Principles of micro economic

Preface ixPART I Introduction Economics: Studying Choice in a World of Scarcity 4 Applying the Cost-Benefit Principle 5Economic Surplus 6 Opportunity Cost 6The Role of Economic Models 7

PRINCIPLES OF MICROECONOMICS

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Library of Congress Cataloging-in-Publication Data

Frank, Robert H.

Principles of microeconomics / Robert H Frank, Ben S Bernanke.-2nd ed p.cm.

Includes index.

ISBN 0-07-255409-6 (alk paper)

1 Microeconomics I Bernanke, Ben II Title.

HBl72 F72 2004

338.5 dc21

2002043208

www.mhhe.com

DIDI(4110N

Professor Frank received his B.S from Georgia Tech in

1966, then taught math and science for two years as a Peace Corps volunteer in rural Nepal He received his M.A in statistics and his Ph.D in economics in 1972 from the University of Cali- fornia at Berkeley He is the

H J Louis Professor of nomics at Cornell University's Johnson Graduate School

Eco-of Management During a leave of absence from Cornell

he served as chief economist for the Civil Aeronautics

Board (1978-1980), a Fellow at the Center for Advanced

Study in the Behavioral Sciences (1992-1993), and

Pro-fessor of American Civilization at l'Ecole des Hautes

Etudes en Sciences Sociales in Paris (2000-2001).

Professor Frank is the author of a best-selling

interme-diate economics textbook-Microeconomics and

Behav-ior, Fifth Edition (McGraw-HillJIrwin, 2003) He has

pub-lished on a variety of subjects, including price and wage

discrimination, public utility pricing, the measurement of

unemployment spell lengths, and the distributional

conse-quences of direct foreign investment His research has

focused on rivalry and cooperation in economic and social

behavior His books on these themes include Choosing the

Right Pond: Human Behavior and the Quest for Status

(Oxford University Press, 1985) and Passions Within

Rea-son: The Strategic Role of the Emotions (W.W Norton,

1988) He and Philip Cook are coauthors of The

Winner-Take-All Society (The Free Press, 1995), which received a

Critic's Choice Award and appeared on both the New

York Times Notable Books list and the Business Week Ten

Best list for 1995 His most recent general-interest

publi-cation, Luxury Fever (The Free Press, 1999), was named

to the Knight-Ridder Best Books list for 1999 He was

awarded an Andrew W Mellon Professorship

(1987-1990), a Kenan Enterprise Award (1993), and a Merrill

Scholars Program Outstanding Educator Citation (1991).

Professor Frank's introductory microeconomics course has

graduated more than 5,000 enthusiastic economic

natural-ists over the years.

Professor Bernanke received his B.A in economics from Harvard University in 1975 and his Ph.D in economics from MIT in 1979 He taught

at the Stanford Graduate School of Business from 1979

to 1985 and moved to ton University in 1985, where he is the Howard Har- rison and Gabrielle Snyder Beck Professor of Economics and Public Affairs, and where

Prince-he served as Chairman of tPrince-he Economics Department He has consulted for the Board of Governors of the European Central Bank and other central banks, and he served on a U.S State Department Committee that advises the Israeli government on economic policy He is a member of the American Academy of Arts and Sciences, Fellow of the Econometrics Society, and a Research Associate for the National Bureau of Economic Research He has been a vis- iting scholar at the Federal Reserve System in Boston, Philadelphia, and New York, and he was recently named to the Board of Governors of the Federal Reserve.

Professor Bernanke's intermediate textbook, with

Andrew Abel, Macroeconomics, Fourth Edition Wesley, 2001) is a best seller in its field He has written more than 50 scholarly publications in macroeconomics, macroeconomic history, and finance He has done signifi- cant research on the causes of the Great Depression, the role of financial markets and institutions in the business cycle, and measuring the effects of monetary policy on the economy His two most recent books, both published by Princeton University Press, are Inflation Targeting: Lessons from the International Experience (with coau-

(Addison-thors) and Essays on the Great Depression. He is the

edi-tor of the American Economic Review and has been the

coeditor of the NBER Macroeconomics Annual and of

Economics Letters He has served as associate editor for the Journal of Financial Intermediation, the Quarterly Journal of Economics, the Journal of Money, Credit, and Banking, and the Review of Economics and Statistics Pro-

fessor Bernanke has taught principles of economics at both Stanford and Princeton.

D n recent years, innovative texts in mathematics, science, foreign

lan-guages, and other fields have achieved dramatic pedagogical gains byabandoning the traditional encyclopedic approach in favor of attempt-ing to teach a short list of core principles in depth The enthusiastic reactions ofusers of the first edition of this book confirm that this less-is-more approachaffords similar gains in introductory economics Although recent editions of afew other texts have paid lip service to this new approach, ours is by consensusthe most carefully thought out and well-executed text in this mold Avoidingexcessive reliance on formal mathematical derivations, it presents concepts intu-itively through examples drawn from familiar contexts It relies throughout on awell-articulated short list of core principles, which it reinforces repeatedly byillustrating and applying each in numerous contexts It asks students periodically

to apply these principles to answer related questions, exercises, and problems.The text encourages students to become "economic naturalists," peoplewho employ basic economic principles to understand and explain what theyobserve in the world around them An economic naturalist understands, forexample, that infant safety seats are required in cars but not in airplanes becausethe marginal cost of space to accommodate these seats is typically zero in carsbut often hundreds of dollars in airplanes Such examples engage student inter-est while teaching them to see each feature of their economic landscape as thereflection of an implicit or explicit cost-benefit calculation

Our second edition incorporates several significant pedagogical improvements.Based on extensive reviewer feedback, it offers (1) even more streamlined coverage

of the cost-benefit approach in the introductory chapter; (2) exercises that aremore closely tied to the examples; (3) for important or difficult concepts, expandednarrative explanations that are more accessible to average students; and (4)expanded coverage of several key topics (see below) The result is a revision that iseven more clutter-free, engaging, and pedagogically effective than its predecessor

FEATURES

• Core Principles Emphasized: A few core principles do most of the work

in economics By focusing almost exclusively on these principles, the textensures that students leave the course with a deep mastery of them In con-trast, traditional encyclopedic texts so overwhelm students with detail thatthey often leave the course with little useful working knowledge at all

• Economic Naturalism Introduced in Micro: Our ultimate goal is to duce "economic naturalists"-people who see each human action as theresult of an implicit or explicit cost-benefit calculation The economic nat-uralist sees mundane details of ordinary existence in a new light andbecomes actively engaged in the attempt to understand them Some repre-sentative examples:

pro-• Why do auto manufacturers no longer make cars without heaters?

• Why are whales, but not chickens, threatened with extinction?

• Why do movie theaters give student discounts on the price of sion but not on the price of popcorn?

admis-ix

• Active Learning Stressed: The only way to learn to hit an overhead smash

in tennis or to speak a foreign language is through repeated practice Thesame is true for learning economics Accordingly, we consistently introducenew ideas in the context of simple examples and then follow them with appli-cations showing how they work in familiar settings At frequent intervals, wepose exercises that both test and reinforce the understanding of these ideas.The end-of-chapter questions and problems are carefully crafted to help stu-dents internalize and extend core concepts Experience with our first editionconfirms that our text really does prepare students to apply basic economicprinciples to solve economic puzzles drawn from the real world

• Modern Microeconomics: Economic surplus, introduced in Chapter 1 and

applied repeatedly thereafter, is more fully developed here than in any othertext This concept underlies the argument for economic efficiency as animportant social goal Rather than speak of trade-offs between efficiencyand other goals, we stress that maximizing economic surplus facilitates the

achievement of all goals Common decision pitfalls identified by 2002 Nobel

Laureate Daniel Kahneman and others-such as the tendency to ignoreimplicit costs, the tendency not to ignore sunk costs, and the tendency toconfuse average and marginal costs and benefits-are introduced early inChapter 1 The book devotes a chapter to the economics of information,making available in intuitively accessible form key insights that earned the

2001 Nobel Prize in economics for George Akerlof, Joseph Stiglitz, andMichael Spence

• Web site: The site was developed by Scott Simkins of North Carolina A&TState University, an expert in the growing field of economics education onthe World Wide Web The ambitious web site contains a host of featuresthat will enhance the principles discussed in the classroom, includingdynamic graphs, email updates, microeconomic experiments, current newsarticles, information about the text, an eLearning session, and more

IMPROVEMENTS

• Introductory Material Shortened and Refined: The material from the first

edition's Chapters 1 and 2 has been reworked and condensed into one ter in an effort to launch these important concepts as clearly and efficiently

chap-as possible From the very beginning, the focus is on how rational peoplemake choices among alternative courses of action

• Separate Chapter on Elasticity Added: The material covered in this

chap-ter (Chapchap-ter 4) was covered in parts of two separate chapchap-ters in the first tion (Chapters 5 and 6) The new combined chapter streamlines the presen-tation by making use of definitions and formulas common to both the supplyand demand sides The chapter also adds several new applications and graph-ical summaries of key relationships

edi-• Cost Curve Coverage Added: Responding to reviewer feedback, we added

an introduction to average total cost and average variable cost curves inChapter 6 To make the presentation as simple and uncluttered as possible,

no single diagram ever portrays more than three cost curves at once, andmost employ only two While this treatment remains faithful to our beliefthat full-blown coverage of production functions and cost curves is ill-advised

at the principles level, it also provides substantially greater teaching flexibility.For example, it enables instructors to portray profits and losses graphically(Chapters 6, 8, and 9) and to discuss a firm's shutdown condition in dia-grammatic terms (Chapter 6) It also facilitates an enriched discussion of theinvisible hand process by which profit and loss signals drive resource alloca-tion in competitive markets (Chapter 8).

• Strategic Theory Accessible: Chapter 10, "Thinking Strategically," includes

many examples of how simple elements of game theory can be used not only

to illuminate the interactions among oligopolists and other imperfectly petitive firms, but also to shed light on common patterns of human socialinteraction This chapter

com-• opens with an account of how the producers of a Robert DeNiro film lostseveral hundred thousand dollars by shooting most of the film before nego-tiating with the singer who was slated to appear in the final scene

• introduces the important Nash equilibrium concept through a series ofintuitively accessible examples

• includes an extended discussion of the important prisoner's dilemma andstrategies that have been developed for solving it

• deals with ultimatum bargaining games and unselfish human behavior

• Discussion of labor Markets and Income Redistribution Streamlined:

Chapter 13 now contains material from the chapters on "Labor Markets"(13) and "Income Redistribution" (16) in the first edition The new chapter

is half the combined length of the earlier chapters, accomplished in part byeliminating examples, in part by trimming topic coverage Sections on monop-sony and comparable worth from the original Chapter 13 and sections onutilitarianism, tax policy and occupational choice, progressive consumptiontaxation, and redistribution and cost-benefit analysis from the original Chap-ter 16 have been deleted

• Discussion of International Trade Expanded: The first edition had a brief

section on international trade at the end of Chapter 3 on comparative tage This material has been expanded to an entire chapter (16) on trade.Because international trade involves important micro principles and policyissues, students will benefit greatly from this expanded coverage earlier in thebook

advan-THE CHALLENGE

The world is a more competitive place now than it was when we started teaching

in the 1970s In arena after arena, business as usual is no longer good enough.Baseball players used to drink beer and go fishing during the off-season, but theynow lift weights and ride exercise bicycles Assistant professors used to work ontheir houses on weekends, but the current crop can be found most weekends at theoffice The competition for student attention has grown similarly more intense.There are many tempting courses in the typical college curriculum, and even moretempting diversions outside the classroom Students are freer than ever to pick andchoose

Yet many of us seem to operate under the illusion that most freshmen arrivewith a burning desire to become economics majors And many of us do not yetseem to have recognized that students' cognitive abilities and powers of concentra-tion are scarce resources To hold our ground we must become not only more selec-tive in what we teach, but also more effective as advocates for our discipline Wemust persuade students that we offer something of value.

A well-conceived and well-executed introductory course in economics canteach our students more about society and human behavior in a single term thanvirtually any other course in the university This course can and should be an intel-lectual adventure of the first order Not all students who take the kind of course weenvisioned when writing this book will go on to become economics majors ofcourse But many will, and even those who do not will leave with a sense of admi-ration for the power of economic ideas

A salesperson knows that he or she often gets only one chance to make a goodfirst impression on a potential customer Analogously, the principles course is oftenour only shot at persuading students to appreciate the value of economics By try-ing to teach them everything we know-rather than teaching them the most impor-tant things we know-we too often squander this opportunity

SUPPLEMENTS

We continue to believe that an ancillary package is most useful if each element in it

is part of a well-considered whole, and here, as with the first edition, we've triedhard to coordinate all the elements We have also worked hard to improve each ele-ment within the package-for example, the Power Points are more extensive andmore sophisticated, the Instructor's Manual now provides more help than before,the Test Banks are larger and the questions more closely tied to the textbook, theStudy Guide sends students to the web site more often, the web site itself is moreextensive and more accessible, and the DiscoverEcon Tutorial Software is morestudent-friendly than ever and now allows instructors e-submission capability andeasy syllabus linking Finally, we listened to you about what, in the first edition,needed work and tried to make it better

FOR THE INSTRUCTOR

Instructor's Manual: Prepared by Margaret Ray at Mary Washington

Col-lege, this manual will be extremely useful for all teachers, but especially forthose new to the job In addition to such general topics as Using the WebSite, Economic Education Resources, Innovative Ideas, and Tips for Teach-ing, there will be, for each chapter, An Overview, An Outline, Core Princi-ples, Important Concepts, Teaching Objectives, Web Site Applications, In-Class Activities, More Economic Naturalists, Answers to Textbook Problems,Sample Homework, and a Sample Reading Quiz

Test Bank: Prepared by Sheryl Ball at Virginia Polytechnic Institute, this

man-ual contains nearly 3,000 multiple-choice questions categorized by TeachingObjective (from the Study Guide); Learning Level (knowledge, comprehen-sion, application, analysis); Type (graph, calculation, word problem); andSource (textbook, Study Guide, website, unique)

Computerized Test Bank: The print test bank is also available in the latest

Diploma test-generating software, ensuring maximum flexibility in test

prepa-ration, including the reconfiguring of graphing exercises This Brownstoneprogram is the gold standard of testing programs It is available in both aWindows and Macintosh format.

PowerPoints: Prepared by Steve Smith and Jeff Caldwell at Rose State, these

slides contain all of the illustrations in the textbook, along with a detailed,chapter-by-chapter review of the important ideas presented in the textbook.These teachers have done PowerPoints for many books at both the principlesand intermediate level

Overhead Transparencies: These more than 150, four-color acetates contain

all the illustrations presented in the textbook

Instructor's CD-ROM: This remarkable Windows software program, which

contains the complete Instructor's Manual, Computerized Test Bank, Points, and a full set of lecture notes for principles of microeconomics, pre-pared by Bob Frank for his successful introductory course at Cornell Uni-versity, also allows the instructor to create presentations from any of thematerials on the CD or from additional material that can be imported

Power-Online Learning Center (www.mhhe.com/economicslfrankbemanke2):

For teachers there are, among other things, an online newsletter called

"Teaching Using the Web"; the Instructor's Manual; the PowerPoints; nomics on the Web, an annotated set of URLs/links to sites of interest toeconomists; a graphing library; and a description of what's on the studentsite along with some optional material from the book

Eco-OR THE STUDENT

Study Guide: Written by Jack Mogab and Bruce McClung at Southwest

Texas State University, this book provides the following elements for eachchapter: a Pretest; a Learning Objective Grid; a Key Point Review with Learn-ing Tips; some Self-Tests (Key Term Matching, Multiple Choice, Problems)with answers; and an extension of the guide to the web site, where studentsmay practice with graphing

Online Learning Center (www.mhhe.com/economics/frankbernanke2):

For students there are such useful and exciting features for the book as a whole

as Interpreting the News-articles and summaries of relevant articles withanalysis and discussion questions; a Math Tutor-help for those whose mathskills are rusty; email updates-periodic sending of information/study tips; theGlossary from the textbook; and Economics on the Web-annotated URLs use-ful for economics students Additionally, for each chapter there is an ElectronicLearning Session that opens with a brief recap of the chapter followed by atest with answers and analysis; next is a set of study sessions based on Eco-nomic Naturalist Exercises; Graphing Exercises; PowerPoints; and Key Terms;and this is finally followed by a second quiz, with answers and analysis

DiscoverEcon CD-ROM: Created by Gerald Nelson of the University of nois, DiscoverEcon is the best-selling academic economics software available.

Illi-It is available as a CD or an online version This widely class-tested software

is Windows-based and text-specific The software is available either in a dard CD format or via the Web by using a unique student pass code packagedfree with each new book Its many features include, for each chapter,

stan-• Multiple-choice test questions: The user chooses the number of questions in

the test; the software selects randomly from the question bank for thechapter

• Two Web questions: Students working online can access Web addresses

directly through their browsers Students without Web access can simplyignore these questions

• Match the terms: This exercise challenges the student to match randomly

selected key glossary terms with their appropriate glossary explanation

• Essay questions

In addition, the software features

• New e-submission capability: Instructors may now set up their courses for

e-submission so that all exercise results for each student can be viewed anddownloaded to other Windows applications (Web-based version only)

• Easy syllabus linking: For those instructors using a course management

system, specific pages in DiscoverEcon can be linked to specific parts ofthe course web site This makes navigation and therefore self-assessmenteasier than ever for both student and instructor

• The opportunity to experiment with graphs, those seen in the classroom

and the textbook The software includes movies (graphs are drawn by-step with explanatory text appearing as the graph is constructed); inter-

step-active graphs (students change a parameter and see how the graph

changes); and interactive exercises (students interpret a graph based on

concepts presented in the text and in the software)

Bus;nessWeek Edition Your students can subscribe to 15 weeks of Business

Week at a specially priced rate Students will receive a pass code card

shrink-wrapped with their new text The card directs students to a web site where

they enter the code and then gain access to BusinessWeek's registration page

to enter address info and set up their print and online subscription as well

Wall Street Journal Edition Your students can subscribe to the Wall Street

Journal for 15 weeks at a specially priced rate Students will receive a "How

to Use the WSJ" handbook plus a pass code card shrink-wrapped with the

text The card directs students to a web site where they enter the code and

then gain access to the WSJ registration page to enter address info and set

up their print and online subscription, and also set up their subscription toDow Jones Interactive online for the span of the 15-week period

ACKNOWLEDGMENTS

Our thanks first and foremost go to our publisher, Gary Burke, for his unwaveringfaith in our project over the past several years Without his support and encourage-ment, we never could have produced this book Tom Thompson, our development

editor, was enormously helpful as he guided us with intelligence, patience, and tactthrough three major revisions of the original manuscript, and further extensiverevisions for the second edition We also thank Paul Shensa, the sponsoring editor,and Marty Quinn, the marketing manager, whose considerable experience, insight-ful suggestions, and extensive knowledge of the marketplace were of incalculablehelp We are especially grateful to Betty Morgan, our superb manuscript editor.And we are also grateful to the production team, whose professionalism was out-standing: Kimberly Hooker, Project Manager; Melonie Salvati, Production Super-visor; Becky Szura, Supplements Coordinator, and Melissa Kansa, Media Tech Pro-ducer.

Finally, our sincere thanks to the following teachers and colleagues, whosethorough reviews and thoughtful suggestions led to innumerable substantiveimprovements to both editions:

James Madison University University of Colorado

Los Angeles Valley College California State

lC ar n erson

ame er OWltz

uatam attac arya

cott lerman

ruce omgen

University of Wisconsin-Oshkosh David Eaton

ancy roo s

ruce rown

Georgetown University San Diego State University

Southern Indiana University New York University

Johah Gelbach" " Her ertb K" I"Ies mg

UnIVersIty of Maryland Indiana University

Linda Ghent" " BruceK"mgma

East Carolma UnIversity State University of New

University of Louisville Leonard Lardaro

Rutgers University-Newark Mary Lesser

Princeton University A thn ony L"Ima

University of California-Berkeley University-Hayward

New Mexico State University U.S Air Force Academy

Bloomsburg University North Central University

University of Missouri The Ohio State University

Sonoma State University Texas Christian University

Washington and Lee University Iowa State University

Massachusetts- Dartmouth University

\

Washington State University Michigan State University

Colorado State University Eastern Kentucky University

University of San Diego Community College of Southern

NevadaRogear Kaufman

Iza et Ke ey" Cl "alre

UnIversity of Wisconsin-Madison

Theodore Palivos Dennis Starleaf

Louisiana State University Iowa State University

Saginaw Valley State University Stephen F Austin University

San Francisco State University Philip Taylor

University of Georgia Jennifer Tessendorf

SteveR b'0 mson Hobart & William Smith College

Carolina-Wilmington University of California-Davis

University of California-Berkeley University of Montana

University of California-Berkeley Ball State University

Sacramento City College Colorado State University

University of North Texas Gettysburg College

Southern Oregon University City University of New

R' hIC ard S Ia VUCCI' York-Baruch College

Pame a c mIttI S h ' University of Nebraska-Omaha

E hst er-M"Iqam Sent / University of Texas-Austin

Illinois State University Zenon Zygmont

Preface ix

1 Thinking Like an Economist 2

2 Comparative Advantage: The Basis for Exchange 33

3 Supply and Demand: An Introduction 57

PART 1 Competition and the Invisible Hand

4 Elasticity 91

5 Demand: The Benefit Side of the Market 117

6 Perfectly Competitive Supply: The Cost Side of the Market 141

7 Efficiency and Exchange 167

8 The Quest for Profit and the Invisible Hand 193

9 Monopoly and Other Forms of Imperfect Competition 221

10 Thinking Strategically 251

11 Externalities and Property Rights 277

12 The Economics of Information 301

13 Labor Markets, Poverty, and Income Distribution 323

14 The Environment, Health, and Safety 351

IS Public Goods and Tax Policy 373

PART 5 International Trade

16 International Trade and Trade Policy 399

Glossary G-l

Index 1-1

xix

Preface ix

PART I Introduction

Economics: Studying Choice in a World of Scarcity 4

Applying the Cost-Benefit Principle 5Economic Surplus 6

Opportunity Cost 6The Role of Economic Models 7

Four Important Decision Pitfalls 8Pitfall 1: Measuring Costs and Benefits as ProportionsRather Than Absolute Dollar Amounts 8

Pitfall 2: Ignoring Opportunity Costs 9Pitfall 3: Failure to Ignore Sunk Costs 10Pitfall 4: Failure to Understand the Average-Marginal Distinction 11

Economics: Micro and Macro 15

The Approach of This Text 15

Economic Naturalism 16

ECONOMIC NATURALIST 1.1: Why do many hardware manufacturers include more than $1,000 worth of "free" software with a computer selling for only slightly more than that? 16

ECONOMIC NATURALIST 1.2: Why don't auto manufacturers make cars without heaters? 17

ECONOMIC NATURALIST 1.3: Why do the keypad buttons on drive-up automatic teller machines have Braille dots? 18

Summary 18

Key Terms 19 Review Questions 19 Problems 19

Answers to In-Chapter Exercises 21 Appendix: Working with Equations, Graphs, and Tables 23

Exchange and Opportunity Cost 34The Principle of Comparative Advantage 35

ECONOMIC NATURALIST 2.1: Where have all the 400 hitters gone? 37Sources of Comparative Advantage 38

ECONOMIC NATURALIST 2.2: Televisions and videocassette recorders were developed and first produced in the United States, but today the U.S.accounts for only a

xxi

A Production Possibilities Curve for a Many-Person Economy 45

Factors that Shift the Economy's Production Possibilities Curve 47Why Have Some Countries Been Slow to Specialize? 49

Can We Have Too Much Specialization? 50

Comparative Advantage and International Trade 51

ECONOMIC NATURALIST 2.3: If trade between nations is so beneficial, why are free-trade agreements so controversial? 51

Summary 51 Core Principles 52 Key Terms 52 Review Questions 52 Problems 53

Answers to In-Chapter Exercises 54

What, How, and for Whom? Central Planning versus the Market 59

Buyers and Sellers in Markets 60The Demand Curve 61

The Supply Curve 62

Market Equilibrium 64Rent Controls Reconsidered 67Pizza Price Controls? 70

Predicting and Explaining Changes in Prices and Quantities 71Shifts in Demand 72

ECONOMIC NATURALIST 3.1: When the federal government implements a large pay increase for its employees, why do rents for apartments located near Washington Metro stations go up relative to rents for apartments located far away from

Metro stations? 74Shifts in the Supply Curve 75

ECONOMIC NATURALIST 3.2: Why do major term papers go through so many more revisions today than in the 1970s? 77

Four Simple Rules 78

ECONOMIC NATURALIST 3.3: Why do the prices of some goods, like airline tickets to Europe, go up during the months of heaviest consumption, while others,like sweet corn,

Answers to In-Chapter Exercises 86

ECONOMIC NATURALIST 4.1: Will a higher tax on cigarettes curb teenage smoking? 95

ECONOMIC NATURALIST 4.2: Why was the luxury tax on yachts such a disaster? 96

A Graphical Interpretation of Price Elasticity 96Price Elasticity Changes along a Straight-Line Demand Curve 98Two Special Cases 99

The Midpoint Formula 100

Elasticity and Total Expenditure 102Income Elasticity and Cross-Price Elasticity of Demand 105

The Price Elasticity of Supply 106Determinants of Supply Elasticity 109

ECONOMIC NATURALIST 4.3: Why are gasoline prices so much more volatile than car prices? 111

Unique and Essential Inputs: The Ultimate Supply Bottleneck 113

Summary 113 Key Terms 114 Review Questions 114 Problems 115

Answers to In-Chapter Exercises 116

Chapter 5 Demand: The Benefit Side of the Market 117

The Law of Demand 118The Origins of Demand 118Needs versus Wants 119

ECONOMIC NATURALIST 5.1: Why does California experience chronic water shortages? 120

Translating Wants into Demand 120Measuring Wants: The Concept of Utility 120Allocating a Fixed Income between Two Goods 124The Rational Spending Rule 127

Income and Substitution Effects Revisited 127

Applying the Rational Spending Rule 129Substitution at Work 130

ECONOMIC NATURALIST 5.2: Why do the wealthy in Manhattan live in smaller houses than the wealthy in Seattle? 130

ECONOMIC NATURALIST 5.3: Why did people turn to four-cylinder cars in the I970s only to shift back to six- and eight-cylinder cars in the 1990s? 130

ECONOMIC NATURALIST 5.4: Why are automobile engines smaller in England than in the United States? 131

The Importance of Income Differences 132

ECONOMIC NATURALIST 5.5: Why are waiting lines longer in poorer neighborhoods? 132

Individual and Market Demand Curves 132Horizontal Addition 132

Problems 13 7

Answers to In-Chapter Exercises 139

Thinking about Supply: The Importance of Opportunity Cost 142

Profit-Maximizing Firms in Perfectly Competitive Markets 145Profit Maximization 145

The Demand Curve Facing a Perfectly Competitive Firm 146Production in the Short Run 147

Some Important Cost Concepts 148Choosing Output to Maximize Profit 149

A Note on the Firm's Shutdown Condition 150Average Variable Cost and Average Total Cost 151

A Graphical Approach to Profit Maximization 151Price = Marginal Cost: The Maximum-Profit Condition 153The "Law" of Supply 155

Determinants of Supply Revisited 156Technology 156

Input Prices 156The Number of Suppliers 157Expectations 157

Changes in Prices of Other Products 157

Applying the Theory of Supply 157

ECONOMIC NATURALIST 6.1: When recycling is left to private market forces, why are many more aluminum beverage containers recycled than glass ones? 157

Supply and Producer Surplus 160Calculating Producer Surplus 160

Summary 161 Key Terms 162 Review Questions 162 Problems 162

Answers to In-Chapter Exercises 165

Market Equilibrium and Efficiency 168Efficiency Is Not the Only Goal 171Why Efficiency Should Be the First Goal 171

The Cost of Preventing Price Adjustments 172Price Ceilings 172

Price Subsidies 175First-Come, First-Served Policies 177

ECONOMIC NATURALIST 7.1: Why does no one complain any longer about being bumped from an overbooked flight? 177

Marginal Cost Pricing of Public Services 180

Answers to In-Chapter Exercises 191

The Quest for Profit and the Invisible Hand 193

The Central Role of Economic Profit 194Three Types of Profit 194

The Invisible Hand Theory 197Two Functions of Price 197Responses to Profits and Losses 198The Importance of Free Entry and Exit 204

Economic Rent versus Economic Profit 205

The Invisible Hand in Action 206The Invisible Hand at the Supermarket and on the Freeway 206

ECONOMIC NATURALIST 8.1: Why do supermarket checkout lines all tend to be roughly the same length? 206

The Invisible Hand and Cost-Saving Innovations 207The Invisible Hand in Regulated Markets 207

ECONOMIC NATURALIST 8.2: Why do New York City taxicab medallions sell for more than $250,OOO? 208

ECONOMIC NATURALIST 8.3: Why did major commercial airlines install piano bars on the upper decks of Boeing 747s in the 1970s? 208

The Invisible Hand in Antipoverty Programs 209The Invisible Hand in the Stock Market 210

ECONOMIC NATURALIST 8.4: Why isn't a stock portfolio consisting of America's

"best-managed companies" a good investment? 212

The Distinction between an Equilibrium and a Social Optimum 213Smart for One, Dumb for All 214

ECONOMIC NATURALIST 8.5: Are there "too many" smart people working as corporate earnings forecasters? 214

Summary 215 Key Terms 216 Review Questions 216 Problems 216

Answers to In-Chapter Exercises 218

Market ImperfectionsMonopoly and Other Forms of Imperfect Competition 221

Imperfect Competition 222Different Forms of Imperfect Competition 222

Government Licenses or Franchises 224Economies of Scale (Natural Monopolies) 224Network Economies 224

Economies of Scale and the Importance of Fixed Costs 225

ECONOMIC NATURALIST 9.1: Why does Intel sell the overwhelming majority of all microprocessors used in personal computers? 228

Profit Maximization for the Monopolist 228Marginal Revenue for the Monopolist 229The Monopolist's Profit-Maximizing Decision Rule 231Being a Monopolist Doesn't Guarantee an Economic Profit 232

Why the Invisible Hand Breaks Down under Monopoly 233

Using Discounts to Expand the Market 235Price Discrimination Defined 235

ECONOMIC NATURALIST 9.2: Why do many movie theaters offer discount tickets

to students? 236How Price Discrimination Affects Output 236The Hurdle Method of Price Discrimination 239

Is Price Discrimination a Bad Thing? 241Examples of Price Discrimination 241

ECONOMIC NATURALIST 9.3: Why might an appliance retailer instruct its clerks to hammer dents into the sides of its stoves and refrigerators? 242

Public Policy toward Natural Monopoly 243State Ownership and Management 243State Regulation of Private Monopolies 244Exclusive Contracting for Natural Monopoly 244Vigorous Enforcement of Antitrust Laws 245

Summary 246 Key Terms 247

The Prisoner's Dilemma 255The Original Prisoner's Dilemma 255Prisoner's Dilemmas Confronting Imperfectly Competitive Firms 256

ECONOMIC NATURALIST 10.1:Why are cartel agreements notoriously unstable? 256

ECONOMIC NATURALIST 10.2:How did Congress unwittingly solve the television advertising dilemma confronting cigarette producers? 258

Prisoner's Dilemmas in Everyday Life 259

ECONOMIC NATURALIST 10.3:Why do people often stand at concerts, even though they can see just as well when everyone sits? 259

The Strategic Role of Preferences 268Are People Fundamentally Selfish? 269Preferences as Solutions to Commitment Problems 270

Summary 271

Key Terms 271 Review Questions 272

Problems 272 Answers to In-Chapter Exercises 275

Externalities and Property Rights 277

External Costs and Benefits 277How Externalities Affect Resource Allocation 278The Graphical Portrayal of Externalities 279The Coase Theorem 280

Legal Remedies for Externalities 284

ECONOMIC NATURALIST 11.1: What is the purpose of speed limits and other traffic laws? 285

ECONOMIC NATURALIST 11.2: Why do most communities have zoning laws? 285

ECONOMIC NATURALIST 11.3: Why do many governments enact laws that limit the discharge of environmental pollutants? 285

ECONOMIC NATURALIST 11.4: What is the purpose of free speech laws? 285

ECONOMIC NATURALIST 11.5: Why does government subsidize the planting of trees on hillsides? 286

The Optimal Amount of Negative Externalities Is Not Zero 286

Property Rights and the Tragedy of the Commons 287The Problem of Unpriced Resources 287

The Effect of Private Ownership 289When Private Ownership Is Impractical 290

ECONOMIC NATURALIST 11.6: Why do blackberries in public parks get picked too soon? 290

ECONOMIC NATURALIST 11.7: Why are shared milkshakes consumed too quickly? 290

Positional Externalities 291Payoffs That Depend on Relative Performance 291

ECONOMIC NATURALIST 11.8: Why do football players take anabolic steroids? 292

Positional Arms Races 293

ECONOMIC NATURALIST 11.9: Why do so many grocery stores stay open all night even in small towns? 293

Positional Arms Control Agreements 294Social Norms as Positional Arms Control Agreements 295

Summary 297 Key Terms 298 Review Questions 298

xxviii CONTENTS

Problems 298 Answers to In-Chapter Exercises 300

Chapter 12 The Economics of Information 301

How the Middleman Adds Value 302

The Optimal Amount of Information 304The Cost-Benefit Test 304

The Free-Rider Problem 305

ECONOMIC NATURALIST 12.1: Why is finding a knowledgeable salesclerk often difficult? 305

ECONOMIC NATURALIST 12.2: Why did Rivergate Books, the last bookstore in Lambertville, New Jersey, recently go out of business? 305

Two Guidelines for Rational Search 306The Gamble Inherent in Search 307The Commitment Problem When Search Is Costly 308

Asymmetric Information 309The Lemons Model 310The Credibility Problem in Trading 312The Costly-to-Fake Principle 312

ECONOMIC NATURALIST 12.3: Why do firms insert the phrase "As advertised on TV" when they advertise their products in magazines and newspapers? 313

ECONOMIC NATURALIST 12.4: Why do many companies care so much about elite educational credentials? 313

Conspicuous Consumption as a Signal of Ability 314

ECONOMIC NATURALIST 12.5: Why do many clients seem to prefer lawyers who wear expensive suits? 314

Statistical Discrimination 314

ECONOMIC NATURALIST 12.6: Why do males under 25 years of age pay more than other drivers for auto insurance? 315

Adverse Selection 316Moral Hazard 316

Disappearing Political Discourse 317

ECONOMIC NATURALIST 12.7: Why do opponents of the death penalty often remain silent? 317

ECONOMIC NATURALIST 12.8: Why do proponents of legalized drugs remain silent? 319

Summary 319 Key Terms 320 Review Questions 320 Problems 320

Answers to In-Chapter Exercises 321

PART 4 Economics of Public polleyChapter 13 Labor Markets, Poverty,and Income Distribution 323

The Economic Value of Work 326

The Equilibrium Wage and Employment Levels 328The Demand Curve for Labor 328

The Supply Curve of Labor 329Market Shifts 329

ECONOMIC NATURALIST 13.2: Why do some ad copy writers earn more than others? 333

Discrimination in the Labor Market 334Winner-Take-All Markets 336

ECONOMIC NATURALIST 13.3: Why does Renee Fleming earn millions more than sopranos of only slightly lesser ability? 336

Recent Trends in Inequality 337

Why Is Income Inequality a Moral Problem? 338

Methods of Income Redistribution 340Welfare Payments and In-Kind Transfers 340Means-Tested Benefit Programs 340

The Negative Income Tax 341Minimum Wages 342

The Earned-Income Tax Credit 343Public Employment for the Poor 344

A Combination of Methods 345

Summary 346 Key Terms 347

Review Questions 347

Problems 347

Answers to In-Chapter Exercises 349

The Economics of Health Care Delivery 352

~pplying the Cost-Benefit Criterion 352Designing a Solution 354

The HMO Revolution 355

ECONOMIC NATURALIST 14.1: Why is a patient with a sore knee more likelyto receive an MRI exam if he has conventional health insurance than if he belongs to a health maintenance organization? 355

Paying for Health Insurance 356

ECONOMIC NATURALIST 14.2: In the richest country on Earth why do so many people lack basic health insurance? 357

Using Price Incentives in Environmental Regulation 358Taxing Pollution 358

Auctioning Pollution Permits 360

Workplace Safety Regulation 361

ECONOMIC NATURALIST 14.3: Why does the government require safety seats for infants who travel in cars, but not for infants who travel in airplanes? 365

Public Health and Security 366

ECONOMIC NATURALIST 14.4: Why do many states have laws requiring students to

be vaccinated against childhood illnesses? 366

ECONOMIC NATURALIST 14.5: Why do more Secret Service agents guard the president than the vice president, and why do no Secret Service agents guard college professors? 367

xxx CONTENTS

Summary 368 Key Terms 369 Review Questions 369 Problems 369

Answers to In-Chapter Exercises 370

Chapter I 5 Public Goods and Tax Policy 373

Government Provision of Public Goods 374Public Goods versus Private Goods 374Paying for Public Goods 376

ECONOMIC NATURALIST 15.1: Why don't most married couples contribute equally

to joint purchases? 378

The Optimal Quantity of a Public Good 379The Demand Curve for a Public Good 379Private Provision of Public Goods 381

ECONOMIC NATURALIST 15.2: Why do television networks favor Jerry Springer over

Masterpiece Theater? 382

Additional Functions of Government 384Externalities and Property Rights 384Local, State, or Federal? 385

Sources of Inefficiency in the Political Process 386Pork Barrel Legislation 386

ECONOMIC NATURALIST 15.3: Why does check-splitting make the total restaurant bill higher? 386

ECONOMIC NATURALIST 15.4: Why do legislators often support one another's pork barrel spending programs? 387

Rent-Seeking 387Starve the Government? 389

What Should We Tax? 390

Summary 392 Key 'Terms 393

Review Questions 393 Problems 393 Answers to In-Chapter Exercises 395

PART 5 International Trade

Chapter 16 International Trade and Trade Policy 399

Comparative Advantage as a Basis for Trade 400

Production and Consumption Possibilities and the Benefits of Trade 401The Two-Worker Production Possibilities Curve 401

The Many-Worker Production Possibilities Curve 403Consumption Possibilities with and without International Trade 405

ECONOMIC NATURALIST 16.1: Does "cheap" foreign labor pose a danger to wage economies? 409

high-A Supply and Demand Perspective on Trade 410Winners and Losers from Trade 413

Protectionist Policies: Tariffs and Quotas 414

ECONOMIC NATURALIST 16.2: Who benefited from and who was hurt by voluntary export restraints on Japanese automobiles in the 1980s? 418

The Inefficiency of Protectionism 419

ECONOMIC NATURALIST 16.3: What should Lula do about foreign trade? 420

PA R T

As you begin the study of economics, perhaps the most important thing to realize is that economics is not a collection of settled facts, to be copied down and memorized Mark Twain said that nothing is older than yesterday's newspaper, and the same can be said of yesterday's economic statistics Indeed, the only predic- tion about the economy that can be made with confidence is that there will continue to be large, and largely unpredictable, changes.

If economics is not a set of durable facts, then what is it? mentally, it is a way of thinking about the world Over many years economists have developed some simple but widely applicable principles that are useful for understanding almost any economic situation, from the relatively simple economic decisions that indi- viduals make every day to the workings of highly complex mar- kets, such as international financial markets The principal objec- tive of this book, and of this course, is to help you learn these principles and how to apply them to a variety of economic ques- tions and issues.

Funda-The three chapters of Part I layout the basic economic ciples that will be used throughout the book Chapter I intro- duces the notion of scarcity-the unavoidable fact that, although our needs and wants are boundless, the resources available to satisfy them are limited The chapter goes on to show that decid- ing whether to take an action by comparing the cost and benefit

prin-of the action is a useful approach for dealing with the inevitable trade-offs that scarcity creates Chapter I then discusses several important decision pitfalls and concludes by introducing the con- cept of economic naturalism. Chapter 2 goes beyond individual decision making to consider trade, among both individuals and countries An important reason for trade is that it permits peo- ple (or countries) to specialize in the production of particular goods and services, which in turn enhances productivity and raises standards of living Finally, Chapter 3 presents an overview of the concepts of supply and demand, perhaps the most basic and famil- iar tools used by economists.

4 CHAPTERI THINKING LIKEAN ECONOMIST

surely compromise the quality of the learning environment Compared to the tom tutorial format, however, it would be dramatically more affordable

cus-In choosing what size introductory economics course to offer, then, universityadministrators confront a classic economic trade-off In making the class larger,they lower the quality of instruction-a bad thing-but at the same time, theyreduce costs, and hence the tuition students must pay-a good thing

ECONOMICS: STUDYING CHOICE

IN A WORLD OF SCARCITY

Even in rich societies like the United States, scarcity is a fundamental fact of life.

There is never enough time, money, or energy to do everything we want to do

or have everything we would like to have Economics is the study of how peoplemake choices under conditions of scarcity, and of the results of those choices forsociety

In the class-size example just discussed, a motivated economics student mightdefinitely prefer to be in a class of 20 rather than a class of 100, everything elsebeing equal But other things, of course, are not equal Students can enjoy thebenefits of having smaller classes, but only at the price of having less money forother activities The student's choice inevitably will come down to the relativeimportance of competing activities

That such trade-offs are widespread and important is one of the core ples of economics We call it the scarcity principle, because the simple fact ofscarcity makes trade-offs necessary Another name for the scarcity principle is theno-free-Iunch principle (which comes from the observation that even lunches thatare given to you are never really free-somebody, somehow, always has to payfor them)

princi-The Scarcity Principle (also called the No-free-Lunch Principle): Although we have boundless needs and wants, the resources available to us are limited So having more of one good thing usually means having less of another.

Inherent in the idea of a trade-off is the fact that choice involves mise between competing interests Economists resolve such trade-offs by using

compro-cost-benefit analysis, which is based on the disarmingly simple principle that an

action should be taken if, and only if, its benefits exceed its costs We call thisstatement the cost-benefit principle, and it, too, is one of the core principles ofeconomics:

The Cost-Benefit Principle: An individual (or a firm, or a society) should take an action if, and only if,the extra benefits from taking the action are at least as great as the extra costs.

With the cost-benefit principle in mind, let's think about our class-size tion again Imagine that classrooms come in only two sizes-l00-seat lecture hallsand 20-seat classrooms-and that your university currently offers introductoryeconomics courses to classes of 100 students Question: Should administratorsreduce the class size to 20 students? Answer: Reduce if, and only if, the value ofthe improvement in instruction outweighs its additional cost

ques-This rule sounds simple, but to apply it we need some way to measure therelevant costs and benefits-a task that is often difficult in practice If we make

a few simplifying assumptions, however, we can see how the analysis might work

On the cost side, the primary expense of reducing class size from 100 to 20 isthat we will now need five professors instead of just one We'll also need five

APPLYINGTHE COST-BENEFITPRINCIPLE 5

smaller classrooms rather than a single big one, and this too may add slightly to

the expense of the move For the sake of discussion, suppose that the cost with

a class size of 20 turns out to be $1,000 per student more than the cost per

stu-dent when the class size is 100 Should administrators switch to the smaller class

size? If they apply the cost-benefit principle, they will realize that the reduction

in class size makes sense only if the value of attending the smaller class is at least

$1,000 per student greater than the value of attending the larger class.

Would you (or your family) be willing to pay an extra $1,000 for a smaller

economics class? If not, and if other students feel the same way, then sticking with

the larger class size makes sense But if you and others would be willing to pay

the extra tuition, then reducing the class size to 20 makes good economic sense

Notice that the "best" class size, from an economic point of view, will

gen-erally not be the same as the "best" size from the point of view of an

educa-tional psychologist. The difference arises because the economic definition of

"best" takes into account both the benefits and the costs of different class sizes.

The psychologist ignores costs and looks only at the learning benefits of

differ-ent class sizes

In practice, of course, different people will feel differently about the value of

smaller classes People with high incomes, for example, tend to be willing to pay

more for the advantage, which helps to explain why average class size is smaller,

and tuition higher, at private schools whose students come predominantly from

high-income families

The cost-benefit framework for thinking about the class-size problem also

suggests a possible reason for the gradual increase in average class size that has

been taking place in American colleges and universities During the last 15 years,

professors' salaries have risen sharply, making smaller classes more costly

Dur-ing the same period, median family income-and hence the willingness to pay

for smaller classes-has remained roughly constant When the cost of offering

smaller classes goes up but willingness to pay for smaller classes does not,

uni-versities shift to larger class sizes

Scarcity and the trade-offs that result also apply to resources other than

money Bill Gates is the richest man on Earth His wealth was once estimated at

over $100 billion-more than the combined wealth of the poorest 40 percent of

Americans Gates has enough mon~y to buy more houses, cars, vacations, and

other consumer goods than he could possibly use Yet Gates, like the rest of us,

has only 24 hours each day and a limited amount of energy So even he confronts

trade-offs, in that any activity he pursues-whether it be building his business

empire or redecorating his mansion-uses up time and energy that he could

oth-erwise spend on other things Indeed, someone once calculated that the value of

Gates's time is so great that pausing to pick up a $100 bill from the sidewalk

simply wouldn't be worth his while

APPLYING THE COS1=-BENEFIT PRINCIPLE

In studying choice under scarcity, we'll usually begin with the premise that

peo-ple are rational, which means they have well-defined goals and try to fulfill them

as best they can The cost-benefit principle illustrated in the class-size example is

a fundamental tool for the study of how rational people make choices

As in the class-size example, often the only real difficulty in applying the

cost-benefit rule is to come up with reasonable measures of the relevant cost-benefits and

costs Only in rare instances will exact dollar measures be conveniently available

But the cost-benefit framework can lend structure to your thinking even when no

relevant market data are available

To illustrate how we proceed in such cases, the following example asks you

to decide whether to perform an action whose cost is described only in vague,

qualitative terms

6 CHAPTERI THINKING LIKEAN ECONOMIST

economic surplus the

economic surplus from taking

any action is the benefit of

taking that action minus its cost

opportunity cost the

opportunity cost of an activity is

the value of the next-best

alternative that must be forgone

in order to undertake the

activity

Should you walk downtown to save $10 on a $25 computer game?

Imagine you are about to buy a $25 computer game at the nearby campus storewhen a friend tells you that the same game is on sale at a downtown store foronly $15 If the downtown store is a 30-minute walk away, where should youbuy the game?

The cost-benefit principle tells us that you should buy it downtown if thebenefit of doing so exceeds the cost The benefit of taking any action is the dollarvalue of everything you gain by taking it Here, the benefit of buying downtown

is exactly $10, since that is the amount you will save on the purchase price ofthe game The cost of taking any action is the dollar value of everything you give

up by taking it Here, the cost of buying downtown is the dollar value you assign

to the time and trouble it takes to make the trip But how do we estimate thatdollar value?

One way is to perform the following hypothetical auction Imagine that astranger has offered to pay you to do an errand that involves the same walkdowntown (perhaps to drop off a letter for her at the post office) If she offeredyou a payment of, say, $1,000, would you accept? If so, we know that your cost

of walking downtown and back must be less than $1,000 Now imagine her offerbeing reduced in small increments until you finally refuse the last offer For exam-ple, if you would agree to walk downtown and back for $9.00 but not for $8.99,then your cost of making the trip is $9.00 In this case, you should buy the gamedowntown, because the $10 you'll save (your benefit) is greater than your $9.00cost of making the trip

But suppose, alternatively, that your cost of making the trip had been greaterthan $10 In that case, your best bet would have been to buy the game fromthe nearby campus store Confronted with this choice, different people maychoose differently, depending on how costly they think it is to make the tripdowntown But although there is no uniquely correct choice, most people whoare asked what they would do in this situation say they would buy the gamedowntown

ECONOMIC SURPLUS

Suppose again that in Example 1.1 your "cost" of making the trip downtownwas $9 Compared to the alternative of buying the game at the campus store,buying it downtown resulted in an economic surplus of $1, the differencebetween the benefit of making the trip and its cost In general, your goal as aneconomic decision maker is to choose those actions that generate the largestpossible economic surplus This means taking all actions that yield a positivetotal economic surplus, which is just another way of restating the cost-benefitprinciple

Note that the fact that your best choice was to buy the game downtowndoesn't imply that youenjoy making the trip, any more than choosing a large classmeans that you prefer large classes to small ones It simply means that the trip isless unpleasant than the prospect of paying $10 extra for the game Once again,you've faced a trade-off-in this case, the choice between a cheaper game and thefree time gained by avoiding the trip

OPPORTUNITY COST

Of course your mental auction could have produced a different outcome pose, for example, that the time required for the trip is the only time you haveleft to study for a difficult test the next day Or suppose you are watching one

Sup-of your favorite movies on cable, or that you are tired and would love a shortnap In such cases, we say that the opportunity cost of making the trip-that is,

APPLYING THECOST-BENERT PRINOPlE 7

the value of what you must sacrifice to walk downtown and back-is high, and

you are more likely to decide against making the trip

In this example, if watching the last hour of the cable TV movie is the most

valuable opportunity that conflicts with the trip downtown, the opportunity cost

of making the trip is the dollar value you place on pursuing that

opportunity-that is, the largest amount you'd be willing to pay to avoid missing the end of

the movie Note that the opportunity cost of making the trip is not the

com-bined value of all possible activities you could have pursued, but only the value

of your best alternative-the one you would have chosen had you not made

the trip

Throughout the text we will pose exercises like the one that follows You'll

find that pausing to answer them will help you to master key concepts in

eco-nomics Because doing these exercises isn't very costly (indeed, many students

report that they are actually fun), the cost-benefit principle indicates that it's well

worth your while to do them

EXERCISE 1.1

You would again save $10 by buying the game downtown rather than at

the campus store, but your cost of making the trip is now $12, not $9.

How much economic surplus would you get from buying the game

down-town? Where should you buy it?

THE ROLE OF ECONOMIC MODELS

Economists use the cost-benefit principle as an abstract model of how an idealized

rational individual would choose among competing alternatives (By "abstract

model" we mean a simplified description that captures the essential elements of

a situation and allows us to analyze them in a logical way.) A computer model

of a complex phenomenon like climate change, which must ignore many details

and includes only the major forces at work, is an example of an abstract model

Noneconomists are sometimes harshly critical of the economist's cost-benefit

model on the grounds that people in the real world never conduct hypothetical

mental auctions before deciding whether to make trips downtown But this

crit-icism betrays a fundamental misunderstanding of how abstract models can help

to explain and predict human behavior Economists know perfectly well that

peo-ple don't conduct hypothetical mental auctions when they make simpeo-ple decisions

All the cost-benefit principle really says is that a rational decision is one that is

explicitly or implicitly based on a weighing of costs and benefits

Most of us make sensible decisions most of the time, without being

con-sciously aware that we are weighing costs and benefits, just as most people ride

a bike without being consciously aware of what keeps them from falling Through

trial and error, we gradually learn what kinds of choices tend to work best in

different contexts, just as bicycle riders internalize the relevant laws of physics,

usually without being conscious of them

Even so, learning the explicit principles of cost-benefit analysis can help us

make better decisions, just as knowing about physics can help in learning to ride

a bicycle For instance, when a young economist was teaching his oldest son to

ride a bike, he followed the time-honored tradition of running alongside the bike

and holding onto his son, then giving him a push and hoping for the best After

several hours and painfully skinned elbows and knees, his son finally got it A

year later, someone pointed out that the trick to riding a bike is to turn slightly

in whichever direction the bike is leaning Of course! The economist passed this

information along to his second son, who learned to ride almost instantly Just

as knowing a little physics can help you learn to ride a bike, knowing a little

economics can help you make better decisions

8 CHAPTERI THINKING LIKEAN ECONOMIST

Scarcity is a basic fact of economic life Because of it, having more of onegood thing almost always means having less of another (the scarcity prin-ciple) The cost-benefit principle holds that an individual (or a firm, or asociety) should take an action if, and only if, the extra benefit from takingthe action is at least as great as the extra cost The benefit of taking any

action minus the cost of taking the action is called the economic surplus

from that action Hence the cost-benefit principle suggests that we take onlythose actions that create additional economic surplus

FOUR IMPORTANT DECISION PITFALLS*

Rational people will apply the cost-benefit principle most of the time, althoughprobably in an intuitive and approximate way, rather than through explicit andprecise calculation Knowing that rational people tend to compare costs and ben-efits enables economists to predict their likely behavior As noted earlier, for exam-ple, we can predict that students from wealthy families are more likely than others

to attend colleges that offer small classes (Again, while the cost of small classes

is the same for all families, the benefit of small classes, as measured by what ple are willing to pay for them, tends to be higher for wealthier families.)

PROPORTIONS RATHER THAN ABSOLUTE DOLLAR AMOUNTS

As the next example makes clear, the cost-benefit principle proves helpful in anotherway The example demonstrates that people aren't born with an infallible instinct forweighing the relevant costs and benefits of many daily decisions Indeed, one of therewards of studying economics is that it can improve the quality of your decisions

should you walk downtown to save $10 on a $2,020 laptop computer?

You are about to buy a $2,020 laptop computer at the nearby campus store when

a friend tells you that the same computer is on sale at a downtown store for only

$2,010 If the downtown store is half an hour's walk away, where should youbuy the computer?

Assuming that the laptop is light enough to carry without effort, the structure

of this example is exactly the same as that of Example 1.1-the only differencebeing that the price of the laptop is dramatically higher than the price of the com-puter game As before, the benefit of buying downtown is the dollar amount you'llsave, namely, $10 And since it's exactly the same trip, its cost must also be thesame as before So if you are perfectly rational, you should make the same decision

in both cases Yet when real people are asked what they would do in these tions, the overwhelming majority say they would walk downtown to buy the gamebut would buy the laptop at the campus store When asked to explain, most ofthem say something like "The trip was worth it for the game because you save 40percent, but not worth it for the laptop because you save only $10 out of $2,020."This is faulty reasoning The benefit of the trip downtown is not the pro-

situa-portion you save on the original price Rather, it is the absolute dol/ar amount

·The examples in this section are inspired by the pioneering research of Daniel Kahneman and the late Amos Tversky Kahneman was awarded the 2002 Nobel Prize in economics for his efforts to integrate insights from psychology into economics.

FOUR IMPOJ(TANT DECISION PITfJ1W S •

you save Since the benefit of walking downtown to buy the laptop is

$10-exactly the same as for the computer game-and since the cost of the trip must

also be the same in both cases, the economic surplus from making both trips must

be exactly the same And that means that a rational decision maker would make

the same decision in both cases Yet, as noted, most people choose differently

EXERCISE 1.2

Which is more valuable, saving $100 on a $2,000 plane ticket to Tokyo or

saving $90 on a $200 plane ticket to Chicago?

The pattern of faulty reasoning in the decision just discussed is one of several

decision pitfalls to which people are often prone In the discussion that follows,

we will identify three additional decision pitfalls In some cases, people ignore

costs or benefits that they ought to take into account, while on other occasions

they are influenced by costs or benefits that are irrelevant

PITFALL 2: IGNORING OPPORTUNITY COSTS

Sherlock Holmes, Arthur Conan Doyle's legendary detective, was successful because

he saw details that most others overlooked In Silver Blaze, Holmes is called on to

investigate the theft of an expensive racehorse from its stable A Scotland Yard

inspector assigned to the case asks Holmes whether some particular aspect of the

crime requires further study "Yes," Holmes replies, and describes "the curious

inci-dent of the dog in the nighttime." "The dog did nothing in the nighttime," responds

the puzzled inspector But as Holmes realized, that was precisely the problem The

watchdog's failure to bark when Silver Blaze was stolen meant that the watchdog

knew the thief This clue ultimately proved the key to unraveling the mystery

Just as we often don't notice when a dog fails to bark, many of us tend to

overlook the implicit value of activities that fail to happen As discussed earlier,

however, intelligent decisions require taking the value of forgone opportunities

properly into account

The opportunity cost of an activity, once again, is the value of the next-best

alternative that must be forgone i~ order to engage in that activity If buying a

computer game downtown means not watching the last hour of a movie, then

the value to you of watching the end of that movie is an opportunity cost of the

trip Many people make bad decisions because they tend to ignore the value of

such forgone opportunities To avoid overlooking opportunity costs, economists

often translate questions like "Should I walk downtown?" into ones like "Should

I walk downtown or watch the end of the movie?"

Should you use your frequent-flyer coupon to fly to Fort Lauderdale for

spring break?

With spring break only a week away, you are still undecided about whether to go

to Fort Lauderdale with a group of classmates at the University of Iowa The

round-trip airfare from Cedar Rapids is $500, but you have a frequent-flyer coupon you

could use to pay for the trip All other relevant costs for the vacation week at the

beach total exactly $1,000 The most you would be willing to pay for the Fort

Lau-derdale vacation is $1,350 That amount is your benefit of taking the vacation Your

only alternative use for your frequent-flyer coupon is for your plane trip to Boston

the weekend after spring break to attend your brother's wedding (Your coupon

expires shortly thereafter.) If the Cedar Rapids-Boston round-trip airfare is $400,

should you use your frequent-flyer coupon to fly to Fort Lauderdale for spring break?

The cost-benefit principle tells us that you should go to Fort Lauderdale if the

benefits of the trip exceed its costs If not for the complication of the frequent-flyer

sunk cost a cost that is beyond

recovery at the moment a

decision must be made

EXAMPLE 1.4

coupon, solving this problem would be a straightforward matter of comparingyour benefit from the week at the beach to the sum of all relevant costs Andsince your airfare and other costs would add up to $1,500, or $150 more thanyour benefit from the trip, you would not go to Fort Lauderdale

But what about the possibility of using your frequent-flyer coupon to makethe trip? Using it for that purpose might make the flight to Fort Lauderdale seemfree, suggesting you would reap an economic surplus of $350 by making the trip.But doing so would also mean you would have to fork over $400 for your airfare, to Boston So the opportunity cost of using your coupon to go to Fort Lauderdale

is really $400 If you use it for that purpose, the trip still ends up being a loser,because the cost of the vacation, $1,400, exceeds the benefit by $50 In cases likethese, you are much more likely to decide sensibly if you ask yourself, "Should Iuse my frequent-flyer coupon for this trip or save it for an upcoming trip?"

We cannot emphasize strongly enough that the key to using the concept ofopportunity cost correctly lies in recognizing precisely what taking a given actionprevents us from doing The following exercise illustrates this point by modifyingthe details of Example 1.3 slightly

EXERCISE 1.3Same as Example 1.3,except that now your frequent-flyer coupon expires

in a week, so your only chance to use it will be for the Fort lauderdaletrip Should you use your coupon?

PITFAll 3: FAilURE TO IGNORE SUNK COSTS

The opportunity cost pitfall is one in which people ignore costs they ought to takeinto account In another common pitfall, the reverse is true: People are influenced

by costs they ought to ignore The only costs that should influence a decision about

whether to take an action are those that we can avoid by not taking the action As

a practical matter, however, many decision makers appear to be influenced by sunkcqsts-costs that are beyond recovery at the moment a decision is made For exam-ple, money spent on a nontransferable, nonrefundable airline ticket is a sunk cost

Because sunk costs must be borne whether or not an action is taken, they

are irrelevant to the decision of whether to take the action The sunk-cost pitfall(the mistake of being influenced by sunk costs) is illustrated clearly in the fol-lowing example

How much should you eat at an all-you-can-eat restaurant?

Sangam, an Indian restaurant in Philadelphia, offers an all-you-can-eat lunch fet for $5 Customers pay $5 at the door, and no matter how many times theyrefill their plates, there is no additional charge One day, as a goodwill gesture,the owner of the restaurant tells 20 randomly selected guests that their lunch is

buf-on the house The remaining guests pay the usual price If all diners are ratibuf-onal,will there be any difference in the average quantity of food consumed by people

in these two groups?

Having eaten their first helping, diners in each group confront the followingquestion: "Should I go back for another helping?" For rational diners, if the ben-efit of doing so exceeds the cost, the answer is yes; otherwise it is no Note that

at the moment of decision about a second helping, the $5 charge for the lunch

is a sunk cost Those who paid it have no way to recover it Thus, for bothgroups, the (extra) cost of another helping is exactly zero And since the peoplewho received the free lunch were chosen at random, there is no reason to sup-pose that their appetites or incomes are different from those of other diners The

FOUR IMPORTANT DECISION PITFAllS II

benefit of another helping thus should be the same, on average, for people in

both groups And since their respective costs and benefits of an additional helping

are the same, the two groups should eat the same number of helpings, on average

Psychologists and economists have experimental evidence, however, that

peo-ple in such groups do not eat similar amounts. 1In particular, those for whom

the luncheon charge is not waived tend to eat substantially more than those for

whom the charge is waived People in the former group seem somehow

deter-mined to "get their money's worth." Their implicit goal is apparently to

mini-mize the average cost per bite of the food they eat Yet minimizing average cost

is not a particularly sensible objective It brings to mind the man who drove his car

on the highway at night, even though he had nowhere to go, because he wanted

to boost his average fuel economy The irony is that diners who are determined

to get their money's worth usually end up eating too much, as evidenced later by

their regrets about having gone back for their last helpings

The fact that the cost-benefit criterion failed the test of prediction in this

example does nothing to invalidate its advice about what people should do If

you are letting sunk costs influence your decisions, you can do better by changing

your behavior

PITFAll 4: FAilURE TO UNDERSTAND THE

AVERAGE-MARGINAl DISTINCTION

Often we are confronted with the choice of whether or not to engage in an

activ-ity (for example, whether or not to shop downtown) But in many situations, the

issue is not whether to pursue the activity at all, but rather the extent to which

it should be pursued We can apply the cost-benefit principle in such situations

by repeatedly asking the question "Should I increase the level at which I am

cur-rently pursuing the activity?"

In attempting to answer this question, the focus should always be on the

ben-efit and cost of an additional unit of activity To emphasize this focus, economists

refer to the cost of an additional unit of activity as the marginal cost of the

activ-ity Similarly, the benefit of an additional unit of the activity is the marginal benefit

of the activity

When the problem is to discover the proper level at which to pursue an

activ-ity, the cost-benefit rule is to keep increasing the level as long as marginal

bene-fit of the activity exceeds its marginal cost As the following example illustrates,

however, people often fail to apply this rule correctly

Should NASA expand the space shuttle program from four launches per

year to five?

Professor Kosten Banifoot, a prominent supporter of the National Aeronautics

and Space Administration's (NASA) space shuttle program, estimated that the

gains from the program are currently $24 billion per year (an average of $6 billion

per launch) and that its costs are currently $20 billion per year (an average of

$5 billion per launch) On the basis of these estimates, Professor Banifoot testified

before Congress that NASA should definitely expand the space shuttle program

Should Congress follow his advice?

To discover whether expanding the program makes economic sense, we must

compare the marginal cost of a launch to its marginal benefit The professor's

estimates, however, tell us only the average cost and average benefit of the

pro-gram-which are, respectively, the total cost of the program divided by the

lSee, for example, Richard Thaler, "Toward a Positive Theory of Consumer Choice,» Journal of

Eco-nomic Behavior and Organization, 1, no 1, 1980.

marginal cost the increase in

total cost that results from carrying out one additional unit

of an activity

marginal benefit the increase

in total benefit that results from carrying out one additional unit

of an activitY

EXAMPLE 1.5

average cost the total cost of undertaking n units of an activity divided by n

average benefit the total benefit of undertaking n units of

an activity divided by n

12 CHAPTER I THINKING LIKE AN ECONOMIST

number of launches and the total benefit divided by the number of launches.Knowing the average benefit and average cost per launch for all shuttles launchedthus far is simply not useful for deciding whether to expand the program Of

course, the average cost of the launches undertaken so far might be the same as

the cost of adding another launch But it might also be either higher or lowerthan the marginal cost of a launch The same statement holds true regardingaverage and marginal benefits

Suppose, for the sake of discussion, that the benefit of an additional launch

is in fact the same as the average benefit per launch thus far, $6 billion ShouldNASA add another launch? Not if the cost of adding the fifth launch would bemore than $6 billion And the fact that the average cost per launch is only $5billion simply does not tell us anything about the marginal cost of the fifthlaunch

Suppose, for example, that the relationship between the number of shuttleslaunched and the total cost of the program is as described in Table 1.1 Theaverage cost per launch (third column) when there are four launches would then

be $20 billion/4 = $5 billion per launch, just as Professor Banifoot testified Butnote in the second column of the table that adding a fifth launch would raisecosts from $20 billion to $32 billion, making the marginal cost of the fifthlaunch $12 billion So if the benefit of an additional launch is $6 billion, increas-ing the number of launches from four to five would make absolutely no eco-nomIC sense

The following example illustrates how to apply the cost-benefit principle rectly in this case

cor-How many space shuttles should NASA launch?

NASA must decide how many space shuttles to launch The benefit of each launch

is estimated to be $6 billion, and the total cost of the program again depends onthe number of launches in the manner shown in Table 1.1 How many shuttlesshould NASA launch?

NASA should continue to launch shuttles as long as the marginal benefit ofthe program exceeds its marginal cost In this example, the marginal benefit isconstant at $6 billion per launch, regardless of the number of shuttles launched.NASA should thus keep launching shuttles as long as the marginal cost per launch

is less than or equal to $6 billion

Applying the definition of marginal cost to the total cost entries in the ond column of Table 1.1 yields the marginal cost values in the third column ofTable 1.2 (Because marginal cost is the change in total cost that results when wechange the number of launches by one, we place each marginal cost entry midway

sec-FOUR IMPORTANTDECISION PITFALLS 13

between the rows showing the corresponding total cost entries.) Thus, for

exam-ple, the marginal cost of increasing the number of launches from one to two is

$4 billion, the difference between the $7 billion total cost of two launches and

the $3 billion total cost of one launch

As we see from a comparison of the $6 billion marginal benefit per launch

with the marginal cost entries in the third column of Table 1.2, the first three

launches satisfy the cost-benefit test, but the fourth and fifth launches do not

NASA should thus launch three space shuttles

EXERCISE 1.4

Ifthe marginal benefit of each launch had been not $6 billion but $9 billion,

how many shuttles should NASA have launched?

The cost-benefit framework emphasizes that the only relevant costs and benefits

in deciding whether to pursue an activity further are marginal costs and

benefits-measures that correspond to the increment of activity under consideration. In

many contexts, however, people seem more inclined to compare the average cost

and benefit of the activity As Example 1.5 made clear, increasing the level of an

activity may not be justified, even though its average benefit at the current level

is significantly greater than its average cost

Here's an exercise that further illustrates the importance of the

average-marginal distinction

EXERCISE 1.5

Should a basketball team's best player take all the team's shots?

A professional basketball team has a new assistant coach The

assis-tant notices that one player scores on a higher percentage of his shots

than other players Based on this information, the assistant suggests to

the head coach that the star player should take all the shots That way,

the assistant reasons, the team will score more points and win more

games.

On hearing this suggestion, the head coach fires his assistant for

incompetence What was wrong with the assistant's idea?

The preceding examples make the point that people sometimes choose

irra-tionally We must stress that our purpose in discussing these examples was not

14 CHAPTER I THINKING LIKE AN ECONOMIST

to suggest that people generally make irrational choices On the contrary, most

people appear to choose sensibly most of the time, especially when their decisionsare important or familiar ones The economist's focus on rational choice thusoffers not only useful advice about making better decisions, but also a basis forpredicting and explaining human behavior We used the cost-benefit approach inthis way when discussing how rising faculty salaries have led to larger class sizes.And as we will see, similar reasoning helps to explain human behavior in virtu-ally every other domain

1 The pitfall of measuring costs or benefits proportionally Many decisionmakers treat a change in cost or benefit as insignificant if it constitutesonly a small proportion of the original amount Absolute dollar amounts,not proportions, should be employed to measure costs and benefits

2 The pitfall of ignoring opportunity costs When performing a fit analysis of an action, it is important to account for all relevant oppor- tunity costs, defined as the values of the most highly valued alternatives

cost-bene-that must be forgone in order to carry out the action A resource (such

as a frequent-flyer coupon) may have a high opportunity cost, even ifyou originally got it "for free," if its best alternative use has high value.The identical resource may have a low opportunity cost, however, if ithas no good alternative uses

3 The pitfall of not ignoring sunk costs When deciding whether to form an action, it is important to ignore sunk costs-those costs thatcannot be avoided even if the action is not taken Even though a ticket

per-to a concert may have cost you $100, if you have already bought it andcannot sell it to anyone else, the $100 is a sunk cost and should notinfluence your decision about whether to go to the concert

4 The pitfall of using average instead of marginal costs and benefits sion makers often have ready information about the total cost and ben-efit of an activity, and from these it is simple to compute the activity'saverage cost and benefit A common mistake is to conclude that an activ-ity should be increased if its average benefit exceeds its average cost.The cost-benefit principle tells us that the level of an activity should be

Deci-increased if, and only if, its marginal benefit exceeds its marginal cost.

Some costs and benefits, especially marginal costs and benefits and nity costs, are important for decision making, while others, like sunk costs andaverage costs and benefits, are essentially irrelevant This conclusion is implicit inour original statement of the cost-benefit principle (an action should be taken if,and only if, the extra benefits of taking it exceed the extra costs) Yet so impor-tant are the pitfalls of using proportions instead of absolute dollar amounts, ofignoring opportunity costs, of taking sunk costs into account, and of confusingaverage and marginal costs and benefits that we enumerate these pitfalls sepa-rately as one of the core ideas for repeated emphasis

costs and benefits (for example, opportunity costs and marginal costs andbenefits) matter in making decisions, whereas others (for example, sunkcosts and average costs and benefits) don't

THE APPROACH OF THIS TEXT 15

ECONOMICS: MICRO AND MACRO

By convention, we use the term microeconomics to describe the study of individual

choices and of group behavior in individual markets Macroeconomics, by contrast,

is the study of the performance of national economies and of the policies that

governments use to try to improve that performance Macroeconomics tries to

understand the determinants of such things as the national unemployment rate,

the overall price level, and the total value of national output

Our focus in this chapter is on issues that confront the individual decision

maker, whether that individual confronts a personal decision, a family decision,

a business decision, a government policy decision, or indeed any other type of

decision Further on, we'll consider economic models of groups of individuals,

such as all buyers or all sellers in a specific market Later still we will turn to

broader economic issues and measures

No matter which of these levels is our focus, however, our thinking will be

shaped by the fact that although economic needs and wants are effectively

unlim-ited, the material and human resources that can be used to satisfy them are finite

Clear thinking about economic problems must therefore always take into account

the idea of trade-offs-the idea that having more of one good thing usually means

having less of another Our economy and our society are shaped to a substantial

degree by the choices people have made when faced with trade-offs

THE APPROACH OF THIS TEXT

Choosing the number of students to register in each class is just one of many

important decisions in planning an introductory economics course Another

deci-sion, to which the scarcity principle applies just as strongly, concerns which of

many different topics to include on the course syllabus There is a virtually

inex-haustible set of topics and issues that might be covered in an introductory course,

but only limited time in which to cover them There is no free lunch Covering

some topics inevitably means omitting others

All textbook authors are necessarily forced to pick and choose A textbook

that covered all the issues ever written about in economics would take up more

than a whole floor of your campus library It is our firm view that most

intro-ductory textbooks try to cover far too much One reason that each of us was

drawn to the study of economics was that a relatively short list of the discipline's

core ideas can explain a great deal of the behavior and events we see in the world

around us So rather than cover a large number of ideas at a superficial level, our

strategy is to focus on this short list of core ideas, returning to each entry again

and again, in many different contexts This strategy will enable you to

internal-ize these ideas remarkably well in the brief span of a single course And the

ben-efit of learning a small number of important ideas well will far outweigh the cost

of having to ignore a host of other, less important ideas

So far, we've already encountered three core ideas: the scarcity principle, the

cost-benefit principle, and the principle that not all costs and benefits matter

equally As these core ideas reemerge in the course of our discussions, we'll call

your attention to them And shortly after a new core idea appears, we'll

high-light it by formally restating it

A second important element in the philosophy of this text is our belief in the

importance of active learning In the same way that you can learn Spanish only

by speaking and writing it, or tennis only by playing the game, you can learn

economics only by doing economics And because we want you to learn how to

do economics, rather than just to read or listen passively as the authors or your

instructor does economics, we will make every effort to encourage you to stay

actively involved

microeconomics the study of individual choice under scarcity and its implications for the behavior of prices and quantities

in individual markets

macroeconomics the study of the performance of national economies and the policies that governments use to try to improve that performance

16 CHAPTER I THINKING LIKE AN ECONOMIST

For example, instead of just telling you about an idea, we will usually firstmotivate the idea by showing you how it works in the context of a specific exam-ple Often, these examples will be followed by exercises for you to try, as well

as applications that show the relevance of the idea to real life Try working the

exercises before looking up the answers (which are at the back of the

corre-sponding chapter)

Think critically about the applications: Do you see how they illustrate thepoint being made? Do they give you new insight into the issue? Work the prob-lems at the end of the chapters, and take extra care with those relating to pointsthat you do not fully understand Apply economic principles to the world aroundyou (We'll say more about this when we discuss economic naturalism below.)Finally, when you come across an idea or example that you find interesting, tell

a friend about it You'll be surprised to discover how much the mere act ofexplaining it helps you understand and remember the underlying principle Themore actively you can become engaged in the learning process, the more effec-tive your learning will be

ECONOMIC NATURALISM

With the rudiments of the cost-benefit framework under your belt, you are now

in a position to become an "economic naturalist," someone who uses insightsfrom economics to help make sense of observations from everyday life Peoplewho have studied biology are able to observe and marvel at many details ofnature that would otherwise have escaped their notice For example, on a walk

in the woods in early April the novice may see only trees whereas the biologystudent notices many different species of trees and understands why some arealready into leaf while others still lie dormant Likewise, the novice may noticethat in some animal species males are much larger than females, but the biologystudent knows that pattern occurs only in species in which males take severalmates Natural selection favors larger males in those species because their greatersize helps them prevail in the often bloody contests among males for access tofemales By contrast, males tend to be roughly the same size as females in monog-amous species, in which there is much less fighting for mates

In similar fashion, learning a few simple economic principles enables us to seethe mundane details of ordinary human existence in a new light Whereas the unini-tiated often fail even to notice these details, the economic naturalist not only seesthem, but becomes actively engaged in the attempt to understand them Let's con-sider a few examples of questions economic naturalists might pose for themselves

Why do many hardware manufacturers include more than $1,000 worth of

"free" software with a computer selling for only slightly more than that?

The software industry is different from many others in the sense that its customerscare a great deal about product compatibility When you and your classmates areworking on a project together, for example, your task will be much simpler if youall use the same word-processing program Likewise, an executive's life will beeasier at tax time if her financial software is the same as her accountant's.The implication is that the benefit of owning and using any given softwareprogram increases with the number of other people who use that same product.This unusual relationship gives the producers of the most popular programs anenormous advantage and often makes it hard for new programs to break into themarket

Recognizing this pattern, the Intuit Corporation offered computer makers free

copies of Quicken, its personal financial-management software Computer makers,

for their part, were only too happy to include the program, since it made their

new computers more attractive to buyers Quicken soon became the standard for

personal financial-management programs By giving away free copies of the

pro-gram, Intuit "primed the pump," creating an enormous demand for upgrades of

Quicken and for more advanced versions of related software Thus TurboTax and

Macintax, Intuit's personal income-tax software, have become the standards for

tax-preparation programs

Inspired by this success story, other software developers have jumped onto

the bandwagon Most hardware now comes bundled with a host of free software

programs Some software developers are even rumored to pay computer makers

to include their programs!

ECONOMIC NATURALISM 17

The free-software example illustrates a case in which the benefit of a

prod-uct depends on the number of other people who own that prodprod-uct As the next

example demonstrates, the cost of a product may also depend on the number of

others who own it

Why don't auto manufacturers make cars without heaters?

Virtually every new car sold in the United States today has a heater But not every

car has a CD player Why this difference?

One might be tempted to answer that although everyone needs a heater,

peo-ple can get along without CD players Yet heaters are of little use in places like

Hawaii and southern California What is more, cars produced as recently as the

1950s did not all have heaters (The classified ad that led one young economic

naturalist to his first car, a 1955 Pontiac, boasted that the vehicle had a radio,

heater, and whitewall tires.)

Although heaters cost extra money to manufacture and are not useful in all

parts of the country, they do not cost much money and are useful on at least a

few days each year in most parts of the country As time passed and people's

incomes grew, manufacturers found that people were ordering fewer and fewer

cars without heaters At some point it actually became cheaper to put heaters in

all cars, rather than bear the administrative expense of making some cars with

heaters and others without No doubt a few buyers would still order a car

with-out a heater if they could save some money in the process But catering to these

customers is just no longer worth it

Similar reasoning explains why certain cars today cannot be purchased

with-out a CD player Buyers of the 2003 BMW 745i, for example, got a CD player

whether they wanted one or not Most buyers of this car, which sells for

approx-imately $75,000, have high incomes, so the overwhelming majority of them would

have chosen to order a CD player had it been sold as an option Because of the

savings made possible when all cars are produced with the same equipment, it

would have actually cost BMW more to supply cars for the few who would want

them without CD players

Buyers of the least-expensive makes of car have much lower incomes on

aver-age than BMW 745i buyers Accordingly, most of them have more pressing

alter-native uses for their money than to buy CD players for their cars, and this explains

why most inexpensive makes continue to offer CD players only as options