely, 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.

8. Imagine driving a car with daggers sticking out of the steering wheel—pointing 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.

2.4 Incentives Matter 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 ben-efits or increase costs of an action, discouraging 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 mar-ginal benefits increased, because then the marginal 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 margin-al costs increased, because then the marginal expected benefits would exceed the marginal expected 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 coun-ter, the benefit of misbehaving—the potential payoff to pestering Mom or Dad for candy—is 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 counter, so more child misbehav-ior is to be expected there.

5. Why do many parents refuse to let their children 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 it’s green, it must be disgusting.”), but that is seldom so of dessert. If par-ents let their children eat dessert first, they would often not eat the food that was “good for them.” But by add-ing 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.

2.5 Specialization and Trade 1. Why do people specialize?

People specialize because by concentrating their ener-gies on the activities to which they are best suited, individuals incur lower opportunity costs. That is, they specialize in doing those things they can do at lower opportunity costs than others, and let others 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 advan-tage in producing a good or service when it can pro-duce 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 better than they do. Exploiting our comparative advantages, and then trading, allows us to produce, and therefore con-sume, 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 mowing the lawn?Your faster speed at mowing the lawn does not estab-lish that you have a comparative advantage in mowing. That can only be established relative to other tasks. The person with a comparative advantage 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 they could only earn $5 per hour (because they were less than half as productive doing other things compared to you), the opportunity cost of them mowing the lawn in an hour is $5. In this case, your spouse or housemate has a comparative 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?The opportunity cost of you doing the dishes is the value of other chores you must give up to do the dish-es. 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 everything 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 relative-ly, or comparatively, worse at that class.

2.6 Markets and Improved 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 collective 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 produc-ers and consumers, to indicate their wants and desires through their actions—how 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 rela-tive 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 controls—both 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 suppliers 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 effi-ciently. Such situations, called market failures, repre-sent 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 com-municated honestly and accurately, and where firms may have market power to distort prices in their favor (against consumers’ interests).

59Chapter 2 The Economic Way of Thinking


60

True or False:

1. In economics, labor includes physical and mental effort, and land includes natural resources.

2. Entrepreneurship is the process of combining labor, land, and capital together to produce goods and services.

3. Even intangible goods can be subjected to economic analysis.

4. Even the wealthy individual who decides to donate all of her money to charity faces the constraints of scarcity.

5. Increases in production could enable us to eliminate scarcity.

6. If we had unlimited resources, we would not have to choose among our desires.

7. Scarcity implies that “there’s no such thing as a free lunch.”

8. The actual result of changing behavior following the rule of rational choice will always make people better off.

9. In terms of the rule of rational choice, zero levels of pollution, crime, and safety would be far too costly in terms of what we would have to give up to achieve them.

10. Most choices in economics are all or nothing.

11. Good economic thinking requires thinking about average amounts rather than marginal amounts.

12. Positive incentives are those that either increase benefits or reduce costs, resulting in an increase in the level of the related activity or behavior; negative incentives either reduce benefits or increase costs, resulting in a decrease in the level of the related activity or behavior.

13. The safety issue is generally not whether a product is safe, but rather how much safety consumers want.

14. People can gain by specializing in the production of the good in which they have a comparative advantage.

15. Without the ability to trade, people would not tend to specialize in those areas where they have a comparative advantage.

16. Voluntary trade directly increases wealth by making both parties better off, and it is the prospect of wealth-increasing exchange that leads to productive specialization.

17. Government price controls can short-circuit the market’s information transmission function.

18. When the economy produces too little or too much of something, the government can potentially improve society’s well-being by intervening.

19. Not only does the market determine what goods are going to be produced and in what quantities, but it also determines the distribution of output among members of society.

Multiple Choice:

1. Which of the following is part of the economic way of thinking? a. When an option becomes less costly, individuals will become more likely to choose it. b. Costs are incurred whenever scarce resources are used to produce goods or services. c. The value of a good is determined by its cost of production. d. Both a and b are part of the economic way of thinking.

2. Ted has decided to buy a burger and fries at a restaurant but is considering whether to buy a drink as well. If the price of a burger is $2.00, fries are $1.00, drinks are $1.00, and a value meal with all three costs $3.40, the marginal cost to Ted of the drink is

a. $1.00. b. $0.40. c. $1.40. d. $3.40. e. impossible to determine from the information given.

CHAPTER 2 STUDY GUIDE


61

3. 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.

4. 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 just been reading about the terrific jobs available for those with chemistry degrees d. a star baseball player who has just received a multimillion-dollar major league contract offer after his junior year

5. “If I hadn’t been set up on this blind date tonight, I would have saved $50 and spent the evening watching TV.” The opportunity cost of the date is

a. $50. b. $50, plus the cost to you of giving up a night of TV. c. smaller, the more you enjoy the date. d. higher, the more you like that night’s TV shows. e. described by both b and d.

6. Say you had an 8 a.m. economics class, but you would still come to campus at the same time even if you skipped your economics class. The cost of coming to the economics class would include

a. the value of the time it took to drive to campus. b. the cost of the gasoline it took to get to campus. c. the cost of insuring the car for that day. d. both a and b. e. none of the above.

7. Which of the following would be likely to raise your opportunity cost of attending a big basketball game this Sunday night?

a. A friend calls you up and offers you free tickets to a concert by one of your favorite bands on Sunday night. b. Your employer offers you double your usual wage to work this Sunday night. c. Late Friday afternoon, your physics professor makes a surprise announcement that there will be a major exam on

Monday morning. d. All of the above.

8. 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

9. 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.

10. If a driver who had no change and whose cell phone battery was dead got stranded near a pay phone and chose to buy a quarter and a dime from a passerby for a dollar bill,

a. the passerby was made better off and the driver was made worse off by the transaction. b. both the passerby and the driver were made better off by the transaction. c. the transaction made the driver worse off by 65 cents. d. both a and c are true.


62

11. Which of the following is not true? a. Voluntary exchange is expected to be advantageous to both parties to the exchange. b. What one trader gains from a trade, the other must lose. c. If one party to a potential voluntary trade decides it does not advance his interests, he can veto the potential trade. d. The expectation of gain motivates people to engage in trade.

12. Which of the following is true? a. Scarcity and poverty are basically the same thing. b. The absence of scarcity means that a minimal level of income is provided to all individuals. c. Goods are scarce because of greed. d. Even in the wealthiest of countries, the desire for material goods is greater than productive capabilities.

13. An example of a capital resource is a. stock in a computer software company. b. the funds in a CD account at a bank. c. a bond issued by a company selling electric generators. d. a dump truck. e. an employee of a moving company.

14. 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 among

students at different universities. e. None of the above statements is true.

15. The opportunity cost of attending college is likely to include all except which of the following? a. the cost of required textbooks b. tuition fees c. the income you forgo in order to attend classes d. the cost of haircuts received during the school term e. the cost of paper and pencils needed to take notes

16. The opportunity cost of an airplane flight a. differs across passengers only to the extent that each traveler pays a different airfare. b. is identical for all passengers and equal to the number of hours a particular flight takes. c. differs across passengers to the extent that both the airfare paid and the highest valued use of travel time vary. d. is equal to the cost of a bus ticket, the next best form of alternative transportation to flying.

17. Lance’s boss offers him twice his usual wage rate to work tonight instead of taking his girlfriend on a romantic date. This offer will likely

a. not affect the opportunity cost of going on the date. b. reduce the opportunity cost of going on the date because giving up the additional work dollars will make his

girlfriend feel even more appreciated. c. increase the opportunity cost of going on the date. d. not be taken into consideration by Lance when deciding what to do tonight.

18. Which of the following best defines rational 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 benefit of all activities exceeds the total cost of all activities d. undertaking activities whenever the marginal benefit exceeds the marginal cost e. undertaking activities as long as the marginal benefit exceeds zero


63

19. Gallons of milk at a local grocery store are priced at one for $4 or two for $6. The marginal cost of buying a second gallon of milk equals

a. $6. b. $4. c. $3. d. $2. e. $0.

20. Which of the following statements is most consistent with the rule of rational choice? a. The Environmental Protection Agency should strive to eliminate virtually all air and water pollution. b. When evaluating new prescription drugs, the Food and Drug Administration should weigh each drug’s potential

health benefits against the potential health risks posed by known side effects. c. Police forces should be enlarged until virtually all crime is eliminated. d. Manufacturers of automobiles should seek to make cars safer, no matter the costs involved.

21. 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. Kelly’s 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 Kelly’s 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.

Problems:

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 innovation allowed the U.S. economy to produce more goods and services since it freed resources involved in transportation 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. McDonald’s once ran a promotion that whenever St. Louis Cardinal’s slugger Mark McGwire hit a home run into the upper deck at Busch Stadium, McDonald’s gave anyone with a ticket to that day’s game a free Big Mac. If holders 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


64

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 market in organs have? Have you made arrange-ments 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 ben-efits 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? c. timber: Iowa or Washington? d. 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. Sugar cane 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 ______ Rises ______ Falls f. Americans are driving more and they are driving bigger, gas-guzzling cars like sports utility vehicles. The price of

gasoline ______ Rises ______ Falls


65

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 benefit–cost 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.


PART 2 S U P P L Y A N D D E M A N D

Chapter 4 Supply and Demand 92

Chapter 5 Bringing Supply and Demand Together 121

Chapter 6 Elasticities 151

91


However, if Carlyle was hinting at the impor-tance of supply and demand, he was right on tar-get. Supply and demand is without a doubt the most powerful tool in the economist’s toolbox. It can help explain much of what goes on in the world and help predict what will happen tomor-row. In this chapter, we begin with an introduc-tion to markets. Every market has a demand side

and a supply side. Buyers represent the demand side of the market and sellers represent the sup-ply side. In this chapter, we will learn about the law of demand and the law of supply and the factors that can change supply and demand. In the following chapter, we will put it together to show markets in motion. ■

According to Thomas Carlyle, a nineteenth-century philosopher, “Teach a parrot the term ‘supply and demand’ and you’ve got an economist.” Unfortunately, economics is more complicated than that.

Supply and Demand

4.1 Markets

4.2 Demand

4.3 Shifts in the Demand Curve

4.4 Supply

4.5 Shifts in the Supply Curve

4

92

# 102882 Cust: Cengage Learning Au: Sexton Pg. No. 92 Title: Exploring Economics: Pathways to Problem Solving Server: _____

C/M/Y/KShort / Normal / Long

DESIGN SERVICES OF

S4-CARLISLEPublishing Services



MarketsS E C T I O N

4.1n What is a market?

n Why is it so difficult to define a market?

Defining a Market

Although we usually think of a market as a place where some sort of exchange occurs, a market

is not really a place at all. A market is the process of buyers and sellers exchanging goods and services. Supermarkets, the New York Stock Exchange, drug stores, roadside stands, garage sales, Internet stores, and restaurants are all markets.

Every market is different. That is, the conditions under which the exchange between buyers and sellers takes place can vary. These

differences make it difficult to precisely define a market. After all, an incredible variety of exchange arrangements exist in the real world—organized secu-rities markets, wholesale auction markets, foreign exchange markets, real estate markets, labor markets, and so forth.

Goods being priced and traded in various ways at various locations by various kinds of buyers and sellers further compound the problem of defining a market. For some goods, such as housing, markets are numer-

ous but limited to a geographic area. Homes in Santa Barbara, California, for example (about 100 miles from downtown Los Angeles), do not compete directly with homes in Los Angeles. Why? Because people who work in Los Angeles will generally look for homes within commuting distance. Even within cities, sepa-rate markets for homes are differentiated by amenities such as more living space, newer construction, larger lots, and better schools.

In a similar manner, markets are numerous but geographically limited for a good such as cement. Because transportation costs are so high relative to the selling price, the good is not shipped any substantial distance, and buyers are usually in contact only with local producers. Price and output are thus determined in a number of small markets. In other markets, such as those for gold or automobiles, markets are global. The important point is not what a market looks like, but what it does—it facilitates trade.

eBay is an Internet auction company that brings together millions of buyers and sellers from all over the world. The gains from these mutually beneficial exchanges are large. Craigslist also uses the power of the internet to connect many buyers and sellers in local markets.

AP

IM

AG

ES

The stock market involves many buyers and sell-ers; and profit statements and stock prices are readily available. New information is quickly under-stood by buyers and sellers and is incorporated into the price of the stock. When people expect a company to do better in the future, the price of the stock rises; when people expect the company to do poorly in the future, the price of the stock falls.

PE

TE

R F

OLE

Y/R

EU

TE

RS

/LA

ND

OV

market the process of buyers and sellers exchanging goods and services



DESIGN SERVICES OF



94 PART 2 Supply and Demand

Buyers and Sellers

The roles of buyers and sellers in markets are important. Buyers, as

a group, determine the demand side of the market. Buyers include the consum-ers who purchase the goods and services and the firms that buy inputs—labor, capital, and raw materials. Sellers, as a group, determine the supply side of the market. Sellers include the firms that produce and sell goods and services and the resource owners who sell their inputs to firms—workers who “sell” their labor and resource owners who sell raw materials and capital. The interaction of buyers and sellers deter-mines market prices and output—through the forces of supply and demand.

In the next few chapters, we focus on how sup-ply and demand work in a competitive market. A

competitive market is one in which a number of buyers and sellers are offer-ing similar products, and no single buyer or seller can influence the mar-ket price. That is, buyers and sell-ers have little market power. Because many markets contain a large degree of competitiveness, the lessons of supply

and demand can be applied to many different types of problems.

The supply and demand model is particularly use-ful in markets like agriculture, finance, labor, construc-tion, services, wholesale, and retail.

In short, a model is only as g ood as it explains and predicts. The model of supply and demand is very good at predicting changes in prices and quantities in many markets large and small.

competitive market a market where the many buyers and sellers have little market power—each buyer’s or seller’s effect on market price is negligible


1. Markets consist of buyers and sellers exchanging goods and services with one another.

2. Markets can be regional, national, or global.

3. Buyers determine the demand side of the market and sellers determine the supply side of the market.

1. Why is it difficult to define a market precisely?

2. Why do you get your produce at a supermarket rather than directly from farmers?

3. Why do the prices people pay for similar items at garage sales vary more than for similar items in a department store?

n What is the law of demand?

n What is an individual demand curve?

n What is a market demand curve?

DemandS E C T I O N

4.2

The Law of Demand

Sometimes observed behavior is so pervasive it is called a law—the

law of demand, for example. According to the law of demand, the quantity of a good or service demanded varies inversely (negatively) with its price, ceteris paribus. More directly, the law

of demand says that, other things being equal, when the price (P) of a good or service falls, the quantity demanded (QD) increases. Conversely, if the price of a good or service rises, the quantity demanded decreases.

P ↑ ⇒ QD ↓ and P ↓ ⇒ QD ↑

law of demand the quantity of a good or service demanded varies inversely (negatively) with its price, ceteris paribus



DESIGN SERVICES OF




Individual DemandAn Individual Demand ScheduleThe individual demand schedule shows the relationship between the price of the good and the quantity demand-ed. For example, suppose Elizabeth enjoys drinking coffee. How many pounds of coffee would Elizabeth be willing and able to buy at various prices during the year? At a price of $3 a pound, Elizabeth buys 15 pounds of coffee over the course of a year. If the price is higher, at $4 per pound, she might buy only 10 pounds; if it is lower, say $1 per pound, she might buy 25 pounds of coffee during the year. Elizabeth’s demand for coffee for the year is summarized in the demand schedule in Exhibit 1. Elizabeth might not be consciously aware of the amounts that she would purchase at prices other than the prevailing one, but that does not alter the fact that she has a schedule in the sense that she would have bought various other amounts had other prices prevailed. It must be emphasized that the schedule is a list of alternative pos-sibilities. At any one time, only one of the prices will prevail, and thus a certain quantity will be purchased.

An Individual Demand CurveBy plotting the different prices and corresponding quantities demanded in Elizabeth’s demand schedule in Exhibit 1 and then connecting them, we can cre-ate the individual demand curve for Elizabeth shown in Exhibit 2. From the curve, we can see that when the price is higher, the quantity demanded is lower, and when the price is lower, the quantity demanded is higher. The demand curve shows how the quantity demanded of the good changes as its price varies.

What Is a Market Demand Curve?

Although we introduced the concept of the demand curve in terms of the individual, economists usu-

ally speak of the demand curve in terms of large groups of people—a whole nation, a community, or a trading area. That is, to analyze how the market works, we will need to use market demand. As you know, every indi-

vidual has his or her demand curve for every product. The horizontal summing of the demand curves of many individuals is called the market demand curve.

Suppose the consumer group is com-posed of Homer, Marge, and the rest of their small community, Springfield, and that the product is still coffee. The effect of price on the quantity of cof-fee demanded by Marge, Homer, and the rest of Springfield is given in the demand schedule and demand curves shown in Exhibit 3. At $4 per pound, Homer would be willing and able to buy 20 pounds of coffee per year, Marge would be willing and able to buy 10 pounds,

and the rest of Springfield would be willing and able to buy 2,970 pounds. At $3 per pound, Homer would be

individual demand schedule a schedule that shows the relationship between price and quantity demanded

individual demand curve a graphical representation that shows the inverse relationship between price and quantity demanded

market demand curve the horizontal summation of individual demand curves

Elizabeth’s Demand Schedule for Coffee

section 4.2exhibit 1

Price of Coffee (per pound)

Quantity of Coffee Demanded

(pounds per year)

$5 5

4 10

3 15

2 20

1 25

Elizabeth’s Demand Curve for Coffee


Pri

ce o

f C

off

ee(p

er m

on

th)

$5

4

3

2

1

5 10 15

Elizabeth’s DemandCurve

20 25

Quantity of Coffee(pounds per year)

0

The dots represent various quantities of coffee that Elizabeth would be willing and able to buy at dif-ferent prices in a given period. The demand curve shows how the quantity demanded varies inversely with the price of the good when we hold every-thing else constant—ceteris paribus. Because of this inverse relationship between price and quantity demanded, the demand curve is downward sloping.



DESIGN SERVICES OF




willing and able to buy 25 pounds of coffee per year, Marge would be willing and able to buy 15 pounds, and the rest of Springfield would be willing and able to buy 4,960 pounds. The market demand curve is simply the (horizontal) sum of the quantities Homer, Marge, and the rest of Springfield demand at each price. That is, at

$4, the quantity demanded in the market would be 3,000 pounds of coffee (20 � 10 � 2,970 � 3,000), and at $3, the quantity demanded in the market would be 5,000 pounds of coffee (25 � 15 � 4,960 � 5,000).

In Exhibit 4, we offer a more complete set of prices and quantities from the market demand for

Creating a Market Demand Curvesection 4.2exhibit 3

$5

4

3

2

1

5 10 15 20 25

Pri

ce (

per

po

un

d)

Quantity of Coffee (pounds per year)

Pri

ce (

per

po

un

d)


Pri

ce (

per

po

un

d)


Pri

ce (

per

po

un

d)


0

$5

4

3

2

1

5 10 15 20 25

Homer Marge

0

DHOMER

$5

4

3

2

1

2,970 4,960

Rest of Springfield

0

DS

$5

4

3

2

1

3,000 5,000

Market Demand

0

DM

� � �

DMARGE

a. Creating a Market Demand Schedule for Coffee

Quantity of Coffee Demanded (pounds per year)

Price Rest of Market(per pound) Homer � Marge � Springfield � Demand

$4 20 � 10 � 2,970 � 3,000

$3 25 � 15 � 4,960 � 5,000

b. Creating a Market Demand Curve for Coffee

A Market Demand Curvesection 4.2exhibit 4

The market demand curve shows the amounts that all the buyers in the market would be willing and able to buy at various prices. We find the market demand curve by adding horizontally the individual demand curves. For example, when the price of coffee is $2 per pound, consumers in the market collectively would be willing and able to buy 8,000 pounds per year. At $1 per pound, the amount collectively demanded would be 12,000 pounds per year.

a. Market Demand Schedule for Coffee b. Market Demand Curve for Coffee

Price Quantity Demanded(per pound) (pounds per year)

$5 1,0004 3,0003 5,0002 8,0001 12,000

Pri

ce (

per

po

un

d)

$5

4

3

2

1

1 3 5 8 12

Quantity(thousands of pounds per year)

0

Market Demand Curve



DESIGN SERVICES OF




A Change in Demand Versus a Change in Quantity Demanded

Consumers are influenced by the prices of goods when they make

their purchasing decisions. At lower pric-es, people prefer to buy more of a good than they do at higher prices, holding other factors constant. Why? Primarily, it is because many goods are substitutes

for one another. For example, an increase in the price of coffee might tempt some buyers to switch from buy-ing coffee to buying tea or soft drinks.

Understanding this relationship between price and quantity demanded is so important that economists make a clear distinction between it and the various other factors that can influence consumer behavior. A change in a good’s own price is said to lead to a change in quantity

demanded. That is, it “moves you along”

coffee during the year. Remember, the market demand curve shows the amounts that all the buyers in the market would be willing and able to buy at various prices. For example, when the price of coffee is $2 per pound, consumers in the market collectively would be willing and able to buy 8,000 pounds per year. At $1 per pound, the amount collectively demanded would

be 12,000 pounds per year. The market demand curve is the negative (inverse) relationship between price and the total quantity demanded, while holding all other factors that affect how much consumers are able and willing to pay constant, ceteris paribus. For the most part, we are interested in how the market works, so we will primarily use market demand curves.


1. The law of demand states that when the price of a good falls (rises), the quantity demanded rises (falls), ceteris paribus.

2. An individual demand curve is a graphical representation of the relationship between the price and the quantity demanded.

3. The market demand curve shows the amount of a good that all buyers in the market would be willing and able to buy at various prices.

1. What is an inverse relationship?

2. How do lower prices change buyers’ incentives?

3. How do higher prices change buyers’ incentives?

4. What is an individual demand schedule?

5. What is the difference between an individual demand curve and a market demand curve?

6. Why does the amount of dating on campus tend to decline just before and during final exams?

n What is the difference between a change in demand and a change in quantity demanded?

n What are the determinants of demand?

n What are substitutes and complements?

n What are normal and inferior goods?

n How does the number of buyers affect the demand curve?

n How do changes in taste affect the demand curve?

n How do changing expectations affect the demand curve?

Shifts in the Demand CurveS E C T I O N

4.3

change in quantity demanded a change in a good’s own price leads to a change in quantity demanded, a move along a given demand curve



DESIGN SERVICES OF




a given demand curve. The demand curve is drawn under the assumption that all other things are held constant, except the price of the good. However, economists know that price is not the only thing that affects the quantity of a good that people buy. The other factors that influence the demand curve are called determinants of demand, and a change in these other fac-tors shifts the entire demand curve. These determinants of demand are called demand shifters and they lead to changes in demand.

Shifts in Demand

An increase in demand shifts the demand curve to the right; a decrease in demand shifts the

demand curve to the left, as shown in Exhibit 1. Some

possible demand shifters are the prices of related goods, income, number of buyers, tastes, and expectations. We will now look more closely at each of these variables.

The Prices of Related Goods

In deciding how much of a good or service to buy, consumers are influenced by the price of that good

or service, a relationship summarized in the law of demand. However, sometimes consumers are also influenced by the prices of related goods and services—substitutes and complements.

SubstitutesSubstitutes are generally goods for which one could be used in place of the other. To many, substitutes would include butter and margarine, domestic and foreign cars, movie tickets and video rentals, jackets and sweaters, Exxon and Shell gasoline, and Nikes and Reeboks.

Suppose you go into a store to buy a couple of six packs of Coca-Cola and you see that Pepsi is on sale for half its usual price. Is it possible that you might decide to buy Pepsi instead of Coca-Cola? Economists argue that many people would. Empirical tests have confirmed that consumers are responsive to both the price of the good in question and the prices of related goods. When goods are substitutes, the more people buy of one good, the less they will buy of the other. Suppose there is a fall in the price of Pepsi; this would cause an increase in the quantity demanded for Pepsi (a movement down along the demand

change in demand the prices of related goods, income, number of buyers, tastes, and expectations can change the demand for a good; that is, a change in one of these factors shifts the entire demand curve

Demand Shiftssection 4.3exhibit 1

Pri

ce

Quantity0

Decrease in

Demand

Increase in

Demand

D3D1 D2

An increase in demand shifts the demand curve to the right. A decrease in demand shifts the demand curve to the left.

QCan you describe the change we would expect to see in the demand curve for Sprite if the relative price for 7-Up increased significantly?

AIf the price of one good increases and, as a result, an individual buys more of another good, the two related goods are substitutes. That is, buying more

of one reduces purchases of the other. In Exhibit 2(a), we see that as the price of 7-Up increases—a move-ment up along the demand curve for 7-Up, from point A to point B. The price increase for 7-Up causes a reduction in the quantity demanded of 7-Up. If the two goods are substitutes, the higher price for 7-Up will cause an increase in the demand for Sprite (a rightward shift), as seen in Exhibit 2 (b).

SUBSTITUTE GOODS



DESIGN SERVICES OF




Substititute Goodssection 4.3exhibit 2

0

P1

P2

Q2

B

Q1

0

a. Market for 7-Up b. Market for Sprite

Quantity of 7-Up Quantity of Sprite

Pri

ce o

f 7-

Up

Pri

ce o

f S

pri

te

A

Demand D1 D2

curve). Many Coke drinkers may switch to the new relatively lower priced Pepsi—causing a reduction in demand for Coca-Cola; shifting the demand curve for Coca-Cola to the left. Alternatively, if there is an increase in the price of Pepsi, this causes a decrease in the quantity demanded of Pepsi (a movement up along the demand curve). At the new higher price for Pepsi, many Pepsi drinkers will switch to the relatively lower priced Coca-Cola—shifting the demand curve for Coca-Cola to the right. In this example, Pepsi and Coca-Cola are said to be substitutes.

Two goods are substitutes if an increase (a decrease) in the price of one good causes the demand curve for another good to shift to the right (left)—a direct (or positive) relationship.

Substitutes

PGOOD A ↑ ⇒ ↑ DGOOD B

PGOOD A ↓ ⇒ ↓ DGOOD B

ComplementsComplements are goods that “go together,” often con-sumed and used simultaneously, such as skis and bind-ings, peanut butter and jelly, hot dogs and buns, digital music players and downloadable music, and printers and ink cartridges. For example, if the price of motor-cycles falls, the quantity of motorcycles demanded will

rise—a movement down along the demand curve for motorcycles. As more people buy motorcycles, they will demand more motorcycle helmets—the demand curve for motorcycle helmets shifts to the right. In short, when goods are complements, the more people buy of one good, the more they will buy of the other. That is, if a decrease in the price of good A leads to an increase in the demand for good B, the two goods are complements. Alternatively, if an

increase in the price of good A leads to a decrease in the demand for good B, the two goods are complements.

Complements

PGOOD A ↑ ⇒ ↓ DGOOD B

PGOOD A ↓ ⇒ ↑ DGOOD B

Income

Economists have observed that generally the consumption of goods and services is posi-

tively related to the income available to consum-ers. Empirical studies support the notion that as individuals receive more income, they tend to increase their purchases of most goods and ser-vices. Other things held equal, rising income usu-ally leads to an increase in the demand for goods (a rightward shift of the demand curve), and decreas-ing income usually leads to a decrease in the demand for goods (a leftward shift of the demand curve).

substitutes an increase (decrease) in the price of one good causes the demand curve for another

good to shift to the right (left)

complementsan increase (decrease) in the price of one good shifts the demand curve for another good to the left (right)



DESIGN SERVICES OF




Normal and Inferior GoodsIf demand for a good increases when incomes rise and decreases when incomes fall, the good is called a normal good. Most goods are normal goods. Consumers will typically buy more CDs, clothes, pizzas, and trips to the movies as their incomes rise. However, if demand for a good decreases when incomes rise or if demand increas-es when incomes fall, the good is called an inferior good. These goods include inexpensive cuts of meat, sec-ond-hand clothing, or retread tires, which customers generally buy only because they cannot afford more expensive substitutes. As incomes rise, buyers shift to preferred sub-stitutes and decrease their demand for the inferior goods. Suppose most individuals prefer hamburger to beans, but low-income families buy beans because they are less

expensive. As incomes rise, many consumers may switch from buying beans to buying hamburgers. Hamburgers may be inferior too; as incomes rise still further, consumers may substitute steak or chicken for hamburger. The term inferior in this sense does not refer to the quality of the good in question but shows that demand decreases when income increases and demand increases when income decreases. So

beans are inferior not because they are low quality, but because you buy less of them as income increases.

Or, if people’s incomes rise and they increase their demand for movie tickets, we say that movie tickets are a normal good. But if people’s incomes fall and they increase their demand for bus rides, we say bus rides are an inferior good. Whether goods are normal or inferior, the point here is that income influences demand—usually positively, but some-times negatively.

normal good if income increases, the demand for a good increases; if income decreases, the demand for a good decreases

inferior good if income increases, the demand for a good decreases; if income decreases, the demand for a good increases

QIf the price of computers fell markedly, what do you think would happen to the demand for printers?

AIf computers and printers are complements, the decrease in the price of computers will lead to more computers purchased (a movement down along

the demand curve from point A to point B) and an increase in the demand for printers (a rightward shift). Of course, the opposite is true too—an increase in the price of computers will lead to fewer people purchas-ing computers (a movement up along the demand curve for computers from point B to point A) and a lower demand for printers (a leftward shift).

COMPLEMENTARY GOODS

Complementary Goodssection 4.3exhibit 3

0D2D1

P2

P1

Q1

B

Q2

0

a. Market for Computers b. Market for Printers

Quantity of Computers Quantity of Printers

Pri

ce o

f C

om

pu

ters

Pri

ce o

f P

rin

tersA

Demand



DESIGN SERVICES OF




Normal Good

Income ↑ ⇒ Demand ↑

Income ↓ ⇒ Demand ↓

Inferior Good

Income ↑ ⇒ Demand ↓

Income ↓ ⇒ Demand ↑

Number of Buyers

The demand for a good or service will vary with the size of the potential consumer population. The demand

for wheat, for example, rises as population increases, because the added population wants to consume wheat products, such as bread or cereal. Marketing experts, who closely follow the patterns of consumer behavior regard-ing a particular good or service, are usually vitally con-cerned with the demographics of the product—the vital statistics of the potential consumer population, including size, race, income, and age characteristics. For example, market researchers for baby food companies keep a close watch on the birth rate.

Consumer’s Preferences and Information

The demand for a good or service may increase or decrease suddenly with changes in people’s tastes or

preferences. Changes in taste may be triggered by adver-tising or promotion, by a news story, by the behavior of some popular public figure, and so on. Changes in taste are particularly noticeable in apparel. Skirt lengths, coat lapels, shoe styles, and tie sizes change frequently.

Changes in preferences naturally lead to changes in demand. A person may grow tired of one type of recre-ation or food and try another type. People may decide they want more organic food; consequently, we will see more stores and restaurants catering to this change in taste. Changes in occupation, number of dependents, state of health, and age also tend to alter preferences. The birth of a baby might cause a family to spend less on recreation and more on food and clothing. Illness increases the demand for medicine and lessens purchases of other goods. A cold winter increases the demand for heating oil. Changes in customs and traditions also affect preferences, and the development of new products draws consumer preferences away from other goods. Compact discs replaced record albums, just as DVD players replaced VCRs. A change in information can also impact consumers’ demand. For example, a breakout of E. coli

Body piercing and tattoos have risen in popularity in recent years. The demand for these services has been pushed to the right. According to the Pew Research Center thirty-six percent of 18-25 year olds have at least one tattoo.

© M

IKE

PA

NIC

IS

TO

CK

PH

OT

O.C

OM

or new information about a defective and/or dangerous product, such as a baby’s crib, can reduce demand.

Expectations

Sometimes the demand for a good or service in a given period will dramatically increase or decrease

because consumers expect the good to change in price or availability at some future date. If people expect the future price to be higher, they will purchase more of the good now before the price increase. If people expect the future price to be lower, they will purchase less of the good now and wait for the price decrease. For example, if you expect the price of computers to fall soon, you may be less willing to buy one today. Or, if you expect to earn additional income next month, you may be more willing to dip into your current savings to buy something this month.



DESIGN SERVICES OF




QChester Field owns a high-quality furniture shop. If a boom in the economy occurs (higher average income per person and fewer people unemployed), can Chester expect to sell more high-quality furniture?

AYes. Furniture is generally considered a nor-mal good, so a rise in income will increase the

demand for high-quality furniture, as shown in (a). However, if Chester sells unfinished, used, or low-quality furniture, the demand for his products might fall, as higher incomes allow customers to buy furniture that is finished, new, or of higher quality. Chester’s furniture would then be an inferior good, as shown in Exhibit 4(b).

NORMAL AND INFERIOR GOODS

Normal and Inferior Goodssection 4.3exhibit 4

0D1 D2

a. Rising Income and a Normal Good b. Rising Income and an Inferior Good

Quantity of High-Quality Furniture Quantity of Low-Quality Furniture

Pri

ce o

f F

urn

itu

re

Pri

ce o

f F

urn

itu

re

0

D1D2

Changes in Demand Versus Changes in Quantity Demanded—Revisited

Economists put particular emphasis on the impact on consumer behavior of a change in the

price of a good. We are interested in distinguishing between consumer behavior related to the price of a good itself (movement along a demand curve) and behavior related to changes in other factors (shifts of the demand curve).

As indicated earlier, if the price of a good changes, it causes a change in quantity demanded. If one of the other factors (determinants) influencing consumer behavior changes, it results in a change in demand. The

effects of some of the determinants that cause changes in demand (shifters) are reviewed in Exhibit 5. For example, there are two different ways to curb teenage smoking: raise the price of cigarettes (a reduction in the quantity of cigarettes demanded) or decrease the demand for cigarettes (a leftward shift in the demand curve for cigarettes). Both would reduce the amount of smoking. Specifically, to increase the price of ciga-rettes, the government could impose a higher tax on manufacturers. Most of this would be passed on to consumers in the form of higher prices (more on this in Chapter 6). Or to shift the demand curve leftward, the government could adopt policies to discourage smok-ing, such as advertising bans and increasing consumer awareness of the harmful side effects of smoking—disease and death.



DESIGN SERVICES OF



Possible Demand Shifterssection 4.3exhibit 5

Price of complement fallsor price of substitute rises

D1 D2

Income increases (normal good)

D1 D2

Income increases (inferior good)

D1D2

Increase in the number ofbuyers in the market

D1 D2

Taste change in favor of the good

D1 D2

Future price increase expected

D1 D2

Pri

ceP

rice

Pri

ceP

rice

Pri

ceP

rice

Quantity

Quantity

Quantity

Quantity

Quantity

Quantity

0

0

0

0

0

0

QHow would you use a graph to demonstrate the two following scenarios? (1) Someone buys more DVDs because the price of DVDs has fallen; and (2) a student buys more DVDs because she just got a 20 percent raise at work giving her additional income.

AIn Exhibit 6, the movement from A to B is called an increase in quantity demanded; the movement from B to A is called a decrease in quantity demanded. Economists use the phrase “increase or decrease in quantity demanded” to describe movements along a given demand curve. However, the change from A to C is called an increase in demand, and the change from C to A is called a decrease in demand. The phrase “increase or decrease in demand” is reserved for a shift in the whole curve. So if an individual buys more DVDs because the price fell, we call it an increase in quantity demanded. However, if she buys more DVDs even at the current price, say $15, we say it is an increase

in demand. In this case, the increase in income was responsible for the increase in demand, because she chose to spend some of her new income on DVDs.

CHANGES IN DEMAND VERSUS CHANGES IN QUANTITY DEMANDED

Change in Demand VersusChange in Quantity Demanded


Quantity of DVDs(per month)

A

B

C

0

$10

$5

Change in demand

Change in quantity demanded

A

A

C

B

3 8

D1 D2

5

Pri

ce o

f D

VD

s

103



DESIGN SERVICES OF





1. A change in the quantity demanded describes a movement along a given demand curve in response to a change in the price of the good.

2. A change in demand shifts the entire demand curve. An increase in demand shifts the demand curve to the right; a decrease shifts it to the left.

3. A change in the price of a substitute shifts the demand curve for the good in question. The relationship is direct.

4. A change in the price of a complement shifts the demand curve for the good in question. The relationship is inverse.

5. Changes in income cause demand curve shifts. For normal goods the relationship is direct; for inferior goods it is inverse.

6. The position of the demand curve will vary according to the number of consumers in the market.

7. Changes in taste will shift the demand curve.

8. Changes in expected future prices and income can shift the current demand curve.

1. What is the difference between a change in demand and a change in quantity demanded?

2. If the price of zucchini increases, causing the demand for yellow squash to rise, what do we call the relation-ship between zucchini and yellow squash?

3. If incomes rise and, as a result, demand for jet skis increases, how do we describe that good?

4. How do expectations about the future influence the demand curve?

5. Would a change in the price of ice cream cause a change in the demand for ice cream? Why or why not?

6. Would a change in the price of ice cream likely cause a change in the demand for frozen yogurt, a substitute?

7. If plane travel is a normal good and bus travel is an inferior good, what will happen to the demand curves for plane and bus travel if people’s incomes increase?

The Law of Supply

In a market, the answer to the funda-mental question, “What do we produce,

and in what quantities?” depends on the interaction of both buyers and sellers. Demand is only half the story. The will-ingness and ability of suppliers to provide goods are equally important factors that must be weighed by decision makers in all societies. As with demand, the price of the good is an important factor. And just as with demand, factors other than the price of the good are also important to suppliers,

n What is the law of supply?

n What is an individual supply curve?

n What is a market supply curve?

SupplyS E C T I O N

4.4

such as the cost of inputs or advances in technology. While behavior will vary among individual suppliers,

economists expect that, other things being equal, the quantity supplied will vary directly with the price of the good, a relationship called the law of

supply. According to the law of sup-ply, the higher the price of the good (P), the greater the quantity supplied

(QS), and the lower the price of the good, the smaller the quantity supplied.

P ↑ ⇒ QS ↑ and P ↓ ⇒ QS ↓

law of supply the higher (lower) the price of the good, the greater (smaller) the quantity supplied



DESIGN SERVICES OF




The relationship described by the law of supply is a direct, or positive, relationship, because the variables move in the same direction.

A Positive Relationship Between Price and Quantity Supplied

Firms supplying goods and services want to increase their profits, and the higher the price per unit, the

greater the profitability generated by supplying more of that good. For example, if you were a coffee grower, wouldn’t you much rather be paid $5 a pound than $1 a pound, ceteris paribus?

When the price of coffee is low, the coffee business is less profitable and less coffee will be produced. Some suppliers may even shut down, reducing their quantity supplied to zero.

An Individual Supply Curve

To illustrate the concept of an indi-

vidual supply curve, consider the amount of coffee that an individual

supplier, Juan Valdes, is willing and able to supply in one year. The law of supply can be illustrated, like the law of demand, by a table or graph. Juan’s supply schedule for coffee is shown in Exhibit 1(a). The combinations of price and quantity supplied were then plotted and joined to create the individual supply curve shown in Exhibit 1(b). Note that the individual supply curve is upward sloping as you move from left to right. At higher prices, it will be more attractive to increase production. Existing firms or growers will produce more at higher prices than at lower prices.

The Market Supply Curve

The market supply curve may be thought of as the horizontal summation of the supply curves for

individual firms. The market supply curve shows how the total quan-tity supplied varies positively with the price of a good, while holding constant all other factors that affect how much producers are able and willing to supply. The market sup-ply schedule, which reflects the total quantity supplied at each price by all of the coffee producers, is shown in Exhibit 2(a). Exhibit 2(b) illustrates the resulting market supply curve for this group of coffee producers.

An Individual Supply Curvesection 4.4exhibit 1

a. Juan’s Supply Schedule for Coffee b. Juan’s Supply Curve for Coffee

Price Quantity Supplied(per pound) (pounds per year)

$5 804 703 502 301 10 Pri

ce o

f C

off

ee(p

er p

ou

nd

)

$5

4

3

2

1

10 30 50 70 80

Quantity of Coffee(pounds per year)

0

Juan’s SupplyCurve

Other things being equal, the quantity supplied will vary directly with the price of the good. As the price rises (falls), the quantity supplied increases (decreases).

individual supply curve a graphical representation that shows the positive relationship between the

price and quantity supplied

market supply curve a graphical representation of the amount of goods and services that suppliers are willing and able to supply at various prices



DESIGN SERVICES OF




A Market Supply Curvesection 4.4exhibit 2

a. Market Supply Schedule for Coffee b. Market Supply Curve for Coffee

Quantity Supplied(pounds per year)

Other MarketPrice(per pound) Juan � Producers � Supply

$5 80 � 7,920 � 8,0004 70 � 6,930 � 7,0003 50 � 4,950 � 5,0002 30 � 2,970 � 3,0001 10 � 990 � 1,000

$5

4

3

2

1

1 3 5 7 80

Pri

ce o

f C

off

ee(p

er p

ou

nd

)

Quantity of Coffee(thousands of pounds per year)

Market Supply Curve

The dots on this graph indicate different quantities of coffee that producers would be willing and able to supply at various prices. The line connecting those combinations is the market supply curve.


1. The law of supply states that the higher (lower) the price of a good, the greater (smaller) the quantity supplied.

2. The relationship between price and quantity supplied is positive because profit opportunities are greater at higher prices and because the higher production costs of increased output mean that suppliers will require higher prices.

3. The market supply curve is a graphical representation of the amount of goods and services that suppliers are willing and able to supply at various prices.

1. What are the two reasons why a supply curve is positively sloped?

2. What is the difference between an individual supply curve and a market supply curve?

A Change in Quantity Supplied Versus a Change in Supply

Changes in the price of a good lead to changes in the quantity supplied by suppliers, just as changes

in the price of a good lead to changes in the quan-tity demanded by buyers. Similarly, a change in sup-ply, whether an increase or a decrease, can occur for reasons other than changes in the price of the product

itself, just as changes in demand may be due to factors (determinants) other than the price of the good. In other words, a change in the price of the good in question is shown as a movement along a given supply curve, lead-ing to a change in quantity supplied. A change in any other factor that can affect supplier behavior (input prices, the prices of related products, expectations, number of suppliers, technology, regulation, taxes and subsidies, and weather) results in a shift in the entire supply curve, leading to a change in supply.

n What is the difference between a change in supply and a change in quantity supplied?

n What are the determinants of supply?

n How does the number of suppliers affect the supply curve?

n How does technology affect the supply curve?

n How do taxes affect the supply curve?

Shifts in the Supply CurveS E C T I O N

4.5



DESIGN SERVICES OF




Shifts in Supply

An increase in supply shifts the supply curve to the right; a decrease in supply shifts the supply curve to

the left, as shown in Exhibit 1. Anything that affects the costs of production will influence supply and the position of the supply curve. We will now look at some of the pos-sible determinants of supply—factors that determine the position of the supply curve—in greater depth.

Input PricesSuppliers are strongly influenced by the costs of inputs used in the production process, such as steel used for automo-biles or microchips used in computers. For example, higher labor, materials, energy, or other input costs increase the costs of production, causing the supply curve to shift to the left at each and every price. If input prices fall, the costs of production decrease, causing the supply curve to shift to the right—more will be supplied at each and every price.

Prices of Related Goods The supply of a good increases if the price of one of its substi-tutes in production falls; and the supply of a good decreases if the price of one of its substitutes in production rises. Suppose you own your own farm, on which you plant cotton and wheat. One year, the price of wheat falls, and farmers reduce the quantity of wheat supplied, as shown in Exhibit 2(a). What effect does the lower price of wheat have on your cot-ton production? It increases the supply of cotton. You want to produce relatively less of the crop that has fallen in price (wheat) and relatively more of the now more attractive other crop (cotton). Cotton and wheat are substitutes in produc-tion because both goods can be produced using the same resources. Producers tend to substitute the production of

more profitable products for that of less profitable prod-ucts. So the decrease in the price in the wheat market has caused an increase in supply (a rightward shift) in the cotton market, as seen in Exhibit 2(b).

If the price of wheat, a substitute in production, increases, then that crop becomes more profitable. This leads to an increase in the quantity supplied of wheat. Consequently, farmers will shift their resources out of the relatively lower-priced crop (cotton); the result is a decrease in supply of cotton.

Other examples of substitutes in production include automobile producers that have to decide between pro-ducing sedans and pick-ups or construction companies that have to choose between building single residential houses or commercial buildings.

Some goods are complements in production. Producing one good does not prevent the production of the other, but actually enables production of the other. For example, leather and beef are complements in produc-tion. Suppose the price of a beef rises and as a result cattle ranchers increase the quantity supplied of beef, moving up the supply curve for beef, as seen in Exhibit 2(c). When cattle ranchers produce more beef they automatically pro-duce more leather. Thus, when the price of beef increases, the supply of the related good, leather, shifts to the right, as seen in Exhibit 2(d). Suppose the price of beef falls, and as a result, the quantity supplied of beef falls; this leads to a decrease (a leftward shift) in the supply of leather.

Other examples of complements in production where goods are produced simultaneously from the same resource include: a lumber mill that produces lumber and sawdust or an oil refinery that can produce gasoline or heating oil from the same resource—crude oil.

ExpectationsAnother factor shifting supply is suppliers’ expectations. If producers expect a higher price in the future, they will supply less now than they otherwise would have, preferring to wait and sell when their goods will be more valuable. For example, if a cotton producer expected the future price of cotton to be higher next year, he might decide to store some of his current production of cotton for next year when the price will be higher. Similarly, if producers expect now that the price will be lower later, they will supply more now. Oil refiners will often store some of their spring supply of gasoline for summer because gasoline prices typically peak in summer. In addition, some of the heating oil for the fall is stored to supply it in the winter when heating oil prices peak.

Number of SuppliersWe are normally interested in market demand and supply (because together they determine prices and quantities) rather than in the behavior of individual consumers and firms. As we discussed earlier in the chapter, the supply

Supply Shiftssection 4.5exhibit 1

Decreasein

Supply

Increase in

Supply

Pri

ce

Quantity

0

S3 S1 S2

An increase in supply shifts the supply curve to the right. A decrease in supply shifts the supply curve to the left.



DESIGN SERVICES OF




Substitutes and Complements in Productionsection 4.5exhibit 2

Substitutions in Production

Complements in Production

0

S1 S2P1

P2

Q2

Supply

Q1

0

a. Market for Wheat

Quantity of Wheat Quantity of Cotton

Pri

ce o

f Wh

eat

Pri

ce o

f C

ott

on

b. Market for Cotton

0

S1 S2P2

P1

Q1

Supply

Q2

0

c. Market for Cattle

Quantity of Cattle Quantity of Leather

Pri

ce o

f C

attl

e

Pri

ce o

f L

eath

er

d. Market for Leather

If land can be used for either wheat or cotton, a decrease in the price of wheat causes a decease in the quantity supplied; a movement down along the supply curve in Exhibit 2(a). This may cause some farmers to shift out of the production of wheat and into the substitute in production—cotton—shifting the cotton supply curve to the right in Exhibit 2(b). If the price of the complement in production increases (cattle), it becomes more profitable and and as a result cattle ranchers increase the quantity supplied of beef, moving up the supply curve for beef, as seen in Exhibit 2 (c). When cattle ranch-ers produce more beef they also produce more leather. Thus, when the price of beef increases, the supply of the related good, leather, shifts to the right, as seen in Exhibit 2(d).

curves of individual suppliers can be summed horizontally to create a market supply curve. An increase in the num-ber of suppliers leads to an increase in supply, denoted by a rightward shift in the supply curve. For example, think of the number of gourmet coffee shops that have sprung up over the last 15 to 20 years, shifting the supply curve of gourmet coffee to the right. An exodus of suppliers has the opposite impact, a decrease in supply, which is indi-cated by a leftward shift in the supply curve.

TechnologyTechnological change can lower the firm’s costs of produc-tion through productivity advances. These changes allow the firm to spend less on inputs and produce the same level of output. Human creativity works to find new ways to produce goods and services using fewer or less costly inputs of labor, natural resources, or capital. Because the

firm can now produce the good at a lower cost it will sup-ply more of the good at each and every price—the supply curve shifts to the right.

Government (Regulation, Taxes, and Subsidies)Supply may also change because of changes in the legal and regulatory environment in which firms operate. Government regulations can influence the costs of production to a firm, leading to cost-induced supply changes similar to those just discussed. For example, if new safety or clean air require-ments increase labor and capital costs, the increased cost will result, other things being equal, in a decrease in supply, shifting the supply curve to the left, or up. However, deregu-lation can shift the supply curve to the right.

Certain types of taxes can also alter the costs of pro-duction borne by the supplier, causing the supply curve to



DESIGN SERVICES OF




shift to the left at each price. A subsidy, the opposite of a tax, can lower a firm’s costs and shift the supply curve to the right. For example, the government sometimes pro-vides farmers with subsidies to encourage the production of certain agricultural products.

WeatherIn addition, weather can sometimes dramatically affect the supply of certain commodities, particularly agricultural products and transportation services. A drought or freezing temperatures will almost certainly cause the supply curves for many crops to shift to the left, while exceptionally good weather can shift a supply curve to the right. For example, unusually cold weather in California during the winter of 2006 destroyed billions of dollars worth of citrus fruit. Hurricane Rita disrupted oil and refining processes. Both events shifted the supply curve for those products to the left.

Change in Supply Versus Change in Quantity Supplied—Revisited

If the price of a good changes, it leads to a change in the quantity supplied. If one of the other factors influences

sellers’ behavior, we say it results in a change in supply.

For example, if production costs rise because of a wage increase or higher fuel costs, other things remaining constant, we would expect a decrease in supply—that is, a leftward shift in the supply curve. Alternatively, if some variable, such as lower input prices, causes the costs of production to fall, the supply curve will shift to the right. Exhibit 3 illustrates the effects of some of the determinants that cause shifts in the supply curve.

A major disaster such as a flood or hurricane can reduce the supply of crops and livestock. Occasionally, floods have spilled over the banks of the Mississippi River—bursting through levees and destroying crops and animals.

© 2

00

9/J

UP

ITE

RIM

AG

ES

Possible Supply Shiftssection 4.5exhibit 3

Input price (wages) increases

Taxes rise

S1S2

S1S2

Input price (fuel) falls

Technological advance occurs

S1 S2

S1 S2S1 S2S1 S2

Bad weather

S1S2

Producer expectsnow that the price will be lower later

S1 S2

Price decreases for a substitute in production

Number of suppliersincreases

Pri

ceP

rice

Pri

ceP

rice

Pri

ceP

rice

Pri

ceP

rice

Quantity

Quantity

Quantity

Quantity

Quantity

Quantity

Quantity

Quantity

0

0

0

0

0

0

0

0



DESIGN SERVICES OF




QHow would you graph the following two scenarios: (1) the price of cotton rises; and (2) good weather causes an unusually abundant cotton harvest?

AIn the first scenario, the price of cotton increases, so the quantity supplied changes (i.e., a movement along the supply curve). In the second scenario, the good weather causes the supply curve for cotton to shift to the right, which is called a change in supply (not quantity supplied). A shift in the whole supply curve is caused by one of the other variables, not by a change in the price of the good in question. As shown in Exhibit 4, the movement from A to B is called an increase in quantity supplied, and the movement from B to A is called a decrease in quan-tity supplied. However, the change from B to C is

called an increase in supply, and the movement from C to B is called a decrease in supply.

CHANGE IN SUPPLY VERSUS CHANGE IN QUANTITY SUPPLIED


A

B C

0 4 7 11

$10.00

$5.00

Change in quantity supplied

Change in supply

A

B

B

C

S1 S2

Quantity of Cotton

Pri

ce o

f C

ott

on


1. A movement along a given supply curve is caused by a change in the price of the good in question. As we move along the supply curve, we experience a change in the quantity supplied.

2. A shift of the entire supply curve is called a change in supply.

3. An increase in supply shifts the supply curve to the right; a decrease shifts it to the left.

4. Changes in Input prices, the prices of related goods, expectations, the number of suppliers, technology, regulation, taxes and subsidies, and weather can all lead to changes in supply.

5. The supply of a good increases (decreases) if the price of one of its substitutes in production falls (rises).

6. If the price of a complement (cattle) rises, so will the supply of the related product (leather). If the price of a complement (cattle) falls, so will the supply of the related product (leather).

1. What is the difference between a change in supply and a change in quantity supplied?

2. If a seller expects the price of a good to rise in the near future, how will that expectation affect the current supply curve?

3. Would a change in the price of wheat change the supply of wheat? Would it change the supply of corn, if wheat and corn can be grown on the same type of land?

4. If a guitar manufacturer increased its wages in order to keep its workers, what would happen to the supply of guitars as a result?

5. What happens to the supply of baby-sitting services in an area when many teenagers get their driver’s licenses at about the same time?



DESIGN SERVICES OF



111Chapter 4 Supply and Demand 111Chapter 4 Supply and Demand

In te rac t i ve Chapter Summary

Fill in the blanks:

1. A(n) _____________ is the process of buyers and sellers _____________ goods and services.

2. The important point about a market is what it does—it facilitates _____________.

3. _____________, as a group, determine the demand side of the market. _____________, as a group, determine the supply side of the market.

4. A(n) _____________ market consists of many buyers and sellers, no single one of whom can influence the market price.

5. According to the law of demand, other things being equal, when the price of a good or service falls, the _____________ increases.

6. An individual _____________ curve reveals the different amounts of a particular good a person would be willing and able to buy at various possible prices in a particular time interval, other things being equal.

7. The _____________ curve for a product is the horizontal summing of the demand curves of the individuals in the market.

8. A change in _____________ leads to a change in quantity demanded, illustrated by a(n) _____________ demand curve.

9. A change in demand is caused by changes in any of the other factors (besides the good’s own price) that would affect how much of the good is purchased: the _____________, _____________, the _____________ of buyers, _____________, and _____________.

10. An increase in demand is represented by a _____________ shift in the demand curve; a decrease in demand is represented by a _____________ shift in the demand curve.

11. Two goods are called _____________ if an increase in the price of one causes the demand curve for another good to shift to the _____________.

12. For normal goods an increase in income leads to a(n) _____________ in demand, and a decrease in income leads to a(n) _____________ in demand, other things being equal.

13. An increase in the expected future price of a good or an increase in expected future income may _____________ current demand.

14. According to the law of supply, the higher the price of the good, the greater the ____________, and the lower the price of the good, the smaller the ____________.

15. The quantity supplied is positively related to the price because firms supplying goods and services want to increase their _____________ and because increasing _____________ costs mean that the suppliers will require _____________ prices to induce them to increase their output.

16. An individual supply curve is a graphical representation that shows the _____________ relationship between the price and the quantity supplied.

17. The market supply curve is a graphical representation of the amount of goods and services that suppliers are _____________ and _____________ to supply at various prices.

18. Possible supply determinants (factors that determine the position of the supply curve) are _____________ prices; _____________; _____________ of suppliers; and _____________, _____________, _____________, and _____________.

19. A fall in input prices will _____________ the costs of production, causing the supply curve to shift to the _____________.

20. The supply of a good _____________ if the price of one of its substitutes in production falls.

21. The supply of a good _____________ if the price of one of its substitutes in production rises.

Answers: 1. market; exchanging 2. trade 3. Buyers; Sellers 4. competitive 5. quantity demanded 6. demand 7. market demand 8. a good’s price; movement along 9. prices of related goods; income; number; tastes; expectations 10. rightward; leftward 11. substitutes; right 12. increase; decrease 13. increase 14. quantity supplied; quantity supplied 15. profits; production; higher 16. positive 17. willing; able 18. input; expectations; number; technology; regulation; taxes and subsidies; weather 19. lower; right 20. increases 21. decreases

Key Terms and Concepts

market 93competitive market 94law of demand 94individual demand schedule 95individual demand curve 95

market demand curve 95change in quantity demanded 97change in demand 98substitutes 99complements 99

normal good 100inferior good 100law of supply 104individual supply curve 105market supply curve 105



DESIGN SERVICES OF



112 PART 2 Supply and Demand112 PART 2 Supply and Demand

Sect ion Check Answers

4.1 Markets 1. Why is it difficult to define a market precisely?

Every market is different. An incredible variety of exchange arrangements arise for different types of products, different degrees of organization, different geographical extents, and so on.

2. Why do you get your produce at a supermarket rather than directly from farmers?Supermarkets act as middlepersons between grow-ers of produce and consumers of produce. You hire them to do this task for you when you buy pro-duce from them, rather than directly from growers, because they conduct those transactions at lower costs than you could (if you could do it more cheap-ly than supermarkets, you would buy directly rather than from supermarkets).

3. Why do the prices people pay for similar items at garage sales vary more than for similar items in a department store?Items for sale at department stores are more standard-ized, easier to compare, and more heavily advertised, which makes consumers more aware of the prices at which they could get a particular good elsewhere, reducing the differences in price that can persist among department stores. Garage sale items are nonstandard-ized, costly to compare, and not advertised, which means people are often quite unaware of how much a given item could be purchased for elsewhere, so that price differences for similar items at different garage sales can be substantial.

4.2 Demand 1. What is an inverse relationship?

An inverse, or negative, relationship is one where one variable changes in the opposite direction from the other—if one increases, the other decreases.

2. How do lower prices change buyers’ incentives?A lower price for a good means that the opportunity cost to buyers of purchasing it is lower than before, and self-interest leads buyers to buy more of it as a result.

3. How do higher prices change buyers’ incentives?A higher price for a good means that the opportunity cost to buyers of purchasing it is higher than before, and self-interest leads buyers to buy less of it as a result.

4. What is an individual demand schedule?An individual demand schedule reveals the different amounts of a good or service a person would be willing

to buy at various possible prices in a particular time interval.

5. What is the difference between an individual demand curve and a market demand curve?The market demand curve shows the total amounts of a good or service all the buyers as a group are willing to buy at various possible prices in a particular time interval. The market quantity demanded at a given price is just the sum of the quantities demanded by each individual buyer at that price.

6. Why does the amount of dating on campus tend to decline just before and during final exams?The opportunity cost of dating—in this case, the value to students of the studying time forgone—is higher just before and during final exams than during most of the rest of an academic term. Because the cost is higher, students do less of it.

4.3 Shifts in the Demand Curve 1. What is the difference between a change in

demand and a change in quantity demanded?A change in demand shifts the entire demand curve, while a change in quantity demanded refers to a move-ment along a given demand curve, caused by a change in the good’s price.

2. If the price of zucchini increases, causing the demand for yellow squash to rise, what do we call the relationship between zucchini and yellow squash?Whenever an increased price of one good increases the demand for another, they are substitutes. The fact that some people consider zucchini an alternative to yellow squash explains in part why zucchini becomes more costly. Therefore, some people substitute into buying relatively cheaper yellow squash now instead.

3. If incomes rise and, as a result, demand for jet skis increases, how do we describe that good?If income rises and, as a result, demand for jet skis increases, we call jet skis a normal good, because for most (or normal) goods, we would rather have more of them than less, so an increase in income would lead to an increase in demand for such goods.

4. How do expectations about the future influence the demand curve?Expectations about the future influence the demand curve because buying a good in the future is an alternative to buying it now. Therefore, the higher



DESIGN SERVICES OF



113Chapter 4 Supply and Demand 113Chapter 4 Supply and Demand

future prices are expected to be compared to the pres-ent, the less attractive future purchases become, and the greater the current demand for that good, as people buy more now when it is expected to be cheaper, rather than later, when it is expected to be more costly.

5. Would a change in the price of ice cream cause a change in the demand for ice cream? Why or why not?No. The demand for ice cream represents the different quantities of ice cream that would be purchased at differ-ent prices. In other words, it represents the relationship between the price of ice cream and the quantity of ice cream demanded. Changing the price of ice cream does not change this relationship, so it does not change demand.

6. Would a change in the price of ice cream likely cause a change in the demand for frozen yogurt, a substitute?Yes. Changing the price of ice cream, a substitute for frozen yogurt, would change the quantity of frozen yogurt demanded at a given price. This change in price means that the whole relationship between the price and quantity of frozen yogurt demanded has changed, which means the demand for frozen yogurt has changed.

7. If plane travel is a normal good and bus travel is an inferior good, what will happen to the demand curves for plane and bus travel if people’s incomes increase?The demand for plane travel and all other normal goods will increase if incomes increase, while the demand for bus travel and all other inferior goods will decrease if incomes increase.

4.4 Supply 1. What are the two reasons why a supply curve is

positively sloped?A supply curve is positively sloped because (1) the benefits to sellers from selling increase as the price they receive increases, and (2) the opportunity costs of supplying additional output rise with output (the law of increasing opportunity costs), so it takes a higher price to make increasing output in the self-interest of sellers.

2. What is the difference between an individual supply curve and a market supply curve?The market supply curve shows the total amounts of a good all the sellers as a group are willing to sell at various prices in a particular time period. The market

quantity supplied at a given price is just the sum of the quantities supplied by each individual seller at that price.

4.5 Shifts in the Supply Curve 1. What is the difference between a change in

supply and a change in quantity supplied?A change in supply shifts the entire supply curve, while a change in quantity supplied refers to a movement along a given supply curve.

2. If a seller expects the price of a good to rise in the near future, how will that expectation affect the current supply curve?Selling a good in the future is an alternative to selling it now. Therefore, the higher the expected future price rel-ative to the current price, the more attractive future sales become, and the less attractive current sales become. This will lead sellers to reduce (shift left) the current supply of that good, as they want to sell later, when the good is expected to be more valuable, rather than now.

3. Would a change in the price of wheat change the supply of wheat? Would it change the supply of corn, if wheat and corn can be grown on the same type of land?The supply of wheat represents the different quanti-ties of wheat that would be offered for sale at different prices. In other words, it represents the relationship between the price of wheat and the quantity of wheat supplied. Changing the price of wheat does not change this relationship, so it does not change the supply of wheat. However, a change in the price of wheat changes the relative attractiveness of raising wheat instead of corn, which changes the supply of corn.

4. If a guitar manufacturer increased its wages in order to keep its workers, what would happen to the supply of guitars as a result?An increase in wages, or any other input price, would decrease (shift left) the supply of guitars, making fewer guitars available for sale at any given price, by raising the opportunity cost of producing guitars.

5. What happens to the supply of baby-sitting services in an area when many teenagers get their driver’s licenses at about the same time?When teenagers get their driver’s licenses, their increased mobility expands their alternatives to baby-sitting substan-tially, raising the opportunity cost of baby-sitting. This change decreases (shifts left) the supply of baby-sitting services.



DESIGN SERVICES OF



114

CHAPTER 4 STUDY GUIDE

True or False:

1. Differences in the conditions under which the exchange between buyers and sellers occurs make it difficult to precisely define a market.

2. All markets are effectively global in scope.

3. The relationship between price and quantity demanded is inverse or negative.

4. The market demand curve is the vertical summation of individual demand curves.

5. A change in a good’s price does not change its demand.

6. A change in demand is illustrated by a shift in the entire demand curve.

7. Because personal tastes differ, substitutes for one person may not be substitutes for another person.

8. Two goods are complements if an increase in the price of one causes an increase in the demand for the other.

9. Those goods for which falling income leads to decreased demand are called inferior goods.

10. Either an increase in the number of buyers or an increase in tastes or preferences for a good or service will increase the market demand for a good or service.

11. A decrease in the price of ice cream would cause an increase in the demand for frozen yogurt, a substitute.

12. The law of supply states that, other things being equal, the quantity supplied will vary directly (a positive relationship) with the price of the good.

13. The market supply curve for a product is the vertical summation of the supply curves for individual firms.

14. A change in the price of a good leads to a change in the quantity supplied, but not to a change in its supply.

15. An increase in supply leads to a movement up along the supply curve.

16. A decrease in supply shifts the supply curve to the left.

17. Just as demanders will demand more now if the price of a good is expected to rise in the near future, sellers will supply more now if the price of a good is expected to rise in the near future.

18. Both technological progress and cost-increasing regulations will increase supply.

Multiple Choice:

1. Which of the following is a market? a. a garage sale b. a restaurant c. the New York Stock Exchange d. an eBay auction e. all of the above

2. In a competitive market, a. there are a number of buyers and sellers. b. no single buyer or seller can appreciably affect the market price. c. sellers offer similar products. d. all of the above are true.

3. If the demand for milk is downward sloping, then an increase in the price of milk will result in a(n) a. increase in the demand for milk. b. decrease in the demand for milk. c. increase in the quantity of milk demanded. d. decrease in the quantity of milk demanded. e. decrease in the supply of milk.



DESIGN SERVICES OF



115

4. Which of the following would be most likely to increase the demand for jelly? a. an increase in the price of peanut butter, which is often used with jelly b. an increase in income; jelly is a normal good c. a decrease in the price of jelly d. medical research that finds that daily consumption of jelly makes people live 10 years less, on average

5. Which of the following would not cause a change in the demand for cheese? a. an increase in the price of crackers, which are consumed with cheese b. an increase in the income of cheese consumers c. an increase in the population of cheese lovers d. an increase in the price of cheese

6. Ceteris paribus, an increase in the price of DVD players would tend to a. decrease the demand for DVD players. b. increase the price of televisions, a complement to DVD players. c. increase the demand for DVD players. d. decrease the demand for DVDs.

7. Whenever the price of Good A decreases, the demand for Good B increases. Goods A and B appear to be a. complements. b. substitutes. c. inferior goods. d. normal goods. e. inverse goods.

8. Whenever the price of Good A increases, the demand for Good B increases as well. Goods A and B appear to be a. complements. b. substitutes. c. inferior goods. d. normal goods. e. inverse goods.

9. The difference between a change in quantity demanded and a change in demand is that a change in a. quantity demanded is caused by a change in a good’s own price, while a change in demand is caused by a change

in some other variable, such as income, tastes, or expectations. b. demand is caused by a change in a good’s own price, while a change in quantity demanded is caused by a change

in some other variable, such as income, tastes, or expectations. c. quantity demanded is a change in the amount people actually buy, while a change in demand is a change in the

amount they want to buy. d. This is a trick question. A change in demand and a change in quantity demanded are the same thing.

10. Suppose CNN announces that bad weather in Central America has greatly reduced the number of cocoa bean plants and for this reason the price of chocolate is expected to rise soon. As a result,

a. the current market demand for chocolate will decrease. b. the current market demand for chocolate will increase. c. the current quantity demanded for chocolate will decrease. d. no change will occur in the current market for chocolate.

11. An upward-sloping supply curve shows that a. buyers are willing to pay more for particularly scarce products. b. suppliers expand production as the product price falls. c. suppliers are willing to increase production of their goods if they receive higher prices for them. d. buyers are willing to buy more as the product price falls.

12. Along a supply curve, a. supply changes as price changes. b. quantity supplied changes as price changes. c. supply changes as technology changes. d. quantity supplied changes as technology changes.



DESIGN SERVICES OF



116

13. All of the following factors will affect the supply of shoes except one. Which will not affect the supply of shoes? a. higher wages for shoe factory workers b. higher prices for leather c. a technological improvement that reduces waste of leather and other raw materials in shoe production d. an increase in consumer income

14. The difference between a change in quantity supplied and a change in supply is that a change in a. quantity supplied is caused by a change in a good’s own price, while a change in supply is caused by a change in

some other variable, such as input prices, prices of related goods, expectations, or taxes. b. supply is caused by a change in a good’s own price, while a change in the quantity supplied is caused by a change

in some other variable, such as input prices, prices of related goods, expectations, or taxes. c. quantity supplied is a change in the amount people want to sell, while a change in supply is a change in the amount

they actually sell. d. supply and a change in the quantity supplied are the same thing.

15. Antonio’s makes the greatest pizza and delivers it hot to all the dorms around campus. Last week Antonio’s supplier of pepperoni informed him of a 25 percent increase in price. Which variable determining the position of the supply curve has changed, and what effect does it have on supply?

a. future expectations; supply decreases b. future expectations; supply increases c. input prices; supply decreases d. input prices; supply increases e. technology; supply increases

16. Which of the following is not a determinant of supply? a. input prices b. technology c. tastes d. expectations e. the prices of related goods

17. If incomes are rising, in the market for an inferior good, a. demand will rise. b. demand will fall. c. supply will rise. d. supply will fall.

18. If a farmer were choosing between growing wheat on his own land and growing soybeans on his own land, a. an increase in the price of soybeans would increase his supply of soybeans. b. an increase in the price of soybeans would increase his supply of wheat. c. an increase in the price of soybeans would decrease his supply of soybeans. d. an increase in the price of soybeans would decrease his supply of wheat. e. an increase in the price of soybeans would not change his supply of either wheat or soybeans.

19. A supply curve illustrates a(n) _____________ relationship between _____________ and _____________. a. direct; price; supply b. direct; price; quantity demanded c. direct; price; quantity supplied d. introverted; price; quantity demanded e. inverse; price; quantity supplied

20. A leftward shift in supply could be caused by a. an improvement in productive technology. b. a decrease in income. c. some firms leaving the industry. d. a fall in the price of inputs to the industry.



DESIGN SERVICES OF



117

Problems:

1. Is the market for laptop computers local, national, or global?

2. Sid moves from New York City, where he lived in a small condominium, to rural Minnesota, where he buys a big house on five acres of land. Using the law of demand, what do you think is true of land prices in New York City relative to those in rural Minnesota?

3. The following table shows Hillary’s demand schedule for Cherry Blossom Makeup. Graph Hillary’s demand curve.

Price

(dollars per ounce)

Quantity Demanded

(ounces per week)

$15 5 oz.12 109 156 203 25

4. The following table shows Cherry Blossom Makeup demand schedules for Hillary’s friends, Barbara and Nancy. If Hillary, Barbara, and Nancy constitute the whole market for Cherry Blossom Makeup, complete the market demand schedule and graph the market demand curve.

Quantity Demanded (ounces per week)

Price

(dollars per ounce) Hillary Barbara Nancy Market

$15 5 0 1512 10 5 209 15 10 256 20 15 303 25 20 35

5. What would be the effects of each of the following on the demand for hamburger in Hilo, Hawaii? In each case, identify the responsible determinant of demand.

a. The price of chicken falls. b. The price of hamburger buns doubles. c. Scientists find that eating hamburger prolongs life. d. The population of Hilo doubles.

6. What would be the effect of each of the following on the demand for Chevrolets in the United States? In each case, identify the responsible determinant of demand.

a. The price of Fords plummets. b. Consumers believe that the price of Chevrolets will rise next year. c. The incomes of Americans rise. d. The price of gasoline falls dramatically.



DESIGN SERVICES OF



118

7. The following graph shows three market demand curves for cantaloupe. Starting at point A, a. which point represents an increase in quantity demanded? b. which point represents an increase in demand? c. which point represents a decrease in demand? d. which point represents a decrease in quantity demanded?

Pri

ce

Quantity of Cantaloupes per Year

c

ea

bf

d0

d1d2

8. Using the demand curve, show the effect of the following events on the market for beef: a. Consumer income increases. b. The price of beef increases. c. An outbreak of “mad cow” disease occurs. d. The price of chicken (a substitute) increases. e. The price of barbecue grills (a complement) increases.

9. Draw the demand curves for the following goods. If the price of the first good listed rises, what will happen to the demand for the second good, and why?

a. hamburger and ketchup b. Coca-Cola and Pepsi c. camera and film d. golf clubs and golf balls e. skateboard and razor scooter

10. If the price of ice cream increased, a. what would be the effect on the demand for ice cream? b. what would be the effect on the demand for frozen yogurt?

11. Using the graph below, answer the following questions: a. What is the shift from D1 to D2 called? b. What is the movement from b to a called? c. What is the movement from a to b called? d. What is the shift from D2 to D1 called?

P2

P1

Q2 Q3

ac

b

Q1

D10

P



DESIGN SERVICES OF



119

12. Felix is a wheat farmer who has two fields he can use to grow wheat. The first field is right next to his house and the topsoil is rich and thick. The second field is 10 miles away in the mountains and the soil is rocky. At current wheat prices, Felix just produces from the field next to his house because the market price for wheat is just high enough to cover his costs of production including a reasonable profit. What would have to happen to the market price of wheat for Felix to have the incentive to produce from the second field?

13. Show the impact of each of the following events on the oil market. a. OPEC becomes more effective in limiting the supply of oil. b. OPEC becomes less effective in limiting the supply of oil. c. The price for natural gas (a substitute for heating oil) rises. d. New oil discoveries occur in Alaska. e. Electric and hybrid cars become subsidized and their prices fall.

14. The following table shows the supply schedule for Rolling Rock Oil Co. Plot Rolling Rock’s supply curve on a graph.

Price

(dollars per barrel)

Quantity Supplied

(barrels per month)

$5 10,00010 15,00015 20,00020 25,00025 30,000

15. The following table shows the supply schedules for Rolling Rock and two other petroleum companies. Armadillo Oil and Pecos Petroleum. Assuming these three companies make up the entire supply side of the oil market, complete the market supply schedule and draw the market supply curve on a graph.

Quantity Supplied (barrels per month)

Price

(dollars per barrel) Rolling Rock Armadillo Oil Pecos Petroleum Market

$5 10,000 8,000 2,000 _________10 15,000 10,000 5,000 _________15 20,000 12,000 8,000 _________20 25,000 14,000 11,000 _________25 30,000 16,000 14,000 _________

16. If the price of corn rose, a. what would be the effect on the supply of corn? b. what would be the effect on the supply of wheat?

17. Using the graph below, answer the following questions: a. What is the shift from S1 to S2 called? b. What is the movement from a to b called? c. What is the movement from b to a called? d. What is the shift from S2 to S1 called?

P1

P2

Q2 Q3

bc

a

Q1

S1 S2

0Q

P



DESIGN SERVICES OF



120

18. What would be the effect of each of the following on the supply of salsa in the United States? In each case, identify the responsible determinant of supply.

a. Tomato prices skyrocket b. Congress places a 26 percent tax on salsa. c. Ed Scissorhands introduces a new, faster vegetable chopper. d. J. Lo, Beyonce, and Adam Sandler each introduce a new brand of salsa.

19. What would be the effects of each of the following on the supply of coffee worldwide? In each case, identify the responsible determinant of supply.

a. Freezing temperatures wipe out half of Brazil’s coffee crop. b. Wages of coffee workers in Latin America rise as unionization efforts succeed. c. Indonesia offers big subsidies to its coffee producers. d. Genetic engineering produces a super coffee bean that grows faster and needs less care. e. Coffee suppliers expect prices to be higher in the future.

20. The following graph shows three market supply curves for cantaloupe. Compared to point A, which point represents a. an increase in quantity supplied? b. an increase in supply? c. a decrease in quantity supplied? d. a decrease in supply?

Pri

ce

Quantity of Cantaloupes per Year

e

d

a

b

c

s0 s1

s2



DESIGN SERVICES OF



sample contents ch2 & ch4

Documents

cherry blossom makeup

supermarket checkout counter

kaiser family foundation

completing yard chores

guitar manufacturer increased

steering wheelpointing directly

jet skis increases

federal reserve system