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Brief Contents Part 1 INTRODUCTION Chapter 14 Monopolistic Competition and Product Differentiation 398 Chapter 1 The Role and Method of Economics 2 Chapter 15 Chapter 2 Oligopoly and Strategic Behavior 419 The Economic Way of Thinking 36 Chapter 3 Part 5 Scarcity, Trade-Offs, and Production Possibilities 66 Part 2 SUPPLY AND DEMAND Chapter 16 The Markets for Labor, Capital, and Land 452 Chapter 4 Chapter 17 Supply and Demand 92 Income and Poverty 480 Chapter 5 Chapter 18 Bringing Supply and Demand Together 121 The Environment 511 Chapter 6 Elasticities Part 3 INPUT MARKETS AND MICROECONOMIC POLICY ISSUES Chapter 19 151 Health Care 535 MARKET EFFICIENCY, MARKET FAILURE, AND THE PUBLIC SYSTEM Part 6 MACROECONOMIC FOUNDATIONS Chapter 20 Chapter 7 Chapter 8 Introduction to Macroeconomics: Unemployment, Inflation, and Economic Fluctuations 558 Market Failure 209 Chapter 21 Chapter 9 Measuring Economic Performance 603 Public Sector and Public Choice 233 Chapter 22 Market Efficiency and Welfare 182 Economic Growth in the Global Economy 627 Part 4 HOUSEHOLDS AND MARKET STRUCTURE Chapter 10 Chapter 23 Financial Markets, Saving, and Investment 649 Consumer Choice Theory 256 Part 7 Chapter 11 The Firm: Production and Costs 287 THE MACROECONOMIC MODELS Chapter 12 Chapter 24 Firms in Perfectly Competitive Markets 326 Aggregate Demand and Aggregate Supply 684 Chapter 13 Chapter 25 Monopoly and Antitrust 359 The Aggregate Expenditure Model 727 iv 52270_00_fm_pi-xxx.indd iv Brief Contents 10/20/09 2:45:13 PM v Brief Contents Part 8 MACROECONOMIC POLICY Part 9 THE GLOBAL ECONOMY Chapter 26 Chapter 30 Fiscal Policy 754 International Trade 906 Chapter 27 Chapter 31 Monetary Institutions 797 International Finance 943 Chapter 28 The Federal Reserve System and Monetary Policy 826 Chapter 29 Issues in Macroeconomic Theory and Policy 869 52270_00_fm_pi-xxx.indd v 10/20/09 2:45:19 PM Table of Contents Part 1 INTRODUCTION What Are Bads? 38 Are Those Who Want More Greedy? 38 Does Everyone Face Scarcity? 38 Will Scarcity Ever Be Eradicated? 39 CHAPTER 1 2.2 Choices, Costs, and Trade-Offs 40 Scarcity Forces Us to Choose 40 Trade-Offs 40 To Choose Is to Lose 40 The Opportunity Cost of Going to College or Having a Child 41 Is That Really a Free Lunch, a Freeway, or a Free Beach? 41 The Role and Method of Economics 2 1.1 Economics: A Brief Introduction 3 Economics—A Word with Many Different Meanings 3 Economics Is All Around Us 3 Why Study Economics? 4 2.3 Marginal Thinking 42 Many Choices We Face Involve Marginal Thinking 42 1.2 Economic Behavior 7 Self-Interest 7 What Is Rational Behavior? 7 1.3 Economic Theory 10 Economic Theories 10 Abstraction Is Important 10 Developing a Testable Proposition 11 Science and Stories 11 The Ceteris Paribus Assumption 12 Why Are Observation and Prediction Harder in the Social Sciences? 12 Why Do Economists Predict on a Group Level? 12 The Two Branches of Economics: Microeconomics and Macroeconomics 13 1.4 Pitfalls to Avoid in Scientific Thinking 14 Confusing Correlation and Causation 14 The Fallacy of Composition 14 1.5 Positive Statements and Normative Statements 16 Positive Statement 16 Normative Statement 17 Positive Versus Normative Analysis 17 Disagreement Is Common in Most Disciplines 17 Often Economists Do Agree 19 Interactive Chapter Summary 20 Key Terms and Concepts 21 Section Check Answers 21 Study Guide 24 Appendix: Working with Graphs 28 CHAPTER 2 The Economic Way of Thinking 36 2.1 Scarcity 37 Scarcity 37 Scarcity and Resources 37 What Are Goods and Services? 38 vi 52270_00_fm_pi-xxx.indd vi 2.4 Incentives Matter 47 People Respond to Changes in Incentives 47 Positive and Negative Incentives 47 2.5 Specialization and Trade 49 Why Do People Specialize? 49 We All Specialize 49 The Advantages of Specialization 49 Specialization and Trade Lead to Greater Wealth and Prosperity 51 2.6 Markets and Improved Efficiency 52 How Does the Market Work to Allocate Resources? 52 Market Prices Provide Important Information 52 What Effect Do Price Controls Have on the Market System? 53 Market Failure 53 Interactive Chapter Summary 55 Key Terms and Concepts 56 Section Check Answers 56 Study Guide 60 CHAPTER 3 Scarcity, Trade-Offs, and Production Possibilities 66 3.1 The Three Economic Questions Every Society Faces 67 Scarcity and the Allocation of Resources 67 What Goods and Services Will Be Produced? 67 How Will the Goods and Services Be Produced? 68 Who Will Get the Goods and Services Produced? 68 3.2 The Circular Flow Model 71 Product Markets 71 Table of Contents 10/20/09 2:45:19 PM Table of Contents Factor Markets 71 The Simple Circular Flow Model 71 3.3 The Production Possibilities Curve 73 The Production Possibilities Curve 73 Using Resources Efficiently 75 Inefficiency and Efficiency 76 The Law of Increasing Opportunity Cost 76 3.4 Economic Growth and the Production Possibilities Curve 78 Generating Economic Growth 78 Growth Does Not Eliminate Scarcity 78 The Effects of a Technological Change on the Production Possibilities Curve 79 Summing Up the Production Possibilities Curve 80 Interactive Chapter Summary 81 Key Terms and Concepts 82 Section Check Answers 82 Study Guide 85 Part 2 SUPPLY AND DEMAND CHAPTER 4 Supply and Demand 92 4.1 Markets 93 Defining a Market 93 Buyers and Sellers 94 4.2 Demand 94 The Law of Demand 94 Individual Demand 95 What Is a Market Demand Curve? 95 4.3 Shifts in the Demand Curve 97 A Change in Demand Versus a Change in Quantity Demanded 97 Shifts in Demand 98 The Prices of Related Goods 98 Income 99 Number of Buyers 101 Consumer’s Preferences and Information 101 Expectations 101 Changes in Demand Versus Changes in Quantity Demanded—Revisited 102 4.4 Supply 104 The Law of Supply 104 A Positive Relationship Between Price and Quantity Supplied 105 An Individual Supply Curve 105 The Market Supply Curve 105 4.5 Shifts in the Supply Curve 106 A Change in Quantity Supplied Versus a Change in Supply 106 Shifts in Supply 107 Change in Supply Versus Change in Quantity Supplied—Revisited 109 52270_00_fm_pi-xxx.indd vii vii Interactive Chapter Summary 111 Key Terms and Concepts 111 Section Check Answers 112 Study Guide 114 CHAPTER 5 Bringing Supply and Demand Together 121 5.1 Market Equilibrium Price and Quantity 122 Equilibrium Price and Quantity 122 Shortages and Surpluses 123 Scarcity and Shortages 123 5.2 Changes in Equilibrium Price and Quantity 127 A Change in Demand 127 A Change in Supply 127 Changes in Both Supply and Demand 129 The Combinations of Supply and Demand Shifts 130 Supply, Demand, and the Market Economy 134 5.3 Price Controls 135 Price Controls 135 Price Ceilings: Rent Controls 135 Price Floors: The Minimum Wage 137 Price Ceilings: Price Controls on Gasoline 138 Unintended Consequences 139 Interactive Chapter Summary 141 Key Terms and Concepts 142 Section Check Answers 142 Study Guide 145 CHAPTER 6 Elasticities 151 6.1 Price Elasticity of Demand 152 Is the Demand Curve Elastic or Inelastic? 152 Types of Demand Curves 152 Calculating the Price Elasticity of Demand: The Midpoint Method 154 The Determinants of the Price Elasticity of Demand 155 6.2 Total Revenue and the Price Elasticity of Demand 158 How Does the Price Elasticity of Demand Impact Total Revenue? 158 Price Elasticity Changes Along a Linear Demand Curve 159 6.3 Other Types of Demand Elasticities 163 The Cross-Price Elasticity of Demand 163 Cross-Price Elasticity and Sodas 163 The Income Elasticity of Demand 163 6.4 Price Elasticity of Supply 165 What Is the Price Elasticity of Supply? 165 Elasticities and Taxes: Combining Supply and Demand Elasticities 166 10/20/09 2:45:21 PM viii Table of Contents Interactive Chapter Summary 172 Key Terms and Concepts 172 Section Check Answers 173 Study Guide 175 Part 3 MARKET EFFICIENCY, MARKET FAILURE, AND THE PUBLIC SYSTEM 8.3 Asymmetric Information 219 What Is Asymmetric Information? 219 What Is Moral Hazard? 222 Interactive Chapter Summary 226 Key Terms and Concepts 227 Section Check Answers 227 Study Guide 229 CHAPTER 9 Public Sector and Public Choice 233 CHAPTER 7 Market Efficiency and Welfare 182 7.1 Consumer Surplus and Producer Surplus 183 Consumer Surplus 183 Marginal Willingness to Pay Falls as More Is Consumed 183 Price Changes and Changes in Consumer Surplus 184 Producer Surplus 184 Market Efficiency and Producer and Consumer Surplus 185 7.2 The Welfare Effects of Taxes, Subsidies, and Price Controls 190 Using Consumer and Producer Surplus to Find the Welfare Effects of a Tax 190 Elasticity and the Size of the Deadweight Loss 192 The Welfare Effects of Subsidies 193 Price Ceilings and Welfare Effects 193 Applications of Consumer and Producer Surplus 194 Price Floors 196 The Welfare Effects of a Price Floor When the Government Buys the Surplus 196 Deficiency Payment Program 198 Interactive Chapter Summary 200 Key Terms and Concepts 200 Section Check Answers 201 Study Guide 203 9.1 Other Functions of Government 234 Property Rights and the Legal System 234 Insufficient Competition in Markets 234 Income Redistribution 234 9.2 Government Spending and Taxation 236 Growth in Government 236 Generating Government Revenue 238 Financing State and Local Government Activities 239 Should We Have a Flat Tax? 240 Taxes: Efficiency and Equity 240 9.3 Public Choice 245 What Is Public Choice Theory? 245 Scarcity and the Public Sector 245 The Individual Consumption-Payment Link 245 Majority Rule and the Median Voters 245 Voters and Rational Ignorance 246 Special Interest Groups 247 Interactive Chapter Summary 248 Key Terms and Concepts 249 Section Check Answers 249 Study Guide 251 Part 4 HOUSEHOLDS AND MARKET STRUCTURE CHAPTER 10 CHAPTER 8 Market Failure 209 8.1 Externalities 210 Negative Externalities in Production 210 What Can the Government Do to Correct for Negative Externalities? 211 Positive Externalities in Consumption 213 What Can the Government Do to Correct for Positive Externalities? 214 Nongovernmental Solutions to Externalities 214 8.2 Public Goods 216 Private Goods Versus Public Goods 216 Public Goods and the Free-Rider Problem 217 The Government and Benefit-Cost Analysis 217 Common Resources and the Tragedy of the Commons 218 52270_00_fm_pi-xxx.indd viii Consumer Choice Theory 256 10.1 Consumer Behavior 257 Wants Versus Needs 257 Do We Need More Freeways? 258 Utility 258 Utility Is a Personal Matter 258 Total Utility and Marginal Utility 259 Diminishing Marginal Utility 261 10.2 The Consumer’s Choice 264 What Is the “Best” Decision for Consumers? 264 Consumer Equilibrium 264 The Law of Demand and the Law of Diminishing Marginal Utility 265 Interactive Chapter Summary 270 Key Terms and Concepts 271 Section Check Answers 271 10/20/09 2:45:21 PM ix Table of Contents Study Guide 273 Appendix: A More Advanced Theory of Consumer Choice 277 CHAPTER 11 The Firm: Production and Costs 287 11.1 Firms and Profits: Total Revenues Minus Total Costs 288 Explicit Costs 288 Implicit Costs 288 Profits 288 Are Accounting Profits the Same as Economic Profits? 288 A Zero Economic Profit Is a Normal Profit 290 Sunk Costs 290 11.2 Production in the Short Run 291 The Short Run Versus the Long Run 291 Production in the Short Run 291 Diminishing Marginal Product 292 11.3 Costs in the Short Run 294 Fixed Costs, Variable Costs, and Total Costs 294 Average Total Costs 294 Marginal Costs 295 How 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 302 Why Are Long-Run Cost Curves Different from Short-Run Cost Curves? 302 What Are Economies of Scale? 304 Why Do Economies and Diseconomies of Scale Occur? 304 Interactive Chapter Summary 305 Key Terms and Concepts 306 Section Check Answers 306 Study Guide 309 Appendix: Using Isoquants and Isocosts 318 CHAPTER 12 Firms in Perfectly Competitive Markets 326 12.1 A Perfectly Competitive Market 327 A Perfectly Competitive Market 327 52270_00_fm_pi-xxx.indd ix 12.2 An Individual Price Taker’s Demand Curve 328 An Individual Firm’s Demand Curve 328 A Change in Market Price and the Firm’s Demand Curve 329 12.3 Profit Maximization 330 Revenues in a Perfectly Competitive Market 330 Total Revenue 331 Average Revenue and Marginal Revenue 331 How Do Firms Maximize Profits? 331 Equating Marginal Revenue and Marginal Cost 331 12.4 Short-Run Profits and Losses 333 The Three-Step Method 333 Evaluating Economic Losses in the Short Run 335 Deriving the Short-Run Market Supply Curve 336 12.5 Long-Run Equilibrium 339 Economic Profits and Losses Disappear in the Long Run 339 The Long-Run Equilibrium for the Competitive Firm 341 12.6 Long-Run Supply 342 A Constant-Cost Industry 342 An Increasing-Cost Industry 342 A Decreasing-Cost Industry 344 Perfect Competition and Economic Efficiency 345 Interactive Chapter Summary 346 Key Terms and Concepts 348 Section Check Answers 348 Study Guide 351 CHAPTER 13 Monopoly and Antitrust 359 13.1 Monopoly: The Price Maker 360 What Is a Monopoly? 360 Pure Monopoly Is a Rarity 360 Barriers to Entry 360 13.2 Demand and Marginal Revenue in Monopoly 361 The Monopolist’s Price in the Elastic Portion of the Demand Curve 364 13.3 The Monopolist’s Equilibrium 366 How Does the Monopolist Determine the Profit-Maximizing Output? 366 Three-Step Method for the Monopolist 366 Profits for a Monopolist 366 Losses for the Monopolist 367 Patents 368 13.4 Monopoly and Welfare Loss 369 Does Monopoly Promote Inefficiency? 369 Does Monopoly Retard Innovation? 371 13.5 Monopoly Policy 371 Antitrust Policies 372 Antitrust Laws 372 Have Antitrust Policies Been Successful? 373 10/20/09 2:45:21 PM x Table of Contents Government Regulation 373 Difficulties in Average Cost Pricing 375 13.6 Price Discrimination and Peak Load Pricing 376 Price Discrimination 376 Conditions for Price Discrimination 376 Why Does Price Discrimination Exist? 377 Examples of Price Discrimination 377 The Welfare Effects of Price Discrimination 379 Peak Load Pricing 383 Interactive Chapter Summary 385 Key Terms and Concepts 386 Section Check Answers 386 Study Guide 390 CHAPTER 14 Monopolistic Competition and Product Differentiation 398 14.1 Monopolistic Competition 399 What Is Monopolistic Competition? 399 The Three Basic Characteristics of Monopolistic Competition 399 14.2 Price and Output Determination in Monopolistic Competition 401 The Firm’s Demand and Marginal Revenue Curve 401 Determining Short-Run Equilibrium 402 Short-Run Profits and Losses in Monopolistic Competition 403 Determining Long-Run Equilibrium 404 Achieving Long-Run Equilibrium 405 14.3 Monopolistic Competition Versus Perfect Competition 406 The Significance of Excess Capacity 406 Failing to Meet Allocative Efficiency, Too 407 What Are the Real Costs of Monopolistic Competition? 408 Are the Differences Between Monopolistic Competition and Perfect Competition Exaggerated? 408 14.4 Advertising 409 Why Do Firms Advertise? 409 Is Advertising “Good” or “Bad” from Society’s Perspective? 410 Interactive Chapter Summary 412 Key Terms and Concepts 413 Section Check Answers 413 Study Guide 415 CHAPTER 15 Oligopoly and Strategic Behavior 419 15.1 Oligopoly 420 What Is Oligopoly? 420 Mutual Interdependence 420 Why Do Oligopolies Exist? 420 52270_00_fm_pi-xxx.indd x Measuring Industry Concentration 420 Economies of Scale as a Barrier to Entry 421 Equilibrium Price and Quantity in Oligopoly 421 15.2 Collusion and Cartels 422 Uncertainty and Pricing Decisions 422 Collusion 422 Joint Profit Maximization 422 Why Are Most Collusive Oligopolies Short Lived? 425 15.3 Other Oligopoly Models 425 The Kinked Demand Curve Model—Price Rigidity 425 Price Leadership 426 What Happens in the Long Run If Entry Is Easy? 427 How Do Oligopolists Deter Market Entry? 427 Antitrust and Mergers 428 Antitrust and Pricing Strategies 428 15.4 Game Theory and Strategic Behavior 431 Some Strategies for Noncollusive Oligopolies 431 What Is Game Theory? 431 Cooperative and Noncooperative Games 431 The Prisoners’ Dilemma 432 Profits Under Different Pricing Strategies 433 Advertising 434 Repeated Games 436 Network Externalities 437 Interactive Chapter Summary 440 Key Terms and Concepts 441 Section Check Answers 441 Study Guide 444 Part 5 INPUT MARKETS AND MICROECONOMIC POLICY ISSUES CHAPTER 16 The Markets for Labor, Capital, and Land 452 16.1 Input Markets 453 Determining the Price of a Productive Factor: Derived Demand 453 16.2 Supply and Demand in the Labor Market 454 Will Hiring That Input Add More to Revenue Than Costs? 454 The Demand Curve for Labor Slopes Downward 455 How Many Workers Will an Employer Hire? 456 The Market Labor Supply Curve 457 16.3 Labor Market Equilibrium 459 Determining Equilibrium in the Competitive Labor Market 459 Shifts in the Labor Demand Curve 459 Shifting the Labor Supply Curve 461 Monopsony 462 10/20/09 2:45:21 PM xi Table of Contents 16.4 Labor Unions 463 Labor Unions in the United States 463 Why Are There Labor Unions? 464 Union Impact on Labor Supply and Wages 464 Wage Differences for Similarly Skilled Workers 464 Can Unions Lead to Increased Productivity? 465 16.5 The Markets for Land and Capital 466 The Supply of and Demand for Land 466 Supply and Demand in the Capital Market 466 The Interdependence of Input Markets 467 Income Distribution and Marginal Productivity 468 18.2 Public Policy and the Environment 514 Why Is a Clean Environment Not Free? 514 The Costs and Benefits of Pollution Control 515 Command and Control Policies: Regulation 515 Pollution (Pigovian) Taxes: A Market-Based Policy 517 Transferable Pollution Rights 519 What Is an Ideal Pollution Control Policy? 519 18.3 Property Rights 523 Property Rights and the Environment 523 The Coase Theorem 523 Transaction Costs and the Coase Theorem 523 Interactive Chapter Summary 468 Key Terms and Concepts 469 Section Check Answers 470 Study Guide 473 Interactive Chapter Summary 526 Key Terms and Concepts 526 Section Check Answers 527 Study Guide 529 CHAPTER 17 CHAPTER 19 Income and Poverty 480 Health Care 535 17.1 Income Distribution 481 Measuring Income Inequality 481 The Lorenz Curve 482 Are We Overstating the Disparity in the Distribution of Income? 483 Permanent Income Hypothesis 484 How Much Movement Happens on the Economic Ladder? 484 Why Do Some Earn More than Others? 485 Income Distribution in Other Countries 487 19.1 The Rising Cost of Health Care 536 17.2 Income Redistribution 488 Equality 489 Income Redistribution Can Reduce Incentives to Work, Invest, and Save 489 Revisiting Marginal Productivity Theory 490 19.2 The Health Care Market 538 Income 538 Insurance and Third-Party Payers 539 Demographic Changes 540 The Supply of Health Care 540 Doctors as Gatekeepers 540 Technological Progress and Quality of Care 541 Imperfect Competition 541 Shortages 542 The Market for Human Organs 543 Health Saving Account (HSA) 543 Interactive Chapter Summary 548 Key Terms and Concepts 549 Section Check Answers 549 Study Guide 551 17.3 The Economics of Discrimination 491 Job-Entry Discrimination 491 Wage Discrimination 491 Discrimination or Differences in Productivity? 491 Why Do People Discriminate? 492 The Costs of Discrimination 493 Part 6 17.4 Poverty 494 Defining Poverty 494 An Alternative Definition of Poverty 494 Income Redistribution 496 CHAPTER 20 Interactive Chapter Summary 501 Key Terms and Concepts 502 Section Check Answers 502 Study Guide 505 CHAPTER 18 The Environment 511 18.1 Negative Externalities and Pollution 512 What Are Social Costs? 512 Negative Externalities and Pollution 512 Measuring Externalities 513 52270_00_fm_pi-xxx.indd xi MACROECONOMIC FOUNDATIONS Introduction to Macroeconomics: Unemployment, Inflation, and Economic Fluctuations 558 20.1 Macroeconomic Goals 559 Three Major Macroeconomic Goals 559 Acknowledging Our Goals: The Employment Act of 1946 559 20.2 Employment and Unemployment 560 The Consequences of High Unemployment 560 What Is the Unemployment Rate? 560 The Worst Case of U.S. Unemployment 561 Variations in the Unemployment Rate 561 10/20/09 2:45:21 PM xii Table of Contents Are Unemployment Statistics Accurate Reflections of the Labor Market? 561 Who Are the Unemployed? 562 Categories of Unemployed Workers 562 How Much Unemployment? 563 How Long Are People Usually Unemployed? 563 Labor Force Participation Rate 564 20.3 Types of Unemployment 565 Frictional Unemployment 565 Should We Worry About Frictional Unemployment? 565 Structural Unemployment 566 Some Unemployment Is Unavoidable 566 Cyclical Unemployment 566 The Natural Rate of Unemployment 567 20.4 Reasons for Unemployment 569 Why Does Unemployment Exist? 569 Minimum Wages and Unemployment 569 The Impact of Unions on the Unemployment Rate 570 Efficiency Wage 570 Job Search 570 Unemployment Insurance 571 Does New Technology Lead to Greater Unemployment? 571 20.5 Inflation 572 Stable Price Level as a Desirable Goal 572 Measuring Inflation 573 The Consumer Price Index and the GDP Deflator 574 How Is a Price Index Created? 574 Producer Price Index 575 GDP Deflator Versus CPI 575 The Price Level over the Years 575 Who Loses with Inflation? 578 Other Costs of Inflation 579 Inflation and Interest Rates 580 Do Creditors Always Lose During Inflation? 581 Protecting Ourselves from Inflation 581 20.6 Economic Fluctuations 583 Short-Term Fluctuations in Economic Growth 583 The Phases of a Business Cycle 583 How Long Does a Business Cycle Last? 584 Seasonal Fluctuations Affect Economic Activity 585 Forecasting Cyclical Changes 585 Interactive Chapter Summary 586 Key Terms and Concepts 588 Section Check Answers 589 Study Guide 593 52270_00_fm_pi-xxx.indd xii CHAPTER 21 Measuring Economic Performance 603 21.1 National Income Accounting: A Standardized Way to Measure Economic Performance 604 What Is Gross Domestic Product? 604 Production, Income, and the Circular Flow Model 604 21.2 Measuring Total Production 606 The Expenditure Approach to Measuring GDP 606 Consumption (C) 606 Investment (I ) 607 Government Purchases in GDP (G) 608 Exports (X ⫺ M) 608 21.3 Other Measures of Total Production and Total Income 609 21.4 Problems in Calculating an Accurate GDP 610 Problems in Calculating an Accurate GDP 610 How Do We Solve This Problem? 610 A Price-Level Index 610 Real GDP 610 Is Real GDP Always Less Than Nominal GDP? 611 Real GDP per Capita 611 Why Is the Measure of per Capita GDP So Important? 612 21.5 Problems with GDP as a Measure of Economic Welfare 613 Nonmarket Transactions 613 The Underground Economy 613 Measuring the Value of Leisure 613 GDP and Externalities 613 Quality of Goods 616 Other Measures of Economic Well-Being 616 Interactive Chapter Summary 617 Key Terms and Concepts 618 Section Check Answers 618 Study Guide 620 CHAPTER 22 Economic Growth in the Global Economy 627 22.1 Economic Growth 628 Defining Economic Growth 628 The Rule of 70 628 22.2 Determinants of Economic Growth 630 Factors That Contribute to Economic Growth 630 New Growth Theory 633 10/20/09 2:45:21 PM xiii Table of Contents 22.3 Public Policy and Economic Growth 634 The Impact of Economic Growth 634 Saving Rates, Investment, Capital Stock, and Economic Growth 634 Infrastructure 634 Research and Development 634 The Protection of Property Rights Impacts Economic Growth 635 Free Trade and Economic Growth 635 Education 636 22.4 Population and Economic Growth 638 Population Growth and Economic Growth 638 The Malthusian Prediction 639 Interactive Chapter Summary 640 Key Terms and Concepts 641 Section Check Answers 641 Study Guide 643 CHAPTER 23 Financial Markets, Saving, and Investment 649 23.1 Financial Institutions and Intermediaries 650 Bonds 650 Stocks 650 Retained Earnings 651 The Value of Securities 651 Reading Stock Tables 652 Executives, 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 655 Analyzing the Market for Loanable Funds 656 23.3 The Financial Crisis of 2008 663 Low Interest Rates (2002–2004) Led to Aggressive Borrowing 663 Deregulation in the Housing Market and Subprime Mortgages 663 Who Bought These Risky Subprime Mortgages? 664 The Fed Raises Interest Rates and the Housing Bust 666 Interactive Chapter Summary 669 Key Terms and Concepts 670 Section Check Answers 670 Study Guide 673 Appendix: Calculating Present Value 680 52270_00_fm_pi-xxx.indd xiii Part 7 THE MACROECONOMIC MODELS CHAPTER 24 Aggregate Demand and Aggregate Supply 684 24.1 The Determinants of Aggregate Demand 685 What Is Aggregate Demand? 685 Consumption (C) 685 Investment (I) 685 Government Purchases (G) 685 Net Exports (X ⫺ M) 685 24.2 The Aggregate Demand Curve 686 How Is the Quantity of Real GDP Demanded Affected by the Price Level? 686 Why Is the Aggregate Demand Curve Negatively Sloped? 687 24.3 Shifts in the Aggregate Demand Curve 688 Shifts Versus Movements Along the Aggregate Demand Curve 688 Aggregate Demand Curve Shifters 688 24.4 The Aggregate Supply Curve 690 What Is the Aggregate Supply Curve? 690 Why Is the Short-Run Aggregate Supply Curve Positively Sloped? 691 Why Is the Long-Run Aggregate Supply Curve Vertical? 691 24.5 Shifts in the Aggregate Supply Curve 693 Shifting Short-Run and Long-Run Supply Curves 693 What Factors Shift Short-Run Aggregate Supply Only? 694 24.6 Macroeconomic Equilibrium 696 Determining Macroeconomic Equilibrium 696 Recessionary and Inflationary Gaps 696 Demand-Pull Inflation 697 Cost-Push Inflation 697 What Helped the United States Recover in the 1980s? 698 A Decrease in Aggregate Demand and Recessions 699 Adjusting to a Recessionary Gap 700 Slow Adjustments to a Recessionary Gap 700 What Causes Wages and Prices to Be Sticky Downward? 700 Adjusting to an Inflationary Gap 701 Price Level and RGDP Over Time 702 10/20/09 2:45:21 PM xiv Table of Contents 24.7 The Classical and the Keynesian Macroeconomic Model 703 The Classical School and Say’s Law 703 Changes in Aggregate Demand in the Classical Model 704 The Keynesian Short-Run Aggregate Supply Curve—Sticky Prices and Wages 705 Interactive Chapter Summary 707 Key Terms and Concepts 709 Section Check Answers 709 Study Guide 714 CHAPTER 25 The Aggregate Expenditure Model 727 25.1 Simple Aggregate Expenditure Model 728 Why Do We Assume the Price Level Is Fixed? 728 The Simplest Aggregate Expenditure Model: Autonomous Consumption Only 728 What Are the Autonomous Factors That Influence Spending? 729 25.2 Finding Equilibrium in the Aggregate Expenditure Model 730 Revisiting Marginal Propensity to Consume and Save 731 Marginal Propensity to Save 731 Equilibrium in the Aggregate Expenditure Model 732 Equilibrium 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 740 Shifts in Aggregate Demand 741 Limitations of the Aggregate Expenditure Model 741 Interactive Chapter Summary 744 Key Terms and Concepts 745 Section Check Answers 745 Study Guide 748 Part 8 MACROECONOMIC POLICY 26.2 Fiscal Policy and the AD/AS Model 757 Fiscal Policy and the AD/AS Model 757 26.3 The Multiplier Effect 761 Government Purchases, Taxes, and Aggregate Demand 761 The Multiplier Effect 761 The Multiplier Effect at Work 762 Changes in the MPC Affect the Multiplier Process 763 The Multiplier and the Aggregate Demand Curve 763 Tax Cuts and the Multiplier 763 Taxes and Investment Spending 764 A Reduction in Government Purchases and Tax Increases 765 Time Lags, Saving, and Imports Reduce the Size of the Multiplier 765 26.4 Supply-Side Effects of Tax Cuts 766 What Is Supply-Side? 766 Impact of Supply-Side Policies 766 The Laffer Curve 767 Research and Development and the Supply Side of the Economy 768 How Do Supply-Side Policies Affect Long-Run Aggregate Supply? 768 Critics of Supply-Side Economics 768 The Supply-Side and Demand-Side Effects of a Tax Cut 769 26.5 Possible Obstacles to Effective Fiscal Policy 774 The Crowding-Out Effect 774 Time Lags in Fiscal Policy Implementation 775 26.6 Automatic Stabilizers 778 Automatic Stabilizers 778 How Do the Tax System and Transfer Payments Stabilize the Economy? 778 26.7 The National Debt 779 Fiscal Stimulus Affects the Budget 779 How Government Finances the Debt 779 Why Run a Budget Deficit? 780 An Increase in the Budget Deficit: Short-Run and Long-Run Effects 781 The Burden of Public Debt 782 Interactive Chapter Summary 784 Key Terms and Concepts 786 Section Check Answers 786 Study Guide 789 CHAPTER 27 CHAPTER 26 Fiscal Policy 754 26.1 Fiscal Policy 755 Fiscal Policy 755 Fiscal Stimulus Affects the Budget 755 The Government and Total Spending 755 52270_00_fm_pi-xxx.indd xiv Monetary Institutions 797 27.1 What Is Money? 798 The Functions of Money 798 27.2 Measuring Money 801 Currency 801 Currency as Legal Tender 802 10/20/09 2:45:22 PM xv Table of Contents Demand Deposits and Other Checkable Deposits 802 The Popularity of Demand Deposits and Other Checkable Deposits 802 Credit Cards 803 Savings Accounts 803 Money Market Mutual Funds 804 Stocks and Bonds 804 Liquidity 804 The Money Supply 804 How Was Money “Backed”? 804 What Really Backs Our Money Now? 805 27.3 How Banks Create Money 807 Financial Institutions 807 The Functions of Financial Institutions 807 How Do Banks Create Money? 807 How Do Banks Make Profits? 807 Reserve Requirements 808 Fractional Reserve System 808 A Balance Sheet 808 The Required Reserve Ratio 809 Loaning Excess Reserves 810 Is More Money More Wealth? 812 27.4 The Money Multiplier 813 The Multiple Expansion Effect 813 New Loans and Multiple Expansions 813 The Money Multiplier 813 Why Is It Only “Potential” Money Creation? 814 27.5 The Collapse of America’s Banking System, 1920–1933 815 What Happened to the Banking Industry? 815 What Caused the Collapse? 815 Bank Failures Today 816 Interactive Chapter Summary 817 Key Terms and Concepts 818 Section Check Answers 818 Study Guide 821 CHAPTER 28 The Federal Reserve System and Monetary Policy 826 28.1 The Federal Reserve System 827 The Functions of a Central Bank 827 Location of the Federal Reserve System 827 The Fed’s Relationship to the Federal Government 828 The Fed’s Ties to the Executive Branch 828 Fed Operations 829 28.2 How Does the Federal Reserve Change the Money Supply? 830 Open Market Operations 830 The Reserve Requirement 831 The Discount Rate 831 How the Fed Reduces the Money Supply 832 How the Fed Increases the Money Supply 832 Difficulties in Controlling the Money Supply 833 52270_00_fm_pi-xxx.indd xv 28.3 Money, Interest Rates, and Aggregate Demand 833 The Money Market 833 The Demand for Money and the Nominal Interest Rate 834 Why Is the Supply of Money Relatively Inelastic? 835 The Money Market 835 How Do Income Changes Affect the Equilibrium Position? 836 How 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? 838 Does the Fed Influence the Real Interest Rate in the Short Run? 839 28.4 Expansionary and Contractionary Monetary Policy 842 Expansionary Monetary Policy in a Recessionary Gap 842 Contractionary Monetary Policy in an Inflationary Gap 842 Monetary Policy in the Open Economy 843 28.5 Money and Inflation 847 The Inflation Rate and the Growth in the Money Supply 848 The Equation of Exchange 848 28.6 Problems in Implementing Monetary and Fiscal Policy 850 Problems in Conducting Monetary Policy 850 How Do Commercial Banks Implement the Fed’s Monetary Policies? 850 Banks That Are Not Part of the Federal Reserve System and Policy Implementation 851 Fiscal and Monetary Coordination Problems 851 Alleviating Coordination Problems 851 Imperfect Information 852 Overall Problems with Monetary and Fiscal Policy 852 Interactive Chapter Summary 854 Key Terms and Concepts 856 Section Check Answers 856 Study Guide 860 CHAPTER 29 Issues in Macroeconomic Theory and Policy 869 29.1 The Phillips Curve 870 Unemployment and Inflation 870 The Phillips Curve 870 The Slope of the Phillips Curve 870 The Phillips Curve and Aggregate Supply and Demand 871 10/20/09 2:45:22 PM xvi Table of Contents 29.2 The Phillips Curve over Time 872 The Phillips Curve—The 1960s 872 Is the Phillips Curve Stable? 872 The Short-Run Phillips Curve Versus the Long-Run Phillips Curve 873 Supply Shocks 875 29.3 Rational Expectations and Real Business Cycles 877 Can Human Behavior Counteract Government Policy? 877 The Rational Expectations Theory 877 Rational Expectations and the Consequences of Government Macroeconomic Policies 878 Anticipation of an Expansionary Monetary Policy 878 Unanticipated Expansionary Policy 879 When an Anticipated Expansionary Policy Change Is Less Than the Actual Policy Change 880 Critics of Rational Expectations Theory 880 New Keynesians and Rational Expectations 881 What Is the Real Business Cycle Theory? 881 29.4 Controversies in Macroeconomic Policy 883 Are Fiscal and Monetary Policies Effective? 883 Policy Difficulties with Supply Shocks 884 What Should the Central Bank Do? 885 Inflation Targeting 885 Indexing and Reducing the Costs of Inflation 888 Interactive Chapter Summary 890 Key Terms and Concepts 892 Section Check Answers 892 Study Guide 895 Part 9 THE GLOBAL ECONOMY CHAPTER 30 International Trade 906 30.1 The Growth in World Trade 907 Importance of International Trade 907 Trading Partners 907 30.2 Comparative Advantage and Gains from Trade 908 Economic Growth and Trade 908 The Principle of Comparative Advantage 908 Comparative Advantage, Specialization, and the Production Possibilities Curves 910 Regional Comparative Advantage 913 30.3 Supply and Demand in International Trade 917 The Importance of Trade: Producer and Consumer Surplus 917 Free Trade and Exports—Domestic Producers Gain More Than Domestic Consumers Lose 918 Free Trade and Imports—Domestic Consumers Gain More Than Domestic Producers Lose 922 52270_00_fm_pi-xxx.indd xvi 30.4 Tariffs, Import Quotas, and Subsidies 923 Tariffs 923 The Domestic Economic Impact of Tariffs 923 Arguments for Tariffs 925 Import Quotas 926 The Domestic Economic Impact of an Import Quota 926 The Economic Impact of Subsidies 926 Interactive Chapter Summary 932 Key Terms & Concepts 933 Section Check Answers 934 Study Guide 936 CHAPTER 31 International Finance 943 31.1 The Balance of Payments 944 Balance of Payments 944 The Current Account 944 The Capital Account 947 31.2 Exchange Rates 948 The Need for Foreign Currencies 948 The Exchange Rate 948 Changes in Exchange Rates Affect the Domestic Demand for Foreign Goods 948 The Demand for a Foreign Currency 948 The Supply of a Foreign Currency 949 Determining Exchange Rates 949 The Demand Curve for a Foreign Currency 949 The Supply Curve for Foreign Currency 950 Equilibrium in the Foreign Exchange Market 950 31.3 Equilibrium Changes in the Foreign Exchange Market 951 Determinants in the Foreign Exchange Market 951 Increased Tastes for Foreign Goods 951 Relative Income Increases or Reductions in U.S. Tariffs 951 European Incomes Increase, Reductions in European Tariffs, or Changes in European Tastes 952 How Do Changes in Relative Real Interest Rates Affect Exchange Rates? 953 Changes in the Relative Inflation Rate 953 Expectations and Speculation 954 31.4 Flexible Exchange Rates 956 The Flexible Exchange Rate System 956 Are Exchange Rates Managed at All? 956 When Exchange Rates Change 957 The Advantages of Flexible Rates 957 Fixed Exchange Rates Can Result in Currency Shortages 957 Flexible Rates Solve the Currency Shortage Problem 958 Flexible Rates Affect Macroeconomic Policies 958 The Disadvantages of Flexible Rates 958 Interactive Chapter Summary 963 Key Terms and Concepts 964 Section Check Answers 964 Study Guide 967 10/20/09 2:45:22 PM 2 The Economic Way of Thinking 2.1 Scarcity ives Ma 2.4 Incentives Matter 2.2 Choices, Costs, and Trade-Offs alization aand Trade 2.5 Specialization 2.3 Marginal Thinking ets and Im ro ed Efficien 2.6 Markets Improved Efficiency Studying economics may teach you how to velo “think better,” because economics helps develop lem a disciplined method of thinking about problems. A student of economics becomes aware that, at a basic level, much of economic life involves choosing one course of action rather than another— making choices among our conflicting wants and desires in a world of scarcity. Economics provides insights about how to intelligently evaluate these options and determine the most appropriate choices in given situations. Most of economics 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. c The basic ideass that you learn in this chapter will occur repeatedly throughout the text. If you nding of these principles develop a good understanding ving skills inhe and master the problem-solving inherent in them, they will serve you well for the rest of onomist your life. Learning to think like an economist takes time. Like most disciplines, economics has its own specialized vocabulary, including such terms as elasticity, comparative advantage, supply and demand, deadweight loss, and consumer surplus. Learning economics requires more than picking up this new terminology; however, it also involves using its powerful tools to improve your understanding of a whole host of issues in the world around you. ■ 36 52270_02_ch02_p036-065.indd 36 11/6/09 5:39:52 AM Chapter 2 SECTION 2.1 The Economic Way of Thinking 37 Scarcity n What are goods and services? n What are tangible and intangible goods? n What are economic goods? Scarcity conomics 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 All the things you see here—grass, trees, rocks, be rare, but if it is not desirable, it is not scarce. You animals—are considered land to economists. won’t find many baseball cards of my son (rare)— about 10—but at the same time, few people outside of the immediate family scarcity Capital is the equipment and strucwant one. Therefore, the card is rare exists when human wants tures used to produce goods and ser(material and nonmaterial) but not scarce. However, if he becomes vices. Office buildings, tools, machines, exceed available resources a major league star, those cards could and factories are all considered capital become scarce—rare and desirable. labor goods. When we invest in factories, the physical and human machines, research and development, effort used in the production or education, we increase the potential of goods and services to create more goods and services in land the future. Capital also includes human the natural resources used in capital—the productive knowledge and he scarce resources used in the prothe production of goods and skill people receive from education and duction of goods and services can services on-the-job training. be grouped into four categories: labor, capital Entrepreneurship is the process land, capital, and entrepreneurship. the equipment and of combining labor, land, and capiLabor is the total of both physical structures used to produce tal to produce goods and services. and mental effort expended by people goods and services Entrepreneurs make the tough and risky in the production of goods and services. human capital decisions about what and how to proThe services of a teacher, nurse, costhe productive knowledge duce goods and services. Entrepreneurs metic surgeon, professional golfer, and and skill people receive are always looking for new ways to an electrician all fall under the general from education, on-theimprove production techniques or to category of labor. job training, health, and create new products. They are lured by Land includes the “gifts of nature” other factors that increase the chance of making a profit. It is this or the natural resources used in the productivity opportunity to make a profit that leads production of goods and services. entrepreneurship entrepreneurs to take risks. Economists consider land to include the process of combining However, not every entrepreneur trees, animals, water, minerals, and so labor, land, and capital to is a Bill Gates (Microsoft) or a Henry on, along with the physical space we produce goods and services Ford (Ford Motor Company). In some normally think of as land. COURTESY OF ROBERT L. SEXTON E Scarcity and Resources T 52270_02_ch02_p036-065.indd 37 11/6/09 5:39:52 AM 38 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? PART 1 Introduction 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 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 charitable 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. oods are the items that we value or desire. Goods tend to be tangible— economic goods objects that can be seen, held, heard, scarce goods created from scarce tasted, or smelled. But other goods resources—goods that are that we cannot reach out and touch desirable but limited in supply are called intangible goods. Intangible bads goods include fairness for all, friendship, items that we do not desire or leisure, knowledge, security, prestige, want, where less is preferred respect, and health. to more, like terrorism, smog, Services are intangible acts for which or poison oak. people are willing to pay, such as legal counsel, medical care, and education. Services are intangible because they are less overtly visible, but they are certainly no less valuable than goods. All goods and services, whether tangible or intane all face scarcity because we cannot have all gible, are produced from scarce resources and can be the goods and services we desire. However, subjected to economic analysis. Scarce goods created because we all have different wants and desires, 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 competition for the available goods and services, a subject we will return to often in the text. G Does Everyone Face Scarcity? © STEVE DIPAOLA/REUTERS/CORBIS W What Are Bads? n contrast to goods, bads are those items that we do not desire or want. For most people, garbage, pollution, weeds, and crime are bads. People tend to eliminate or minimize bads, so they will often pay to have bads, like garbage, removed. The elimination of the bad—garbage removal, for example—is a good. I Are Those Who Want More Greedy? e all want more tangible and intangible goods and services. In economics, we assume that more goods lead to greater satisfaction. However, just W 52270_02_ch02_p036-065.indd 38 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.” 11/6/09 5:39:53 AM Chapter 2 The Economic Way of Thinking scarcity affects everyone differently. For example, a child in a developing country may face a scarcity of food and clean drinking water, while a rich man may face a scarcity of garage space for his growing antique car collection. Likewise, a harried middle-class working mother may find time for exercise particularly scarce, while a pharmaceutical company may be concerned with the scarcity of the natural resources it uses in its production process. Its effects may vary, but no one can escape scarcity. We often hear it said of rich people that “He has everything” or “She can buy anything she wants.” Actually, even the richest person must live with scarcity and must, at some point, choose one want or desire over another. And of course, we all have only 24 hours in a day! The problem is that as we get more affluent, we learn of new luxuries to provide us with satisfaction. Wealth, then, creates a new set of wants to be satisfied. No evidence indicates that people would not find a valuable use for additional income, no matter SECTION 39 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? t 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. I CHECK 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 produce goods and services, and the productive knowledge and skill people receive from education and on-thejob 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? 52270_02_ch02_p036-065.indd 39 11/6/09 5:39:54 AM 40 PART 1 SECTION 2.2 Introduction Choices, Costs, and Trade-Offs 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? that is desirable, you must accept less of something else that you also value. For example, time spent exercising costs time that ach of us may want a nice home, two luxury could be spent doing something else that is valuable— cars, wholesome and good-tasting food, a perperhaps relaxing with friends or studying for an sonal trainer, and a therapist, all enjoyed in a pristine upcoming exam. One of the reasons drivers talk so environment with zero pollution. If we had unlimited much on their cell phones is because they have little else resources, and thus an ability to produce all the goods to do with their time while driving—a low opportunity and services everyone wants, we would not have to cost. However, drivers using cell phones should pay choose among those desires. However, we all face scarattention; otherwise, they are giving up safety. Tradecity, and as a consequence, we must make choices. If offs are everywhere. The famous poet, Robert Frost, we did not have to make meaningful economic choices, understood that to live is to choose. In his poem, “The the study of economics would not be necessary. The Road Not Taken,” he writes, “two roads diverged in a essence of economics is to understand fully the implicayellow wood, and sorry I could not travel both.” tions that scarcity has for wise decision making. 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 n a world of scarcity, we all face tradeopportunity cost Winfrey dropped out of Tennessee State offs. If you spend more time at work the value of the best forgone to pursue a career in broadcasting. At you might give up an opportunity to alternative that was not the early age of 19, she became the cogo shopping at the mall or watch your chosen anchor of the evening news. Staying in favorite TV show. Or when you decide school would have cost each of them how to spend your income, buying a millions of dollars. We cannot say it new car may mean you have to forgo a summer vacawould have been the wrong decision to stay in school; tion. Businesses have trade-offs too. If a farmer chooses but it would have been costly. Their opportunity cost to plant his land in cotton this year, he gives up the of staying in school was high. opportunity to plant his land in wheat. If a firm decides Scarcity Forces Us to Choose E Trade-Offs I 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 tradeoffs. For example, the federal government faces tradeoffs 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 very 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 E 52270_02_ch02_p036-065.indd 40 Money Prices and Costs If 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 parking 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 11/6/09 5:39:54 AM Chapter 2 The Economic Way of Thinking if you had to wait in line for six hours in the freezing cold? Waiting and enduring the cold are costs too. Seldom are costs just dollars and cents. Shopping at a large discount store may save you on the money price, but cost you time waiting in long checkout lines. Also, buying food in bulk quantities may be less expensive per ounce, but cost inventory space in your pantry, or the food may spoil before it is eaten. Remember that many costs do not involve money but are still costs. Do I major in economics or engineering? Do I go to Billy Madison University or Tech State University? Should I get an MBA now or work and wait a few years to go back to school? Policy makers are unavoidably faced with opportunity 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! 41 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? he 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? T The Opportunity Cost of Going to College or Having a Child he average person often does not correctly calculate opportunity costs. For example, the (opportunity) cost of going to college includes not just the direct expenses of tuition and books. Of course, those expenses do involve an opportunity cost because the money used for books and tuition could be used to buy other things that you value. But what about the nonmoney costs? That is, going to college also includes the opportunity cost of your time. Specifically, the time spent going to school is time that could have been spent on a job earning, say, $30,000 over the course of an academic year. What about room and board? That aspect is a little tricky because you would presumably have to pay room and board whether you went to college or not. The relevant question may be how much more it costs you to live at school rather than at home (and living at home may have substantial nonmoney costs). Even if you stayed at home, your parents would sacrifice something; they could rent your room out or use the room for some other purpose such as storage, guest room, home office, a sibling’s room, and so on. 52270_02_ch02_p036-065.indd 41 COURTESY OF ROBERT L. SEXTON T You may think tuition, room and board are expensive! Now add the opportunity cost of your time— perhaps working during those nine months. 11/6/09 5:39:54 AM 42 Introduction COURTESY OF ROBERT L. SEXTON PART 1 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. SECTION 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 society’s scarce resources, but one that the person receiving it does not have to pay for personally. CHECK 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? SECTION 2.3 Marginal Thinking n What do we mean by marginal thinking? n What is the rule of rational choice? Many Choices We Face Involve Marginal Thinking ome decisions are “all or nothing,” like whether to start a new business or go to work for someone else, or whether to attend graduate school or take S 52270_02_ch02_p036-065.indd 42 n Why do we use the word expected with marginal benefits and costs? 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 11/6/09 5:40:01 AM Chapter 2 The Economic Way of Thinking 43 study this semester but how much you study. You might respects, so the actual result of changing behavior may think to yourself, “If I studied a little more, I might be not always make people better off—but on average it able to improve my grade,” or “If I had a little better will. However, as a matter of rationality, people are concentration when I was studying, I could improve assumed to engage only in behavior that they think my grade.” That is, spending more time has an addiahead of time will make them better off. That is, inditional expected benefit (a higher grade) and an addividuals will only pursue an activity if their expected tional expected cost (giving up time to do something marginal benefits are greater than their expected marelse that is valuable, such as watching TV or sleeping). ginal costs of pursuing that activity one step further, These examples reflect what economists call marginal E(MB) > E(MC). thinking because the focus is on the additional, or marThis fairly unrestrictive and realistic view of indiginal, choices available to you. Or think of marginal viduals seeking self-betterment can be used to analyze as the edge—marginal decisions are made around the a variety of social phenomena. edge of what you are currently doing. Marginal choices Suppose that you have to get up for an 8 a.m. class involve the effects of adding or subtracting from the but have been up very late. When the alarm goes off current situation. In short, they are the small (or large) at 7 a.m. you are weighing the marginal benefits and incremental changes to a plan of action. marginal costs of an extra 15 minutes of sleep. If you Businesses are constantly engaged in marginal perceive the marginal benefits of 15 additional minthinking. For example, firms have to decide whethutes of sleep to be greater than the marginal costs of er the additional (marginal) revenue received from those extra minutes, you may choose to hit the snooze increasing production is greater than the marginal cost button. Or perhaps you may decide to blow off class of that production. completely. But it’s unlikely that you Always watch out for the difference will choose that action if it’s the day marginal thinking between average and marginal costs. of the final exam—because it is now focusing on the additional, or Suppose an airline had 10 unoccupied likely that the net benefits (the differmarginal, choices; marginal seats on a flight from Los Angeles to New ence between the expected marginal choices involve the effects of adding or subtracting, from York, and the average cost was $400 per benefits and the expected marginal the current situation, the seat (the total cost divided by the number costs) of skipping class have changed. small (or large) incremental of seats—$100,000/250). If 10 people When people have opportunities to changes to a plan of action are waiting on standby, each willing to make themselves better off they usually pay $300, should the airline sell them take them. And they will continue to rule of rational choice individuals will pursue an the tickets? Yes! The unoccupied seats seek those opportunities as long as they activity if the expected earn nothing for the airline. What are expect a net benefit from doing so. marginal benefits are the additional (marginal) costs of a few The rule of rational choice is simgreater than the expected more passengers? The marginal costs are ply the rule of being sensible, and most marginal costs minimal—slight wear and tear on the economists believe that individuals act net benefit airplane, handling some extra baggage, as if they are sensible and apply the rule the difference between the and 10 extra in-flight meals. In this case, of rational choice to their daily lives. It expected marginal benefits thinking at the margin can increase total is a rule that can help us understand and the expected marginal profits, even if it means selling at less our decisions to study, walk, shop, costs than the average cost of production. exercise, clean house, cook, and perAnother good example of marginal form just about every other action. thinking is an auction. Prices are bid up marginally as It is also a rule that we will continue to use the auctioneer calls out one price after another. When throughout the text. Because whether it is consumers, bidders view the new price (the marginal cost) to be producers, or policy makers, they all must compare the greater than the value they place on the good (the marexpected marginal benefits and the expected marginal ginal benefit), they withdraw from further bidding. cost to determine the best level to consume, produce, In trying to make themselves better off, people or provide public programs. alter their behavior if the expected marginal benefits from doing so outweigh the expected marginal costs, Zero Pollution Would Be Too Costly which is the rule of rational choice. Economic theory Let’s use the concept of marginal thinking to evaluate is often called marginal analysis because it assumes pollution levels. We all know the benefits of a cleaner that people are always weighing the expected marginal environment, but what would we have to give up—that benefits against the expected marginal costs. The term is, what marginal costs would we have to incur—to expected is used with marginal benefits and marginal achieve zero pollution? A lot! You could not drive a costs because the world is uncertain in many important 52270_02_ch02_p036-065.indd 43 11/6/09 5:40:08 AM 44 PART 1 Introduction ECONOMICS AND FOOTBALL: WEIGHING THE BENEFITS AND COSTS OF GOING FOR IT ON FOURTH DOWN 52270_02_ch02_p036-065.indd 44 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 successful 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. . . . MIKE BLAKE/REUTERS/LANDOV W ith just over five minutes to play in yesterday’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 specifically 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 calculations 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 calling, even fans usually don’t go as far as the economist 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. 11/6/09 5:40:08 AM Chapter 2 “It used to be that going for it on fourth down was the macho thing to do,” Romer said. But after his findings 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. 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. 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. © TIM McGUIRE/CORBIS 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 airbags would also alter behavior, because they change the driver’s incentives. Seat belts and airbags make accidents less costly, by reducing the chance of serious injury or death; thus they reduce the benefit to safe driving, causing some motorists to drive more recklessly. 52270_02_ch02_p036-065.indd 45 45 The Economic Way of Thinking car, fly in a plane, or even ride a bicycle, especially if everybody else were riding bikes, too (because congestion is a form of pollution). How would you get to school or work, or go to the movies or the grocery store? Everyone would have to grow their own food because transporting, storing, and producing food uses machinery and equipment that pollute. And even growing your own food would be a problem because many plants emit natural 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 Safety Like pollution, crime and safety can have optimal (or best) levels that are greater than zero. Take crime. What would it cost society to have zero crime? It would be prohibitively costly to divert a tremendous amount of our valuable resources toward the complete elimination of crime. In fact, it would be impossible to eliminate crime totally. Even reducing crime 11/6/09 5:40:12 AM 46 PART 1 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, optimal 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 willing to take. Additional safety can only come at higher costs. To make all products perfectly safe would be impossible, so we must weigh the benefits and costs SECTION Introduction 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 driving and more accidents. The safety regulations did result in fewer deaths per automobile accident, but the total number of deaths remained unchanged because more accidents occurred. Reckless driving has a benefit in the form of getting somewhere more quickly, but it can also have a 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. CHECK 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? 52270_02_ch02_p036-065.indd 46 11/6/09 5:40:13 AM Chapter 2 SECTION 2.4 The Economic Way of Thinking 47 Incentives Matter n Can we predict how people will respond to changes in incentives? n What are positive incentives? n What are negative incentives? People Respond to Changes in Incentives ecause 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. STEPHEN SHAVER/UPI/LANDOV B Positive and Negative Incentives A subsidy on hybrid electric vehicles would be a lmost all of economics can be reduced to incenpositive incentive that would encourage greater tive [E(MB) versus E(MC)] stories, where conproduction and consumption of these vehicles. sumers and producers are driven by incentives that A wide variety of incentives are offered at the affect expected costs or benefits. Prices, wages, federal, state, and local levels to encourage the profits, taxes, and subsidies are all examples of ecoexpanded use of alternative-fuel vehicles. 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, Because most people seek opportunities that make either reduce benefits or increase costs, resulting in a them better off, we can predict what will happen when decreased level of the related activity or behavior. For incentives are changed. If salaries increase for engineers example, a tax on cars that emit lots of and decrease for MBAs, we would prepollution (an increase in costs) would dict fewer people would go to graduate positive incentive be a negative incentive that would lead school in business and more would go an incentive that either reduces costs or increases benefits, to a reduction in emitted pollution. On into engineering. A permanent change to resulting in an increase in an the other hand, a subsidy (the opposite a much higher price of gasoline would activity or behavior of a tax) on hybrid cars—part electric, lead us to expect fewer gas guzzlers on part internal combustion—would be a the highway. People who work on comnegative incentive positive incentive that would encouran incentive that either mission tend to work harder. If the price increases costs or reduces age greater production and consumpof downtown parking increased, we benefits, resulting in a tion of hybrid cars. Human behavior is would predict that commuters would decrease in the activity or influenced in predictable ways by such look for alternative methods to get to behavior changes in economic incentives, and work that would save money. If houseeconomists use this information to preholds were taxed to conserve water dict what will happen when the benefits and costs of economists would expect people to use less water and any choice are changed. In short, economists study the substantially less water than if they were simply asked incentives and consequences of particular actions. to conserve water. Incentives matter. A 52270_02_ch02_p036-065.indd 47 11/6/09 5:40:13 AM 48 in the news PART 1 Introduction Incentives Matter Estonia’s Total Fertility Rate Increasing in Part Because of Government Program Encouraging Women to Give Birth stonia’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 population 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 fastestshrinking 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 counseling 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. 52270_02_ch02_p036-065.indd 48 COURTESY OF ROBERT L. SEXTON E 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 predict 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. 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. 11/6/09 5:40:25 AM Chapter 2 SECTION The Economic Way of Thinking 49 CHECK 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? SECTION 2.5 Specialization and Trade n What is the relationship between opportunity cost and specialization? n What are the advantages of specialization in production? specialization. For example, we may specialize in selling or fixing automobiles. The wages from that work can then be used to buy goods from a farmer who s you look around, you can see that people spehas chosen to specialize in the production of food. cialize in what they produce. They tend to dediLikewise, the farmer can use the money earned from cate their resources to one primary activity, whether it selling his produce to get his tractor be child rearing, driving a cab, or makfixed by someone who specializes in that specializing ing bagels. Why? The answer, short and activity. concentrating in the production simple, is opportunity costs. By concenSpecialization is evident not only of one, or a few, goods trating their energies on only one, or a among individuals but among regions few, activities, individuals are specialcomparative advantage and countries as well. In fact, the story of izing. This focus allows them to make occurs when a person or the economic development of the United country can produce a the best use of (and thus gain the most States and the rest of the world involves good or service at a lower benefit from) their limited resources. A opportunity cost than others specialization. Within the United States, person, a region, or a country can gain the Midwest with its wheat, the coastal by specializing in the production of the waters of the Northeast with its fishgood in which they have a comparaing fleets, and the Northwest with its timber are each tive advantage. That is, if they can produce a good or examples of regional specialization. service at a lower opportunity cost than others, we say Why Do People Specialize? A that they have a comparative advantage in the production of that good or service. The Advantages of Specialization We All Specialize e all specialize to some extent and rely on others to produce most of the goods and services we want. The work that we choose to do reflects our W 52270_02_ch02_p036-065.indd 49 n a small business, every employee usually performs a wide variety of tasks—from hiring to word processing 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 I 11/6/09 5:40:31 AM 50 PART 1 Introduction pecialization 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 comparative 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 outfield. 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 advantage over Mariah in the infield and outfield? It would be best to play Mariah in the infield because she is S primary advantages of specialization are that employees acquire greater skill from repetition, they avoid wasted time in shifting from one task to another, and they do the types of work for which they are best suited—and specialization promotes the use of specialized equipment for specialized tasks. The advantages of specialization are seen throughout the workplace. For example, in larger firms, specialists conduct personnel relations, and accounting is in the 52270_02_ch02_p036-065.indd 50 just a little worse than Jessica in the infield and a lot worse than Jessica in the outfield. Remember, comparative advantage is a relative concept. Finally, why did hitters put up higher batting 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 specialization. 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 different 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. MCT/LANDOV SPECIALIZATION, COMPARATIVE ADVANTAGE, AND BASEBALL 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 traffic patterns, income levels, demographics, and so on. 11/6/09 5:40:31 AM Chapter 2 51 The Economic Way of Thinking COMPARATIVE ADVANTAGE 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? Specialization and Trade Lead to Greater Wealth and Prosperity rade, 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 products that others produce at a lower opportunity cost. That is, we trade with others because it frees up time and resources to do other things that we do better. In short, if we divide tasks and produce what we do relatively best and trade for the rest, we will be better off than if we were self-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 coffee than is the United States. The United States and Brazil would each benefit if the United States produces wheat and trades some of it to Brazil for coffee. Coffee growers T SECTION 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 assistant to type her documents, because the administrative assistant has the comparative advantage (lowest opportunity cost) in this case, despite being half as good in absolute terms. in the United States could grow coffee in expensive greenhouses, but it would result in higher coffee costs and prices, while leaving fewer resources available for employment in more beneficial jobs, such as wheat production. 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 voluntary 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 countries can supply their natural and human resources. Rich countries can supply their know-how. When these are combined, everyone can be better off. The 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 specialization and trade, a country can gain a greater variety of goods and services at a lower cost. So while counties may be competitors inn the global market they are also partners. CHECK 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) 52270_02_ch02_p036-065.indd 51 11/6/09 5:40:33 AM 52 PART 1 Introduction 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 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? 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. SECTION Markets and Improved Efficiency 2.6 n n n n How does a market economy allocate scarce resources? What are the important signals that market prices communicate? What are the effects of price controls? What is a market failure? How Does the Market Work to Allocate Resources? 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. n a world of scarcity, competition is inescapable, and one method of allocating resources among competing uses is the market economy. The market economy provides a way for 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 arket prices communicate important informaas large as possible. tion to both buyers and sellers. These prices Competitive markets are powerful—they can make communicate information about the relative availexisting products better and/or less expensive, they ability of products to buyers, and they provide sellcan improve production processes, and they can create ers with critical information about the new products, from video games to liferelative value that consumers place on saving drugs. Buyers and sellers indiefficiency those products. In short, buyers look at cate their wants through their action when an economy gets the price and decide how much they are and inaction in the marketplace, and the most out of its scarce willing and able to demand and sellers it is this collective “voice” that deterresources look at the price and decide how much mines how resources are allocated. But they are able and willing to supply. The how is this information communicated? market price reflects the value a buyer places on a Market prices serve as the language of the market sysgood and the cost to society of producing that good. tem. By understanding what these market prices mean, Thus, market prices provide a way for both buyers you can get a better understanding of the vital function and sellers to communicate about the relative value of that the market economy performs. resources. To paraphrase Adam Smith, prices adjust Markets may not always lead to your desired tastes like an “invisible hand” to direct buyers and sellers to and preferences. You may think that markets produce an outcome that is socially desirable. We will see how too many pet rocks, chia pets, breast enhancements, this works beginning in Chapter 4. and face lifts. Some markets are illegal—the market for I Market Prices Provide Important Information M 52270_02_ch02_p036-065.indd 52 11/6/09 5:40:33 AM Chapter 2 The Economic Way of Thinking 53 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 disovernment policies called price controls sometribute them. times force prices above or below what they Take something as simple as the production of a would be in a market economy. Unfortunately, these pencil. Where did the wood come from? Perhaps the controls often impose harm on the same people Northwest or Georgia. The graphite may have come they are trying to help, in large part from the mines in Michigan and the rubby short-circuiting the market’s inforber may be from Malaysia. The paint, price controls mation-transmission function. That is, the glue, the metal piece that holds the government-mandated minimum or maximum prices price controls effectively strip the mareraser—who knows? The point is that ket price of its meaning for both buyers market forces coordinated this producmarket failure and sellers (as we will see in Chapter 5). tion activity among literally thousands when the economy fails to A sales tax also distorts price signals, of people, some of whom live in different allocate resources efficiently leading to a misallocation of resources on its own countries and speak different languages. (as we will see in Chapter 6). 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 he market mechanism is a simple but effective millions of goods and services around the world, from and efficient general means of allocating resourcautomobiles and computers to pencils and paper clips. es among alternative uses. When the economy fails The same is true of the IPod and IPhone. The to allocate resources efficiently on its own, however, entrepreneur of Apple have learned how to combine it is known as market failure. For example, a steel almost 500 generic parts to make something of much mill might put soot and other forms of “crud” into greater value. The whole is greater than the sum of the air as a by-product of making steel. When it does, the parts. What Effect Do Price Controls Have on the Market System? G Market Failure T COUNTRIES THAT DO NOT RELY ON A MARKET SYSTEM 52270_02_ch02_p036-065.indd 53 AP IMAGES C ountries 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-quality 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 transportation 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.” 11/6/09 5:40:33 AM PART 1 COURTESY OF ROBERT L. SEXTON 54 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. it imposes costs on others not connected with using or producing steel from the steel mill. The soot may require homeowners to paint their homes more often, entailing a cost. And studies show that respiratory diseases are greater in areas with more severe air pollution, imposing costs that may even include life itself. In addition, the steel mill might discharge chemicals into a stream, thus killing wildlife and spoiling recreational activities for the local population. In this case, the steel factory does not bear the costs of its polluting actions, and it continues to emit too much pollution. In other words, by transferring the pollution costs onto society, the firm lowers its costs of production and so produces more than the ideal 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 participating 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, 52270_02_ch02_p036-065.indd 54 Introduction 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 example, the only regional cement company in the area has the ability to charge a higher price and provide lowerquality services than if the company were in a highly competitive market. In this case, the lack of competition can lead to higher prices and reduced product quality. And without adequate information, unscrupulous producers may be able to misrepresent their products to the disadvantage of unwary consumers. 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 market rewards those that produce goods and services that others are willing and able to buy. But this does not guarantee a “fair” or equal 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 Solution However, just because the government could improve the situation does not mean it will. After all, the political process has its own set of problems, such as special interests, shortsightedness, and 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 government failure as well as market failure. 11/6/09 5:40:36 AM Chapter 2 SECTION 55 The Economic Way of Thinking CHECK 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? Interactive 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 _____________. 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. 5. Entrepreneurs are always looking for new ways to improve _____________ or _____________. They are lured by the chance of making a _____________. 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. 6. _____________ goods include fairness, friendship, knowledge, security, and health. 18. In acting rationally, people respond to _____________. 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 _____________. 52270_02_ch02_p036-065.indd 55 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 11/6/09 5:40:38 AM 56 PART 1 Introduction 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. 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 production of that good or service. 23. The primary advantages of specialization are that employees acquire greater _____________ from repetition, 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 market system. They communicate information about the ____________ to buyers, and they provide sellers with 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 scientific research. 29. Sometimes a painful trade-off exists between how much an economy can produce _____________ and how that output is _____________. 30. In the case of market _____________, appropriate government 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 Key Terms and Concepts scarcity 37 labor 37 land 37 capital 37 human capital 37 entrepreneurship 37 goods 38 tangible goods 38 intangible goods 38 services 38 economic goods 38 bads 38 opportunity cost 40 marginal thinking 43 rule of rational choice 43 net benefit 43 positive incentive 47 negative incentive 47 specializing 49 comparative advantage 49 efficiency 52 price controls 53 market failure 53 Section Check Answers 2.1 Scarcity 1. What must be true for something to be an economic good? An economic good, tangible or intangible, is any good or service that we value or desire. This definition includes the reduction of things we don’t want—bads— as a good. 52270_02_ch02_p036-065.indd 56 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. 11/6/09 5:40:38 AM Chapter 2 The Economic Way of Thinking 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 abilities, 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 different 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, citizens’ 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 unlimited resources, because we would then be able to produce 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 opportunity to pursue other valued alternatives with the same time or resources. 52270_02_ch02_p036-065.indd 57 57 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 production 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 lucrative 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 experienced 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 something 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 11/6/09 5:40:38 AM 58 PART 1 could be restated as: People will make choices for which net benefits are expected to be positive. 4. Why does rational choice involve expectations? Because the world is uncertain in many important respects, we can seldom know for certain whether the marginal benefits of an action will in fact exceed the marginal costs. Therefore, the rule of rational choice deals with expectations decision makers hold at the time they make their decisions, recognizing that mistakes can be made. 5. 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 expectations 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 benefits or increase costs of an action, discouraging the action. 52270_02_ch02_p036-065.indd 58 Introduction 2. According to the rule of rational choice, would you do more or less of something if its expected marginal benefits increased? Why? You would do more of something if its expected marginal benefits increased, because then the 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 marginal 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 counter, 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 misbehavior 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 parents let their children eat dessert first, they would often not eat the food that was “good for them.” But by adding the benefit of getting dessert to the choice of eating their other food, parents can often get their children to eat the rest of their dinner, too. 2.5 Specialization and Trade 1. Why do people specialize? People specialize because by concentrating their energies 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 advantage in producing a good or service when it can produce it at a lower opportunity cost than other persons, regions, or countries. 11/6/09 5:40:38 AM Chapter 2 The Economic Way of Thinking 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 consume, more than we could otherwise from our scarce resources. 4. If you can mow your lawn in half the time it takes your spouse or housemate to do it, do you have a comparative advantage in mowing the lawn? Your faster speed at mowing the lawn does not establish 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 dishes. Therefore, an increase in your productivity doing yard chores would increase the opportunity cost of doing the dishes, and could well eliminate your current comparative advantage in doing the dishes compared to other members of your family. 6. Could a student who gets a C in one class but a D or worse in everything else have a comparative advantage over someone who gets a B in that class but an A in 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 52270_02_ch02_p036-065.indd 59 59 if the B student gets As in other classes, she is relatively, 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 producers 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 relative availability of products to consumers; the prices consumers are willing to pay communicate the relative value consumers place on products to producers. That is, market prices provide a way for both consumers and suppliers to communicate about the relative value of resources. 4. How do price controls undermine the market as a communication device? Price 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 efficiently. Such situations, called market failures, represent situations such as externalities, where costs can be imposed on some individuals without their consent (e.g., from dumping “crud” in their air or water), where information in the market may not be communicated honestly and accurately, and where firms may have market power to distort prices in their favor (against consumers’ interests). 11/6/09 5:40:38 AM CHAPTER 2 STUDY GUIDE 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 wellbeing 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. 60 52270_02_ch02_p036-065.indd 60 11/6/09 5:40:38 AM 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. 61 52270_02_ch02_p036-065.indd 61 11/6/09 5:40:38 AM 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 62 52270_02_ch02_p036-065.indd 62 11/6/09 5:40:38 AM 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 63 52270_02_ch02_p036-065.indd 63 11/6/09 5:40:38 AM 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 arrangements to leave your organs to your local organ bank? Would you do so if you could receive $50,000 for them? 13. Throughout history, many countries have chosen the path of autarky, choosing to not trade with other countries. Explain why this path would make a country poorer. 14. Farmer Fran can grow soybeans and corn. She can grow 50 bushels of soybeans or 100 bushels of corn on an acre of her land for the same cost. The price of soybeans is $1.50 per bushel and the price of corn is $0.60 per bushel. Show the benefits to Fran of specialization. What should she specialize in? 15. Which region has a comparative advantage in the following goods: a. wheat: Colombia or the United States? b. coffee: Colombia or the United States? 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 64 52270_02_ch02_p036-065.indd 64 11/6/09 5:40:38 AM 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. 65 52270_02_ch02_p036-065.indd 65 11/6/09 5:40:39 AM 2 SUPPLY AND DEMAND PART Chapter 4 Supply and Demand 92 Chapter 5 Bringing Supply and Demand Together 121 Chapter 6 Elasticities 151 91 52270_04_ch04_p091-120.indd 91 11/6/09 6:03:11 AM 4 Supply and Demand 4.1 Markets 4.4 Supply 4.2 Demand 4.5 Shifts in the Supply Curve 4.3 Shifts in the Demand Curve 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. However, if Carlyle was hinting at the importance of supply and demand, he was right on target. 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 tomorrow. In this chapter, we begin with an introduction to markets. Every market has a demand side and a supply side. Buyers represent the demand side of the market and sellers represent the supply 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. ■ 92 # 102882 Cust: 52270_04_ch04_p091-120.indd 92 Cengage Learning Au: Sexton Pg. No. 92 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE 11/6/09 Publishing Services 6:03:24 AM Chapter 4 SECTION 4.1 93 Supply and Demand Markets n What is a market? n Why is it so difficult to define a market? Defining a Market lthough 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 market conditions under which the process of buyers and sellers exchanging the exchange between goods and services 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 securities 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. AP IMAGES 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. Cust: Cengage Learning Au: Sexton Pg. No. 93 Title: Exploring Economics: Pathways to Problem Solving PETER FOLEY/REUTERS/LANDOV A The stock market involves many buyers and sellers; and profit statements and stock prices are readily available. New information is quickly understood 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. For some goods, such as housing, markets are numerous 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, separate 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. # 10288293 52270_04_ch04_p091-120.indd Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 S4-CARLISLE Publishing Services 6:03:24 AM 94 PART 2 Supply and Demand competitive market is one in which a number of buyers and sellers are offera market where the many ing similar products, and no single he roles of buyers and sellers in buyers and sellers have little buyer or seller can influence the marmarkets are important. Buyers, as market power—each buyer’s ket price. That is, buyers and sellor seller’s effect on market a group, determine the demand side of ers have little market power. Because price is negligible the market. Buyers include the consummany markets contain a large degree of ers who purchase the goods and services competitiveness, the lessons of supply and the firms that buy inputs—labor, capital, and raw and demand can be applied to many different types materials. Sellers, as a group, determine the supply side of problems. of the market. Sellers include the firms that produce The supply and demand model is particularly useand sell goods and services and the resource owners ful in markets like agriculture, finance, labor, construcwho sell their inputs to firms—workers who “sell” tion, services, wholesale, and retail. their labor and resource owners who sell raw materials In short, a model is only as g ood as it explains and and capital. The interaction of buyers and sellers deterpredicts. The model of supply and demand is very good mines market prices and output—through the forces of at predicting changes in prices and quantities in many supply and demand. markets large and small. In the next few chapters, we focus on how sup- Buyers and Sellers competitive market T ply and demand work in a competitive market. A SECTION CHECK 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? SECTION 4.2 Demand n What is the law of demand? n What is an individual demand curve? n What is a market demand curve? The Law of Demand law of demand the quantity of a good or 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. service demanded varies ometimes observed behavior is so inversely (negatively) with its pervasive it is called a law—the price, ceteris paribus law of demand, for example. According to the law of demand, the quantity of a good or service demanded varies inversely (negatively) P ↑ ⇒ QD ↓ and with its price, ceteris paribus. More directly, the law S # 102882 Cust: 52270_04_ch04_p091-120.indd 94 Cengage Learning Au: Sexton Pg. No. 94 Title: Exploring Economics: Pathways to Problem Solving Server: _____ P ↓ ⇒ QD ↑ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE 11/6/09 Publishing Services 6:03:34 AM Chapter 4 95 Supply and Demand Individual Demand What Is a Market Demand Curve? An Individual Demand Schedule The individual demand schedule shows the relationship lthough we introduced the concept of the demand between the price of the good and the quantity demandcurve in terms of the individual, economists usued. For example, suppose Elizabeth enjoys drinking ally speak of the demand curve in terms of large groups coffee. How many pounds of coffee would Elizabeth of people—a whole nation, a community, or a trading be willing and able to buy at various prices during area. That is, to analyze how the market works, we will the year? At a price of $3 a pound, Elizabeth buys need to use market demand. As you know, every indi15 pounds of coffee over the course of a year. If the vidual has his or her demand curve for price is higher, at $4 per pound, she every product. The horizontal summing might buy only 10 pounds; if it is individual demand of the demand curves of many individuals schedule lower, say $1 per pound, she might is called the market demand curve. a schedule that shows the buy 25 pounds of coffee during the Suppose the consumer group is comrelationship between price year. Elizabeth’s demand for coffee for posed of Homer, Marge, and the rest and quantity demanded the year is summarized in the demand of their small community, Springfield, schedule in Exhibit 1. Elizabeth might individual demand curve and that the product is still coffee. The a graphical representation not be consciously aware of the amounts effect of price on the quantity of cofthat shows the inverse that she would purchase at prices other fee demanded by Marge, Homer, and relationship between price than the prevailing one, but that does the rest of Springfield is given in the and quantity demanded not alter the fact that she has a schedule demand schedule and demand curves in the sense that she would have bought market demand curve shown in Exhibit 3. At $4 per pound, the horizontal summation various other amounts had other prices Homer would be willing and able to buy of individual demand curves prevailed. It must be emphasized that 20 pounds of coffee per year, Marge would the schedule is a list of alternative posbe willing and able to buy 10 pounds, sibilities. At any one time, only one of the prices will and the rest of Springfield would be willing and able to prevail, and thus a certain quantity will be purchased. buy 2,970 pounds. At $3 per pound, Homer would be A By plotting the different prices and corresponding quantities demanded in Elizabeth’s demand schedule in Exhibit 1 and then connecting them, we can create 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. section 4.2 section 4.2 exhibit 2 Elizabeth’s Demand Schedule for Coffee exhibit 1 Price of Coffee (per pound) 5 4 10 3 15 2 20 1 25 Cust: Cengage Learning Au: Sexton Pg. No. 95 Title: Exploring Economics: Pathways to Problem Solving Elizabeth’s Demand Curve 4 3 2 1 0 5 10 15 20 25 Quantity of Coffee (pounds per year) Quantity of Coffee Demanded (pounds per year) $5 Elizabeth’s Demand Curve for Coffee $5 Price of Coffee (per month) An Individual Demand Curve The dots represent various quantities of coffee that Elizabeth would be willing and able to buy at different prices in a given period. The demand curve shows how the quantity demanded varies inversely with the price of the good when we hold everything else constant—ceteris paribus. Because of this inverse relationship between price and quantity demanded, the demand curve is downward sloping. # 10288295 52270_04_ch04_p091-120.indd Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 S4-CARLISLE Publishing Services 6:03:34 AM 96 PART 2 section 4.2 Supply and Demand Creating a Market Demand Curve exhibit 3 a. Creating a Market Demand Schedule for Coffee Quantity of Coffee Demanded (pounds per year) Price (per pound) ⴙ Homer Marge Rest of Springfield ⴙ Market Demand ⴝ $4 20 ⫹ 10 ⫹ 2,970 ⫽ 3,000 $3 25 ⫹ 15 ⫹ 4,960 ⫽ 5,000 b. Creating a Market Demand Curve for Coffee Marge 3 DHOMER 2 1 0 5 10 15 20 25 Quantity of Coffee (pounds per year) section 4.2 exhibit 4 $5 4 ⴙ 3 2 DMARGE 1 0 5 10 15 20 25 Quantity of Coffee (pounds per year) $5 4 ⴝ 3 2 DS 1 0 Price (per pound) ⴙ Price (per pound) Price (per pound) 4 Market Demand Rest of Springfield $5 Price (per pound) Homer $5 4 3 1 0 2,970 4,960 Quantity of Coffee (pounds per year) DM 2 3,000 5,000 Quantity of Coffee (pounds per year) A Market Demand Curve a. Market Demand Schedule for Coffee $5 4 3 2 1 $5 Quantity Demanded (pounds per year) Price (per pound) Price (per pound) b. Market Demand Curve for Coffee 1,000 3,000 5,000 8,000 12,000 4 Market Demand Curve 3 2 1 0 1 3 5 8 12 Quantity (thousands of pounds per year) 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. 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 Cengage Learning Au: Sexton Pg. No. 96 Title: Exploring Economics: Pathways to Problem Solving $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 # 102882 Cust: 52270_04_ch04_p091-120.indd 96 Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE 11/6/09 Publishing Services 6:03:34 AM Chapter 4 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 SECTION 97 Supply and Demand 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. CHECK 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? SECTION 4.3 Shifts in the Demand Curve 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? for one another. For example, an increase in the price of coffee might tempt some buyers to switch from buying coffee to buying tea or soft drinks. Understanding this relationship between price and quantity demanded is change in quantity so important that economists make a clear demanded distinction between it and the various a change in a good’s own other factors that can influence consumer price leads to a change in behavior. A change in a good’s own price quantity demanded, a move is said to lead to a change in quantity along a given demand curve demanded. That is, it “moves you along” A Change in Demand Versus a Change in Quantity Demanded onsumers are influenced by the prices of goods when they make their purchasing decisions. At lower prices, 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 C # 10288297 52270_04_ch04_p091-120.indd Cust: Cengage Learning Au: Sexton Pg. No. 97 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 S4-CARLISLE Publishing Services 6:03:35 AM 98 PART 2 Supply and Demand a given demand curve. The demand curve possible demand shifters are the prices change in demand is drawn under the assumption that all of related goods, income, number of the prices of related goods, other things are held constant, except the buyers, tastes, and expectations. We will income, number of buyers, price of the good. However, economists now look more closely at each of these tastes, and expectations know that price is not the only thing that variables. can change the demand for affects the quantity of a good that people a good; that is, a change in buy. The other factors that influence the one of these factors shifts the entire demand curve demand curve are called determinants of demand, and a change in these other factors shifts the entire demand curve. These determinants of demand are called demand shifters and they lead to n deciding how much of a good or service to buy, changes in demand. 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. n increase in demand shifts the demand curve The Prices of Related Goods I Shifts in Demand A to the right; a decrease in demand shifts the demand curve to the left, as shown in Exhibit 1. Some section 4.3 Price exhibit 1 Demand Shifts Increase in Demand Decrease in Demand D3 D1 D2 0 Quantity An increase in demand shifts the demand curve to the right. A decrease in demand shifts the demand curve to the left. Substitutes Substitutes 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 SUBSTITUTE GOODS Q A Can you describe the change we would expect to see in the demand curve for Sprite if the relative price for 7-Up increased significantly? If 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 Cengage Learning Au: Sexton Pg. No. 98 Title: Exploring Economics: Pathways to Problem Solving of one reduces purchases of the other. In Exhibit 2(a), we see that as the price of 7-Up increases—a movement 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). # 102882 Cust: 52270_04_ch04_p091-120.indd 98 Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE 11/6/09 Publishing Services 6:03:35 AM Chapter 4 section 4.3 exhibit 2 99 Supply and Demand Substititute Goods b. Market for Sprite Price of Sprite Price of 7-Up a. Market for 7-Up B P2 A P1 Demand 0 Q2 D1 0 Q1 Quantity of 7-Up D2 Quantity of Sprite curve). Many Coke drinkers may rise—a movement down along the demand substitutes switch to the new relatively lower curve for motorcycles. As more people an increase (decrease) in the priced Pepsi—causing a reduction buy motorcycles, they will demand more price of one good causes the in demand for Coca-Cola; shifting motorcycle helmets—the demand curve for demand curve for another the demand curve for Coca-Cola to motorcycle helmets shifts to the right. In good to shift to the right (left) the left. Alternatively, if there is an short, when goods are complements, the complements increase in the price of Pepsi, this more people buy of one good, the more an increase (decrease) in the causes a decrease in the quantity they will buy of the other. That is, if a price of one good shifts the demanded of Pepsi (a movement up decrease in the price of good A leads to an demand curve for another along the demand curve). At the new increase in the demand for good B, the two good to the left (right) higher price for Pepsi, many Pepsi goods are complements. Alternatively, if an drinkers will switch to the relatively lower priced increase in the price of good A leads to a decrease in the Coca-Cola—shifting the demand curve for Coca-Cola demand for good B, the two goods are complements. to the right. In this example, Pepsi and Coca-Cola are said to be substitutes. Complements Two goods are substitutes if an increase (a decrease) PGOOD A ↑ ⇒ ↓ DGOOD B in the price of one good causes the demand curve for another good to shift to the right (left)—a direct (or PGOOD A ↓ ⇒ ↑ DGOOD B positive) relationship. Substitutes Income PGOOD A ↑ ⇒ ↑ DGOOD B Complements Complements are goods that “go together,” often consumed and used simultaneously, such as skis and bindings, 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 motorcycles falls, the quantity of motorcycles demanded will Cust: Cengage Learning Au: Sexton Pg. No. 99 Title: Exploring Economics: Pathways to Problem Solving conomists have observed that generally the consumption of goods and services is positively related to the income available to consumers. Empirical studies support the notion that as individuals receive more income, they tend to increase their purchases of most goods and services. Other things held equal, rising income usually leads to an increase in the demand for goods (a rightward shift of the demand curve), and decreasing income usually leads to a decrease in the demand for goods (a leftward shift of the demand curve). E PGOOD A ↓ ⇒ ↓ DGOOD B # 10288299 52270_04_ch04_p091-120.indd Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 S4-CARLISLE Publishing Services 6:03:36 AM 100 PART 2 Supply and Demand COMPLEMENTARY GOODS Q A If the price of computers fell markedly, what do you think would happen to the demand for printers? If computers and printers are complements, the decrease in the price of computers will lead to more computers purchased (a movement down along section 4.3 exhibit 3 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 purchasing 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 P1 A B P2 b. Market for Printers Price of Printers Price of Computers a. Market for Computers Demand 0 Q1 Q2 Quantity of Computers D1 D2 0 Quantity of Printers Normal and Inferior Goods expensive. As incomes rise, many consumers may switch from buying beans to buying hamburgers. If demand for a good increases when incomes rise Hamburgers may be inferior too; as incomes rise still and decreases when incomes fall, the good is called further, consumers may substitute steak or chicken a normal good. Most goods are normal goods. for hamburger. The term inferior in this sense does Consumers will typically buy more CDs, clothes, not refer to the quality of the good in question but pizzas, and trips to the movies as their incomes rise. shows that demand decreases when income increases However, if demand for a good decreases when and demand increases when income decreases. So incomes rise or if demand increasbeans are inferior not because they are es when incomes fall, the good is low quality, but because you buy less of normal good called an inferior good. These goods them as income increases. if income increases, include inexpensive cuts of meat, secthe demand for a good Or, if people’s incomes rise and they ond-hand clothing, or retread tires, increases; if income increase their demand for movie tickets, which customers generally buy only decreases, the demand we say that movie tickets are a normal because they cannot afford more for a good decreases good. But if people’s incomes fall and expensive substitutes. As incomes they increase their demand for bus rides, inferior good rise, buyers shift to preferred subif income increases, we say bus rides are an inferior good. stitutes and decrease their demand the demand for a good Whether goods are normal or inferior, for the inferior goods. Suppose decreases; if income the point here is that income influences most individuals prefer hamburger decreases, the demand demand—usually positively, but someto beans, but low-income families for a good increases times negatively. buy beans because they are less # 102882 Cust: 52270_04_ch04_p091-120.indd 100 Cengage Learning Au: Sexton Pg. No. 100 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE 11/6/09 Publishing Services 6:03:36 AM Chapter 4 101 Supply and Demand Normal Good Income ↑ ⇒ Demand ↑ or new information about a defective and/or dangerous product, such as a baby’s crib, can reduce demand. Income ↓ ⇒ Demand ↓ Inferior Good Income ↑ ⇒ Demand ↓ Income ↓ ⇒ Demand ↑ Number of Buyers he 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 regarding a particular good or service, are usually vitally concerned 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. T Expectations ometimes 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. S Consumer’s Preferences and Information he 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 advertising 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 recreation 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 # 102882101 52270_04_ch04_p091-120.indd © MIKE PANIC ISTOCKPHOTO.COM T 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. Cust: Cengage Learning Au: Sexton Pg. No. 101 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 S4-CARLISLE Publishing Services 6:03:37 AM 102 PART 2 Supply and Demand NORMAL AND INFERIOR GOODS Q Chester 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? A Yes. Furniture is generally considered a normal good, so a rise in income will increase the exhibit 4 Normal and Inferior Goods Price of Furniture a. Rising Income and a Normal Good D1 D2 0 Quantity of High-Quality Furniture Changes in Demand Versus Changes in Quantity Demanded—Revisited conomists 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 E # 102882 Cust: 52270_04_ch04_p091-120.indd 102 b. Rising Income and an Inferior Good Price of Furniture section 4.3 demand for high-quality furniture, as shown in (a). However, if Chester sells unfinished, used, or lowquality 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). 0 D2 D1 Quantity of Low-Quality Furniture 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 cigarettes, 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 smoking, such as advertising bans and increasing consumer awareness of the harmful side effects of smoking— disease and death. Cengage Learning Au: Sexton Pg. No. 102 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE 11/6/09 Publishing Services 6:03:41 AM Price Possible Demand Shifters Price exhibit 5 0 D2 D2 0 Quantity Income increases (normal good) Price Quantity Price of complement falls or price of substitute rises Price 0 D1 D2 D1 D2 Quantity Increase in the number of buyers in the market D1 0 D1 Quantity Income increases (inferior good) Price D1 0 Price section 4.3 D1 D2 0 Quantity Taste change in favor of the good D2 Quantity Future price increase expected CHANGES IN DEMAND VERSUS CHANGES IN QUANTITY DEMANDED Q How 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. 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. section 4.3 Change in Demand Versus Change in Quantity Demanded exhibit 6 A A $10 Price of DVDs In 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 C B $5 A C Change in demand A B Change in quantity demanded D1 0 3 5 D2 8 Quantity of DVDs (per month) 103 # 102882103 52270_04_ch04_p091-120.indd Cust: Cengage Learning Au: Sexton Pg. No. 103 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 S4-CARLISLE Publishing Services 6:03:41 AM 104 PART 2 SECTION Supply and Demand CHECK 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 relationship 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? SECTION 4.4 Supply n What is the law of supply? n What is an individual supply curve? n What is a market supply curve? such as the cost of inputs or advances in technology. While behavior will vary among individual suppliers, economists expect that, other things n a market, the answer to the fundabeing equal, the quantity supplied law of supply mental question, “What do we produce, will vary directly with the price of the the higher (lower) the price and in what quantities?” depends on the of the good, the greater good, a relationship called the law of interaction of both buyers and sellers. (smaller) the quantity supply. According to the law of supDemand is only half the story. The willsupplied ply, the higher the price of the good ingness and ability of suppliers to provide (P), the greater the quantity supplied goods are equally important factors that (Q ), and the lower the price of the good, the smaller S must be weighed by decision makers in all societies. the quantity supplied. As with demand, the price of the good is an important The Law of Supply I factor. And just as with demand, factors other than the price of the good are also important to suppliers, # 102882 Cust: 52270_04_ch04_p091-120.indd 104 Cengage Learning Au: Sexton Pg. No. 104 Title: Exploring Economics: Pathways to Problem Solving Server: _____ P ↑ ⇒ QS ↑ and P ↓ ⇒ QS ↓ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE 11/6/09 Publishing Services 6:03:42 AM Chapter 4 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 105 Supply and Demand 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. irms 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 he market supply curve may be thought of as the $1 a pound, ceteris paribus? horizontal summation of the supply curves for When the price of coffee is low, the coffee business individual firms. The market supply is less profitable and less coffee will be curve shows how the total quanproduced. Some suppliers may even individual supply curve tity supplied varies positively with shut down, reducing their quantity a graphical representation the price of a good, while holding supplied to zero. that shows the positive constant all other factors that affect relationship between the how much producers are able and price and quantity supplied willing to supply. The market supmarket supply curve ply schedule, which reflects the total a graphical representation quantity supplied at each price by all of the amount of goods and of the coffee producers, is shown in services that suppliers are o illustrate the concept of an indiExhibit 2(a). Exhibit 2(b) illustrates willing and able to supply at vidual supply curve, consider the the resulting market supply curve for various prices amount of coffee that an individual this group of coffee producers. F The Market Supply Curve T An Individual Supply Curve T exhibit 1 An Individual Supply Curve a. Juan’s Supply Schedule for Coffee Price (per pound) $5 4 3 2 1 b. Juan’s Supply Curve for Coffee $5 Quantity Supplied (pounds per year) 80 70 50 30 10 Price of Coffee (per pound) section 4.4 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). # 102882105 52270_04_ch04_p091-120.indd Cust: Cengage Learning Au: Sexton Pg. No. 105 Title: Exploring Economics: Pathways to Problem Solving Server: _____ 4 Juan’s Supply Curve 3 2 1 0 10 30 50 70 80 Quantity of Coffee (pounds per year) C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 S4-CARLISLE Publishing Services 6:03:42 AM 106 PART 2 section 4.4 Supply and Demand A Market Supply Curve exhibit 2 a. Market Supply Schedule for Coffee b. Market Supply Curve for Coffee $5 Price (per pound) Juan $5 4 3 2 1 80 70 50 30 10 ⴙ Other Producers ⴝ Market Supply ⫹ ⫹ ⫹ ⫹ ⫹ 7,920 6,930 4,950 2,970 990 ⫽ ⫽ ⫽ ⫽ ⫽ 8,000 7,000 5,000 3,000 1,000 Price of Coffee (per pound) Quantity Supplied (pounds per year) 4 3 Market Supply Curve 2 1 0 1 3 5 7 8 Quantity of Coffee (thousands of pounds per year) 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. SECTION CHECK 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? SECTION 4.5 Shifts in the Supply Curve 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 n How does technology affect the supply curve? n How do taxes affect the supply curve? the supply curve? A Change in Quantity Supplied Versus a Change in Supply hanges 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 quantity demanded by buyers. Similarly, a change in supply, whether an increase or a decrease, can occur for reasons other than changes in the price of the product C # 102882 Cust: 52270_04_ch04_p091-120.indd 106 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, leading 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. Cengage Learning Au: Sexton Pg. No. 106 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE 11/6/09 Publishing Services 6:03:43 AM Chapter 4 Shifts in Supply n 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 possible determinants of supply—factors that determine the position of the supply curve—in greater depth. A Input Prices Suppliers are strongly influenced by the costs of inputs used in the production process, such as steel used for automobiles 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 substitutes 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 cotton 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 production because both goods can be produced using the same resources. Producers tend to substitute the production of section 4.5 exhibit 1 Supply Shifts Price S3 S1 S2 Decrease Increase in in Supply Supply 0 Quantity An increase in supply shifts the supply curve to the right. A decrease in supply shifts the supply curve to the left. # 102882107 52270_04_ch04_p091-120.indd 107 Supply and Demand more profitable products for that of less profitable products. 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 producing 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 production. 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 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). 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. Expectations Another 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 Suppliers We 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 Cust: Cengage Learning Au: Sexton Pg. No. 107 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 S4-CARLISLE Publishing Services 6:03:43 AM 108 section 4.5 exhibit 2 PART 2 Supply and Demand Substitutes and Complements in Production Substitutions in Production Supply P1 P2 0 Q2 b. Market for Cotton Price of Cotton Price of Wheat a. Market for Wheat S1 S2 0 Q1 Quantity of Wheat Quantity of Cotton Complements in Production Supply P2 P1 0 Q1 d. Market for Leather Price of Leather Price of Cattle c. Market for Cattle S1 S2 0 Q2 Quantity of Cattle Quantity of 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 ranchers 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 number 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 indicated by a leftward shift in the supply curve. Technology Technological change can lower the firm’s costs of production 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 # 102882 Cust: 52270_04_ch04_p091-120.indd 108 firm can now produce the good at a lower cost it will supply 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 requirements 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, deregulation can shift the supply curve to the right. Certain types of taxes can also alter the costs of production borne by the supplier, causing the supply curve to Cengage Learning Au: Sexton Pg. No. 108 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE 11/6/09 Publishing Services 6:03:43 AM 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 provides farmers with subsidies to encourage the production of certain agricultural products. Weather In 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 f 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. I Possible Supply Shifts Price S2 0 Quantity Input price (wages) increases Quantity Number of suppliers increases # 102882109 52270_04_ch04_p091-120.indd S2 S1 S2 0 Quantity Taxes rise S1 S1 0 Cust: Cengage Learning Au: Sexton Pg. No. 109 Title: Exploring Economics: Pathways to Problem Solving Server: _____ S2 0 Quantity Price decreases for a substitute in production Quantity Producer expects now that the price will be lower later S2 S2 Price S2 S1 0 Quantity Input price (fuel) falls Price Price S1 0 S1 Price S1 Price S2 0 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. S1 Price exhibit 3 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. Price section 4.5 109 Supply and Demand © 2009/JUPITERIMAGES Chapter 4 Quantity Technological advance occurs 0 C/M/Y/K Short / Normal / Long Quantity Bad weather DESIGN SERVICES OF 11/6/09 S4-CARLISLE Publishing Services 6:03:44 AM 110 PART 2 Supply and Demand CHANGE IN SUPPLY VERSUS CHANGE IN QUANTITY SUPPLIED Q A How would you graph the following two scenarios: (1) the price of cotton rises; and (2) good weather causes an unusually abundant cotton harvest? section 4.5 exhibit 4 S1 Price of Cotton In 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 quantity supplied. However, the change from B to C is SECTION called an increase in supply, and the movement from C to B is called a decrease in supply. B $10.00 $5.00 0 S2 C A B Change in quantity supplied B C Change in supply A 4 7 11 Quantity of Cotton CHECK 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? # 102882 Cust: 52270_04_ch04_p091-120.indd 110 Cengage Learning Au: Sexton Pg. No. 110 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE 11/6/09 Publishing Services 6:03:45 AM Chapter 4 111 Supply and Demand Interactive 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 93 competitive market 94 law of demand 94 individual demand schedule 95 individual demand curve 95 # 102882 111 Cust: 52270_04_ch04_p091-120.indd market demand curve 95 change in quantity demanded 97 change in demand 98 substitutes 99 complements 99 Cengage Learning Au: Sexton Pg. No. 111 Title: Exploring Economics: Pathways to Problem Solving Server: _____ normal good 100 inferior good 100 law of supply 104 individual supply curve 105 market supply curve 105 C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 S4-CARLISLE Publishing Services 6:03:46 AM 112 PART 2 Supply and Demand Section 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 growers of produce and consumers of produce. You hire them to do this task for you when you buy produce from them, rather than directly from growers, because they conduct those transactions at lower costs than you could (if you could do it more cheaply 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 standardized, 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 nonstandardized, 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 # 102882 Cust: 52270_04_ch04_p091-120.indd 112 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 movement 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 Cengage Learning Au: Sexton Pg. No. 112 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE 11/6/09 Publishing Services 6:03:46 AM Chapter 4 future prices are expected to be compared to the present, 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. 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 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 different 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 # 102882 113 Cust: 52270_04_ch04_p091-120.indd 113 Supply and Demand Cengage Learning Au: Sexton Pg. No. 113 Title: Exploring Economics: Pathways to Problem Solving Server: _____ 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 relative 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 quantities 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 substantially, raising the opportunity cost of baby-sitting. This change decreases (shifts left) the supply of baby-sitting services. C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 S4-CARLISLE Publishing Services 6:03:46 AM 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. 114 52270_04_ch04_p091-120.indd 114 # 102882 Cust: Cengage Learning Au: Sexton Pg. No. 114 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE Publishing Services 11/6/09 6:03:46 AM 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. 115 52270_04_ch04_p091-120.indd 115 # 102882 Cust: Cengage Learning Au: Sexton Pg. No. 115 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 6:03:46 AM S4-CARLISLE Publishing Services 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. 116 52270_04_ch04_p091-120.indd 116 # 102882 Cust: Cengage Learning Au: Sexton Pg. No. 116 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE Publishing Services 11/6/09 6:03:46 AM 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 12 9 6 3 5 oz. 10 15 20 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 $15 12 9 6 3 5 10 15 20 25 0 5 10 15 20 15 20 25 30 35 Market 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. 117 52270_04_ch04_p091-120.indd 117 # 102882 Cust: Cengage Learning Au: Sexton Pg. No. 117 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 6:03:46 AM S4-CARLISLE Publishing Services 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? c e Price a b f d0 d1 d2 Quantity of Cantaloupes per Year 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? P P1 a b P2 0 c D1 Q1 Q2 Q3 118 52270_04_ch04_p091-120.indd 118 # 102882 Cust: Cengage Learning Au: Sexton Pg. No. 118 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE Publishing Services 11/6/09 6:03:47 AM 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 15 20 25 10,000 15,000 20,000 25,000 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 15 20 25 10,000 15,000 20,000 25,000 30,000 8,000 10,000 12,000 14,000 16,000 2,000 5,000 8,000 11,000 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? P S1 b P2 P1 0 S2 c a Q1 Q2 Q3 Q 119 52270_04_ch04_p091-120.indd 119 # 102882 Cust: Cengage Learning Au: Sexton Pg. No. 119 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF 11/6/09 6:03:47 AM S4-CARLISLE Publishing Services 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? s0 b e s2 a Price s1 c d Quantity of Cantaloupes per Year 120 52270_04_ch04_p091-120.indd 120 # 102882 Cust: Cengage Learning Au: Sexton Pg. No. 120 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C/M/Y/K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE Publishing Services 11/6/09 6:03:47 AM
