MICROeCONOMICS Principles & Applications pot

1Scarcity and Individual Choice 1 The Concept of Opportunity Cost, 2 Scarcity and Social Choice 6 The Four Resources, 6 • Opportunity Cost and Society’s Tradeoffs, 7 The World of Econom

Department of Economics, New York University

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

Microeconomics: Principles & Applications, 5th Edition

Robert E Hall

Marc Lieberman

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1 2 3 4 5 6 7 13 12 11 10 09

Part I: Preliminaries

1 What Is Economics? 1

2 Scarcity, Choice, and Economic Systems 24

Part II: Supply and Demand

3 Supply and Demand 51

4 Working with Supply and Demand 89

5 Elasticity 121

Part III: Microeconomic

Decision Makers

6 Consumer Choice 148

7 Production and Cost 189

8 How Firms Make Decisions:

Profit Maximization 227

Part IV: Product Markets

9 Perfect Competition 250

10 Monopoly 287

11 Monopolistic Competition and Oligopoly 325

Part V: Labor, Capital, and Financial Markets

12 Labor Markets 355

13 Capital and Financial Markets 396

Part VI: Efficiency, Government, and the Global Economy

14 Economic Efficiency and the Competitive Ideal 434

15 Government’s Role in Economic Efficiency 458

16 Comparative Advantage and the Gains from International Trade 493

Glossary G-1Index I-1

B R I E F C O N T E N T S

iii

Chapter 1: What Is Economics? 1

Scarcity and Individual Choice 1

The Concept of Opportunity Cost, 2

Scarcity and Social Choice 6

The Four Resources, 6 • Opportunity Cost and Society’s

Tradeoffs, 7

The World of Economics 8

Microeconomics and Macroeconomics, 8 • Positive

and Normative Economics, 8

Why Study Economics? 10

The Methods of Economics 11

The Art of Building Economic Models, 11 • Assumptions

and Conclusions, 12 • Math, Jargon, and Other

Concerns , 13

How to Study Economics 13

Summary 14

Problem Set 14

Appendix: Graphs and Other Useful Tools 16

Chapter 2: Scarcity, Choice, and Economic Systems 24 Society’s Production Choices 24 The Production Possibilities Frontier 25

Increasing Opportunity Cost, 26

The Search for a Free Lunch 27

Operating Inside the PPF, 27 • Economic Growth, 31

Economic Systems 34

Specialization and Exchange, 35 • Comparative Advantage, 36 • International Comparative Advantage, 39 • Resource Allocation, 41

Using the Theory: Are We Saving Lives Efficiently? 45 Summary 48

The Law of Demand, 56 • The Demand Schedule and the

Demand Curve, 57 • Shifts versus Movements Along the

Demand Curve, 58 • Factors That Shift the Demand

Curve, 60 • Demand: A Summary, 62

Supply 63

The Law of Supply, 64 • The Supply Schedule and the

Supply Curve, 64 • Shifts versus Movements Along the

Supply Curve, 66 • Factors That Shift the Supply

Curve, 67 • Supply—A Summary, 70

Putting Supply and Demand Together 71

Finding the Equilibrium Price and Quantity, 71

What Happens When Things Change? 74

Example: Income Rises, Causing an Increase in Demand, 74 • Example: Bad Weather , Supply Decreases, 75 • Example: Higher Income and Bad Weather Together, 76

The Three-Step Process 78 Using the Theory: The Oil Price Spike of 2007–2008 79 Summary 84

Problem Set 84 Appendix: Solving for Equilibrium Algebraically 87 Chapter 4: Working with Supply and Demand 89 Government Intervention in Markets 89

Fighting the Market: Price Ceilings, 90 • Fighting the Market: Price Floors, 92 • Manipulating the Market: Taxes, 95 • Manipulating the Market: Subsidies, 99

Part II: Supply and Demand

iv

Contents v

Chapter 6: Consumer Choice 148

The Budget Constraint 148

Changes in the Budget Line, 150

Preferences 152

Rationality, 152 • More Is Better, 153

Consumer Decisions: The Marginal Utility Approach 154

Utility and Marginal Utility, 154 • Combining the

Budget Constraint and Preferences, 156 • What Happens

When Things Change?, 160 • The Consumer’s Demand

Curve, 165

Income and Substitution Effects 165

The Substitution Effect, 165 • The Income Effect, 166 •

Combining Substitution and Income Effects, 166

Consumers in Markets 168

Consumer Theory in Perspective 169

Extensions of the Model, 170 • Behavioral

Economics, 170

Using the Theory: Improving Education 173

Summary 176

Problem Set 177

Appendix: The Indifference Curve Approach 180

Chapter 7: Production and Cost 189

Production 189

Technology and Production, 190 • Short-Run versus

Long-Run Decisions, 190

Production in the Short Run 191

Marginal Returns to Labor, 193

Thinking About Costs 194

The Irrelevance of Sunk Costs, 194 • Explicit versus Implicit Costs, 195

Cost in the Short Run 196

Measuring Short-Run Costs, 197 • Explaining the Shape

of the Marginal Cost Curve, 201 • The Relationship between Average and Marginal Costs, 202

Production and Cost in the Long Run 204

The Relationship between Long-Run and Short-Run Costs, 206 • Explaining the Shape of the LRATC

Curve, 209

Cost: A Summary 212 Using the Theory: The Urge to Merge 213 Summary 216

Problem Set 216 Appendix: Isoquant Analysis: Finding the Least-Cost Input Mix 220

Chapter 8: How Firms Make Decisions:

Profit Maximization 227 The Goal of Profit Maximization 227 Understanding Profit 228

Two Definitions of Profit, 228 • Why Are There Profits?, 230

The Firm’s Constraints 231

The Demand Curve Facing the Firm, 231 • The Cost Constraint, 233

The Profit-Maximizing Output Level 233

The Total Revenue and Total Cost Approach, 233 • The Marginal Revenue and Marginal Cost Approach, 234 •

Profit Maximization Using Graphs, 237 • What about

Part III: Microeconomic Decision Makers

Supply and Demand in Housing Markets 101

What’s Different about Housing Markets, 101 • Supply

and Demand Curves in a Housing Market, 102 • Housing

Market Equilibrium, 105 • What Happens When Things

Price Elasticity of Demand 121

Problems with Slope, 122 • The Elasticity

Approach, 123 • Calculating Price Elasticity

of Demand, 123 • Categorizing Demand, 125 • Elasticity and Straight-Line Demand Curves, 127 • Elasticity and Total Revenue, 128 • Determinants of Elasticity, 130 •

Time Horizons and Demand Curves, 134 • Two Practical Examples, 135

Other Elasticities 137

Income Elasticity of Demand, 137 • Cross-Price Elasticity

of Demand, 139 • Price Elasticity of Supply, 139

Using the Theory: Applications of Elasticity 141 Summary 145

Problem Set 146

vi Contents

Chapter 9: Perfect Competition 250

What Is Perfect Competition? 250

The Four Requirements of Perfect Competition, 251 •

Is Perfect Competition Realistic?, 253

The Perfectly Competitive Firm 253

The Competitive Firm’s Demand Curve, 254 • Cost and

Revenue Data for a Competitive Firm, 255 • Finding the

Profit-Maximizing Output Level, 257 • Measuring Total

Profit, 258 • The Firm’s Short-Run Supply Curve, 260

Competitive Markets in the Short Run 262

The Market Supply Curve, 262 • Short-Run

Equilibrium, 262

Competitive Markets in the Long Run 266

Profit and Loss and the Long Run, 266 • Long-Run

Equilibrium, 267 • The Notion of Zero Profit in

Perfect Competition, 269 • Perfect Competition and

Plant Size, 270 • A Summary of the Competitive Firm

in the Long Run, 271

What Happens When Things Change? 272

A Change in Demand, 272 • Market Signals and the

Economy, 277 • A Change in Technology, 279

Using the Theory: Short- and Long-Run Adjustment in the

Solar Power Industry 281

Summary 284

Problem Set 285

Chapter 10: Monopoly 287

What Is a Monopoly? 287

How Monopolies Arise 288

Economies of Scale, 288 • Legal Barriers, 289 • Network

Externalities, 291

Monopoly Behavior 293

Single Price versus Price Discrimination, 293 • Monopoly

Price or Output Decision, 293 • Monopoly and Market

Power, 296 • Profit and Loss, 297

Equilibrium in Monopoly Markets 299

Short-Run Equilibrium, 299 • Long-Run Equilibrium,

299 • Comparing Monopoly to Perfect Competition, 300 •

Government and Monopoly Profit, 303

What Happens When Things Change? 304

A Change in Demand, 304 • A Cost-Saving Technological Advance, 306

Price Discrimination 307

Requirements for Price Discrimination, 308 • Effects

of Price Discrimination, 309 • Perfect Price Discrimination, 312 • How Firms Choose Multiple Prices, 314 • Price Discrimination in Everyday Life, 315

Using the Theory: Monopoly Pricing and Parallel Trade

in Pharmaceuticals 316 Summary 321

Problem Set 321 Chapter 11: Monopolistic Competition and Oligopoly 325

The Concept of Imperfect Competition 325 Monopolistic Competition 326

Monopolistic Competition in the Short Run, 328 •

Monopolistic Competition in the Long Run, 328 •

Excess Capacity Under Monopolistic Competition, 330 •

Using the Theory: Advertising in Monopolistic Competition and Oligopoly 346

Summary 352 Problem Set 352

Part IV: Product Markets

Average Costs?, 240 • The Marginal Approach

to Profit, 241

Dealing with Losses 241

The Short Run and the Shutdown Rule, 242 • The Long

Run and the Exit Decision, 244

Using the Theory: Getting It Wrong and Getting It Right: Two Classic Examples 244

Summary 247 Problem Set 247

Contents vii

Chapter 12: Labor Markets 355

Labor Markets in Perspective 355

Defining a Labor Market, 357 • The Wage Rate, 357 •

Competitive Labor Markets, 357

Labor Demand 358

The Labor Demand Curve, 358 • Shifts in the Labor

Demand Curve, 360

Labor Supply 361

Variable Hours versus Fixed Hours, 362 • The Labor

Supply Curve, 362 • Shifts in the Labor Supply

Curve, 363

Labor Market Equilibrium 364

What Happens when Things Change, 364

Why Do Wages Differ? 367

An Imaginary World, 368 • Compensating Differentials,

369 • Differences in Ability, 371 • Barriers to

Entry, 374 • Discrimination, 376

The Minimum Wage Controversy 381

Who Pays for a Higher Minimum Wage?, 381 • Who

Benefits from a Higher Minimum Wage?, 381 • Labor

Market Effects of the Minimum Wage, 382 • The EITC

Alternative, 384 • Opposing Views, 384

Using the Theory: The College Wage Premium 385

Summary 388

Problem Set 389

Appendix: The Profit-Maximizing Employment Level 391

Chapter 13: Capital and Financial Markets 396 Physical Capital and the Firm’s Investment Decision 396

A First, Simple Approach: Renting Capital, 397 • The Value of Future Dollars, 399 • Purchasing Capital, 402 •

What Happens when Things Change: The Investment Curve, 404

Markets for Financial Assets 406

Primary and Secondary Asset Markets, 407 • Financial Assets and Present Value, 408

The Bond Market 409

How Much Is a Bond Worth?, 409 • Why Do Bond Yields Differ?, 411 • Explaining Bond Prices, 412 • What Happens When Things Change?, 414

The Stock Market 416

Why Do People Hold Stock?, 416 • Valuing a Share of Stock, 417 • Explaining Stock Prices, 418 • What Happens when Things Change? 420

The Efficient Markets View 421

The Meaning of an Efficient Stock Market, 421 •

Common Objections to Efficient Markets Theory, 423 •

Efficient Markets Theory and the Average Investor, 426

Using the Theory: The Present Value of a College Degree 427 Summary 431

Problem Set 431Part V: Labor, Capital, and Financial Markets

Chapter 14: Economic Efficiency

and the Competitive Ideal 434

The Meaning of Economic Efficiency 434

Pareto Improvements, 435 • Side Payments and Pareto

Improvements, 436

Competitive Markets and Economic Efficiency 437

Reinterpreting the Demand Curve, 437 • Reinterpreting

the Supply Curve, 438 • The Efficient Quantity of a

Good, 439 • The Efficiency of Perfect Competition, 441

Measuring Market Gains 441

Consumer Surplus, 441 • Producer Surplus, 443 • Total

Benefits and Efficiency, 445 • Perfect Competition: The

Total Benefits View, 446

Inefficiency and Deadweight Loss 446

A Price Ceiling, 447 • A Price Floor, 448 •

The Legal System, 459 • Regulation, 459 • The Importance of Infrastructure, 460 • Market Failures, 461

Monopoly 462

Potential Remedies for Monopoly Power, 462 • The Special Case of Natural Monopoly, 462 • Regulation of Natural Monopoly, 464

Part VI: Efficiency, Government, and the Global Economy

viii Contents

Efficiency and Government in Perspective 484

Government Failure, 485 • Deadweight Loss from

Chapter 16: Comparative Advantage and the Gains

from International Trade 493

The Logic of Free Trade 494

International Comparative Advantage 494

Determining a Nation’s Comparative

Advantage, 495 • How Specialization Increases World

Production, 496 • How Each Nation Gains from

International Trade, 498 • The Terms of Trade, 501

Some Provisos about Specialization, 501

The Sources of Comparative Advantage 502

Resource Abundance and Comparative Advantage, 503 •

Beyond Resources, 504

Why Some People Object to Free Trade 505

The Anti-Trade Bias, 507 • Some Antidotes

to the Anti-Trade Bias, 507

How Free Trade Is Restricted 508

Tariffs, 509 • Quotas, 510 • Quotas versus Tariffs, 510

Preface ix

P R E F A C E

ix

Microeconomics: Principles and Applications is about

eco-nomic principles and how economists use them to understand

the world It was conceived, written, and for the fifth edition,

substantially revised to help your students focus on those basic

principles and applications We originally decided to write this

book, because we thought that existing texts tended to fall into

one of three categories In the first category are the

encyclope-dias—the heavy tomes with a section or a paragraph on every

topic or subtopic you might possibly want to present to your

students These books are often useful as reference tools But

because they cover so many topics—many of them superficially—

the central themes and ideas can be lost in the shuffle The

second type of text we call the “scrapbook.” In an effort to

elevate student interest, these books insert multicolored boxes,

news clippings, interviews, cartoons, and whatever else they

can find to jolt the reader on each page While these special

features are often entertaining, there is a trade-off: These books

sacrifice a logical, focused presentation of the material Once

again, the central themes and ideas are often lost Finally, a

third type of text, perhaps in response to the first two, tries to

do less in every area—a lot less But instead of just omitting

extraneous or inessential details, these texts often throw out

key ideas, models, and concepts Students who use these books

may think that economics is overly simplified and unrealistic

After the course, they may be less prepared to go on in the field,

or to think about the economy on their own.

A Distinctive Approach

Our approach is very different We believe that the best way to

teach principles is to present economics as a coherent, unified

subject This does not happen automatically On the contrary,

principles students often miss the unity of what we call “the

economic way of thinking.” For example, they are likely to see

the analysis of goods markets, labor markets, and financial

mar-kets as entirely different phenomena, rather than as a repeated

application of the same methodology with a new twist here and

there So the principles course appears to be just “one thing after

another,” rather than the coherent presentation we aim for.

Careful Focus

Because we have avoided encyclopedic complexity, we have

had to think hard about what topics are most important As

you will see:

We avoid nonessential material

When we believed a topic was not essential to a basic understanding of economics, we left it out However, we

have strived to include core material to support an

instruc-tor who wants to present special topics in class So, for example, we do not have separate chapters on environmen- tal economics, agricultural economics, urban economics, health care economics, or comparative systems But instruc- tors should find in the text a good foundation for building any of these areas—and many others—into their course And we have included examples from each of these areas as

applications of core theory where appropriate throughout

the text.

We avoid distracting features

This text does not have interviews, news clippings, or boxed inserts with only distant connections to the core material The

features your students will find in our book are there to help

them understand and apply economic theory itself, and to help them avoid common mistakes in applying the theory (the Dangerous Curves feature).

We explain difficult concepts patiently

By freeing ourselves from the obligation to introduce every

possible topic in economics, we can explain the topics we do

cover more thoroughly and patiently We lead students, by-step, through each aspect of the theory, through each graph, and through each numerical example In developing this book, we asked other experienced teachers to tell us which aspects of economic theory were hardest for their stu- dents to learn, and we have paid special attention to the trouble spots.

step-We use concrete examples

Students learn best when they see how economics can explain the world around them Whenever possible, we develop the theory using real-world examples You will find numerous references to real-world corporations and govern- ment policies throughout the text When we employ hypo- thetical examples because they illustrate the theory more clearly, we try to make them realistic In addition, almost every chapter ends with a thorough, extended application (the “Using the Theory” section) focusing on an interesting real-world issue.

Features That Reinforce

To help students see economics as a coherent whole, and to

reinforce its usefulness, we have included some important

features in this book.

Most economists, when approaching a problem, begin by

thinking about buyers and sellers, and the markets in which

they come together to trade They move on to characterize a

market equilibrium, and then give their model a workout in a

comparative statics exercise To understand what economics is

about, students need to understand this process and see it in

action in different contexts To help them do so, we have

iden-tified and stressed a “three-step process” that economists use

in analyzing problems The three key steps are:

1 Characterize the Market Decide which market or markets

best suit the problem being analyzed, and identify the

decision makers (buyers and sellers) who interact there.

2 Find the Equilibrium Describe the conditions necessary

for equilibrium in the market, and a method for

determin-ing that equilibrium.

3 Determine What Happens When Things Change Explore

how events or government policies change the market

equilibrium.

The steps themselves are introduced toward the end of

Chapter 3 Thereafter, the content of most chapters is

orga-nized around this three-step process We believe this helps

students learn how to think like economists, and in a very

natural way And they come to see economics as a unified

whole, rather than as a series of disconnected ideas.

Anyone who teaches economics for a while learns that,

semes-ter afsemes-ter semessemes-ter, students tend to make the same familiar

errors In class, in office hours, and on exams, students seem

pulled, as if by gravity, toward certain logical pitfalls in

think-ing about, and usthink-ing, economic theory We’ve discovered in

our own classrooms that merely explaining the theory

prop-erly isn’t enough; the most common errors need to be

con-fronted, and the student needs to be shown specifically why a

particular logical path is incorrect This was the genesis of our

“Dangerous Curves” feature—boxes that anticipate the most

common traps and warn students just when they are most

likely to fall victim to them We’ve been delighted to hear from

instructors how effective this feature has been in overcoming

the most common points of confusion for their students.

This text is full of applications that are woven throughout the

narrative In addition, almost every chapter ends with an extended

application (”Using the Theory”) that pulls together several of the tools learned in that chapter These are not news clippings or world events that relate only tangentially to the material Rather, they are step-by-step presentations that help students see how the tools of economics can explain things about the world—things that would be difficult to explain without those tools.

In addition to the special features just described, you will find some important differences from other texts in topical approach and arrangement These, too, are designed to make the theory stand out more clearly, and to make learning easier These are not pedagogical experiments, nor are they innova- tion for the sake of innovation The differences you will find

in this text are the product of years of classroom experience.

Scarcity, Choice, and Economic Systems (Chapter 2)

This early chapter, while covering standard material such as opportunity cost, also introduces some central concepts much earlier than other texts Most importantly, it introduces the

concept of comparative advantage, and the basic principle of

specialization and exchange We have placed them at the front

of our book, because we believe they provide important ing blocks for much that comes later For example, comparative

build-advantage and specialization within the firm help explain

economies of scale (Chapter 6) International trade (Chapter 16) can be seen as a special application of these principles, extending them to trade between nations.

How Firms Make Decisions: Profit Maximization (Chapter 8)

Many texts introduce the theory of the firm using the fectly competitive model first While this has logical appeal to economists, we believe it is an unfortunate choice for students encountering this material for the first time Leading with perfect competition forces students to simultaneously master

per-the logic of profit maximization and per-the details of a raper-ther

counter-intuitive kind of market at the same time Students

quite naturally think of firms as facing downward-sloping

demand curves—not horizontal ones We have found that they have an easier time learning the theory of the firm with the more familiar, downward-sloping demand curve Further, by

treating the theory of the firm in a separate chapter, before perfect competition, we can separate concepts that apply in all

market structures (the shapes of marginal cost and average cost curves, the MC and MR approach to profit maximization, the shut-down rule, etc.), from concepts that are unique to perfect competition (horizontal demand curve, marginal reve- nue the same as price, etc.) This avoids confusion later on.

Monopolistic Competition and Oligopoly (Chapter 11)

Two features of our treatment are worth noting First, we emphasize advertising, a key feature of both of these types of

markets Students are very interested in advertising and how

firms make decisions about it Second, we have omitted older

theories of oligopoly that raised more questions than they

answered, such as the kinked demand curve model Our

treat-ment of oligopoly is strictly game theoretic, but we have taken

great care to keep it simple and clear Here, as always, we

provide the important tools to support instructors who want

to take game theory further, without forcing every instructor

to do so by including too much.

Capital and Financial Markets (Chapter 13)

This chapter focuses on the common theme of these subjects:

the present value of future income Moreover, it provides

simple, principles-level analyses of the stock and bond

mar-kets—something that students are hungry for but that many

principles textbooks neglect.

Description versus Assessment

(Chapters 9–11 and 14–15)

In treating product market structures, most texts switch back

and forth between the description and analysis of different

markets on the one hand and their efficiency properties on the

other Our book deals with description and analysis first, and

only then discusses efficiency, in two comprehensively

chap-ters The first of these (Chapter 14) covers the concept and

measurement of economic efficiency, using Pareto

improve-ments as well as consumer and producer surplus The second

(Chapter 15) deals with market failures and government’s role

in economic efficiency This arrangement of the material

per-mits instructors to focus on description and prediction when

first teaching about market structures—a full plate, in our

experience Second, two chapters devoted to efficiency allows

a more comprehensive treatment of the topic than we have

seen elsewhere Finally, our approach—in which students

learn about efficiency after they have mastered the four

market structures—allows them to study efficiency with the

perspective needed to really understand it.

Comparative Advantage and the Gains from

International Trade (Chapter 16)

We’ve found that international trade is best understood through

clear numerical examples, and we’ve developed them carefully

in this chapter We also try to bridge the gap between the

eco-nomics and politics of international trade with a systematic

discussion of winners and losers.

Organizational Flexibility

We have arranged the contents of each chapter, and the table

of contents as a whole, according to our recommended order

of presentation But we have also built in flexibility.

• Chapter 6 develops consumer theory with both marginal utility and (in an appendix) indifference curves, allowing you

to present either method in class (Instructors will find it even easier to make their choice in this edition—see following.)

• If you wish to highlight international trade or present parative advantage earlier in the course, you could assign Chapter 16 immediately following Chapter 3.

com-• If you wish to introduce consumer and producer surplus earlier in the course, all of Chapter 14 can be assigned after Chapter 9 And if you feel strongly that economic efficiency should be interwoven bit-by-bit with the chapters

on market structure, Chapter 14 can be easily broken into parts The relevant sections can then be assigned sepa- rately with Chapters 3, 4, 9, and 10.

Finally, we have included only those chapters that we thought were both essential and teachable in a one-semester course But not everyone will agree about what is essential While we—as authors—cringe at the thought of a chapter being omitted in the interest of time, we have allowed for that possibility Nothing in Chapter 12 (labor markets), Chapter 13 (capital and financial markets), Chapter 15 (government’s role in economic efficiency), or Chapter 16 (international trade) is essential to any of the other chapters in the book Skipping any of these should not cause continuity problems.

New to the Fifth Edition

The fifth edition is our most significant revision yet This will not surprise anyone who was teaching an economics princi- ples course during or after September 2008, when the finan- cial crisis hit its peak While teaching at the time, we had the daily task of integrating the flood of unprecedented events into the course When the semester was over, the two of us thought long and hard about what worked, what didn’t, and how the course should respond to the changes we had seen.

We wanted to be able to discuss recent events and draw out their long-lasting lessons and challenges We knew this would require adding some new concepts and tools But we

were mindful that this is a first course in economics and did

not want to migrate into areas that we could not fully explain

at the principles level In our discussions, we kept coming back

to the same place: that by adding two new core concepts, we could open up a myriad of other doors to understanding recent economic events Both of these concepts are introduced

in Chapter 4 (Working with Supply and Demand).

The first new concept we’ve introduced in this new edition is

leverage While leverage is at the heart of the recent economic

turmoil, it has not been part of the traditional principles gogy We’ve introduced it in a simple, intuitive way in the body

peda-of Chapter 4 We then delve a bit deeper in the short appendix

to that chapter, which explains the concept of owners’ equity

(in a home), and presents a simple leverage ratio that students

can work with Teaching this concept not only creates an early,

fresh connection between the classroom and current policy

debates but also lays the foundation for later applications in

the text For example, students will see how leverage

contrib-uted to the recent housing boom and bust (in Chapter 4) and

moral hazard in financial institutions (Chapter 15).

The second new core concept is how supply and demand

can be used for stock variables, and not just flow variables

While this idea was present in prior editions, it came late in

the text and was not fully established as a key concept We’ve

long wanted to introduce the stock-flow distinction earlier,

and more carefully, so we could analyze the market for the

housing stock with supply and demand But we never thought

this was essential until now.

As you’ll see in Chapter 4, treating housing as a stock

vari-able opens another door to understanding the recent housing

boom and bust We also believe that teaching the stock-flow

distinction early—with the rather intuitive case of housing—

makes it easier to think about stock variables later in other

contexts (such as financial markets, covered in Chapter 13).

Our overall approach, and the sequence of the material, will

be mostly familiar to those who’ve used past editions But we

wanted to highlight some other pedagogical changes, in

addi-tion to the new concepts (discussed earlier) in Chapter 4.

In this edition, our biggest change (at the request of many

instructors) is the new, simplified treatment of labor markets The

previous two chapters (one on labor markets and one on income

inequality) are now combined into the single Chapter 12 (Labor

Markets) The development of the labor demand curve is

stream-lined, so you can get to interesting applications (such as wage

inequality) with less delay (Those who liked the prior approach

to labor demand will find it in the appendix to that chapter.)

Two other pedagogical changes we should note are the shift

of the section on opportunity cost from Chapter 2 to Chapter

1 and an earlier introduction of international trade (within the

discussion of comparative advantage in Chapter 2).

There are dozens of new applications in this edition—some

woven into the narrative, others as new or substantially revised

“Using the Theory” sections, where the analysis is more

exten-sive The entirely new “Using the Theory” sections are:

• “The Oil Price Spike of 2007–2008” (Chapter 3)

• “The Housing Boom and Bust of 1997–2008” (Chapter 4)

• “Monopoly Pricing and Parallel Trade in Pharmaceuticals”

Teaching and Learning Aids

To help you present the most interesting principles courses possible, we have created an extensive set of supplementary items Many of them can be downloaded from the Hall/ Lieberman Web site www.cengage.com/economics/hall. The list includes the following items.

• The Instructor’s Manual is revised by Natalija Novta,

New York University, and Jeff Johnson, Sullivan University The manual provides chapter outlines, teaching ideas, experiential exercises for many chapters, suggested answers to the end-of-chapter review questions, and solu- tions to all end-of-chapter problems.

• Instructor’s Resource CD-ROM This easy-to-use CD

allows quick access to instructor ancillaries from your desktop It also allows you to review, edit, and copy exactly the material you need Or, you may choose to go

to Instructor Resources on the Product Support Web Site.

• Instructor Resources on the Product Support Web Site

This site at www.cengage.com/economics/hall features the essential resources for instructors, password-protect-

ed, in downloadable format: the Instructor’s Manual in

Word, the test banks in Word, and PowerPoint lecture and exhibit slides.

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About the Authors

Robert E Hall

Robert E Hall is a prominent

applied economist He is the

Robert and Carole McNeil

Professor of Economics at

Stanford University and Senior

Fellow at Stanford’s Hoover

Institution where he conducts

research on inflation,

unemploy-ment, taxation, monetary policy,

and the economics of high

tech-nology He received his Ph.D

from MIT and has taught there

as well as at the University of California, Berkeley Hall is

director of the research program on Economic Fluctuations of

the National Bureau of Economic Research, and chairman of

the Bureau’s Committee on Business Cycle Dating, which

maintains the semiofficial chronology of the U.S business

cycle He has published numerous monographs and articles in

scholarly journals, in addition to co-authoring this well-known

intermediate text Hall has advised the Treasury Department

and the Federal Reserve Board on national economic policy

and has testified on numerous occasions before congressional

committees Hall is President-elect of the American Economic

Association and will serve as President in 2010 He presented

the Ely Lecture to the Association in 2001 and served as Vice

President in 2005.

Although we have worked hard on the five editions of this book, we know there is always room for further improvement For that, our fellow users are indispensable We invite your comments and suggestions wholeheartedly We especially wel- come your suggestions for additional “Using the Theory” sec- tions and Dangerous Curves You may send your comments to either of us, care of South-Western.

Robert E Hall Marc Lieberman

Marc Lieberman

Marc Lieberman is Clinical Professor of Economics at New York University He received his Ph.D from Princeton University

Lieberman has presented his extremely popular Principles of Economics course at Harvard, Vassar, the University of California at Santa Cruz, and the University of Hawaii, as well as

at NYU He has twice won NYU’s Golden Dozen teaching award, and also the Economics Society Award for Excellence

in Teaching He is coeditor and contributor to The Road to

Capitalism: Economic Transformation in Eastern Europe and the Former Soviet Union Lieberman has consulted for

the Bank of America and the Educational Testing Service

In his spare time, he is a professional screenwriter, and teaches screenwriting at NYU’s School of Continuing and Professional Studies.

Economics The word conjures up all sorts of images: manic stock traders

on Wall Street, an economic summit meeting in a European capital, a

somber television news anchor announcing good or bad news about the

economy You probably hear about economics several times each day What

exactly is economics?

First, economics is a social science It seeks to explain something about society,

just like other social sciences, such as psychology, sociology, and political science

But economics is different from these other social sciences because of what

econo-mists study and how they study it Econoecono-mists ask different questions, and they

answer them using tools that other social scientists find rather exotic

A good definition of economics, which stresses its differences from other social

sciences, is the following:

Economics is the study of choice under conditions of scarcity. Economics The study of choice

under conditions of scarcity.

This definition may appear strange to you Where are the familiar words we

ordinar-ily associate with economics: “money,” “stocks and bonds,” “prices,” “budgets,” ?

As you will soon see, economics deals with all of these things and more But first, let’s

take a closer look at two important ideas in this definition: scarcity and choice

Scarcity and Individual Choice

Think for a moment about your own life Is there anything you don’t have that

you’d like to have? Anything you’d like more of? If your answer is “no,”

congratu-lations! You are well advanced on the path of Zen self-denial The rest of us,

how-ever, feel the pinch of limits to our material standard of living This simple truth is

at the very core of economics It can be restated this way: We all face the problem

of scarcity.

At first glance, it may seem that you suffer from an infinite variety of scarcities

There are so many things you might like to have right now—a larger room or

apart-ment, a new car, more clothes the list is endless But a little reflection suggests

that your limited ability to satisfy these desires is based on two other, more basic

limitations: scarce time and scarce spending power.

As individuals, we face a scarcity of time and spending power Given more

of either, we could each have more of the goods and services that we desire.

Scarcity A situation in which the amount of something available is insufficient to satisfy the desire for it.

What Is Economics?

C H A P T E R 1

2 Part 1: Preliminaries

The scarcity of spending power is no doubt familiar to you We’ve all wished for higher incomes so that we could afford to buy more of the things we want But the scarcity of time is equally important So many of the activities we enjoy—seeing movies, taking vacations, making phone calls—require time as well as money Just

as we have limited spending power, we also have a limited number of hours in each day to satisfy our desires

Because of the scarcities of time and spending power, each of us is forced to

make choices We must allocate our scarce time to different activities: work, play, education, sleep, shopping, and more We must allocate our scarce spending power

among different goods and services: housing, food, furniture, travel, and many others And each time we choose to buy something or do something, we also

choose not to buy or do something else

Economists study the choices we make as individuals, as well as their quences When some of the consequences are harmful, economists study what—if anything—the government can or should do about them

conse-For example, in the United States, as incomes have risen, more and more people have chosen to purchase automobiles The result is increasing traffic jams in our major cities The problem is even worse in rapidly developing countries In China and India, for example, recent income growth and migration from rural to urban areas has led to an explosion of driving Economists have come up with some cre-ative ideas to reduce traffic congestion, while preserving individual choices about driving A few cities have used these ideas, with some success, and more are consid-ering them

What does it cost you to go to the movies? If you answered 9 or 10 dollars because that is the price of a movie ticket, then you are leaving out a lot Most of us are used

to thinking of “cost” as the money we must pay for something Certainly, the money

we pay for goods or services is a part of its cost But economics takes a broader view

of costs The true cost of any choice we make—buying a car, producing a computer,

or even reading a book—is everything we must give up when we take that action This cost is called the opportunity cost of the action, because we give up the oppor-

tunity to have other desirable things

The opportunity cost of any choice is what we must forego when we make

that choice.

Opportunity cost What is given

up when taking an action or making

a choice.

Opportunity cost is the most accurate and complete concept of cost—the one we should use when making our own decisions or analyzing the decisions of others.Suppose, for example, it’s 8 p.m on a weeknight and you’re spending a couple of hours reading this chapter As authors, that thought makes us very happy We know there are many other things you could be doing: going to a movie, having dinner with friends, playing ping pong, earning some extra money, watching TV But, assuming you’re still reading—and you haven’t just run out the door because we’ve given you better ideas—let’s relate this to opportu-nity cost

What is the opportunity cost of reading this chapter? Is it all of those other

pos-sibilities we’ve listed? Not really, because in the time it takes to read this chapter,

you’d probably be able to do only one of those other activities You’d no doubt

Chapter 1: What Is Economics? 3

choose whichever one you regarded as best So, by reading, you sacrifice only the

best choice among the alternatives that you could be doing instead.

When the alternatives to a choice are mutually exclusive, only the next best

choice—the one that would actually be chosen—is used to determine the

opportunity cost of the choice.

For many choices, a large part of the opportunity cost is the money sacrificed

If you spend $15 on a new DVD, you have to part with $15, which is money you

could have spent on something else (whatever the best choice among the

alterna-tives turned out to be) But for other choices, money may be only a small part, or

no part, of what is sacrificed If you walk your dog a few blocks, it will cost you

time but not money

Still, economists often like to attach a monetary value even to the parts of

oppor-tunity cost that don’t involve money The opporoppor-tunity cost of a choice can then be

expressed as a dollar value, albeit a roughly estimated one That, in turn, enables us to

compare the cost of a choice with its benefits, which we also often express in dollars

An Example: The Opportunity Cost of College

Let’s consider an important choice you’ve made for this year: to attend college

What is the opportunity cost of this choice? A good starting point is to look at the

actual monetary costs—the annual out-of-pocket expenses borne by you or your

family for a year of college Table 1 shows the College Board’s estimates of these

expenses for the average student (ignoring scholarships) For example, the third

column of the table shows that the average in-state resident at a four-year state

col-lege pays $6,585 in tuition and fees, $1,077 for books and supplies, $7,748 for

room and board, and $2,916 for transportation and other expenses, for a total of

$18,326 per year

So, is that the average opportunity cost of a year of college at a public

institu-tion? Not really Even if $18,326 is what you or your family actually pays out for

college, this is not the dollar measure of the opportunity cost

TABLE 1

Average Cost of a Year

of College, 2008–2009 Type of Institution Two-Year Public Four-Year Public Four-Year Private

Tuition and fees $2,402 $6,585 $25,143

Books and supplies $1,036 $1,077 $1,054

Room and board $7,341 $7,748 $8,989

Transportation and other

expenses

$3,275 $2,916 $2,204

Total out-of-pocket costs $14,054 $18,326 $37,390

Source: Trends in College Pricing, 2008, The College Board, New York, NY.

Notes: Averages are enrollment-weighted by institution, to reflect the average experience among students across

the United States Average tuition and fees at public institutions are for in-state residents only Room and board

charges are for students living on campus at four-year institutions, and off-campus (but not with parents) at

two-year institutions Four-year private includes nonprofit only.

4 Part 1: Preliminaries

First, the $18,326 your family pays in this example includes some expenses that

are not part of the opportunity cost of college For example, room and board is something you’d need no matter what your choice For example, if you didn’t go to

college, you might have lived in an apartment and paid rent But suppose, instead, that if you didn’t go to college you would have chosen to live at home in your old room Even then, you could not escape a cost for room and board Your family

could have rented out the room to someone else, or used it for some other valuable

purpose Either way, something would be sacrificed for room and board, whether you go to college or not

Let’s suppose, for simplicity, that if you weren’t in college, you or your ily would be paying the same $7,748 for room and board as your college charg-

fam-es Then, the room and board expense should be excluded from the opportunity cost of going to college And the same applies to transportation and other expenses, at least the part that you would have spent anyway even if you weren’t

in college We’ll assume these other expenses, too, are the same whether or not you go to college

Now we’re left with payments for tuition and fees, and for books and supplies For an in-state resident going to a state college, this averages $6,585  $1,077 

$7,662 per year Since these dollars are paid only when you attend college, they represent something sacrificed for that choice and are part of its opportunity cost

Costs like these—for which dollars are actually paid out—are called explicit costs,

and they are part of the opportunity cost.

But college also has implicit costs—sacrifices for which no money changes

hands The biggest sacrifice in this category is time But what is that time worth? That depends on what you would be doing if you weren’t in school For many stu-

dents, the alternative would be working full-time at a job If you are one of these

students, attending college requires the sacrifice of the income you could have earned at a job—a sacrifice we call foregone income.

How much income is foregone when you go to college for a year? In

2008, the average yearly income of an 18- to 24-year-old high school graduate who worked full-time was about $24,000 If we assume that only nine months of work must be sacrificed to attend college and that you could still work full-time in the summer, then foregone income is about 3/4 of $24,000, or

$18,000

Summing the explicit and implicit costs gives us a rough estimate of the tunity cost of a year in college For a public institution, we have $7,662 in explicit costs and $18,000 in implicit costs, giving us a total of $25,662 per year Notice that this is significantly greater than the total charges estimated by the College Board we calculated earlier When you consider paying this opportunity cost for four years, its magnitude might surprise you Without financial aid in the form of tuition grants or other fee reductions, the average in-state resident will sacrifice about $103,000 to get a bachelor’s degree at a state college and about $177,000 at

Explicit cost The dollars

sacrificed—and actually paid

out—for a choice.

Implicit cost The value of

something sacrificed when no

direct payment is made.

Chapter 1: What Is Economics? 5

A Brief Digression: Is College the Right Choice?

Before you start questioning your choice to be in college, there are a few things to

remember First, for many students, scholarships reduce the costs of college to less

than those in our example Second, in addition to its high cost, college has

substan-tial benefits, including financial ones In fact, over a 40-year work life, the average

college graduate will make about $2.5 million, which is about a million dollars more

than the average high school graduate

True, much of that income is earned in the future, and a dollar gained years from

now is worth less than a dollar spent today Also, some of the higher earnings of

college graduates result from the personal characteristics of people who are likely to

attend college, rather than from the education or the degree itself But even when we

make reasonable adjustments for these facts, attending college appears to be one of

the best financial investments you can make.1

Finally, remember that we’ve left out of our

discus-sion many important aspects of this choice that would be

harder to estimate in dollar terms but could be very

important to you Do you enjoy being at college? If so,

your enjoyment is an added benefit, even though it may

be difficult to value that enjoyment in dollars (Of course,

if you hate college and are only doing it for the financial

rewards or to satisfy your parents, that’s an implicit

cost—which is part of your opportunity cost—that we

haven’t included.)

Time Is Money

Our analysis of the opportunity cost of college points

out a general principle, one understood by economists

and noneconomists alike It can be summed up in the

expression, “Time is money.”

For some people, this maxim applies directly: when

they spend time on something, they actually give up

money—money they could have earned during that time

Consider Jessica, a freelance writer with a backlog of

projects on which she can earn $25 per hour For each

hour Jessica spends not working, she sacrifices $25.

What if Jessica decides to see a movie? What is the

opportunity cost, in dollar terms? Suppose the ticket

costs $10 and the entire activity takes three hours—

including time spent getting there and back The

oppor-tunity cost is the sum of the explicit cost ($10 for the

ticket) and the implicit cost ($75 for three hours of

fore-gone income), making the total opportunity cost $85

The idea that a movie “costs” $85 might seem absurd

to you But if you think about it, $85 is a much better

estimate than $10 of what the movie actually costs

Jessica—$85 is what she sacrifices to see the movie

1 If you are studying microeconomics, you’ll learn more about the value of college as an investment and

the general technique economists use to compare future earnings with current costs in a later chapter.

dangerous curves

If you think the opportunity cost of your time is zero What if you can’t work extra hours for additional

pay, so you cannot actually turn time into money? Does this

mean that the opportunity cost of your time is zero?

If you think the answer is yes, the authors of this textbook would like to hire you for help with some household chores, for 25 cents an hour Does this sound like a good deal to you?

It would, if the opportunity cost of your time really had no value If it doesn’t sound like a good deal, then the time you’d

be giving up must have some positive value to you If pressed, you could state that value in money terms—and it would no doubt exceed 25 cents per hour.

50 CENTS CASH BACK

some-Scarcity and Social Choice

Now let’s think about scarcity and choice from society’s point of view What are

the goals of our society? We want a high standard of living for our citizens, clean air, safe streets, good schools, and more What is holding us back from accomplish-ing all of these goals in a way that would satisfy everyone? You already know the

answer: scarcity In society’s case, the problem is a scarcity of resources—the things

we use to make goods and services that help us achieve our goals

Resources are the most basic elements used to make goods and services We can classify resources into four categories:

• Labor—the time human beings spend producing goods and services.

• Capital—any long-lasting tool, that is itself produced, and helps us make other

goods and services

More specifically, physical capital consists of things like machinery and

equipment, factory buildings, computers, and even hand tools like hammers and

screwdrivers These are all long-lasting physical tools that we produce to help us

make other goods and services

Another type of capital is human capital—the skills and knowledge

pos-sessed by workers These satisfy our definition of capital: They are produced (through education and training), they help us produce other things, and they

last for many years, typically through an individual’s working life

Note the word long-lasting in the definition If something is used up quickly

in the production process—like the flour a baker uses to make bread—it is

gen-erally not considered capital A good rule of thumb is that capital should last at

least a year, although most types of capital last considerably longer

The capital stock is the total amount of capital at a nation’s disposal at any

point in time It consists of all the capital—physical and human—created in previous periods that is still productively useful

• Land—the physical space on which production takes place, as well as useful

materials—natural resources—found under it or on it, such as crude oil, iron,

coal, or fertile soil

• Entrepreneurship—the ability (and the willingness to use it) to combine the

other resources into a productive enterprise An entrepreneur may be an

innovator who comes up with an original idea for a business or a risk taker who

provides her own funds or time to nurture a project with uncertain rewards

Anything produced in the economy comes, ultimately, from some combinations

of the four resources

Resources The labor, capital, land

(including natural resources), and

entrepreneurship that are used to

produce goods and services.

Labor The time human beings

spend producing goods and services.

Capital A long-lasting tool that is

used to produce other goods.

Physical capital The part of the

capital stock consisting of physical

goods, such as machinery,

equip-ment, and factories.

Human capital The skills and

training of the labor force.

Capital stock The total amount

of capital in a nation that is

productively useful at a particular

point in time.

Land The physical space on which

production takes place, as well as

the natural resources that come

with it.

Entrepreneurship The ability and

willingness to combine the other

resources—labor, capital, and land—

into a productive enterprise.

Chapter 1: What Is Economics? 7

Think about the last lecture you attended at your

college Some resources were used directly: Your

instruc-tor’s labor and human capital (his or her knowledge of

economics); physical capital (the classroom building, a

blackboard or projector); and land (the property on

which your classroom building sits) Somebody played

the role of entrepreneur, bringing these resources

together to create your college in the first place (If you

attend a public institution, the entrepreneurial role was

played by your state government.)

Many other inputs—besides those special inputs

we call resources—were also used to produce the

lecture But these other inputs were themselves produced from resources, as

illus-trated in Figure 1 For example, the electricity used to power the lights in your

classroom is an input, not a resource Electricity is produced using crude oil, coal

or natural gas (land and natural resources); coal miners or oil-riggers (labor); and

electricity-generating turbines and power cables (capital)

For an individual, opportunity cost arises from the scarcity of time or money But for

society as a whole, opportunity cost arises from the scarcity of resources Our desire

for goods is limitless, but we have limited resources to produce them Therefore,

virtually all production carries an opportunity cost: To produce more of one

thing, society must shift resources away from producing something else.

For example, we’d all like better health for our citizens What would be

needed to achieve this goal? Perhaps more frequent medical checkups for more

people and greater access to top-flight medicine when necessary These, in turn,

would require more and better-trained doctors, more hospital buildings and

laboratories, and more high-tech medical equipment In order for us to produce

these goods and services, we would have to pull resources—land, labor, capital,

• Raw Materials (such as cement, steel, plastic)

FIGURE 1 Resources and Production

All goods and services come ultimately from the four resources Resources are used directly by firms that produce goods and services They are also used indirectly, to make the other inputs firms use to produce goods and services.

dangerous curves

Resources versus inputs The term resources is often

con-fused with another, more general term—inputs An input is

anything used to make a good or service Inputs include not

only resources but also many other things made from them (cement, rolled steel, electricity), which are, in turn, used to

make goods and services Resources, by contrast, are the special

inputs that fall into one of four categories: labor, land, capital, and entrepreneurship They are the ultimate source of every- thing that is produced.

Input Anything (including a resource) used to produce a good

or service.

8 Part 1: Preliminaries

and entrepreneurship—out of producing other things that we also enjoy The opportunity cost of improved health care, then, consists of those other goods and services we would have to do without

The World of Economics

The field of economics is surprisingly broad It ranges from the mundane (why does

a pound of steak cost more than a pound of chicken?) to the personal (how do couples decide how many children to have?) to the profound (could we ever have another Great Depression in the United States, with tens of millions plunged into sudden poverty?) With a field this broad, it is useful to have some way of classifying the different types of problems economists study and the different methods they use

to analyze them

The field of economics is divided into two major parts: microeconomics and

macroeconomics Microeconomics comes from the Greek word mikros, meaning

“small.” It takes a close-up view of the economy, as if looking through a microscope

Microeconomics is concerned with the behavior of individual actors on the economic

scene—households, business firms, and governments It looks at the choices they

make and how they interact with each other when they come together to trade

spe-cific goods and services What will happen to the cost of movie tickets over the next

five years? How many management-trainee jobs will open up for college graduates?

These are microeconomic questions because they analyze individual parts of an economy rather than the whole.

Macroeconomics—from the Greek word makros, meaning “large”—takes an

overall view of the economy Instead of focusing on the production of carrots or

computers, macroeconomics lumps all goods and services together and looks at the

economy’s total output Instead of focusing on

employ-ment of manageemploy-ment trainees or manufacturing

work-ers, it considers total employment in the economy

Macroeconomics focuses on the big picture and ignores the fine details

The micro versus macro distinction is based on the level of detail we want to consider Another useful dis-

tinction has to do with our purpose in analyzing a

problem Positive economics explains how the

econo-my works, plain and simple If someone says, “The decline in home prices during 2008 and 2009 was a major cause of the recent recession,” he or she is mak-ing a positive economic statement A statement need not be accurate or even sensible to be classified as positive For example, “Government policy has no effect on our standard of living” is a statement that virtually every economist would regard as false But it

is still a positive economic statement Whether true or

Microeconomics The study of the

behavior of individual households,

firms, and governments; the choices

they make; and their interaction in

specific markets.

Macroeconomics The study of

the behavior of the overall economy.

Positive economics The study

of how the economy works.

dangerous curves

Seemingly Positive Statements Be alert to statements

that may seem purely positive, but contain hidden value

judg-ments Here’s an example: “If we want to reduce greenhouse

gas emissions, our society will have to use less gasoline.” This

may sound positive, because it seems to refer only to a fact

about the world But it’s also at least partly normative Why?

Cutting back on gasoline is just one policy among many that

could reduce emissions To say that we must choose this

method makes a value judgment about its superiority to other

methods A purely positive statement on this topic would be,

“Using less gasoline—with no other change in living habits—

would reduce greenhouse gas emissions.”

Similarly, be alert to statements that use vague terms that

hide value judgments An example: “All else equal, the less

gasoline we use, the better our quality of life.” Whether you

agree or disagree, this is not a purely positive statement

People can disagree over the meaning of the phrase “quality of

life,” and what would make it better This disagreement could

not be resolved just by looking at the facts.

Chapter 1: What Is Economics? 9

not, it’s about how the economy works and its accuracy can be tested by looking

at the facts—and just the facts

Normative economics prescribes solutions to economic problems It goes beyond

just “the facts” and tells us what we should do about them Normative economics

requires us to make judgments about different outcomes and therefore depends on

our values

If an economist says, “We should cut total government spending,” he or she is

engaging in normative economic analysis Cutting government spending would

ben-efit some citizens and harm others, so the statement rests on a value judgment A

normative statement—like the one about government spending earlier—cannot be

proved or disproved by the facts alone

Positive and normative economics are intimately related in practice For one

thing, we cannot properly argue about what we should or should not do unless

we know certain facts about the world Every normative analysis is therefore based

on an underlying positive analysis But while a positive analysis can, at least in

prin-ciple, be conducted without value judgments, a normative analysis is always based,

at least in part, on the values of the person conducting it

Why Economists Disagree about Policy

Suppose the country is suffering from a serious recession—a significant, nationwide

decrease in production and employment Two economists are interviewed on a cable

news show

Economist A says, “We should increase government spending on roads, bridges,

and other infrastructure This would directly create jobs and help end the

reces-sion.” Economist B says, “No, we should cut taxes instead This will put more

money in the hands of households and businesses, leading them to spend more and

create jobs that way.” Why do they disagree?

It might be based on positive economics—different views about how the economy

works Economist A might think that government spending will create more jobs,

dollar for dollar, than will tax cuts Economist B might believe the reverse Positive

differences like these can arise because our knowledge of how the economy works—

while always improving—remains imperfect

But the disagreement might stem from a difference in values—specifically, what

each economist believes about government’s proper role in the economy Those toward

the left of the political spectrum tend to believe that government should play a larger

economic role They tend to view increases in government spending more favorably

Those toward the right tend to believe that government’s role should be smaller They

would prefer tax cuts that result in more private, rather than government, spending

This difference in values can explain why two economists—even if they have the same

positive views about the outcome of a policy—might disagree about its wisdom

Policy differences among economists arise from (1) positive disagreements

(about what the outcome of different policies will be), or (2) differences in

values (how those outcomes are evaluated).

Policy disputes among economists are common But on some policy issues, most

economists agree For example, in microeconomics there is wide agreement that

cer-tain types of goods and services should be provided by private business firms and that

certain others are best provided by government In macroeconomics, almost all

economists agree that some of the government policies during the Great Depression

Normative economics The practice of recommending policies

to solve economic problems.

10 Part 1: Preliminaries

of the 1930s were mistakes Indeed, as the U.S and global economies sank deeper into recession in 2008–2009, economists were virtually united in warning against repeat-ing these mistakes You will learn more about these and other areas of agreement in the chapters to come

Why Study Economics?

If you’ve read this far into the chapter, chances are you’ve already decided to allocate some of your scarce time to studying economics We think you’ve made a wise choice But it’s worth taking a moment to consider what you might gain from this choice.Why study economics?

To Understand the World BetterApplying the tools of economics can help you understand global and catastrophic events such as wars, famines, epidemics, and depressions But it can also help you understand much of what happens to you locally and personally—the salary you will earn after you graduate, or the rent you’ll pay on your apartment Economics has the power to help us understand these phenomena because they result, in large part, from the choices we make under conditions of scarcity

Economics has its limitations, of course But it is hard to find any aspect of life

about which economics does not have something important to say Economics cannot explain why so many Americans like to watch television, but it can explain

how TV networks decide which programs to offer Economics cannot protect you

from a robbery, but it can explain why some people choose to become thieves and

why no society has chosen to eradicate crime completely Economics will not improve your love life, resolve unconscious conflicts from your childhood, or help

you overcome a fear of flying, but it can tell us how many skilled therapists,

minis-ters, and counselors are available to help us solve these problems

To Achieve Social Change

If you are interested in making the world a better place, economics is able There is no shortage of serious social problems worthy of our attention—unemployment, hunger, poverty, disease, child abuse, drug addiction, violent crime Economics can help us understand the origins of these problems, explain why previous efforts to solve them haven’t succeeded, and help us to design new, more effective solutions

indispens-To Help Prepare for Other CareersEconomics has long been a popular college major for individuals intending to work in business But it has also been popular among those planning careers in politics, inter-national relations, law, medicine, engineering, psychology, and other professions This

is for good reason: Practitioners in each of these fields often find themselves ing economic issues For example, lawyers increasingly face judicial rulings based on the principles of economic efficiency And doctors will need to understand how new technologies or changes in the structure of health insurance will affect their practices

confront-To Become an EconomistOnly a tiny minority of this book’s readers will decide to become economists This

is welcome news to the authors, and after you have studied labor markets in your

Chapter 1: What Is Economics? 11

microeconomics course you will understand why But if you do decide to become an

economist—obtaining a master’s degree or a Ph.D.—you will find many possibilities

for employment The economists with whom you have most likely had personal

contact are those who teach and conduct research at colleges and universities But

as many economists work outside of colleges and universities as work inside them

Economists are hired by banks to assess the risk of investing abroad; by

manufactur-ing companies to help them determine new methods of producmanufactur-ing, marketmanufactur-ing, and

pricing their products; by government agencies to help design policies to fight crime,

disease, poverty, and pollution; by international organizations to help create and

reform aid programs for less developed countries; by the media to help the public

interpret global, national, and local events; and by nonprofit organizations to

pro-vide advice on controlling costs and raising funds more effectively

The Methods of Economics

One of the first things you will notice as you begin to study economics is the heavy

reliance on models.

You have no doubt encountered many models in your life As a child, you played

with model trains, model planes, or model people (dolls) You may have also seen

architects’ cardboard models of buildings These are physical models, three-

dimensional replicas that you can pick up and hold Economic models, on the other

hand, are built not with cardboard, plastic, or metal but with words, diagrams, and

mathematical statements

What, exactly, is a model?

A model is an abstract representation of reality. Model An abstract representation

of reality.

The two key words in this definition are abstract and representation A model is

not supposed to be exactly like reality Rather, it represents the real world by

abstracting or taking from the real world that which will help us understand it By

definition, a model leaves out features of the real world

When you build a model, how do you know which real-world details to include and

which to leave out? There is no simple answer to this question The right amount of

detail depends on your purpose in building the model in the first place There is,

however, one guiding principle:

A model should be as simple as possible to accomplish its purpose.

This means that a model should contain only the necessary details.

To understand this a little better, think about a map A map is a model that

represents a part of the earth’s surface But it leaves out many details of the real

world First, a map leaves out the third dimension—height—of the real world

Second, maps always ignore small details, such as trees and houses and potholes But

when you buy a map, how much detail do you want it to have?

Suppose you’re in Boston and you want to drive from Logan Airport to the

downtown convention center You will need a detailed street map, as on the left side

The same principle applies in building economic models The level of detail that would be just right for one purpose will usually be too much or too little for another When you feel yourself objecting to an economic model because something has been left out, keep in mind the purpose for which the model is built In introductory economics, the purpose is entirely educational—to help you understand some sim-ple, but powerful, principles about how the economy operates Keeping the models simple makes it easier to see these principles at work and remember them later.

Every economic model makes two types of assumptions: simplifying assumptions and critical assumptions.

A simplifying assumption is just what it sounds like—a way of making a model

simpler without affecting any of its important conclusions A road map, for ple, makes the simplifying assumption, “There are no trees.” Having trees on a map would only get in the way Similarly, in an economic model, we might assume that there are only two goods that households can choose from or that there are only

exam-two nations in the world We make such assumptions not because we think they are

true, but because they make a model easier to follow and do not change any of the important insights we can get from it

A critical assumption, by contrast, is an assumption that affects the conclusions

of a model in important ways When you use a road map, you make the critical assumption, “All of these roads are open.” If that assumption is wrong, your conclusion—the best route to take—might be wrong as well

In an economic model, there are always one or more critical assumptions You don’t have to look very hard to find them because economists like to make them explicit right from the outset For example, when we study the behavior of business firms, our model will assume that firms try to earn the highest possible profit for

Simplifying assumption Any

assumption that makes a model

simpler without affecting any of its

important conclusions.

Critical assumption Any

assump-tion that affects the conclusions of

a model in an important way.

FIGURE 2 Maps as Models

These maps are models But each would be used for a different purpose.

Chapter 1: What Is Economics? 13

their owners By stating this critical assumption up front, we can see immediately

where the model’s conclusions spring from

Economists often express their ideas using mathematical concepts and a special

vocabulary Why? Because these tools enable economists to express themselves more

precisely than with ordinary language For example, someone who has never studied

economics might say, “When gas is expensive, people don’t buy big, gas-guzzling

cars.” That statement might not bother you right now But once you’ve finished your

first economics course, you’ll be saying it something like this: “When the price of

gas rises, the demand curve for big, gas-guzzling cars shifts leftward.”

Does the second statement sound strange to you? It should First, it uses a

special term—a demand curve—that you’ve yet to learn Second, it uses a

mathe-matical concept—a shifting curve—with which you might not be familiar But while

the first statement might mean a number of different things, the second statement—

as you will see in Chapter 3—can mean only one thing By being precise, we can

steer clear of unnecessary confusion

If you are worried about the special vocabulary of economics, you can relax

After all, you may never have heard the term “opportunity cost” before, but now

you know what it means New terms will be defined and carefully explained as you

encounter them Indeed, this textbook does not assume you have any special

knowl-edge of economics It is truly meant for a “first course” in the field

But what about the math? Here, too, you can relax While professional

econo-mists often use sophisticated mathematics to solve problems, only a little math is

needed to understand basic economic principles And virtually all of this math

comes from high school algebra and geometry

Still, if you have forgotten some of your high school math, a little brushing up

might be in order This is why we have included an appendix at the end of this

chapter It covers some of the most basic concepts—such as interpreting graphs, the

equation for a straight line, and the concept of a slope—that you will need in this

course You may want to glance at this appendix now, just so you’ll know what’s

there Then, from time to time, you can go back to it when you need it

How to Study Economics

As you read this book or listen to your instructor, you may find yourself following

along and thinking that everything makes perfect sense Economics may even seem

easy Indeed, it is rather easy to follow economics, since it’s based so heavily on

simple logic But following and learning are two different things You will

eventu-ally discover (preferably before your first exam) that economics must be studied

actively, not passively

If you are reading these words lying back on a comfortable couch, a phone in

one hand and a remote control in the other, you are going about it in the wrong way

Active studying means reading with a pencil in your hand and a blank sheet of paper

in front of you It means closing the book periodically and reproducing what you

have learned It means listing the steps in each logical argument, retracing the flow

of cause and effect in each model, and drawing the graphs It does require some

work, but the payoff is a good understanding of economics and a better

understand-ing of your own life and the world around you

14 Part 1: Preliminaries

1 Discuss whether each statement is a purely positive

statement, or also contains normative elements and/or

value judgments:

a An increase in the personal income tax will slow

the growth rate of the economy

b The goal of any country’s economic policy should

be to increase the well-being of its poorest, most

vulnerable citizens

c The best way to reduce the national poverty rate

is to increase the federal minimum wage

d The 1990s were a disastrous decade for the U.S

economy Income inequality increased to its

highest level since before World War II

2 For each of the following, state whether economists

would consider it a resource, and if they would,

identify which of the four types of resources the

item is

a A computer used by an FBI agent to track the

whereabouts of suspected criminals

b The office building in which the FBI agent works

c The time that an FBI agent spends on a case

d A farmer’s tractor

e The farmer’s knowledge of how to operate

the tractor

f Crude oil

g A package of frozen vegetables

h A food scientist’s knowledge of how to

commer-cially freeze vegetables

i The ability to bring together resources to start

a frozen food company

j Plastic bags used by a frozen food company to hold its product

3 Suppose you are using the second map in Figure 2, which shows main highways only You’ve reached a conclusion about the fastest way to drive from the Boston city center to an area south of the city State whether each of the following assump-

tions of the map would be a simplifying or critical

assumption for your conclusion, and explain briefly (Don’t worry about whether the assumption is true

or not.)

a The thicker, numbered lines are major highways without traffic lights

b The earth is two-dimensional

c When two highways cross, you can get from one to the other without going through city traffic

d Distances on the map are proportional to distances

in the real world

4 Suppose that you are considering what to do with an upcoming weekend Here are your options, from least

to most preferred: (1) study for upcoming midterms; (2) fly to Colorado for a quick ski trip; (3) go into seclusion in your dorm room and try to improve your score on a computer game What is the opportunity

PROBLEM SET Answers to even-numbered Questions and Problems can be found on the text website at www.cengage.com/economics/hall.

One of the most fundamental concepts in economics is

opportunity cost The opportunity cost of any choice is what

we give up when we make that choice

Economics is the study of choice under conditions of

scarcity As individuals—and as a society—we have

unlimited desires for goods and services Unfortunately,

our ability to satisfy those desires is limited, so we must

usually sacrifice something for any choice we make

The correct measure of the cost of a choice is not just

the money price we pay, but the opportunity cost: what we

must give up when we make a choice

At the individual level, opportunity cost arises from the

scarcity of time or money For society as a whole, it arises

from the scarcity of resources: land, labor, capital, and

entrepreneurship To produce and enjoy more of one thing,

society must shift resources away from producing

some-thing else Therefore, we must choose which desires to

satisfy and how to satisfy them Economics provides the tools that explain those choices

The field of economics is divided into two major areas

Microeconomics studies the behavior of individual

house-holds, firms, and governments as they interact in specific

markets Macroeconomics, by contrast, concerns itself with

the behavior of the entire economy It considers variables such as total output, total employment, and the overall price level

Economics makes heavy use of models—abstract

rep-resentations of reality—to help us understand how the economy operates All models are simplifications, but a good model will have just enough detail for the purpose at

hand The simplifying assumptions in a model just make it easier to use The critical assumptions are the ones that

affect the model’s conclusions

SUMMARY

Chapter 1: What Is Economics? 15

cost of a decision to play the computer game all

weekend?

5 Use the information in Table 1 as well as the

assump-tion about foregone income made in the chapter to

calculate the average opportunity cost of a year in

college for a student at a four-year private institution

under each of the following assumptions:

a The student receives free room and board at

home at no opportunity cost to the parents

b The student receives an academic scholarship

covering all tuition and fees (in the form of a

grant, not a loan or a work study aid)

c The student works half time while at school at no

additional emotional cost

6 Use the information in Table 1 (as well as the

assumption about foregone income made in the

chapter) to compare the opportunity cost of

attending a year of college for a student at a

two-year public college, under each of the following assumptions:

a The student receives free room and board at home at no opportunity cost to the parents

b The student receives an academic scholarship covering all tuition and fees (in the form of a grant, not a loan or a work study aid)

c The student works half time while at school (assume that the leisure or study time sacrificed has no opportunity cost)

7 Consider Kylie, who has been awarded academic scholarships covering all tuition and fees at three dif-ferent colleges College #1 is a two-year public col-lege College #2 is a four-year public college, and College #3 is a four-year private college Explain why,

if the decision is based solely on opportunity cost, Kylie will turn down her largest scholarship offers (Use Table 1 in the chapter.)

Tables and Graphs

A brief glance at this text will tell you that graphs are

important in economics Graphs provide a convenient

way to display information and enable us to

immedi-ately see relationships between variables.

Suppose that you’ve just been hired at the

adver-tising department of Len & Harry’s—an

up-and-coming manufacturer of high-end ice cream products,

located in Texas You’ve been asked to compile a

report on how advertising affects the company’s sales

It turns out that the company’s spending on

advertis-ing has changed repeatedly in the past, so you have

lots of data on monthly advertising expenditure and

monthly sales revenue, both measured in thousands

of dollars

Table A.1 shows a useful way of arranging this data

The company’s advertising expenditure in different

months are listed in the left-hand column, while the

right-hand column lists total sales revenue (“sales” for

short) during the same months Notice that the data in

this table is organized so that spending on advertising

increases as we move down the first column Often, just

looking at a table like this can reveal useful patterns In

this example, it’s clear that higher spending on

advertis-ing is associated with higher monthly sales These two

variables—advertising and sales—have a positive

rela-tionship A rise in one is associated with a rise in the

other If higher advertising had been associated with

lower sales, the two variables would have a negative or inverse relationship: A rise in one would be associated

with a fall in the other

We can be even more specific about the positive relationship between advertising and sales: Logic tells us

that the association is very likely causal We’d expect that sales revenue depends on advertising outlays, so we call sales our dependent variable and advertising our

independent variable Changes in an independent

vari-able cause changes in a dependent varivari-able, but not the other way around

To explore the relationship further, let’s graph it

As a rule, the independent variable is measured on the

horizontal axis and the dependent variable on the vertical axis In economics, unfortunately, we do not

always stick to this rule, but for now we will In Figure A.1, monthly advertising expenditure—our independent variable—is measured on the horizontal

axis If we start at the origin—the corner where the

two axes intersect—and move rightward along the horizontal axis, monthly advertising spending increases from $0 to $1,000 to $2,000 and so on The vertical axis measures monthly sales—the dependent variable Along this axis, as we move upward from the origin, sales rise

The graph in Figure A.1 shows six labeled points, each representing a different pair of numbers from our

A P P E N D I X

Graphs and Other Useful Tools

TABLE A.1

Advertising and Sales

at Len & Harry’s Advertising Expenditures

($1,000 per Month)

Sales ($1,000 per Month)

table For example, point A—which represents the

num-bers in the first row of the table—shows us that when the

firm spends $2,000 on advertising, sales are $24,000 per

month Point B represents the second row of the table,

and so on Notice that all of these points lie along a

straight line.

You’ll encounter straight-line graphs often in

econom-ics, so it’s important to understand one special property

they possess: The “rate of change” of one variable

com-pared with the other is always the same For example,

look at what happens as we move from point A to

point B: Advertising rises by $1,000 (from $2,000

to $3,000), while sales rise by $3,000 (from $24,000 to

$27,000) If you study the graph closely, you’ll see that

anywhere along this line, whenever advertising increases

by $1,000, sales increase by $3,000 Or, if we define a

“unit” as “one thousand dollars,” we can say that every

time advertising increases by one unit, sales rise by three

units So the “rate of change” is three units of sales for

every one unit of advertising

The rate of change of the vertically measured

vari-able for a one-unit change in the horizontally measured

variable is also called the slope of the line The slope of

the line in Figure A.1 is three, and it remains three no matter where along the line we measure it For exam-

ple, make sure you can see that from point C to point D, advertising rises by one unit and sales rise by

three units

What if we had wanted to determine the slope of

this line by comparing points D and E, which has

adver-tising rising by four units instead of just one? In that

case, we’d have to calculate the rise in one variable per

unit rise in the other To do this, we divide the change in

the vertically measured variable by the change in the horizontally measured variable

Slope of a straight line  Change in horizontal variableChange in vertical variable

We can make this formula even simpler by using two shortcuts First, we can call the variable on the vertical

axis “Y” and the variable on the horizontal axis “X.” In our case, Y is sales, while X is spending on advertising

Second, we use the Greek letter ∆ (“delta”) to denote the words “change in.” Then, our formula becomes:

Slope of straight line  ∆Y _

∆X

Let’s apply this formula to get the slope as we move

from point D to point E, so that advertising (X) rises

Advertising ($1,000 per month)

Sales ($1,000 per month)

1 2 3 4 5 6 7 8 9 10 11 12

18 24 27 36

54

39 51

from 7 units to 11 units This is an increase of 4, so

∆X  4 For this move, sales rise from 39 to 51, an

increase of 12, so ∆Y  12 Applying our formula,

Slope  ∆Y _

∆X  12 _

4  3

This is the same value for the slope that we found

earlier Not surprising, since it’s a straight line and a

straight line has the same slope everywhere The

par-ticular pair of points we choose for our calculation

doesn’t matter

Although many of the relationships you’ll encounter

in economics have straight-line graphs, many others

do not Figure A.2 shows another possible

relation-ship between advertising and sales that we might have

found from a different set of data As you can see, the

line is curved But as advertising rises, the curve gets

flatter and flatter Here, as before, each time we spend

another $1,000 on advertising, sales rise But now, the

rise in sales seems to get smaller and smaller This

means that the slope of the curve is itself changing as

we move along this curve In fact, the slope is getting

smaller

How can we measure the slope of a curve? First, note that since the slope is different at every point along the curve, we aren’t really measuring the slope of “the

curve” but the slope of the curve at a specific point

along it How can we do this? By drawing a tangent line—a straight line that touches the curve at just one

point and that has the same slope as the curve at that point For example, in the figure, a tangent line has been

drawn for point B To measure the slope of this tangent line, we can compare any two points on it, say, H and

B, and calculate the slope as we would for any straight

line Moving from point H to point B, we are moving from 0 to 3 on the horizontal axis (∆X  3) and from

21 to 27 on the vertical axis (∆Y  6) Thus, the slope

of the tangent line—which is the same as the slope of

the curved line at point B—is

∆Y

_

∆X  6 _

3  2

This says that, at point B, the rate of change is two units

of sales for every one unit of advertising Or, going back

to dollars, the rate of change is $2,000 in sales for every

$1,000 spent on advertising

The curve in Figure A.2 slopes everywhere upward, reflecting a positive relationship between the vari-ables But a curved line can also slope downward to

1

A

2 3 4 5 6 7

18 21 24 27 32

Sales ($1,000 per month)

1 The slope of this curve at point B

2 is the slope of the straight line that

is tangent to the curve

FIGURE A.2 Measuring the Slope of a Curve

Appendix 19

illustrate a negative relationship between variables, or

slope first one direction and then the other You’ll see

plenty of examples of each type of curve in later

chap-ters, and you’ll learn how to interpret each one as it’s

presented

Linear Equations

Let’s go back to the straight-line relationship between

advertising and sales, as shown in Table A.1 What if

you need to know how much in sales the firm could

expect if it spent $5,000 on advertising next month?

What if it spent $8,000, or $9,000? It would be nice to

be able to answer questions like this without having to

pull out tables and graphs to do it As it turns out,

any-time the relationship you are studying has a

straight-line graph, it is easy to figure out an equation for the

entire relationship—a linear equation You then can

use the equation to answer any such question that

might be put to you

All straight lines have the same general form If Y

stands for the variable on the vertical axis and X for the

variable on the horizontal axis, every straight line has

an equation of the form

Y  a  bX, where a stands for some number and b for another

number The number a is called the vertical intercept,

because it marks the point where the graph of this

equation hits (intercepts) the vertical axis; this occurs

when X takes the value zero (If you plug X  0 into

the equation, you will see that, indeed, Y  a.) The

number b is the slope of the line, telling us how much

Y will change every time X changes by one unit To

confirm this, note that when X  0, the equation tells

us that Y  a When X  1, it tells us that Y  a  b

So as X increases from 0 to 1, Y goes from a to a  b

The number b is therefore the change in Y

correspond-ing to a one-unit change in X—exactly what the slope

of the graph should tell us

If b is a positive number, a one-unit increase in X

causes Y to increase by b units, so the graph of our line

would slope upward, as illustrated by the line in the

upper left panel of Figure A.3 If b is a negative number,

then a one-unit increase in X will cause Y to decrease by

b units, so the graph would slope downward, as the line

does in the lower left panel Of course, b could equal

zero If it does, a one-unit increase in X causes no

change in Y, so the graph of the line is flat, like the line

in the middle left panel

The value of a has no effect on the slope of the graph Instead, different values of a determine the graph’s position When a is a positive number, the graph will intercept the vertical Y-axis above the origin, as

the line does in the upper right panel of Figure A.3

When a is negative, however, the graph will intercept the Y-axis below the origin, like the line in the lower right panel When a is zero, the graph intercepts the

Y-axis right at the origin, as the line does in the middle

right panel

Let’s see if we can figure out the equation for the

relationship depicted in Figure A.1 There, X denotes advertising and Y denotes sales Earlier, we calculated that the slope of this line, b, is 3 But what is a, the

vertical intercept? In Figure A.1, you can see that when advertising outlays are zero, sales are $18,000 That

tells us that a  18 Putting these two observations together, we find that the equation for the line in Figure A.1 is

Y  18  3X.

Now if you need to know how much in sales to

expect from a particular expenditure on advertising (both in thousands of dollars), you would be able to come up with an answer: You’d simply multiply the amount spent on advertising by 3, add 18, and that would be your sales in thousands of dollars To confirm

this, plug in for X in this equation any amount of

adver-tising in dollars from the left-hand column of Table A.1 You’ll see that you get the corresponding amount of sales in the right-hand column

How Straight Lines and Curves Shift

So far, we’ve focused on relationships where some

vari-able Y depends on a single other varivari-able, X But in

many of our theories, we recognize that some variable

of interest to us is actually affected by more than just

one other variable When Y is affected by both X and

some third variable, changes in that third variable will

usually cause a shift in the graph of the relationship between X and Y This is because whenever we draw the graph between X and Y, we are holding fixed every other variable that might possibly affect Y.

A graph between two variables X and Y is only

a picture of their relationship when all other

variables affecting Y are held constant.

But suppose one of these other variables does

change? What happens then?

Think back to the relationship between

advertis-ing and sales Earlier, we supposed sales depend

only on advertising But suppose we make an

impor-tant discovery: Ice cream sales are also affected by

how hot the weather is What’s more, all of the data

in Table A.1 on which we previously based our analysis turns out to have been from the month of June in different years, when the average tempera-ture in Texas is 80 degrees What’s going to happen

Appendix 21

In Figure A.4 we’ve redrawn the graph from

Figure A.1, this time labeling the line “June.” Often,

a good way to determine how a graph will shift is to

perform a simple experiment like this: Put your

pen-cil tip anywhere on the graph labeled June—let’s say

at point C Now ask the following question: If I hold

advertising constant at $6,000, do I expect to sell

more or less ice cream as temperature rises in July?

If you expect to sell more, then the amount of sales

corresponding to $6,000 of advertising will be above

point C, at a point such as C (pronouned “C prime”),

representing sales of $44,000 From this, we can tell

that the graph will shift upward as temperature rises

In September, however, when temperatures fall, the

advertising would be less than it is at point C It

“C double-prime”) In that case, the graph would

shift downward

The same procedure works well whether the

origi-nal graph slopes upward or downward and whether it

is a straight line or a curved one Figure A.5 sketches

two examples In panel (a), an increase in some third

variable, Z, increases the value of Y for each value of X,

so the graph of the relationship between X and Y shifts

upward as Z increases We often phrase it this way: “An

increase in Z causes an increase in Y, at any value of X.”

In panel (b), we assume that an increase in Z decreases

the value of Y, at any value of X, so the graph of the

relationship between X and Y shifts downward as Z

increases

You’ll notice that in Figures A.4 and A.5, the original line is darker, while the new line after the shift is drawn in a lighter shade We’ll often use this convention—a lighter shade for the new line after a shift in this book

If you look back at Figure A.1, you’ll see that when advertising increases (say, from $2,000 to $3,000), we

move along our line, from point A to point B But

you’ve just learned that when average temperature

changes, the entire line shifts This may seem strange to

you After all, in both cases, an independent variable changes (either advertising or temperature) Why

should we move along the line in one case and shift it

in the other?

The reason for the difference is that in one case

(advertising), the independent variable is in our

graph, measured along one of the axes When an

independent variable in the graph changes, we simply move along the line In the other case (temperature),

the independent variable does not appear in our

graph Instead, it’s been in the background, being held constant

Advertising ($1,000 per month)

Sales ($1,000 per month)

FIGURE A.4 Shift in the Graphs of Advertising and Sales

Here’s a very simple—but crucial—rule:

Suppose Y is the dependent variable, which is

measured on one of the axes in a graph If the

independent variable measured on the other

axis changes, we move along the line But if any

other independent variable changes, the entire

line shifts.

Be sure you understand the phrase “any other

indepen-dent variable.” It refers to any variable that actually

affects Y but is not measured on either axis in the

graph

This rule applies to straight lines as well as curved

lines And it applies even in more complicated

situa-tions, such as when two different lines are drawn in

the same graph, and a shift of one causes a movement

along the other (You’ll encounter this situation in

Chapter 3.) But for now, make sure you can see how

we’ve been applying this rule in our example, where

the three variables are total sales, advertising, and

temperature

Solving Equations

When we first derived the equation for the relationship

between advertising and sales, we wanted to know what

level of sales to expect from different amounts of ing But what if we’re asked a slightly different question? Suppose, this time, you are told that the sales committee has set an ambitious goal of $42,000 for next month’s sales The treasurer needs to know how much to budget for advertising, and you have to come up with the answer

advertis-Since we know how advertising and sales are related,

we ought to be able to answer this question One way is just to look at the graph in Figure A.1 There, we could first locate sales of $42,000 on the vertical axis Then, if

we read over to the line and then down, we find the amount of advertising that would be necessary to generate that level of sales Yet even with that carefully drawn diagram, it is not always easy to see just exactly how much advertising would be required If we need to be precise, we’d better use the equation for the graph instead

According to the equation, sales (Y) and advertising (X) are related as follows:

Y  18  3X.

In the problem before us, we know the value we want for sales, and we need to solve for the corresponding amount of advertising Substituting the sales target of

$42, for Y, we need to find that value of X for which

Appendix 23

Whenever we solve an equation for one unknown,

say, X, we need to isolate X on one side of the equals

sign and everything else on the other side of the equals

sign We do this by performing identical operations on

both sides of the equals sign Here, we can first subtract

18 from both sides, getting

24  3X.

We can then divide both sides by 3 and get

8  X.

This is our answer If we want to achieve sales of

$42,000, we’ll need to spend $8,000 on advertising

Of course, not all relationships are linear, so this technique will not work in every situation But no mat-ter what the underlying relationship, the idea remains the same:

To solve for X in any equation, rearrange the equation, following the rules of algebra, so that

X appears on one side of the equals sign and everything else in the equation appears on the other side.