Tài liệu The Scope and Method of Economics pdf

Things that are produced and then used in the production of other goods and services are called capital resources, or simply capital.. Her production possibilities are illustrated by the

The Scope and Method of Economics

The study of economics should

begin with a sense of wonder Pause

for a moment and consider a

typi-cal day in your life It might start

with a bagel made in a local bakery

with flour produced in Minnesota

from wheat grown in Kansas and

bacon from pigs raised in Ohio

packaged in plastic made in New

Jersey You spill coffee from

Colombia on your shirt made in

Texas from textiles shipped from

South Carolina

After class you drive with a

friend on an interstate highway

that is part of a system that took

20 years and billions of dollars to build You stop for gasoline refined in Louisiana from Saudi

Arabian crude oil brought to the United States on a supertanker that took 3 years to build at a

shipyard in Maine

Later you log onto the Web with a laptop computer assembled in Indonesia from parts

made in China and send an e-mail to your brother in Mexico City, and you call a buddy on a cell

phone made by a company in Finland Your call is picked up by a microwave dish hidden in a

church steeple rented from the church by a cellular company that was just bought by a European

conglomerate

You use or consume tens of thousands of things, both tangible and intangible, every day:

buildings, rock music, iPods, telephone services, staples, paper, toothpaste, tweezers, pizza, soap,

digital watches, fire protection, banks, electricity, eggs, insurance, football fields, computers,

buses, rugs, subways, health services, sidewalks, and so forth Somebody made all these things

Somebody organized men and women and materials to produce and distribute them Thousands

of decisions went into their completion Somehow they got to you

In the United States, over 146 million people—almost half the total population—work at

hundreds of thousands of different jobs producing over $14 trillion worth of goods and services

every year Some cannot find work; some choose not to work Some are rich; others are poor

The United States imports over $257 billion worth of automobiles and parts and about

$229 billion worth of petroleum and petroleum products each year; it exports around $62 billion

worth of agricultural products, including food High-rise office buildings go up in central cities

Condominiums and homes are built in the suburbs In other places, homes are abandoned and

boarded up

Some countries are wealthy Others are impoverished Some are growing Some are not

Some businesses are doing well Others are going bankrupt

At any moment in time, every society faces constraints imposed by nature and by previous

generations Some societies are handsomely endowed by nature with fertile land, water, sunshine,

and natural resources Others have deserts and few mineral resources Some societies receive

much from previous generations—art, music, technical knowledge, beautiful buildings, and

pro-ductive factories Others are left with overgrazed, eroded land, cities leveled by war, or polluted

natural environments All societies face limits

CHAPTER OUTLINE Why Study

Economics? p 2

To Learn a Way of Thinking

To Understand Society

To Understand Global Affairs

To Be an Informed Citizen

The Scope of Economics p 7 Microeconomics and Macroeconomics The Diverse Fields of Economics

The Method of Economics p 10 Descriptive Economics and Economic Theory Theories and Models Economic Policy

An Invitation p 15

Appendix: How to Read and Understand Graphs p 18

1

economics T h e study o f

how individuals and societies

c h o o s e t o use the scarce

resources t h a t nature and

previous g e n e r a t i o n s have

provided

Economics is the study of how individuals and societies choose to use the scarce resources

that nature and previous generations have provided The key word in this definition is

choose Economics is a behavioral, or social, science In large measure, it is the study of

how people make choices The choices that people make, when added up, translate into societal choices

The purpose of this chapter and the next is to elaborate on this definition and to introduce the subject matter of economics What is produced? How is it produced? Who gets it? Why? Is the result good or bad? Can it be improved?

Why Study Economics?

There are four main reasons to study economics: to learn a way of thinking, to understand ety, to understand global affairs, and to be an informed citizen

soci-To Learn a Way of Thinking

Probably the most important reason for studying economics is to learn a way of thinking Economics has three fundamental concepts that, once absorbed, can change the way you look at everyday choices: opportunity cost, marginalism, and the working of efficient markets

opportunity cost T h e

best alternative t h a t we forgo,

or give up, when we make a

c h o i c e or a decision

scarce Limited

Opportunity Cost What happens in an economy is the outcome of thousands of ual decisions People must decide how to divide their incomes among all the goods and services available in the marketplace They must decide whether to work, whether to go to school, and how much to save Businesses must decide what to produce, how much to produce, how much to charge, and where to locate It is not surprising that economic analysis focuses on the process of decision making

individ-Nearly all decisions involve trade-offs A key concept that recurs in analyzing the

decision-making process is the notion of opportunity cost The full "cost" of decision-making a specific choice

includes what we give up by not making the alternative choice The best alternative that we forgo,

or give up, when we make a choice or a decision is called the opportunity cost of that decision

When asked how much a movie costs, most people cite the ticket price For an economist, this is only part of the answer: to see a movie takes not only a ticket but also time The opportu-nity cost of going to a movie is the value of the other things you could have done with the same money and time If you decide to take time off from work, the opportunity cost of your leisure is the pay that you would have earned had you worked Part of the cost of a college education is the income you could have earned by working full-time instead of going to school If a firm pur-chases a new piece of equipment for $3,000, it does so because it expects that equipment to gen-erate more profit There is an opportunity cost, however, because that $3,000 could have been deposited in an interest-earning account To a society, the opportunity cost of using resources to launch astronauts on a space shuttle is the value of the private/civilian or other government goods that could have been produced with the same resources

Opportunity costs arise because resources are scarce Scarce simply means limited Consider

one of our most important resources—time There are only 24 hours in a day, and we must live our lives under this constraint A farmer in rural Brazil must decide whether it is better to con-tinue to farm or to go to the city and look for a job A hockey player at the University of Vermont must decide whether to play on the varsity team or spend more time studying

Marginalism A second key concept used in analyzing choices is the notion of

marginalism In weighing the costs and benefits of a decision, it is important to weigh only the

costs and benefits that arise from the decision Suppose, for example, that you live in New Orleans and that you are weighing the costs and benefits of visiting your mother in Iowa If business required that you travel to Kansas City, the cost of visiting Mom would be only the additional, or

marginal, time and money cost of getting to Iowa from Kansas City

Consider the music business To produce a typical CD, music labels spend approximately

$300,000 on recording the music and music video, developing marketing materials, and

distrib-uting the album Once the label has made this investment, physically producing another copy of

the CD for sale typically costs about $2 When the music label is deciding whether to sign a new

artist and produce a CD, the $300,000 investment is important Companies such as EMI and

Columbia Records spend a great deal of time thinking about whether a new CD by a newly

dis-covered artist will sell enough copies to make a profit But once an artist is signed and the

invest-ment is made and the music label is trying to decide whether to manufacture the 100,001st copy

of a new CD, the key cost number is $2 Every new copy costs only $2, and as long as EMI can sell

that copy for more than $2, it is better off making the copy The original investment made to

cre-ate the music is irrelevant—a sunk cost Sunk costs are costs that cannot be avoided because

they have already been incurred

Technically, we call the incremental cost of producing one more unit of a good or service the

marginal cost One of the interesting changes in the music business is what has happened to the

marginal cost of producing another copy of a CD given the introduction of iTunes as an

alterna-tive to the physical CD While it is not always easy to figure out what the marginal cost is (and we

will spend some time in this text honing your skills in this area), understanding the idea of

mar-ginalism when thinking about choices is critical

There are numerous examples in which the concept of marginal cost is useful For an

air-plane that is about to take off with empty seats, the marginal cost of an extra passenger is

essen-tially zero; the total cost of the trip is roughly unchanged by the addition of an extra passenger

Thus, setting aside a few seats to be sold at big discounts through www.priceline.com or other

Web sites can be profitable even if the fare for those seats is far below the average cost per seat of

making the trip As long as the airline succeeds in filling seats that would otherwise have been

empty, doing so is profitable

sunk costs C o s t s t h a t

c a n n o t be avoided because they have already been incurred

Efficient Markets—No Free Lunch Suppose you are ready to check out of a busy

grocery store on the day before a storm and seven checkout registers are open with several

people in each line Which line should you choose? Usually, the waiting time is approximately

the same no matter which register you choose (assuming you have more than 12 items) If one

line is much shorter than the others, people will quickly move into it until the lines are

equal-ized again

As you will see later, the term profit in economics has a very precise meaning Economists,

however, often loosely refer to "good deals" or risk-free ventures as profit opportunities Using

the term loosely, a profit opportunity exists at the checkout lines when one line is shorter than

the others In general, such profit opportunities are rare At any time, many people are

search-ing for them; as a consequence, few exist Markets like this, where any profit opportunities are

eliminated almost instantaneously, are said to be efficient markets (We discuss markets, the

institutions through which buyers and sellers interact and engage in exchange, in detail in

Chapter 2.)

The common way of expressing the efficient markets concept is "there's no such thing as a

free lunch." How should you react when a stockbroker calls with a hot tip on the stock market?

With skepticism Thousands of individuals each day are looking for hot tips in the market If a

particular tip about a stock is valid, there will be an immediate rush to buy the stock, which will

quickly drive up its price This view that very few profit opportunities exist can, of course, be

carried too far There is a story about two people walking along, one an economist and one not

The noneconomist sees a $20 bill on the sidewalk and says, "There's a $20 bill on the sidewalk."

The economist replies, "That is not possible If there were, somebody would already have

picked it up."

There are clearly times when profit opportunities exist Someone has to be first to get the

news, and some people have quicker insights than others Nevertheless, news travels fast and

there are thousands of people with quick insights The general view that large profit

opportuni-ties are rare is close to the mark

To Understand Society

Industrial Revolution

T h e period in England during

the late eighteenth and early

nineteenth centuries in which

new manufacturing

technologies and improved

t r a n s p o r t a t i o n gave rise to the

modern factory system and a

massive movement o f the

population from the

countryside to the cities

Another reason for studying economics is to understand society better Past and present nomic decisions have an enormous influence on the character of life in a society The current state of the physical environment, the level of material well-being, and the nature and number of jobs are all products of the economic system

eco-To get a sense of the ways in which economic decisions have shaped our environment, ine looking out a top-floor window of an office tower in any large city The workday is about to begin All around you are other tall glass and steel buildings full of workers In the distance, you see the smoke of factories Looking down, you see thousands of commuters pouring off trains and buses and cars backed up on freeway exit ramps You see trucks carrying goods from one place to another You also see the face of urban poverty: Just beyond the freeway is a large public housing project and, beyond that, burned-out and boarded-up buildings

imag-What you see before you is the product of millions of economic decisions made over hundreds

of years People at some point decided to spend time and money building those buildings and tories Somebody cleared the land, laid the tracks, built the roads, and produced the cars and buses Economic decisions not only have shaped the physical environment but also have deter-mined the character of society At no time has the impact of economic change on a society been more evident than in England during the late eighteenth and early nineteenth centuries, a

fac-period that we now call the Industrial Revolution Increases in the productivity of

agricul-ture, new manufacturing technologies, and development of more efficient forms of tion led to a massive movement of the British population from the countryside to the city At the beginning of the eighteenth century, approximately 2 out of 3 people in Great Britain worked in agriculture By 1812, only 1 in 3 remained in agriculture; by 1900, the figure was fewer than 1 in 10 People jammed into overcrowded cities and worked long hours in factories England had changed completely in two centuries—a period that in the run of history was nothing more than the blink of an eye

transporta-It is not surprising that the discipline of economics began to take shape during this period Social critics and philosophers looked around and knew that their philosophies must expand to

accommodate the changes Adam Smith's Wealth of Nations appeared in 1776 It was followed by

the writings of David Ricardo, Karl Marx, Thomas Malthus, and others Each tried to make sense out of what was happening Who was building the factories? Why? What determined the level of

wages paid to workers or the price of food? What would happen in the future, and what should

happen? The people who asked these questions were the first economists

Similar changes continue to affect the character of life in more recent times In fact, many argue that the late 1990s marked the beginning of a new Industrial Revolution As we turned the corner into the new millennium, the "e" revolution was clearly having an impact on virtually every aspect of our lives: the way we buy and sell products, the way we get news, the way we plan vacations, the way we communicate with each other, the way we teach and take classes, and on and on These changes have had and will clearly continue to have profound impacts on societies across the globe, from Beijing to Calcutta to New York

These changes have been driven by economics Although the government was involved in the early years of the World Wide Web, private firms that exist to make a profit (such as Facebook, YouTube, Yahoo!, Microsoft, Google, Monster.com, Amazon.com, and E-Trade) created almost all the new innovations and products How does one make sense of all this? What will the effects of these innovations be on the number of jobs, the character of those jobs, the family incomes, the structure of our cities, and the political process both in the United States and in other countries? During the last days of August 2005, Hurricane Katrina slammed into the coasts of Louisiana and Mississippi, causing widespread devastation, killing thousands, and leaving hundreds of thousands homeless The economic impact of this catastrophic storm was huge Thinking about various markets involved helps frame the problem

For example, the labor market was massively affected By some estimates, over 400,000 jobs were lost as the storm hit Hotels, restaurants, small businesses, and oil refineries, to name just a few, were destroyed All the people who worked in those establishments instantaneously lost their jobs and their incomes The cleanup and rebuilding process took time to organize, and it eventu-ally created a great deal of employment

The storm created a major disruption in world oil markets Loss of refinery capacity sent gasoline prices up immediately, nearly 40 percent to over $4 per gallon in some locations The

price per gallon of crude oil rose to over $70 per barrel Local governments found their tax bases

destroyed, with no resources to pay teachers and local officials Hundreds of hospitals were

destroyed, and colleges and universities were forced to close their doors, causing tens of

thou-sands of students to change their plans

While the horror of the storm hit all kinds of people, the worst hit were the very poor, who

could not get out of the way because they had no cars or other means of escape The storm raised

fundamental issues of fairness, which we will be discussing for years to come

The study of economics is an essential part of the study of society

To Understand Global Affairs

A third reason for studying economics is to understand global affairs News headlines are filled

with economic stories International events often have enormous economic consequences The

destruction of the World Trade Center towers in New York City in 2001 and the subsequent war

on terror in Afghanistan and elsewhere led to a huge decline in both tourism and business travel

Several major airlines, including U.S Airways and Swissair, went bankrupt Hotel operators

worldwide suffered huge losses The war in Iraq and a strike in Venezuela, a major oil exporter, in

2003 sent oil markets gyrating dramatically, initially increasing the cost of energy across the

globe The rapid spread of HIV and AIDS across Africa will continue to have terrible economic

consequences for the continent and ultimately for the world

Some claim that economic considerations dominate international relations Certainly,

politi-cians place the economic well-being of their citizens near the top of their priority lists It would be

surprising if that were not so Thus, the economic consequences of things such as environmental

policy, free trade, and immigration play a huge role in international negotiations and policies

Great Britain and the other countries of the European Union have struggled with the agreement

among most members to adopt a common currency, the euro In 2005, France and the Netherlands

rejected a proposed European constitution that would have gone a long way toward a completely

open economy in Europe The nations of the former Soviet Union are wrestling with a growing

phe-nomenon that clouds their efforts to "privatize" formerly state-owned industries: organized crime

Another important issue in today's world is the widening gap between rich and poor nations

In 2007, world population was over 6.5 billion Of that number, over 2.4 billion lived in

low-income (less than $900 annually per capita) countries and just over 1 billion lived in high-low-income

(over $11,000 per capita per year) countries The 37 percent of the world's population that lives

in the low-income countries receives less than 3.3 percent of the world's income In dozens of

countries, per capita income is only a few hundred dollars a year The 15 percent of the

popula-tion in high-income countries earn 75 percent of the world's income

An understanding of economics is essential to an understanding of global affairs

To Be an Informed Citizen

A knowledge of economics is essential to being an informed citizen During the last 35 years, the

U.S economy has been on a roller coaster In 1973-1974, the Organization of Petroleum

Exporting Countries (OPEC) succeeded in raising the price of crude oil by 400 percent

Simultaneously, a sequence of events in the world food market drove food prices up by 25

per-cent By mid-1974, prices in the United States were rising across the board at a very rapid rate

Partially as a result of government policy to fight runaway inflation, the economy went into a

recession in 1975 (An inflation is an increase in the overall price level in the economy; a recession

is a period of decreasing output and rising unemployment.) The recession succeeded in slowing

price increases, but in the process, millions found themselves unemployed

From 1979 through 1983, it happened all over again Prices rose rapidly, the government

reacted with more policies designed to stop prices from rising, and the United States ended up

with an even worse recession in 1982 By the end of that year, 10.8 percent of the work force was

unemployed Then, in mid-1990—after almost 8 years of strong economic performance—the

iPod and the World

It is impossible to understand the workings of

an economy without first understanding the ways in which economies are connected across borders The United States was importing goods and services at a rate of over $2 trillion per year in 2007 and was exporting at a rate of over $1.5 trillion per year

For literally hundreds of years, the virtues of free trade have been the subject of heated debate Opponents have argued that buying foreign-produced goods costs Americans jobs and hurts American producers Proponents argue that there are gains from trade—that all countries can gain from specializing in the pro-duction of the goods and services that they produce best

But in today's global economy, it is often unclear what is an import and what is an export

Consider the following column in The New York Times in 2007:

A n i P o d H a s Global Value A s k t h e ( M a n y ) C o u n t r i e s T h a t M a k e It

The New York Times

Who makes the Apple iPod? Here's a hint: It is not Apple The company outsources the entire manufacture of the device to a number of Asian enterprises, among them Asustek, Inventec Appliances, and Foxconn

But this list of companies isn't a satisfactory answer either: They only do final bly What about the 451 parts that go into the iPod? Where are they made and by whom? Three researchers at the University of California, Irvine—Greg Linden, Kenneth L Kraemer, and Jason Dedrick—applied some investigative cost accounting to this question, using a report from Portelligent Inc that examined all the parts that went into the iPod Their study, sponsored by the Sloan Foundation, offers a fascinating illustration of the complexity of the global economy, and how difficult it is to understand that com-plexity by using only conventional trade statistics

assem-The retail value of the 30-gigabyte video iPod that the authors examined was

$ 2 9 9 The most expensive component in it was the hard drive, which was tured by Toshiba and costs about $ 7 3 The next most costly components were the display module (about $ 2 0 ) , the video/multimedia processor chip ( $ 8 ) , and the controller chip ( $ 5 ) They estimated that the final assembly, done in China, cost only about $4 a unit

manufac-The researchers estimated that $163 of the iPod's $299 retail value in the United States was captured by American companies and workers, breaking it down to $75 for distribution and retail costs, $80 to Apple, and $8 to various domestic component makers Japan contributed about $26 to the value added (mostly via the Toshiba disk drive), while Korea contributed less than $1

The real value of the iPod doesn't lie in its parts or even in putting those parts together The bulk of the iPod's value is in the conception and design of the iPod That

is why Apple gets $80 for each of these video iPods it sells, which is by far the largest piece of value added in the entire supply chain

Those clever folks at Apple figured out how to combine 451 mostly generic parts into a valuable product They may not make the iPod, but they created it In the end, that's what really matters

Source: HalR Varian, Published: June 28, 2007, The New York Times, reprinted with permission

U.S economy went into another recession During the third and fourth quarters of 1990 and the

first quarter of 1991, gross domestic product (GDP, a measure of the total output of the U.S

econ-omy) fell and unemployment again increased sharply The election of Bill Clinton late in 1992

was no doubt in part influenced by the so-called "jobless recovery."

From the second quarter of 1991 through the early part of the new millennium, the U.S

economy experienced the longest expansion in its history More than 24 million new jobs were

created, pushing unemployment below 4 percent by the year 2000 The stock market boomed to

historic levels, and the biggest worry facing the American economy was that things were too good!

The presidential election of 2000 was close, to say the least, with the outcome not known

until early December In mid-December, President-elect George W Bush and his economic

advis-ers began to worry about the possibility of a recession occurring in 2001 The stock market was

below its highs for the year, corporate profits were not coming in as well as expected, and there

were some signs that demand for goods was slowing

Indeed, following the election, the economy slipped into a recession and economic conditions

were made worse by the September 11, 2001, attacks on the World Trade Center and on the

Pentagon The stock market, which suffered losses as early as 2000, fell for 3 consecutive years,

reducing people's wealth by trillions of dollars Total employment dropped by nearly 2.7 million

But by 2002, the economy began to grow again, slowly, and by 2005, nearly 3.5 million jobs had

been created

The war in Iraq and the threat of international terrorism following the 9/11 attacks increased

military expenditures in the United States substantially At the same time, tax cuts proposed by

President Bush and passed by Congress led to large deficits in the federal budget

The housing market began to boom in 2001 Fueled by lower interest rates that made

bor-rowing less expensive, foreign demand, and a highly competitive mortgage market that made

mortgage credit available to virtually any applicant, house prices rose substantially around the

country Housing starts, the number of new housing units begun each period, rose steadily to a

record high by 2005 of over 2 million annually Sales of existing homes at the same time rose

above 7 million per year In addition, as house values rose, home owners had higher wealth and

increased their spending Much spending was driven by borrowing against the house When you

add all the services surrounding house sales, the huge spending on new units, and the purchases

at stores such as Home Depot that go with new house sales, the economy was strongly stimulated

by the housing market until the middle of 2006, when housing began to slow

One of the key factors that fueled the housing boom was the expansion of mortgage credit to

borrowers who in earlier years would have not have qualified Some borrowers had bad credit

histories, low incomes, or other substantial debts These mortgages came to be called subprime

loans In addition, mortgage loans that carried low monthly payments for a few years that were

later followed by substantially higher payments became prevalent

In the summer of 2007, the housing market stalled, prices began to fall, and the huge amount of

mortgage debt outstanding (over $10 trillion by 2007) experienced rising delinquency and default

Losses were huge and sent financial markets, including the stock market, into a sharp decline The

question at the start of 2008 was whether the sharp slowdown of the housing market combined with

the problems of the credit markets would lead the economy as a whole into a recession

To be an informed citizen requires a basic understanding of economics

The Scope of Economics

Most students taking economics for the first time are surprised by the breadth of what they study

Some think that economics will teach them about the stock market or what to do with their

money Others think that economics deals exclusively with problems such as inflation and

unem-ployment In fact, it deals with all those subjects, but they are pieces of a much larger puzzle

Economics has deep roots in and close ties to social philosophy An issue of great importance

to philosophers, for example, is distributional justice Why are some people rich and others poor?

And whatever the answer, is this fair? A number of nineteenth-century social philosophers

wres-ded with these questions, and out of their musings, economics as a separate discipline was born

The easiest way to get a feel for the breadth and depth of what you will be studying is to explore briefly the way economics is organized First of all, there are two major divisions of eco-nomics: microeconomics and macroeconomics

microeconomics T h e

branch o f e c o n o m i c s t h a t

examines t h e functioning o f

individual industries and the

behavior o f individual

decision-making units—that is, firms

and so on—on a national scale

Microeconomics and Macroeconomics

Microeconomics deals with the functioning of individual industries and the behavior of

indi-vidual economic decision-making units: firms and households Firms' choices about what to duce and how much to charge and households' choices about what and how much to buy help to explain why the economy produces the goods and services it does

pro-Another big question addressed by microeconomics is who gets the goods and services that are produced Wealthy households get more than poor households, and the forces that determine this distribution of output are the province of microeconomics Why does poverty exist? Who is poor? Why do some jobs pay more than others?

Think again about what you consume in a day and then think back to that view over a big city Somebody decided to build those factories Somebody decided to construct the roads, build the hous-ing, produce the cars, and smoke the bacon Why? What is going on in all those buildings? It is easy to see that understanding individual microdecisions is very important to any understanding of society

Macroeconomics looks at the economy as a whole Instead of trying to understand what

determines the output of a single firm or industry or what the consumption patterns are of a gle household or group of households, macroeconomics examines the factors that determine

sin-national output, or sin-national product Microeconomics is concerned with household income; macroeconomics deals with national income

Whereas microeconomics focuses on individual product prices and relative prices, economics looks at the overall price level and how quickly (or slowly) it is rising (or falling) Microeconomics questions how many people will be hired (or fired) this year in a particular industry or in a certain geographic area and focuses on the factors that determine how much

macro-labor a firm or an industry will hire Macroeconomics deals with aggregate employment and

unemployment: how many jobs exist in the economy as a whole and how many people who are willing to work are not able to find work

To summarize:

Microeconomics looks at the individual unit—the household, the firm, the industry It sees and examines the "trees." Macroeconomics looks at the whole, the aggregate It sees and analyzes the "forest."

Table 1.1 summarizes these divisions of economics and some of the subjects with which they are concerned

The Diverse Fields of Economics

Individual economists focus their research and study in many diverse areas Many of these specialized

fields are reflected in the advanced courses offered at most colleges and universities Some are

con-cerned with economic history or the history of economic thought Others focus on international

eco-nomics or growth in less developed countries Still others study the ecoeco-nomics of cities (urban

economics) or the relationship between economics and law These fields are summarized in Table 1.2

Economists also differ in the emphasis they place on theory Some economists specialize in

developing new theories, whereas other economists spend their time testing the theories of

oth-ers Some economists hope to expand the frontiers of knowledge, whereas other economists are

more interested in applying what is already known to the formulation of public policies

positive economics An

a p p r o a c h t o e c o n o m i c s t h a t

seeks to understand behavior

and the operation o f systems

effect, action and reaction

As you begin your study of economics, look through your school's course catalog and talk to the faculty about their interests You will discover that economics encompasses a broad range of inquiry and is linked to many other disciplines

Economics asks and attempts to answer two kinds of questions: positive and normative Positive

economics attempts to understand behavior and the operation of economic systems without

making judgments about whether the outcomes are good or bad It strives to describe what exists

and how it works What determines the wage rate for unskilled workers? What would happen if

we abolished the corporate income tax? The answers to such questions are the subject of positive economics

In contrast, normative economics looks at the outcomes of economic behavior and

asks whether they are good or bad and whether they can be made better Normative ics involves judgments and prescriptions for courses of action Should the government subsi-dize or regulate the cost of higher education? Should medical benefits to the elderly under Medicare be available only to those with incomes below some threshold? Should the United States allow importers to sell foreign-produced goods that compete with U.S.-produced prod-ucts? Should we reduce or eliminate inheritance taxes? Normative economics is often called

econom-policy economics

Of course, most normative questions involve positive questions To know whether the

gov-ernment should take a particular action, we must know first if it can and second what the

conse-quences are likely to be (For example, if we lower import fees, will there be more competition and lower prices?)

Some claim that positive, value-free economic analysis is impossible They argue that lysts come to problems with biases that cannot help but influence their work Furthermore, even

ana-in choosana-ing what questions to ask or what problems to analyze, economists are ana-influenced by political, ideological, and moral views

Although this argument has some merit, it is nevertheless important to distinguish between analyses that attempt to be positive and those that are intentionally and explicitly normative Economists who ask explicitly normative questions should be forced to specify their grounds for judging one outcome superior to another

Positive economics is often divided into descriptive economics and economic theory

Descriptive economics is simply the compilation of data that describe phenomena and facts

Examples of such data appear in the Statistical Abstract of the United States, a large volume of data

published by the Department of Commerce every year that describes many features of the U.S economy Massive volumes of data can now be found on the World Wide Web As an example, look at www.bls.gov (Bureau of Labor Statistics)

Where do all these data come from? The Census Bureau collects an enormous amount of raw data every year, as do the Bureau of Labor Statistics, the Bureau of Economic Analysis, and non-government agencies such as the University of Michigan Survey Research Center One important

study now published annually is the Survey of Consumer Expenditure, which asks individuals to keep careful records of all their expenditures over a long period of time Another is the National

Longitudinal Survey of Labor Force Behavior, conducted over many years by the Center for

Human Resource Development at The Ohio State University

Economic theory attempts to generalize about data and interpret them An economic

theory is a statement or set of related statements about cause and effect, action and reaction One

of the first theories you will encounter in this text is the law of demand, which was most clearly

stated by Alfred Marshall in 1890: When the price of a product rises, people tend to buy less of it; when the price of a product falls, people tend to buy more

Theories do not always arise out of formal numerical data All of us have been collecting observations of people's behavior and their responses to economic stimuli for most of our

The Method of Economics

Descriptive Economics and Economic Theory

lives We may have observed our parents' reaction to a sudden increase—or decrease—in

income or to the loss of a job or the acquisition of a new one We all have seen people standing

in line waiting for a bargain Of course, our own actions and reactions are another important

source of data

Theories and Models

In many disciplines, including physics, chemistry, meteorology, political science, and economics,

theorists build formal models of behavior A model is a formal statement of a theory It is usually

a mathematical statement of a presumed relationship between two or more variables

A variable is a measure that can change from time to time or from observation to

observa-tion Income is a variable—it has different values for different people and different values for the

same person at different times The rental price of a movie on a DVD is a variable; it has different

values at different stores and at different times There are countless other examples

Because all models simplify reality by stripping part of it away, they are abstractions Critics

of economics often point to abstraction as a weakness Most economists, however, see abstraction

as a real strength

The easiest way to see how abstraction can be helpful is to think of a map A map is a

repre-sentation of reality that is simplified and abstract A city or state appears on a piece of paper as a

series of lines and colors The amount of reality that the mapmaker can strip away before the map

loses something essential depends on what the map will be used for If you want to drive from

St Louis to Phoenix, you need to know only the major interstate highways and roads You lose

absolutely nothing and gain clarity by cutting out the local streets and roads However, if you

need to get around Phoenix, you may need to see every street and alley

Most maps are two-dimensional representations of a three-dimensional world; they show

where roads and highways go but do not show hills and valleys along the way Trail maps for

hikers, however, have "contour lines" that represent changes in elevation When you are in a car,

changes in elevation matter very little; they would make a map needlessly complex and more

difficult to read However, if you are on foot carrying a 50-pound pack, a knowledge of

eleva-tion is crucial

Like maps, economic models are abstractions that strip away detail to expose only those

aspects of behavior that are important to the question being asked The principle that irrelevant

detail should be cut away is called the principle of Ockham's razor after the fourteenth-century

philosopher William of Ockham

Be careful—although abstraction is a powerful tool for exposing and analyzing specific

aspects of behavior, it is possible to oversimplify Economic models often strip away a good deal

of social and political reality to get at underlying concepts When an economic theory is used to

help formulate actual government or institutional policy, political and social reality must often be

reintroduced if the policy is to have a chance of working

The key here is that the appropriate amount of simplification and abstraction depends on

the use to which the model will be put To return to the map example: you do not want to walk

around San Francisco with a map made for drivers—there are too many very steep hills

All Else Equal: Ceteris Paribus It is usually true that whatever you want to explain with a

model depends on more than one factor Suppose, for example, that you want to explain the total

number of miles driven by automobile owners in the United States The number of miles driven

will change from year to year or month to month; it is a variable The issue, if we want to

under-stand and explain changes that occur, is what factors cause those changes

Obviously, many things might affect total miles driven First, more or fewer people may be

driving This number, in turn, can be affected by changes in the driving age, by population

growth, or by changes in state laws Other factors might include the price of gasoline, the

house-hold's income, the number and age of children in the household, the distance from home to

work, the location of shopping facilities, and the availability and quality of public transport

When any of these variables change, the members of the household may drive more or less If

changes in any of these variables affect large numbers of households across the country, the total

number of miles driven will change

model A formal s t a t e m e n t

of a theory, usually a

m a t h e m a t i c a l s t a t e m e n t o f a presumed relationship between two or more variables

variable A measure t h a t can c h a n g e from time to time

or from observation to observation

Ockham's razor The

principle t h a t irrelevant detail should be cut away

ceteris paribus, or all else

equal A device used to

analyze the relationship

between two variables while

the values o f o t h e r variables

are held unchanged

Very often we need to isolate or separate these effects For example, suppose we want to know the impact on driving of a higher tax on gasoline This change would raise the price of gasoline at the pump but would not (at least in the short run) affect income, workplace location, number of children, and so on

To isolate the impact of one single factor, we use the device of ceteris paribus, or all else

equal We ask: What is the impact of a change in gasoline price on driving behavior, ceteris

paribus, or assuming that nothing else changes? If gasoline prices rise by 10 percent, how much

less driving will there be, assuming no simultaneous change in anything else—that is, assuming that income, number of children, population, laws, and so on, all remain constant? Using the

device of ceteris paribus is one part of the process of abstraction In formulating economic theory,

the concept helps us simplify reality to focus on the relationships that interest us

Expressing Models in Words, Graphs, and Equations Consider the following statements: Lower airline ticket prices cause people to fly more frequently Higher interest rates slow the rate of home sales When firms produce more output, employment increases Higher gasoline prices cause people to drive less and to buy more fuel-efficient cars

Each of those statements expresses a relationship between two variables that can be fied In each case, there is a stimulus and a response, a cause and an effect Quantitative relation-ships can be expressed in a variety of ways Sometimes words are sufficient to express the essence

quanti-of a theory, but quanti-often it is necessary to be more specific about the nature quanti-of a relationship or about the size of a response The most common method of expressing the quantitative relation-

ship between two variables is graphing that relationship on a two-dimensional plane In fact, we

will use graphic analysis extensively in Chapter 2 and beyond Because it is essential that you be familiar with the basics of graphing, the Appendix to this chapter presents a careful review of graphing techniques

Quantitative relationships between variables can also be presented through equations For

example, suppose we discovered that over time, U.S households collectively spend, or consume,

90 percent of their income and save 10 percent of their income We could then write:

C = 90 Y and S = 10Y

post hoc, ergo propter hoc

Literally, "after this (in t i m e ) ,

where C is consumption spending, Y is income, and S is saving Writing explicit algebraic

expressions like these helps us understand the nature of the underlying process of decision making Understanding this process is what economics is all about

Cautions and Pitfalls In formulating theories and models, it is especially important to

avoid two pitfalls: the post hoc fallacy and the fallacy of composition

The Post Hoc Fallacy Theories often make statements or sets of statements about cause and

effect It can be quite tempting to look at two events that happen in sequence and assume that the

first caused the second to happen This is not always the case This common error is called the post

hoc, ergo propter hoc (or "after this, therefore because of this") fallacy

There are thousands of examples The Colorado Rockies have won seven games in a row Last

night you went to the game and they lost You must have jinxed them They lost because you went to

the game

Stock market analysts indulge in what is perhaps the most striking example of the post hoc

fallacy in action Every day the stock market goes up or down, and every day some analyst on

some national news program singles out one or two of the day's events as the cause of some

change in the market: "Today the Dow Jones industrial average rose 5 points on heavy trading; analysts say that the increase was due to progress in talks between Israel and Syria." Research has shown that daily changes in stock market averages are very largely random Although major news events clearly have a direct influence on certain stock prices, most daily changes cannot be linked directly to specific news stories

Very closely related to the post hoc fallacy is the often erroneous link between correlation and causation Two variables are said to be correlated if one variable changes when the other

variable changes However, correlation does not imply causation Cities that have high crime rates also have many automobiles, so there is a very high degree of correlation between number

of cars and crime rates Can we argue, then, that cars cause crime? No The reason for the

cor-relation may have nothing to do with cause and effect Big cities have many people, many

peo-ple have many cars; therefore, big cities have many cars Big cities also have high crime rates

for many reasons—crowding, poverty, anonymity, unequal distribution of wealth, and readily

available drugs, to mention only a few However, the presence of cars is probably not one

of them

This caution must also be viewed in reverse Sometimes events that seem entirely

uncon-nected actually are conuncon-nected In 1978, Governor Michael Dukakis of Massachusetts ran for

reelection Still quite popular, Dukakis was nevertheless defeated in the Democratic primary that

year by a razor-thin margin The weekend before, the Boston Red Sox, in the thick of the division

championship race, had been badly beaten by the New York Yankees in four straight games Some

very respectable political analysts believe that hundreds of thousands of Boston sports fans

vented their anger on the incumbent governor the following Tuesday

The Fallacy of Composition To conclude that what is true for a part is necessarily true for

the whole is to fall into the fallacy of composition Suppose that a large group of cattle

ranch-ers graze their cattle on the same range To an individual rancher, more cattle and more grazing

mean a higher income However, because its capacity is limited, the land can support only so

many cattle If every cattle rancher increased the number of cattle sent out to graze, the land

would become overgrazed and barren; as a result, everyone's income would fall In short, theories

that seem to work well when applied to individuals or households often break down when they

are applied to the whole

Testing Theories and Models: Empirical Economics In science, a theory is

rejected when it fails to explain what is observed or when another theory better explains what is

observed Prior to the sixteenth century, almost everyone believed that Earth was the center of

the universe and that the sun and stars rotated around it The astronomer Ptolemy (A.D 127 to

151) built a model that explained and predicted the movements of the heavenly bodies in a

geo-centric (Earth-centered) universe Early in the sixteenth century, however, the Polish astronomer

Nicholas Copernicus found himself dissatisfied with the Ptolemaic model and proposed an

alternative theory or model, placing the sun at the center of the known universe and relegating

Earth to the status of one planet among many The battle between the competing models was

waged, at least in part, with data based on observations—actual measurements of planetary

movements The new model ultimately predicted much better than the old, and in time it came

to be accepted

In the seventeenth century, building on the works of Copernicus and others, Sir Isaac Newton

constructed yet another body of theory that seemed to predict planetary motion with still more

accuracy Newtonian physics became the accepted body of theory, relied on for almost 300 years

Then, in the early twentieth century, Albert Einstein's theory of relativity replaced Newtonian

physics for particular types of problems because it was able to explain some problems that earlier

theories could not

Economic theories are also confronted with new and often conflicting data from time to

time The collection and use of data to test economic theories is called empirical economics

Numerous large data sets are available to facilitate economic research For example,

econo-mists studying the labor market can now test behavioral theories against the actual working

expe-riences of thousands of randomly selected people who have been surveyed continuously since the

1960s by economists at The Ohio State University Macroeconomists continuously monitoring

and studying the behavior of the national economy pass thousands of items of data, collected by

both government agencies and private companies, back and forth over the Internet

Scientific research often seeks to isolate and measure the responsiveness of one variable to a

change in another variable, ceteris paribus Physical scientists such as physicists and geologists

can often impose the condition of ceteris paribus by conducting controlled experiments They

can, for example, measure the effect of one chemical on another while literally holding all else

constant in an environment that they control completely Social scientists, who study people,

rarely have this luxury

Although controlled experiments are difficult in economics and other social sciences, they

are not impossible During recent presidential and congressional elections, many candidates

efficiency In e c o n o m i c s ,

allocative efficiency An

efficient e c o n o m y is o n e t h a t

produces w h a t people w a n t a t

the least possible c o s t

pointed to dramatic declines in crime rates in most American cities Of course, incumbent didates took credit, claiming that the decline was due to their policies In fact, careful analysis shows that the decline in crime was largely due to two factors essentially beyond the control of political leaders: fewer people in the age groups that tend to commit crimes and a very strong economy with low unemployment How do researchers know this? They look at data over time

can-on crimes committed by people of various ages, they look at crime rates across states with ent economic conditions, and they look at the pattern of crime rates nationally over time under different economic conditions Even though economists cannot generally do controlled experi-ments, fluctuations in economic conditions and factors such as birthrate patterns in a way set up natural experiments

differ-Economic Policy

Economic theory helps us understand how the world works, but the formulation of economic

policy requires a second step We must have objectives What do we want to change? Why? What is

good and what is bad about the way the system is operating? Can we make it better?

Such questions force us to be specific about the grounds for judging one outcome superior to another What does it mean to be better? Four criteria are frequently applied in judging economic outcomes:

In economics, efficiency means allocative efficiency An efficient economy is one that

pro-duces what people want at the least possible cost If the system allocates resources to the tion of goods and services that nobody wants, it is inefficient If all members of a particular society were vegetarians and somehow half of all that society's resources were used to produce meat, the result would be inefficient It is inefficient when steel beams lie in the rain and rust because somebody fouled up a shipping schedule If a firm could produce its product using

produc-25 percent less labor and energy without sacrificing quality, it too is inefficient

The clearest example of an efficient change is a voluntary exchange If you and I each want something that the other has and we agree to exchange, we are both better off and no one loses When a company reorganizes its production or adopts a new technology that enables it to pro-duce more of its product with fewer resources, without sacrificing quality, it has made an effi-cient change At least potentially, the resources saved could be used to produce more of something

Inefficiencies can arise in numerous ways Sometimes they are caused by government tions or tax laws that distort otherwise sound economic decisions Suppose that land in Ohio is best suited for corn production and that land in Kansas is best suited for wheat production A law that requires Kansas to produce only corn and Ohio to produce only wheat would be inefficient

regula-If firms that cause environmental damage are not held accountable for their actions, the incentive

to minimize those damages is lost and the result is inefficient

Equity While efficiency has a fairly precise definition that can be applied with some degree of

rigor, equity (fairness) lies in the eye of the beholder To many, fairness implies a more equal

dis-tribution of income and wealth Fairness may imply alleviating poverty, but the extent to which the poor should receive cash benefits from the government is the subject of enormous disagree-ment For thousands of years, philosophers have wrestled with the principles of justice that should guide social decisions They will probably wrestle with such questions for thousands of years to come

Despite the impossibility of defining equity or fairness universally, public policy makers judge the fairness of economic outcomes all the time Rent control laws were passed because

equity Fairness

some legislators thought that landlords treated low-income tenants unfairly Certainly, most

social welfare programs are created in the name of equity

Growth As the result of technological change, the building of machinery, and the

acqui-sition of knowledge, societies learn to produce new goods and services and to produce old

ones better In the early days of the U.S economy, it took nearly half the population to

pro-duce the required food supply Today less than 2.5 percent of the country's population works

in agriculture

When we devise new and better ways of producing the goods and services we use now and

when we develop new goods and services, the total amount of production in the economy

increases Economic growth is an increase in the total output of an economy If output

grows faster than the population, output per capita rises and standards of living increase

Presumably, when an economy grows, it produces more of what people want Rural and

agrar-ian societies become modern industrial societies as a result of economic growth and rising per

capita output

Some policies discourage economic growth, and others encourage it Tax laws, for

exam-ple, can be designed to encourage the development and application of new production

tech-niques Research and development in some societies are subsidized by the government

Building roads, highways, bridges, and transport systems in developing countries may speed

up the process of economic growth If businesses and wealthy people invest their wealth

out-side their country rather than in their country's industries, growth in their home country

may be slowed

Stability Economic stability refers to the condition in which national output is growing

steadily, with low inflation and full employment of resources During the 1950s and 1960s, the

U.S economy experienced a long period of relatively steady growth, stable prices, and low

unem-ployment Between 1951 and 1969, consumer prices never rose more than 5 percent in a single

year and in only 2 years did the number of unemployed exceed 6 percent of the labor force From

the end of the Gulf War in 1991 to the beginning of 2001, the U.S economy enjoyed price

stabil-ity and strong economic growth with rising employment It was the longest expansion in

American history

The decades of the 1970s and 1980s, however, were not as stable The United States

experi-enced two periods of rapid price inflation (over 10 percent) and two periods of severe

unem-ployment In 1982, for example, 12 million people (10.8 percent of the workforce) were looking

for work The beginning of the 1990s was another period of instability, with a recession

occur-ring in 1990-1991 Around the world, economic fluctuations have been severe in recent years

During the late 1990s, many economies in Asia fell into recessions with falling incomes and

ris-ing unemployment The transition economies of Eastern Europe and the former Soviet Union

have experienced periods of decline as well as periods of rapidly rising prices since the fall of the

Berlin Wall in 1989

The causes of instability and the ways in which governments have attempted to stabilize the

economy are the subject matter of macroeconomics

economic growth An

increase in t h e total o u t p u t of

an e c o n o m y

stability A condition in which national o u t p u t is growing steadily, with low inflation and full employment

o f resources

An Invitation

This chapter has prepared you for your study of economics The first part of the chapter invited

you into an exciting discipline that deals with important issues and questions You cannot begin

to understand how a society functions without knowing something about its economic history

and its economic system

The second part of the chapter introduced the method of reasoning that economics requires

and some of the tools that economics uses We believe that learning to think in this very powerful

way will help you better understand the world

As you proceed, it is important that you keep track of what you have learned in earlier

chap-ters This book has a plan; it proceeds step-by-step, each section building on the last It would be

a good idea to read each chapter's table of contents at the start of each chapter and scan each

chapter before you read it to make sure you understand where it fits in the big picture

S U M M A R Y

1 Economics is the study of how individuals and societies

choose to use the scarce resources that nature and previous

generations have provided

WHY STUDY ECONOMICS? p 2

2 There are many reasons to study economics, including (a) to

learn a way of thinking, (b) to understand society, (c) to

understand global affairs, and (d) to be an informed citizen

3 The best alternative that we forgo when we make a choice or

a decision is the opportunity cost of that decision

THE SCOPE OF ECONOMICS p 7

4 Microeconomics deals with the functioning of individual

markets and industries and with the behavior of individual

decision-making units: business firms and households

5 Macroeconomics looks at the economy as a whole It deals

with the economic behavior of aggregates—national output,

national income, the overall price level, and the general rate

of inflation

6 Economics is a broad and diverse discipline with many

spe-cial fields of inquiry These include economic history,

inter-national economics, and urban economics

THE METHOD OF ECONOMICS p 10

7 Economics asks and attempts to answer two kinds of

ques-tions: positive and normative Positive economics attempts

to understand behavior and the operation of economies

without making judgments about whether the outcomes

are good or bad Normative economics looks at the results of

economic behavior and asks whether they are good or bad and whether they can be improved

8 Positive economics is often divided into two parts

Descriptive economics involves the compilation of data that

accurately describe economic facts and events Economic

theory attempts to generalize and explain what is observed

It involves statements of cause and effect—of action and reaction

9 An economic model is a formal statement of an economic

theory Models simplify and abstract from reality

10 It is often useful to isolate the effects of one variable on

another while holding "all else constant." This is the device of

ceteris paribus

11 Models and theories can be expressed in many ways The

most common ways are in words, in graphs, and in equations

12 Because one event happens before another, the second event

does not necessarily happen as a result of the first To assume

that "after" implies "because" is to commit the fallacy of post

hoc, ergo propter hoc The erroneous belief that what is true

for a part is necessarily true for the whole is the fallacy of

composition

13 Empirical economics involves the collection and use of data to

test economic theories In principle, the best model is the one that yields the most accurate predictions

14 To make policy, one must be careful to specify criteria for

making judgments Four specific criteria are used most often

in economics: efficiency, equity, growth, and stability

Ockham's razor, p 11 opportunity cost, p 2 positive economics, p 10

post hoc, ergo propter hoc, p 12

scarce, p 2 stability, p 15 sunk costs, p 3 variable, p 11

Visit www myeconlab.com to complete the problems marked in orange online You will receive

instant feedback on your answers, tutorial help, and access to additional practice problems

One of the scarce resources that constrain our behavior is time

Each of us has only 24 hours in a day How do you go about

allocating your time in a given day among competing

alterna-tives? How do you go about weighing the alternaalterna-tives? Once

you choose a most important use of time, why do you not

spend all your time on it? Use the notion of opportunity cost in

your answer

In the summer of 2007, the housing market and the mortgage

market were both in decline Housing prices in most U.S cities

began to decline in mid-2006 With prices falling and the

inven-tory of unsold houses rising, the production of new homes fell

to around 1.5 million in 2007 from 2.3 million in 2005 With

new construction falling dramatically, it was expected that

con-struction employment would fall and that this would have the

potential of slowing the national economy and increasing the

general unemployment rate Go to www.bls.gov and check out

the recent data on total employment and construction

employ-ment Have they gone up or down from their levels in August

2007? What has happened to the unemployment rate? Go to

www.ofheo.gov and look at the housing price index Have home

prices risen or fallen since August 2007? Finally, look at the

lat-est GDP release at www.bea.gov Look at residential and

nonres-idential investment (Table 1.1.5) during the last 2 years Do you

see a pattern? Does it explain the employment numbers?

Explain your answer

Which of the following statements are examples of positive

eco-nomic analysis? Which are examples of normative analysis?

a The inheritance tax should be repealed because it is unfair

b Allowing Chile to join NAFTA would cause wine prices in

the United States to drop

c The first priorities of the new regime in the Democratic

Republic of Congo (DRC, formerly Zaire) should be to

rebuild schools and highways and to provide basic

health care

Selwyn signed up with an Internet provider for a fixed fee of

$19.95 per month For this fee, he gets unlimited access to the

World Wide Web During the average month in 2007, he was

logged onto the Web for 17 hours What is the average cost of an

hour of Web time to Selwyn? What is the marginal cost of an

additional hour?

A question facing many U.S states is whether to allow casino gambling States with casino gambling have seen a substantial increase in tax revenue flowing to state government This revenue can be used to finance schools, repair roads, maintain social programs, or reduce other taxes

a Recall that efficiency means producing what people want at

the least cost Can you make an efficiency argument in favor

of allowing casinos to operate?

b What nonmonetary costs might be associated with

gam-bling? Would these costs have an impact on the efficiency argument you presented in part a?

c Using the concept of equity, argue for or against the

legaliza-tion of casino gambling

For each of the following situations, identify the full cost (opportunity cost) involved:

a A worker earning an hourly wage of $8.50 decides to cut

back to part-time to attend Houston Community College

b Sue decides to drive to Los Angeles from San Francisco to

visit her son, who attends UCLA

c Tom decides to go to a wild fraternity party and stays out all

night before his physics exam

d Annie spends $200 on a new dress

e The Confab Company spends $1 million to build a new

branch plant that will probably be in operation for at least

10 years

f Alex's father owns a small grocery store in town Alex works

40 hours a week in the store but receives no compensation

[Related to the ECONOMICS IN PRACTICE on p 6] Log onto www census.gov Click on "Foreign Trade," then on "Statistics," and finally on "State Export Data." There you will find a list of the products produced in your state and exported to countries around the world In looking over that list, are you surprised by anything? Do you know of any firms that produce these items? Search the Web to find a company that does Do some research and write a paragraph about your company: what it produces, how many people it employs, and whatever else you can learn about the firm You might even call the company to obtain the information

1

2

P R O B L E M S

A P P E N D I X

HOW TO READ AND UNDERSTAND GRAPHS

Economics is the most quantitative of the social sciences If you

flip through the pages of this or any other economics text, you

will see countless tables and graphs These serve a number of

purposes First, they illustrate important economic

relation-ships Second, they make difficult problems easier to understand

and analyze Finally, they can show patterns and regularities that

may not be discernible in simple lists of numbers

A graph is a two-dimensional representation of a set of

numbers, or data There are many ways that numbers can be

illustrated by a graph

T I M E S E R I E S G R A P H S

It is often useful to see how a single measure or variable

changes over time One way to present this information is to

plot the values of the variable on a graph, with each value

corresponding to a different time period A graph of this kind

is called a time series graph On a time series graph, time is

measured along the horizontal scale and the variable being graphed is measured along the vertical scale Figure 1A.1 is a time series graph that presents the total disposable personal income in the U.S economy for each year between 1975 and

2006.1 This graph is based on the data found in Table 1A.1

By displaying these data graphically, we can see that (1) total disposable personal income has increased steadily since 1975 and (2) during certain periods, income has increased at a faster rate than during other periods

1 The measure of income presented in Table 1A.1 and in Figure 1A.1 is disposable personal income in billions of dollars It is the total personal income received by all households in the United States minus the taxes that they pay

• FIGURE 1A.1 Total Disposable Personal Income in the United

States: 1 9 7 5 - 2 0 0 6 (in billions of dollars)

Source: See Table 1A 1

Source: U S Department of Commerce, Bureau of Economic

Analysis

GRAPHING TWO VARIABLES ON A CARTESIAN

COORDINATE SYSTEM

More important than simple graphs of one variable are

graphs that contain information on two variables at the

same time The most common method of graphing two

vari-ables is the Cartesian coordinate system This system is

constructed by drawing two perpendicular lines: a

horizon-tal line, or X-axis, and a vertical line, or Y-axis The axes

contain measurement scales that intersect at 0 (zero) This

point is called the origin On the vertical scale, positive

numbers lie above the horizontal axis (that is, above the

ori-gin) and negative numbers lie below it On the horizontal

scale, positive numbers lie to the right of the vertical axis (to

the right of the origin) and negative numbers lie to the left of

it The point at which the graph intersects the Y-axis is called

the Y-intercept The point at which the graph intersects the

X-axis is called the X-intercept

When two variables are plotted on a single graph, each point

represents a pair of numbers The first number is measured on

the X-axis, and the second number is measured on the Y-axis For

example, the following points (X, Y) are plotted on the set of axes

drawn in Figure 1A.2: (4,2), (2, - 1 ) , ( - 3 , 4 ) , (-3, - 2 ) Most, but

not all, of the graphs in this book are plots of two variables where

both values are positive numbers [such as (4,2) in Figure 1A.2]

On these graphs, only the upper right quadrant of the coordinate

system (that is, the quadrant in which all X and Y values are

posi-tive) will be drawn

^ FIGURE 1 A.2 A Cartesian Coordinate System

A Cartesian coordinate system is constructed by drawing two

perpendic-ular lines: a vertical axis (the V-axis) and a horizontal axis (the X-axis)

Each axis is a measuring scale

PLOTTING INCOME AND CONSUMPTION DATA FOR HOUSEHOLDS

Table 1A.2 presents data collected by the Bureau of Labor Statistics (BLS) In a recent survey, 5,000 households were asked to keep track of all their expenditures This table shows average income and average spending for those households, ranked by income For example, the average income for the top fifth (20 percent) of the households was $147,737 The average spending for the top 20 percent was $90,469

Figure 1A.3 presents the numbers from Table 1A.2 ically using the Cartesian coordinate system Along the hori-zontal scale, the X-axis, we measure average income Along the vertical scale, the Y-axis, we measure average consumption spending Each of the five pairs of numbers from the table is represented by a point on the graph Because all numbers are positive numbers, we need to show only the upper right quad-rant of the coordinate system

graph-To help you read this graph, we have drawn a dotted line connecting all the points where consumption and income

would be equal This 45° line does not represent any data

Instead, it represents the line along which all variables on the X-axis correspond exactly to the variables on the Y-axis, for example, [10,000, 10,000], [20,000, 20,000], and [37,000, 37,000] The heavy blue line traces the data; the purpose of the dotted line is to help you read the graph

There are several things to look for when reading a graph The first thing you should notice is whether the line slopes upward or downward as you move from left to right The blue line in Figure 1A.3 slopes upward, indicating that

there seems to be a positive relationship between income

and spending: The higher a household's income, the more

a household tends to consume If we had graphed the centage of each group receiving welfare payments along the Y-axis, the line would presumably slope downward, indicat-ing that welfare payments are lower at higher income levels The income level/welfare payment relationship is thus a

per-negative relationship

Source: Consumer Expenditures in 2005, U S Bureau of Labor Statistics; Report 998,

Feb 2007

> FIGURE 1A.3

Household

Consumption and

Income

A graph is a simple

two-dimen-sional geometric representation

of data This graph displays the

data from Table 1 A.2 Along the

horizontal scale (X-axis), we

measure household income

Along the vertical scale (Y-axis),

we measure household

con-sumption Note: At point A,

consumption equals $ 1 9 , 1 2 0

and income equals $ 9 , 6 7 6 At

point 6, consumption equals

$ 2 8 , 9 2 1 and income equals

$ 2 5 , 5 4 6

Source: See Table 1A.2

> FIGURE 1A.4 A Curve

with ( a ) Positive Slope

and ( b ) Negative Slope

A positive slope indicates that

increases in X are associated with

increases in Y and that decreases

in X are associated with

decreases in Y A negative slope

indicates the opposite—when X

increases, Y decreases; and when

X decreases, Y increases

and income that is very different from the one in Table 1A.2 and Figure 1A.3 First, each point in Figure 1A.6 represents a different year; in Figure 1A.3, each point represented a dif-

ferent group of households at the same point in time (2005) Second, the points in Figure 1A.6 represent aggregate con-

sumption and income for the whole nation measured in

billions of dollars; in Figure 1A.3, the points represented

average household income and consumption measured in

dollars

It is interesting to compare these two graphs All points on the aggregate consumption curve in Figure 1A.6 lie below the 45° line, which means that aggregate consumption is always less than aggregate income However, the graph of average household income and consumption in Figure 1 A.3 crosses the 45° line, implying that for some households, consumption is larger than income

> FIGURE 1A.6 National

Income and

Consumption

It is important to think carefully

about what is represented by

points in the space defined by

the axes of a graph In this

graph, we have graphed income

with consumption, as in

Figure 1A.3, but here each

obser-vation point is national income

and aggregate consumption in

different years, measured in

billions of dollars

Source: See Table 1A 3

S U M M A R Y

A graph is a two-dimensional representation of a set of

num-bers, or data A time series graph illustrates how a single

vari-able changes over time

The most common method of graphing two variables on

one graph is the Cartesian coordinate system, which includes

an X (horizontal)-axis and a Y (vertical)-axis The points at

which the two axes intersect is called the origin The point at

which a graph intersects the Y-axis is called the Y-intercept

The point at which a graph intersects the X-axis is called the

X-intercept

The slope of a line or curve indicates whether the

relation-ship between the two variables graphed on a Cartesian dinate system is positive or negative and how much of a

coor-response there is in Y (the variable on the vertical axis) when

X (the variable on the horizontal axis) changes The slope of

a line between two points is the change in the quantity sured on the Y-axis divided by the change in the quantity measured on the X-axis

mea-C a r t e s i a n c o o r d i n a t e s y s t e m A

common method of graphing two variables

that makes use of two perpendicular lines

against which the variables are plotted, p 19

g r a p h A two-dimensional representation

of a set of numbers, or data p 18

n e g a t i v e r e l a t i o n s h i p A

relationship between two variables, X and Y,

in which a decrease in X is associated with an

increase in Y and an increase in X is

associated with a decrease in Y p 19

o r i g i n On a Cartesian coordinate system,

the point at which the horizontal and

vertical axes intersect, p 19

s l o p e A measurement that indicates

whether the relationship between variables is positive or negative and how much of a response there is in Y (the variable on the vertical axis) when X (the variable on the

horizontal axis) changes, p 20

t i m e s e r i e s g r a p h A graph illustrating

how a variable changes over time p 18

X - a x i s On a Cartesian coordinate system,

the horizontal line against which a variable is

plotted, p 19

X - i n t e r c e p t The point at which a graph

intersects the X-axis p 19

Y - a x i s On a Cartesian coordinate system,

the vertical line against which a variable is

plotted, p 19

Y - i n t e r c e p t The point at which a graph

intersects the Y-axis p 19

2

3

P R O B L E M S

Graph each of the following sets of numbers Draw a line

through the points and calculate the slope of each line

For each of the graphs in Figure 1, determine whether the curve has a positive or negative slope Give an intuitive explanation for what is happening with the slope of each curve

For each of the following equations, graph the line and calculate its slope

a P = 10 — 2 qD (Put qD on the X-axis.)

b P = 100 - 4 qD (Put qD on the X-axis.)

c P = 50 + 6qs (Put qs on the X-axis.)

d I = 10,000 - 500r (Put J on the X-axis.)

The Economic Problem: Scarcity

and Choice

Chapter 1 began with a very broad

definition of e c o n o m i c s Every

society, no matter how small or

large, no matter how simple or

complex, has a system or process

that works to t r a n s f o r m the

resources that nature and previous

generations provide into useful

form E c o n o m i c s is the study of

that process and its outcomes

Figure 2.1 illustrates three

basic questions that must be

answered to understand the

func-tioning of the economic system:

• What gets produced?

• How is it produced?

• W h o gets what is produced?

This chapter explores these questions in detail In a sense, this entire chapter is the definition

of economics It lays out the central problems addressed by the discipline and presents a

frame-work that will guide you through the rest of the book The starting point is the presumption that

human wants are unlimited but resources are not Limited or scarce resources force individuals and

societies to choose among competing uses of resources—alternative combinations of produced

goods and services—and among alternative final distributions of what is produced among

households

These questions are positive or descriptive That is, they ask how the system functions without

passing judgment about whether the result is good or bad They must be answered first before we

ask more normative questions such as these:

• Is the outcome good or bad?

• Can it be improved?

The term resources is very broad The sketch on the left side of Figure 2.1 shows several

cate-gories of resources Some resources are the products of nature: land, wildlife, fertile soil, minerals,

timber, energy, and even the rain and wind In addition, the resources available to an economy

include things such as buildings and equipment that have been produced in the past but are now

being used to produce other things And perhaps the most important resource of a society is its

human workforce with people's talents, skills, and knowledge

Things that are produced and then used in the production of other goods and services are

called capital resources, or simply capital. Buildings, equipment, desks, chairs, software, roads,

bridges, and highways are a part of the nations stock of capital

The basic resources available to a society are often referred to as factors of production, or

simply factors. T h e three key factors o f production are land, labor, and capital The process that

transforms scarce resources into useful goods and services is called production. In many

soci-eties, most of the production of goods and services is done by private firms Private airlines in

2

CHAPTER OUTLINE Scarcity, Choice, and Opportunity Cost p 26 Scarcity and Choice in a One-Person Economy Scarcity and Choice in an Economy of Two or More The Production Possibility Frontier

The Economic Problem

Economic Systems p 38 Command Economies Laissez-Faire Economies: The Free Market Mixed Systems, Markets, and Governments

Looking Ahead p 41

capital Things t h a t are produced and then used in the production o f other

production T h e process that transforms scarce resources into useful goods and services

2 5

Every society has some system or process that transforms its scarce resources into useful goods and services

In doing so, it must decide what gets produced, how it is produced, and to whom it is distributed The mary resources that must be allocated are land, labor, and capital

pri-inputs or resources

Anything provided by nature or

previous g e n e r a t i o n s t h a t can

be used directly or indirectly to

satisfy human wants

Resources or factors of production are the inputs into the process of production; goods and services of value to households are the outputs of the process of production

Scarcity and Choice in a One-Person Economy

The simplest economy is one in which a single person lives alone on an island Consider Bill, the survivor of a plane crash, who finds himself cast ashore in such a place Here individual and soci-

ety are one; there is no distinction between social and private Nonetheless, nearly all the same

basic decisions that characterize complex economies must also be made in a simple economy That is,

although Bill will get whatever he produces, he still must decide how to allocate the island's resources, what to produce, and how and when to produce it

First, Bill must decide what he wants to produce Notice that the word needs does not appear

here Needs are absolute requirements; but beyond just enough water, basic nutrition, and shelter

to survive, needs are very difficult to define What is an "absolute necessity" for one person may not be for another person In any case, Bill must put his wants in some order of priority and make some choices

Next, he must look at the possibilities What can he do to satisfy his wants given the limits of

the island? In every society, no matter how simple or complex, people are constrained in what they can do In this society of one, Bill is constrained by time, his physical condition, his knowl-edge, his skills, and the resources and climate of the island

Given that resources are limited, Bill must decide how to best use them to satisfy his

hierar-chy of wants Food would probably come close to the top of his list Should he spend his time gathering fruits and berries? Should he hunt for game? Should he clear a field and plant seeds? The answers to those questions depend on the character of the island, its climate, its flora and

fauna (are there any fruits and berries?), the extent of his skills and knowledge (does he know

anything about farming?), and his preferences (he may be a vegetarian)

Scarcity, Choice, and Opportunity Cost

In the second half of this chapter we discuss the global economic landscape Before you can understand the different types of economic systems, it is important to master the basic economic concepts of scarcity, choice, and opportunity cost

^ FIGURE 2.1 The Three Basic Questions

Opportunity Cost The concepts of constrained choice and scarcity are central to the

disci-pline of economics They can be applied when discussing the behavior of individuals such as Bill

and when analyzing the behavior of large groups of people in complex societies

Given the scarcity of time and resources, if Bill decides to hunt, he will have less time to gather

fruits and berries He faces a trade-off between meat and fruit There is a trade-off between food

and shelter too If Bill likes to be comfortable, he may work on building a nice place to live, but that

may require giving up the food he might have produced As we noted in Chapter 1, the best

alter-native that we give up, or forgo, when we make a choice is the opportunity cost of that choice

Bill may occasionally decide to rest, to lie on the beach, and to enjoy the sun In one sense,

that benefit is free—he does not have to buy a ticket to lie on the beach In reality, however,

relax-ing does have an opportunity cost The true cost of that leisure is the value of the other threlax-ings Bill

could have produced, but did not, during the time he spent on the beach

The Houston Dynamos are a championship soccer team currently playing in an old arena on

the University of Houston campus In the summer of 2007, the Harris County Houston Sports

Authority and local politicians were actively debating whether to spend taxpayers money on a

new arena for the team An important part of that debate was the opportunity cost of the

taxpay-ers' dollars: what else could tax dollars be spent on, and how much value would the alternatives

bring to the local taxpayers? Perhaps without the new arena, taxes could be lower Here the

opportunity cost would include the value taxpayers receive from goods and services they would

consume with the earnings that are no longer taxed Most discussions of public expenditures at

all levels of government include active considerations of opportunity costs

In making everyday decisions, it is often helpful to think about opportunity costs Should you

go to the dorm party or not? First, it costs $4 to attend When you pay money for anything, you

give up the other things you could have bought with that money Second, it costs 2 or 3 hours

Time is a valuable commodity for a college student You have exams next week, and you need to

study You could go to a movie instead of the party You could go to another party You could sleep

Just as Bill must weigh the value of sunning on the beach against more food or better housing, so

you must weigh the value of the fun you may have at the party against everything else you might

otherwise do with the time and money

opportunity cost T h e

best alternative t h a t we give

up, or forgo, when we make a

c h o i c e or decision

Scarcity and Choice in an Economy of Two or More

Now suppose that another survivor of the crash, Colleen, appears on the island Now that Bill is

not alone, things are more complex and some new decisions must be made Bill's and Colleen's

preferences about what things to produce are likely to be different They will probably not have the

same knowledge or skills Perhaps Colleen is very good at tracking animals and Bill has a knack for

building things How should they split the work that needs to be done? Once things are produced,

the two castaways must decide how to divide them How should their products be distributed?

The mechanism for answering these fundamental questions is clear when Bill is alone on the

island The "central plan" is his; he simply decides what he wants and what to do about it The

minute someone else appears, however, a number of decision-making arrangements immediately

become possible One or the other may take charge, in which case that person will decide for both

of them The two may agree to cooperate, with each having an equal say, and come up with a joint

plan; or they may agree to split the planning as well as the production duties Finally, they may go

off to live alone at opposite ends of the island Even if they live apart, however, they may take

advantage of each other's presence by specializing and trading

Modern industrial societies must answer the same questions that Colleen and Bill must

answer, but the mechanics of larger economies are more complex Instead of two people living

together, the United States has over 300 million people Still, decisions must be made about what

to produce, how to produce it, and who gets it

Specialization, Exchange, and Comparative Advantage The idea that

mem-bers of society benefit by specializing in what they do best has a long history and is one of the

most important and powerful ideas in all of economics David Ricardo, a major

nineteenth-century British economist, formalized the point precisely According to Ricardo's theory of

comparative advantage, specialization and free trade will benefit all trading parties, even

theory of comparative advantage Ricardo's theory t h a t specialization and free trade will benefit all trading parties, even t h o s e t h a t may be "absolutely" more efficient producers

Frozen Foods and Opportunity Costs

In 2 0 0 7 , $27 billion of frozen foods were sold in U.S grocery stores, one quarter of it in the form

of frozen dinners and entrees In the m i d - 1 9 5 0 s , sales of frozen foods amounted to only $1 billion,

a tiny fraction of the overall grocery store sales

One industry observer attributes this growth to the fact that frozen food tastes much better than

it did in the past Can you think of anything else that might be occurring?

The growth of the frozen dinner entree market in the last 50 years is a good example of the role of opportunity costs in our lives One of the most significant social changes in the U.S economy in this period has been the increased participation of women in the labor force In

1950, only 24 percent of married women worked; by 2 0 0 0 , that fraction had risen to 61 cent Producing a meal takes two basic ingredients: food and time When both husbands and wives work, the opportunity cost of time for housework—including making meals—goes up This tells us that making a home-cooked meal became more expensive in the last 50 years A natural result is to shift people toward labor-saving ways to make meals Frozen foods are an obvious solution to the problem of increased opportunity costs

per-Another, somewhat more subtle, opportunity cost story is at work encouraging the sumption of frozen foods In 1960, the first microwave oven was introduced The spread of this device into America's kitchens was rapid The microwave turned out to be a quick way to defrost and cook those frozen entrees So this technology lowered the opportunity cost of making frozen dinners, reinforcing the advantage these meals had over home-cooked meals Microwaves made cooking with frozen foods cheaper once opportunity cost was considered while home-cooked meals were becoming more expensive

con-The entrepreneurs among you also might recognize that the rise we described in the

opportunity cost of the h o m e - c o o k e d meal contributed in part to the spread of the

microwave, creating a reinforcing cycle In fact, many entrepreneurs find that the simple tools

of economics—like the idea of opportunity costs—help them anticipate what products will

be profitable for them to produce in the future The growth of the two-worker family has stimulated many entrepreneurs to search for labor-saving solutions to family tasks

The public policy students among you might be interested to know that some researchers attribute part of the growth in obesity in the United States to the lower opportunity costs of making meals associated with the growth of the markets for frozen foods and the microwave (See David M.Cutler, Edward L Glaeser, and Jesse M Shapiro, "Why Have Americans Become

More Obese?" Journal of Economic Perspectives, Summer 2 0 0 3 , 9 3 - 1 1 8 )

when some are "absolutely" more efficient producers than others Ricardo's basic point applies just as much to Colleen and Bill as it does to different nations

To keep things simple, suppose that Colleen and Bill have only two tasks to accomplish each week: gathering food to eat and cutting logs to burn If Colleen could cut more logs than Bill in

1 day and Bill could gather more nuts and berries than Colleen could, specialization would clearly lead to more total production Both would benefit if Colleen only cuts logs and Bill only gathers nuts and berries, as long as they can trade Suppose that Bill is slow and somewhat clumsy in his

nut gathering and that Colleen is better at cutting logs and gathering food

At first, it might seem that since Colleen is better at everything, she should do everything But that cannot be right Colleen's time is limited after all, and even though Bill is clumsy and not very clever, he must be able to contribute something

One of Ricardo's lasting contributions to economics has been his analysis of exactly this uation His analysis, which is illustrated in Figure 2.2, shows both how Colleen and Bill should divide the work of the island and how much they will gain from specializing and exchanging even

sit-if, as in this example, one party is absolutely better at everything than the other party

< FIGURE 2.2

Comparative Advantage and the Gains from Trade

In this figure, ( a ) shows the number of logs and bushels of food that Colleen and Bill can produce for every day spent at the task and ( b ) shows how much output they could produce

in a month, assuming they wanted an equal number of logs and bushels Colleen would split her time 5 0 / 5 0 , devoting 15 days

to each task and achieving total output of 1 5 0 logs and

1 5 0 bushels of food Bill would spend 20 days cutting wood and

10 days gathering food As shown in ( c ) and ( d ) , by special- izing and trading, both Colleen and Bill will be better off Going from ( c ) to ( d ) , Colleen trades

1 0 0 logs to Bill in exchange for

1 4 0 bushels o f food

Suppose Colleen can cut 10 logs per day and Bill can cut only 4 Also suppose Colleen can

gather 10 bushels of food per day and Bill can gather only 8 A producer has an absolute

advantage over another in the production of a good or service if he or she can produce the

good or service using fewer resources, including time Since Colleen can cut more logs per day

than Bill, we say that she has an absolute advantage in the production of logs Similarly, Colleen

has an absolute advantage over Bill in the production of food

Thinking just about productivity and the output of food and logs, you might conclude that

it would benefit Colleen to move to the other side of the island and be by herself Since she is

more productive in cutting logs and gathering food, would she not be better off on her own? How

could she benefit by hanging out with Bill and sharing what they produce?

To answer that question we must remember that Colleen's time is limited: This limit creates

opportunity cost A producer has a comparative advantage over another in the production of

a good or service if he or she can produce the good or service at a lower opportunity cost First,

think about Bill He can produce 8 bushels of food per day, or he can cut 4 logs To get 8

addi-tional bushels of food, he must give up cutting 4 logs Thus, for Bill, the opportunity cost of

8 bushels of food is 4 logs Think next about Colleen She can produce 10 bushels of food per day,

or she can cut 10 logs She thus gives up 1 log for each additional bushel; so for Colleen, the

opportunity cost of 8 bushels of food is 8 logs Bill has a comparative advantage over Colleen in the

production of food because he gives up only 4 logs for an additional 8 bushels, whereas Colleen

gives up 8 logs

Think now about what Colleen must give up in terms of food to get 10 logs To produce

10 logs she must work a whole day If she spends a day cutting 10 logs, she gives up a day of

gath-ering 10 bushels of food Thus, for Colleen, the opportunity cost of 10 logs is 10 bushels of food What

must Bill give up to get 10 logs? To produce 4 logs, he must work 1 day For each day he cuts logs,

he gives up 8 bushels of food He thus gives up 2 bushels of food for each log; so for Bill, the

absolute advantage

A producer has an a b s o l u t e advantage over a n o t h e r in the production of a g o o d or service if he or she can produce

t h a t product using fewer resources

comparative advantage

A producer has a comparative advantage over a n o t h e r in the production of a g o o d or service if he or she can produce

t h a t product at a lower

opportunity cost

opportunity cost of 10 logs is 20 bushels of food Colleen has a comparative advantage over Bill in the

production of logs since she gives up only 10 bushels of food for an additional 10 logs, whereas Bill gives up 20 bushels

Ricardo then argues that two parties can benefit from specialization and trade even if one party has an absolute advantage in the production of both goods Suppose Colleen and Bill both want equal numbers of logs and bushels of food If Colleen goes off on her own, in a 30-day month, she can produce 150 logs and 150 bushels, devoting 15 days to each task For Bill to produce equal numbers of logs and bushels on his own requires that he spend 10 days

on food and 20 days on logs This yields 80 bushels of food (10 days X 8 bushels per day) and

80 logs (20 days X 4 logs per day) Between the two, they produce 230 logs and 230 bushels

of food

Let's see if specialization and trade can work If Bill spends all his time on food, he produces

240 bushels in a month (30 days x 8 bushels per day) If Colleen spends 3 days on food and 27 days

on logs, she produces 30 bushels of food (3 days x 10 bushels per day) and 270 logs (27 days x

10 logs per day) Between the two, they produce 270 logs and 270 bushels of food, which is more than the 230 logs and 230 bushels they produced when not specializing Thus, by specializing in the production of the good in which they enjoyed a comparative advantage, there are more of both goods We see in this example how the fundamental concept of opportunity cost covered earlier in this chapter relates to the theory of comparative advantage

Even if Colleen were to live at another place on the island, she could specialize, producing

30 bushels of food and 270 logs, then trading 100 of her logs to Bill for 140 bushels of food This would leave her with 170 logs and 170 bushels of food, which is more than the 150 of each she could produce on her own Bill would specialize completely in food, producing 240 bushels Trading 140 bushels of food to Colleen for 100 logs leaves him with 100 of each, which is more than the 80 of each he could produce on his own

The simple example of Bill and Colleen should begin to give you some insight into why most economists see value in free trade Even if one country is absolutely better than another country at producing everything, our example has shown that there are gains to specializing and trading

A Graphical Presentation of Comparative Advantage and Gains from Trade Graphs can also be used to show the benefits from specialization and trade in the example of Colleen and Bill To construct a graph reflecting Colleen's production choices (Figure 2.3 (a)), we start with the end points If she were to devote an entire month (30 days) to log production, she could cut 300 logs—10 logs per day X 30 days Similarly, if she were to devote an entire month to food gathering, she could produce 300 bushels If she chose to split her time evenly (15 days to logs and 15 days to food), she would have 150 bushels and 150 logs Her production possibilities are

illustrated by the straight line between A and B and illustrate the trade-off that she faces

between logs and food: By reducing her time spent in food gathering, Colleen is able to devote more time to logs; and for every 10 bushels of food that she gives up, she gets 10 logs

In Figure 2.3(b), we construct a graph of Bill's production possibilities Recall that Bill can produce 8 bushels of food per day, but he can cut only 4 logs Again, starting with the end points, if Bill devoted all his time to food production, he could produce 240 bushels—8 bushels

of food per day x 30 days Similarly, if he were to devote the entire 30 days to log cutting, he could cut 120 logs—4 logs per day x 30 days By splitting his time, with 20 days spent on log cut-ting and 10 days spent gathering food, Bill could produce 80 logs and 80 bushels of food His

production possibilities are illustrated by the straight line between D and E By shifting his

resources and time from logs to food, he gets 2 bushels for every log

Figures 2.3(a) and 2.3(b) illustrate the maximum amounts of food and logs that Bill and Colleen can produce acting independently with no specialization or trade, which is 230 logs and

230 bushels Now let us have each specialize in producing the good in which he or she has a parative advantage Back in Figure 2.2 on p 29, we showed that if Bill devoted all his time to food production, producing 240 bushels (30 days x 8 bushels per day), and Colleen devoted the vast majority of her time to cutting logs (27 days) and just a few days to gathering food (3 days), their combined total would be 270 logs and 270 bushels of food Colleen would produce 270 logs and

com-30 bushels of food to go with Bill's 240 bushels of food

a Colleen's production possibilities (monthly output) b Bill's production possibilities (monthly output)

^ FIGURE 2.3 Production Possibilities with No Trade

The figure in ( a ) shows all of the combinations of logs and bushels of food that Colleen can produce by

herself If she spends all 30 days each month on logs, she produces 3 0 0 logs and no food (point A) If she

spends all 30 days on food, she produces 3 0 0 bushels of food and no logs (point B ) If she spends 15 days

on logs and 15 days on food, she produces 1 5 0 of each (point C)

The figure in ( b ) shows all of the combinations of logs and bushels of food that Bill can produce by

him-self If he spends all 30 days each month on logs, he produces 1 2 0 logs and no food (point D ) If he

spends all 30 days on food, he produces 2 4 0 bushels of food and no logs (point E) If he spends 20 days

on logs and 10 days on food, he produces 80 of each (point F)

Finally, we arrange a trade, and the result is shown in Figures 2.4(a) and 2.4(b) Bill trades

140 bushels of food to Colleen for 100 logs; and he ends up with 100 logs and 100 bushels of food,

20 more of each than he would have had before the specialization and trade

Colleen ends up with 170 logs and 170 bushels, again 20 more of each than she would have

had before the specialization and trade Both are better off Both move beyond their individual

production possibilities

^ FIGURE 2.4 Colleen and Bill Gain from Trade

By specializing and engaging in trade, Colleen and Bill can move beyond their own production possibilities

If Bill spends all his time producing food, he will produce 2 4 0 bushels of food and no logs If he can trade

1 4 0 of his bushels of food to Colleen for 1 0 0 logs, he will end up with 1 0 0 logs and 1 0 0 bushels of food

The figure in ( b ) shows that he can move from point F t o point P

If Colleen spends 27 days cutting logs and 3 days producing food, she will produce 2 7 0 logs and 30 bushels

of food If she can trade 1 0 0 of her logs to Bill for 1 4 0 bushels of food, she will end up with 1 7 0 logs and

1 7 0 bushels of food The figure in ( a ) shows that she can move from point C to point C

Weighing Present and Expected Future Costs and Benefits Very often we find

ourselves weighing benefits available today against benefits available tomorrow Here, too, the

notion of opportunity cost is helpful

a Colleen moves beyond her

original production possibilties

b Bill moves beyond his original production possibilties

The simplest example of trading present for future benefits is the act of saving When you put income aside today for use in the future, you give up some things that you could have had today in exchange for something tomorrow Because nothing is certain, some judgment about future events and expected values must be made What will your income be in 10 years? How long are you likely to live?

We trade off present and future benefits in small ways all the time If you decide to study instead of going to the dorm party, you are trading present fun for the expected future benefits of higher grades If you decide to go outside on a very cold day and run 5 miles, you are trading dis-comfort in the present for being in better shape later

Capital Goods and Consumer Goods A society trades present for expected future benefits when it devotes a portion of its resources to research and development or to investment

in capital As we said earlier in this chapter, capital in its broadest definition is anything that has

already been produced that will be used to produce other valuable goods or services over time Building capital means trading present benefits for future ones Bill and Colleen might trade gathering berries or lying in the sun for cutting logs to build a nicer house in the future In a mod-

ern society, resources used to produce capital goods could have been used to produce consumer

goods—that is, goods for present consumption Heavy industrial machinery does not directly

sat-isfy the wants of anyone, but producing it requires resources that could instead have gone into ducing things that do satisfy wants directly—for example, food, clothing, toys, or golf clubs Capital is everywhere A road is capital Once a road is built, we can drive on it or transport goods and services over it for many years to come A house is also capital Before a new manufac-turing firm can start up, it must put some capital in place The buildings, equipment, and inven-tories that it uses comprise its capital As it contributes to the production process, this capital yields valuable services over time

pro-In Chapter 1, we talked about the enormous amount of capital—buildings, factories, housing, cars, trucks, telephone lines, and so on—that you might see from a window high in a skyscraper Much

of that capital was put in place by previous generations, yet it continues to provide valuable services today; it is part of this generation's endowment of resources To build every building, every road, every factory, every house, and every car or truck, society must forgo using resources to produce consumer goods today To get an education, you pay tuition and put off joining the workforce for a while Capital does not need to be tangible When you spend time and resources developing skills

or getting an education, you are investing in human capital—your own human capital This ital will continue to exist and yield benefits to you for years to come A computer program pro-duced by a software company may come on a CD that costs 7 5 ¢ to make, but its true intangible value comes from the ideas embodied in the program itself, which will drive computers to do valuable, time-saving tasks over time It too is capital

cap-The process of using resources to produce new capital is called investment (In everyday

language, the term investment often refers to the act of buying a share of stock or a bond, as in "I invested in some Treasury bonds." In economics, however, investment always refers to the cre-

ation of capital: the purchase or putting in place of buildings, equipment, roads, houses, and the like.) A wise investment in capital is one that yields future benefits that are more valuable than the present cost When you spend money for a house, for example, presumably you value its future benefits That is, you expect to gain more from living in it than you would from the things you could buy today with the same money Because resources are scarce, the opportunity cost of every investment in capital is forgone present consumption

production possibility

frontier (ppf) A graph

t h a t shows all the c o m b i n a t i o n s

o f g o o d s and services t h a t can

be produced if all of society's

resources are used efficiently

The Production Possibility Frontier

A simple graphic device called the production possibility frontier (ppf) illustrates the

prin-ciples of constrained choice, opportunity cost, and scarcity The ppf is a graph that shows all the combinations of goods and services that can be produced if all of a society's resources are used efficiently Figure 2.5 shows a ppf for a hypothetical economy

< FIGURE 2.5

Production Possibility Frontier

The ppf illustrates a number of economic concepts One of the

most important is opportunity cost

The opportunity cost of ing more capital goods is fewer

produc-consumer goods Moving from E

to F, the number of capital goods

increases from 5 5 0 to 8 0 0 , but the number of consumer goods decreases from 1,300 to 1,100

On the Y-axis, we measure the quantity of capital goods produced On the X-axis, we

mea-sure the quantity of consumer goods All points below and to the left of the curve (the shaded

area) represent combinations of capital and consumer goods that are possible for the society

given the resources available and existing technology Points above and to the right of the curve,

such as point G, represent combinations that cannot be reached If an economy were to end up

at point A on the graph, it would be producing no consumer goods at all; all resources would be

used for the production of capital If an economy were to end up at point B, it would be

devot-ing all its resources to the production of consumer goods and none of its resources to the

forma-tion of capital

While all economies produce some of each kind of good, different economies emphasize

dif-ferent things About 17.1 percent of gross output in the United States in 2005 was new capital In

Japan, capital historically accounted for a much higher percent of gross output, while in the

Congo, the figure was 7 percent Japan is closer to point A on its ppf, the Congo is closer to B, and

the United States is somewhere in between

Points that are actually on the ppf are points of both full resource employment and

produc-tion efficiency (Recall from Chapter 1 that an efficient economy is one that produces the things

that people want at the least cost Production efficiency is a state in which a given mix of outputs is

produced at the least cost.) Resources are not going unused, and there is no waste Points that lie

within the shaded area but that are not on the frontier represent either unemployment of

resources or production inefficiency An economy producing at point D in Figure 2.5 can

pro-duce more capital goods and more consumer goods, for example, by moving to point E This is

possible because resources are not fully employed at point D or are not being used efficiently

Unemployment During the Great Depression of the 1930s, the U.S economy experienced

prolonged unemployment Millions of workers found themselves without jobs In 1933, 25

per-cent of the civilian labor force was unemployed This figure stayed above 14 perper-cent until 1940,

when increased defense spending by the United States created millions of jobs In June 1975, the

unemployment rate went over 9 percent for the first time since the 1930s In December 1982,

when the unemployment rate hit 10.8 percent, nearly 12 million people were looking for work In

2007, the figure was 7.1 million

In addition to the hardship that falls on the unemployed, unemployment of labor means

unemployment of capital During economic downturns or recessions, industrial plants run at less

than their total capacity When there is unemployment of labor and capital, we are not producing

all that we can

Periods of unemployment correspond to points inside the ppf, points such as D in Figure 2.5

Moving onto the frontier from a point such as D means achieving full employment of resources

Inefficiency Although an economy may be operating with full employment of its land, labor,

and capital resources, it may still be operating inside its ppf (at a point such as D in Figure 2.5) It could be using those resources inefficiently

Waste and mismanagement are the results of a firm operating below its potential If you are the owner of a bakery and you forget to order flour, your workers and ovens stand idle while you figure out what to do

Sometimes inefficiency results from mismanagement of the economy instead of agement of individual private firms Suppose, for example, that the land and climate in Ohio are best suited for corn production and that the land and climate in Kansas are best suited for wheat production If Congress passes a law forcing Ohio farmers to plant 50 percent of their acreage with wheat and Kansas farmers to plant 50 percent with corn, neither corn nor wheat production

misman-will be up to potential The economy misman-will be at a point such as A in Figure 2.6—inside the ppf

Allowing each state to specialize in producing the crop that it produces best increases the

pro-duction of both crops and moves the economy to a point such as B in Figure 2.6

> FIGURE 2.6

Inefficiency from

Misallocation of Land

in Farming

Society can end up inside its ppf

at a point such as A by using its

resources inefficiently If, for

example, Ohio's climate and soil

were best suited for corn

produc-tion and those of Kansas were

best suited for wheat

produc-tion, a law forcing Kansas

farm-ers to produce corn and Ohio

farmers to produce wheat would

result in less of both In such a

case, society might be at point A

instead of point 6

The Efficient Mix of Output To be efficient, an economy must produce what people

want This means that in addition to operating on the ppf, the economy must be operating at the

right point on the ppf This is referred to as output efficiency, in contrast to production efficiency

Suppose that an economy devotes 100 percent of its resources to beef production and that the beef industry runs efficiently using the most modern techniques Also suppose that everyone in the society is a vegetarian The result is a total waste of resources (assuming that the society can-not trade its beef for vegetables produced in another country)

Points B and C in Figure 2.6 are points of production efficiency and full employment Whether B is more or less efficient than C, however, depends on the preferences of members of

society and is not shown in the ppf graph

Negative Slope and Opportunity Cost As we have seen, points that lie on the ppf resent points of full resource employment and production efficiency Society can choose only one point on the curve Because a society's choices are constrained by available resources and existing technology, when those resources are fully and efficiently employed, it can produce more capital goods only by reducing production of consumer goods The opportunity cost of the additional capital is the forgone production of consumer goods

rep-The fact that scarcity exists is illustrated by the negative slope of the ppf (If you need a

review of slope, see the Appendix to Chapter 1.) In moving from point E to point F in Figure 2.5, capital production increases by 800 — 550 = 250 units (a positive change), but that increase in

capital can be achieved only by shifting resources out of the production of consumer goods

Thus, in moving from point E to point F in Figure 2.5, consumer goods production decreases by

< FIGURE 2.7 Corn and

W h e a t Production in Ohio and Kansas

The ppf illustrates that the opportunity cost of corn produc- tion increases as we shift resources from wheat produc- tion to corn production Moving

from point £ to D, we get an

additional 1 0 0 million bushels of corn at a cost of 50 million bushels of wheat Moving

from point 6 to A, we get only

50 million bushels of corn at a cost of 1 0 0 million bushels of

wheat The cost per bushel of

corn—measured in lost w h e a t has increased

-Suppose that society's demand for corn dramatically increases If this happens, farmers

would probably shift some of their acreage from wheat production to corn production Such a

shift is represented by a move from point C (where corn = 510 and wheat = 380) up and to the

left along the ppf toward points A and B in Figure 2.7 As this happens, it becomes more difficult

to produce additional corn The best land for corn production was presumably already in corn,

and the best land for wheat production was already in wheat As we try to produce more corn, the

land is less well suited to that crop As we take more land out of wheat production, we are taking

increasingly better wheat-producing land In other words, the opportunity cost of more corn,

measured in terms of wheat, increases

Moving from point E to D, Table 2.1 shows that we can get 100 million bushels of corn

(400 — 300) by sacrificing only 50 million bushels of wheat (550 — 500)—that is, we get

1,300 — 1,100 = 200 units (a negative change) The slope of the curve, the ratio of the change in

capital goods to the change in consumer goods, is negative

The value of the slope of a society's ppf is called the marginal rate of transformation

(MRT) In Figure 2.5, the MRT between points E and F is simply the ratio of the change in

capi-tal goods (a positive number) to the change in consumer goods (a negative number)

The Law of Increasing Opportunity Cost The negative slope of the ppf indicates the

trade-off that a society faces between two goods We can learn something further about the shape

of the frontier and the terms of this trade-off Let's look at the trade-off between corn and wheat

production in Ohio and Kansas In a recent year, Ohio and Kansas together produced 510 million

bushels of corn and 380 million bushels of wheat Table 2.1 presents these two numbers, plus

some hypothetical combinations of corn and wheat production that might exist for Ohio and

Kansas together Figure 2.7 graphs the data from Table 2.1

marginal rate of transformation (MRT)

T h e slope o f t h e production possibility frontier (ppf)

2 bushels of corn for every bushel of wheat However, when we are already stretching the ability

of the land to produce corn, it becomes harder to produce more and the opportunity cost

increases Moving from point B to A, we can get only 50 million bushels of corn (700 — 650) by

sacrificing 100 million bushels of wheat (200 — 100) For every bushel of wheat, we now get only

half a bushel of corn However, if the demand for wheat were to increase substantially and we

were to move down and to the right along the ppf, it would become increasingly difficult to

pro-duce wheat and the opportunity cost of wheat, in terms of corn, would increase This is the law

of increasing opportunity cost

If you think about the example we discussed earlier of Colleen and Bill producing logs and food on an island, you will recognize that the production possibilities described were highly simpli-

fied In that example, we drew a downward slope, straight line ppf, to make the problem easier, we

assume constant opportunity costs In a real economy, ppf's would be expected to look like Figure 2.5 Although it exists only as an abstraction, the ppf illustrates a number of very important concepts that we will use throughout the rest of this book: scarcity, unemployment, inefficiency, opportunity cost, the law of increasing opportunity cost, economic growth, and the gains from trade

It is important to remember that the ppf represents choices available within the constraints imposed by the current state of agricultural technology In the long run, technology may

improve, and when that happens, we have growth

economic growth An

increase in t h e total output of

an e c o n o m y It o c c u r s when a

society acquires new resources

or when it learns to produce

more using existing resources

Economic Growth Economic growth is characterized by an increase in the total output

of an economy It occurs when a society acquires new resources or learns to produce more with existing resources New resources may mean a larger labor force or an increased capital stock The production and use of new machinery and equipment (capital) increase workers' productivity (Give a man a shovel, and he can dig a bigger hole; give him a steam shovel, and wow!) Improved

productivity also comes from technological change and innovation, the discovery and application

of new, more efficient production techniques

In the past few decades, the productivity of U.S agriculture has increased dramatically Based

on data compiled by the Department of Agriculture, Table 2.2 shows that yield per acre in corn production has increased fivefold since the late 1930s, while the labor required to produce it has dropped significantly Productivity in wheat production has also increased, at only a slightly less remarkable rate: Output per acre has more than tripled, while labor requirements are down nearly 90 percent These increases are the result of more efficient farming techniques, more and better capital (tractors, combines, and other equipment), and advances in scientific knowledge and technological change (hybrid seeds, fertilizers, and so on) As you can see in Figure 2.8, increases such as these shift the ppf up and to the right

a Data not available

Source: U.S Department of Agriculture, Economic Research Service, Agricultural Statistics, Crop Summary, wwwersusdagov ,

< FIGURE 2.8 Economic Growth Shifts the P P F

Up and to the Right

Productivity increases have enhanced the ability of the United States to produce both corn and wheat As Table 2.2 shows, productivity increases were more dramatic for corn than for wheat Thus, the shifts

in the ppf were not parallel

Note: The ppf also shifts if the

amount of land or labor in corn and wheat production changes Although

we emphasize productivity increases here, the actual shifts between years were due in part to land and labor changes

Sources of Growth and the Dilemma of Poor Countries Economic growth

arises from many sources, the two most important over the years having been the

accumula-tion of capital and technological advances For poor countries, capital is essential; they must

build the communication networks and transportation systems necessary to develop

industries that function efficiently They also need capital goods to develop their agricultural

sectors

Recall that capital goods are produced only at a sacrifice of consumer goods The same can

be said for technological advances Technological advances come from research and development

that use resources; thus, they too must be paid for The resources used to produce capital goods—

to build a road, a tractor, or a manufacturing plant—and to develop new technologies could have

been used to produce consumer goods

When a large part of a country's population is very poor, taking resources out of the

produc-tion of consumer goods (such as food and clothing) is very difficult In addiproduc-tion, in some

coun-tries, people wealthy enough to invest in domestic industries choose instead to invest abroad

because of political turmoil at home As a result, it often falls to the governments of poor

coun-tries to generate revenues for capital production and research out of tax collections

All these factors have contributed to the growing gap between some poor and rich nations

Figure 2.9 shows the result using ppf's On the left, the rich country devotes a larger portion of

its production to capital while the poor country produces mostly consumer goods On the right,

you see the results: the ppf of the rich country shifts up and out farther and faster

The importance of capital goods and technological developments to the position of workers

in less developed countries is well illustrated by Robert Jensen's study of South India's industry

Conventional telephones require huge investments in wires and towers and, as a result, many less

developed areas are without landlines Mobile phones, on the other hand, require a less expensive

investment; thus, in many areas, people upgraded from no phones directly to cell phones Jensen

found that in small fishing villages, the advent of cell phones allowed fishermen to determine on

any given day where to take their catch to sell, resulting in a large decrease in fish wasted and an

increase in fishing profits The ability of newer communication technology to aid development is

one of the exciting features of our times (See Robert Jensen, "The Digital Provide: Information

Technology, Market Performance, and Welfare in the South Indian Fisheries Sector," Quarterly

Journal of Economics, August 2007, 879-924.)

> FIGURE 2.9 Capital

Goods and Growth in

Poor and Rich Countries

Rich countries find it easier than

poor countries to devote

resources to the production of

capital, and the more resources

that flow into capital

produc-tion, the faster the rate of

eco-nomic growth Thus, the gap

between poor and rich countries

has grown over time

The Economic Problem

Recall the three basic questions facing all economic systems: (1) What gets produced? (2) How is

it produced? and (3) Who gets it?

When Bill was alone on the island, the mechanism for answering those questions was ple: He thought about his own wants and preferences, looked at the constraints imposed by the resources of the island and his own skills and time, and made his decisions As Bill set about his work, he allocated available resources quite simply, more or less by dividing up his available time Distribution of the output was irrelevant Because Bill was the society, he got it all

sim-Introducing even one more person into the economy—in this case, Colleen—changed all that With Colleen on the island, resource allocation involves deciding not only how each person spends his or her time but also who does what; and now there are two sets of wants and prefer-ences If Bill and Colleen go off on their own and form two separate self-sufficient economies, there will be lost potential Two people can do more things together than each person can do alone They may use their comparative advantages in different skills to specialize Cooperation and coordination may give rise to gains that would otherwise not be possible

When a society consists of millions of people, the problem of coordination and cooperation becomes enormous, but so does the potential for gain In large, complex economies, specializa-tion can go wild, with people working in jobs as different in their detail as an impressionist paint-ing is from a blank page The range of products available in a modern industrial society is beyond anything that could have been imagined a hundred years ago, and so is the range of jobs

The amount of coordination and cooperation in a modern industrial society is almost impossible to imagine Yet something seems to drive economic systems, if sometimes clumsily and inefficiently, toward producing the goods and services that people want Given scarce resources, how do large, complex societies go about answering the three basic economic ques-tions? This is the economic problem, which is what this text is about

Economic Systems

Now that you understand the economic problem, we can explore how different economic systems

go about answering the three basic questions

In the long struggle between the United States and the USSR in the post-World War II period,

there was a general view that authoritarian political systems went hand in hand with highly

cen-tralized and governmentally controlled economic systems The recent explosive growth in China

and the structure of the Chinese economy have created some debate over that connection

China has become a magnet for private capital and entrepreneurship and has one of the

most rapidly growing economies in the world For the last decade, China has been growing at

double-digit rates Between 2001 and 2004, China's national output went up almost 50 percent

In the single month of June 2005, the Chinese sold $21 billion worth of goods and services to the

United States, while the United States sold only $3.4 billion to China While the Chinese political

system is still highly controlled, the economy has many hallmarks of a free market system

Exciting new work is taking place to help better understand the connections between the

eco-nomic system and the political system

Command Economies

In a pure command economy, the basic economic questions are answered by a central

govern-ment Through a combination of government ownership of state enterprises and central

plan-ning, the government, either directly or indirectly, sets output targets, incomes, and prices

While the extremes of central planning have been rejected, so too has the idea that "markets

solve all problems." The real debate is not about whether we have government at all, it is about the

extent and the character of a limited government role in the economy One of the major themes

of this book is that government involvement, in theory, may improve the efficiency and fairness

of the allocation of a nation's resources At the same time, a poorly functioning government can

destroy incentives, lead to corruption, and result in the waste of a society"s resources

command economy An

e c o n o m y in which a central government either directly or indirectly sets o u t p u t targets,

i n c o m e s , and prices

Laissez-Faire Economies: The Free Market

At the opposite end of the spectrum from the command economy is the laissez-faire economy

The term laissez-faire, which translated literally from French means "allow [them] to do," implies

a complete lack of government involvement in the economy In this type of economy, individuals

and firms pursue their own self-interest without any central direction or regulation; the sum total

of millions of individual decisions ultimately determines all basic economic outcomes The

cen-tral institution through which a laissez-faire system answers the basic questions is the market, a

term that is used in economics to mean an institution through which buyers and sellers interact

and engage in exchange

The interactions between buyers and sellers in any market range from simple to complex

Early explorers of the North American Midwest who wanted to exchange with Native Americans

did so simply by bringing their goods to a central place and trading them Today the World Wide

Web is revolutionizing exchange A jewelry maker in upstate Maine can exhibit wares through

digital photographs on the Web Buyers can enter orders or make bids and pay by credit card

Companies such as eBay facilitate the worldwide interaction of tens of thousands of buyers and

sellers sitting at their computers

market T h e institution through which buyers and sellers interact and engage in exchange

Some markets are simple and others are complex, but they all involve buyers and sellers

engaging in exchange The behavior of buyers and sellers in a laissez-faire economy

deter-mines what gets produced, how it is produced, and who gets it

The following chapters explore market systems in great depth A quick preview is worthwhile

here, however

Consumer Sovereignty In a free, unregulated market, goods and services are produced

and sold only if the supplier can make a profit In simple terms, making a profit means selling

goods or services for more than it costs to produce them You cannot make a profit unless

someone wants the product that you are selling This logic leads to the notion of consumer

sovereignty: The mix of output found in any free market system is dictated ultimately by the

consumer sovereignty

T h e idea t h a t c o n s u m e r s ultimately d i c t a t e w h a t will be produced ( o r n o t p r o d u c e d ) by

c h o o s i n g w h a t t o purchase

tastes and preferences of consumers who "vote" by buying or not buying Businesses rise and fall in response to consumer demands No central directive or plan is necessary

Individual Production Decisions: Free Enterprise Under a free market system, individual producers must also determine how to organize and coordinate the actual production

of their products or services The owner of a small shoe repair shop must alone buy the needed equipment and tools, hang signs, and set prices In a big corporation, so many people are involved

in planning the production process that in many ways, corporate planning resembles the planning

in a command economy In a free market economy, producers may be small or large One person who hand-paints eggshells may start to sell them as a business; a person good with computers may start a business designing Web sites On a larger scale, a group of furniture designers may put together a large portfolio of sketches, raise several million dollars, and start a bigger business At the extreme are huge corporations such as Microsoft, Mitsubishi, and Intel, each of which sells tens

of billions of dollars' worth of products every year Whether the firms are large or small, however, production decisions in a market economy are made by separate private organizations acting in what they perceive to be their own interests

Often the market system is called a free enterprise system Free enterprise means the

free-dom of individuals to start private businesses in search of profits Because new businesses require capital investment before they can begin operation, starting a new business involves risk A well-run business that produces a product for which demand exists is likely to succeed; a poorly run business or one that produces a product for which little demand exists now or in the future is likely to fail It is through free enterprise that new products and new production techniques find their way into use

Proponents of free market systems argue that free enterprise leads to more efficient tion and better response to diverse and changing consumer preferences If a producer produces inefficiently, competitors will come along, fight for the business, and eventually take it away Thus, in a free market economy, competition forces producers to use efficient techniques of pro-duction It is competition, then, that ultimately dictates how output is produced

produc-Distribution of Output In a free market system, the distribution of output—who gets what—is also determined in a decentralized way The amount that any one household gets

depends on its income and wealth Income is the amount that a household earns each year It comes in a number of forms: wages, salaries, interest, and the like Wealth is the amount that

households have accumulated out of past income through saving or inheritance

To the extent that income comes from working for a wage, it is at least in part determined by individual choice You will work for the wages available in the market only if these wages (and the products and services they can buy) are sufficient to compensate you for what you give up by working Your leisure certainly has a value also You may discover that you can increase your

income by getting more education or training You cannot increase your income, however, if you

acquire a skill that no one wants

Price Theory The basic coordinating mechanism in a free market system is price A price is the amount that a product sells for per unit, and it reflects what society is willing to pay Prices of inputs—labor, land, and capital—determine how much it costs to produce a product Prices of var-

ious kinds of labor, or wage rates, determine the rewards for working in different jobs and

profes-sions Many of the independent decisions made in a market economy involve the weighing of prices and costs, so it is not surprising that much of economic theory focuses on the factors that influence

and determine prices This is why microeconomic theory is often simply called price theory

free enterprise The

freedom o f individuals t o start

and o p e r a t e private businesses

in search of profits

In a free market system, the basic economic questions are answered without the help of a central government plan or directives This is what the "free" in free market means—the sys-tem is left to operate on its own with no outside interference Individuals pursuing their own self-interest will go into business and produce the products and services that people want Other individuals will decide whether to acquire skills; whether to work; and whether to buy, sell, invest, or save the income that they earn The basic coordinating mechanism is price

In sum: