Class Notes for InMicro, 2018 Edition

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Instructor’s Manual
InMicro
FIRST EDITION
R. Glenn Hubbard
Anthony Patrick O’Brien

Contents
Chapter 1: Economics: Foundations and Models 1
Appendix: Using Graphs and Formulas 12
Chapter 2: Trade-offs, Comparative Advantage, and the Market System 14
Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 22
Chapter 4: Economic Efficiency, Government Price Setting, and Taxes 34
Appendix: Quantitative Demand and Supply Analysis 42
Chapter 5: Externalities, Environmental Policy, and Public Goods 45
Chapter 6: Elasticity: The Responsiveness of Demand and Supply 56
Chapter 7: The Economics of Health Care 69
Chapter 8: Firms, the Stock Market, and Corporate Governance 79
Appendix: Tools to Analyze Firms’ Financial Information 90
Chapter 9: Comparative Advantage and the Gains from International Trade 93
Chapter 10: Consumer Choice and Behavioral Economics 109
Appendix: Using Indifference Curves and Budget Lines to Understand
Consumer Behavior 119
Chapter 11: Technology, Production, and Costs 122
Appendix: Using Isoquants and Isocost Lines to Understand Production and Cost 137

Chapter 12: Firms in Perfectly Competitive Markets 141
Chapter 13: Monopolistic Competition: The Competitive Model in a More
Realistic Setting 156
Chapter 14: Oligopoly: Firms in Less Competitive Markets 171
Chapter 15: Monopoly and Antitrust Policy 188
Chapter 16: Pricing Strategy 202
Chapter 17: The Markets for Labor and Other Factors of Production 208
Chapter 18: Public Choice, Taxes, and the Distribution of Income 222
Preface
Features of this Instructor’s Manual
Each chapter of this Instructor’s Manual contains the following elements:

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Chapter Summary: An overview of the main economic concepts covered.
Learning Objectives: A list of the student learning goals listed at the beginning of each chapter.
Chapter Outline with Teaching Tips: Detailed descriptions of the economic concepts in the course, key
term definitions, and teaching tip boxes. The teaching tip boxes include recommendations on how to
integrate key figures.
Extra Solved Problems: Each chapter of the main course has a Solved Problem to support two of the
chapter’s learning objectives. This Instructor’s Manual includes extra Solved Problems that you can
assign as homework or present during classroom lectures.
Extra Economics in Your Life: Each chapter of the course opens and closes with a special feature entitled
Economics in Your Life that emphasizes the connection between the material and the students’ personal
experiences and questions. This Instructor’s Manual includes an extra Economics in Your Life for each
chapter to present in class.
Extra Apply the Concept: Each chapter of the course has two or more Apply the Concept features to
provide real-world reinforcement of key concepts. This Instructor’s Manual includes extra Apply the
Concept to present in class.

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Organizing Your Syllabus
The Instructor’s Manual can be a valuable resource for both experienced and first-time instructors. Both
the Revel course and Instructor’s Manual provide comprehensive coverage of economic theory, policy,
and real-world applications.
This course covers relatively new developments in the field, such as the economics of information
(Chapter 7, “The Economics of Health Care”) and personnel economics (Chapter 17, “The Markets for
Labor and Other Factors of Production”). The authors include business applications in each chapter and
have a dedicated chapter on firms, the stock market, and corporate governance (Chapter 8, “Firms, the
Stock Market, and Corporate Governance”). The comprehensive coverage of microeconomics and
business topics allows instructors to select chapters for diverse groups of students.
Most instructors will not want to cover indifference curve analysis or isoquant and isocost curves, but
those who wish to will find these topics covered in the appendices to Chapter 10, “Consumer Choice and
Behavioral Economics,” and Chapter 11, “Technology, Production, and Costs,” respectively. Chapter 14 of
this instructor’s manual, “Oligopoly: Firms in Less Competitive Markets,” includes coverage of the kinked
demand curve that does not appear in the main course.
First-time users of the Revel course should be aware that some topics introduced in one chapter are
applied in a later chapter. Chapter 4, “Economic Efficiency, Government Price Setting, and Taxes,”
introduces consumer, producer, and economic surplus to describe the impact of government-imposed
price controls. The appendix to Chapter 4, “Quantitative Demand and Supply Analysis,” explains in detail
how consumer and producer surplus are calculated using linear demand and supply curves. Chapter 9,
“Comparative Advantage and the Gains from International Trade,” uses the same tools to measure the
effect of tariffs and quotas on international trade.

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The following chart helps you organize your syllabus based on your teaching preferences and objectives:
CORE POLICY OPTIONAL
Chapter 1: Economics: Foundations
and Models
Chapter 2: Trade-offs, Comparative
Advantage, and the Market
System
Chapter 3: Where Prices Come
From: The Interaction of Demand
and Supply
Chapter 6: Elasticity: The
Responsiveness of Demand and
Supply
Chapter 9: Comparative Advantage
and the Gains from International
Trade
Chapter 11: Technology, Production,
and Costs
Chapter 12: Firms in Perfectly
Competitive Markets
Chapter 13: Monopolistic
Competition: The Competitive
Model in a More Realistic Setting
Chapter 14: Oligopoly: Firms in Less
Competitive Markets
Chapter 15: Monopoly and Antitrust
Policy
Chapter 4: Economic Efficiency,
Government Price Setting, and
Taxes
Chapter 5: Externalities,
Environmental Policy, and Public
Goods
This chapter may be delayed until
after Chapter 15.
Chapter 7: The Economics of
Health Care
Chapter 18: Public Choice, Taxes,
and the Distribution of Income
Chapter 1 Appendix: Using Graphs
and Formulas
Chapter 4 Appendix: Quantitative
Demand and Supply Analysis
Chapter 8: Firms, the Stock Market,
and Corporate Governance
Chapter 8 Appendix: Tools to
Analyze Firms’ Financial
Information
Chapter 10: Consumer Choice and
Behavioral Economics
Chapter 10 Appendix: Using
Indifference Curves and Budget
Lines to Understand Consumer
Behavior
Chapter 11 Appendix: Using
Isoquants and Isocost Lines to
Understand Production and Cost
Chapter 16: Pricing Strategy

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Other Supplements for Instructors
▪ Test Item File
▪ TestGen Computerized Test Program
▪ PowerPoint Lecture Presentation
▪ Digital Interactives
Test Item File (in electronic TestGen format)
The Test Item File includes more than 4,000 multiple-choice, short answer, and graphing questions.
Test questions are annotated with the following information:
Difficulty: 1 for straight recall, 2 for some analysis, 3 for complex analysis
Type: multiple-choice, true/false, short-answer, essay
Topic: the term or concept the question supports
Learning outcome
AACSB (see description that follows)
The Association to Advance Collegiate Schools of Business (AACSB)
The test bank authors have connected select test bank questions to the general knowledge and skill
guidelines found in the AACSB standards.
What Is the AACSB?
AACSB is a not-for-profit corporation of educational institutions, corporations, and other organizations
devoted to the promotion and improvement of higher education in business administration and
accounting. A collegiate institution offering degrees in business administration or accounting may
volunteer for AACSB accreditation review. The AACSB makes initial accreditation decisions and conducts
periodic reviews to promote continuous quality improvement in management education. Pearson
Education is a proud member of the AACSB and is pleased to provide advice to help you apply AACSB
Learning Standards.
What Are AACSB Learning Standards?
One of the criteria for AACSB accreditation is the quality of the curricula. Although no specific courses
are required, the AACSB expects a curriculum to include learning experiences in such areas as:
• Written and Oral Communication
• Ethical Understanding and Reasoning

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• Analytical Thinking Skills
• Information Technology
• Diverse and Multicultural Work
• Reflective Thinking
• Application of Knowledge
These categories are AACSB Learning Standards. Questions that test skills relevant to these standards are
tagged with the appropriate standard. For example, a question testing the moral questions associated
with externalities would receive the Ethical Reasoning tag.
How Can Instructors Use the AACSB Tags?
Tagged questions help you measure whether students are grasping the course content that aligns with
the AACSB guidelines noted above. In addition, the tagged questions may help instructors identify
potential applications of these skills. This in turn may suggest enrichment activities or other educational
experiences to help students achieve these skills.
TestGen
The computerized TestGen package allows instructors to customize, save, and generate classroom tests.
The test program permits instructors to edit, add, or delete questions from the test banks; edit existing
graphics and create new graphics; analyze test results; and organize a database of tests and student
results. This software allows for extensive flexibility and ease of use. It provides many options for
organizing and displaying tests, along with search and sort features. The software and the test banks can
be downloaded from the Instructor’s Resource Center (www.pearsonhighered.com).
PowerPoint Slides
PowerPoint slides can be used by instructors for class presentations or by students for lecture preview or
review. These slides include graphs, tables, and equations from the Revel course. They are presented in a
step-by-step mode, in which you can build graphs as you would on a blackboard, and automated mode,
in which you use a single click per slide.
Digital Interactives
Focused on a single core topic and organized in progressive levels, each interactive immerses students in
an assignable and auto-graded activity. Digital Interactives are also engaging lecture tools for traditional,
online, and hybrid courses, many incorporating real-time data, data displays, and analysis tools for rich
classroom discussions.

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CHAPTER 1 | Economics: Foundations
and Models
Brief Chapter Summary and Learning Objectives
1.1 Three Key Economic Ideas
Explain these three key economic ideas: People are rational; people respond to economic
incentives; and optimal decisions are made at the margin.
▪ People must make choices as they try to attain their goals. People make choices because
resources are scarce.
1.2 The Economic Problem That Every Society Must Solve
Discuss how an economy answers these questions: What goods and services will be produced? How
will the goods and services be produced? Who will receive the goods and services produced?
▪ A limited amount of resources will produce a limited amount of goods and services.
▪ The cost of producing more of one good is the value of what must be given up to produce it.
1.3 Economic Models
Describe the role of models in economic analysis.
▪ Economists use models—simplified versions of reality—to analyze real-world issues.
1.4 Microeconomics and Macroeconomics
Distinguish between microeconomics and macroeconomics.
1.5 A Preview of Important Economic Terms
Define important economic terms.
Appendix: Using Graphs and Formulas
Use graphs and formulas to analyze economic situations.
Key Terms
Allocative efficiency. A state of the economy in
which production is in accordance with consumer
preferences; in particular, every good or service is
produced up to the point where the last unit
provides a marginal benefit to society equal to the
marginal cost of producing it.
Centrally planned economy. An economy in
which the government decides how economic
resources will be allocated.
Economic model. A simplified version
of reality used to analyze real-world economic
situations.
Economic variable. Something measurable that
can have different values,
such as the incomes of doctors.
Economics. The study of the choices people
make to attain their goals, given their scarce
resources.

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2 CHAPTER 1 | Economics: Foundations and Models
Equity. The fair distribution of economic
benefits.
Macroeconomics. The study of the economy as
a whole, including topics such as inflation,
unemployment, and economic growth.
Marginal analysis. Analysis that involves
comparing marginal benefits and marginal costs.
Market. A group of buyers and sellers of a good
or service and the institution or arrangement by
which they come together to trade.
Market economy. An economy in which the
decisions of households and firms interacting in
markets allocate economic resources.
Microeconomics. The study of how households
and firms make choices, how they interact in
markets, and how the government attempts to
influence their choices.
Mixed economy. An economy in which most
economic decisions result from the interaction of
buyers and sellers in markets but in which the
government plays a significant role in the
allocation of resources.
Normative analysis. Analysis concerned with
what ought to be.
Opportunity cost. The highest-valued
alternative that must be given up to engage in an
activity.
Positive analysis. Analysis concerned with what
is.
Productive efficiency. A situation in which a
good or service is produced at the lowest
possible cost.
Scarcity. A situation in which unlimited wants
exceed the limited resources available to fulfill
those wants.
Trade-off. The idea that, because of scarcity,
producing more of one good or service means
producing less of another good or service.
Voluntary exchange. A situation that occurs in
markets when both the buyer and the seller of a
product are made better off by the transaction.
Chapter Outline
Will Smart Devices Revolutionize Health Care?
Scanadu, a California-based firm, developed a small disk that when pressed against someone’s head can
read the person’s blood pressure, heart rate and temperature. Apple and other firms also have developed
new consumer medical devices. These firms reacted to several trends. More people have become health
conscious, as the population ages, more people are experiencing medical problems, and technological
progress has made it possible for small electronic devices to monitor blood pressure and perform other
tasks. These firms are responding to the economic incentives that a market system provides. New and
improved goods and services increase the standard of living of the average person.

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CHAPTER 1 | Economics: Foundations and Models 3
Teaching Tips
There are special features in the course:
1. The introduction, or chapter opener, uses a real-world business example to preview the economic
issues discussed in the chapter.
2. A boxed feature titled Economics in Your Life complements the business example that opens the
chapter. Economics in Your Life poses questions that help students make a personal connection with the
chapter theme. At the end of the chapter, the authors use the concepts described in the chapter to answer
these questions. Extra Economics in Your Life features are included in the Instructor’s Manuals.
3. Don’t Let This Happen to You is a box feature that alerts students to common pitfalls covered in that
chapter.
4. There are between two and four Apply the Concept features in each chapter that provide real world
reinforcement of key concepts by citing news stories that focus on business and policy issues. Extra
Apply the Concept features appear in the Instructor’s Manual.
5. Solved Problems use a step-by-step process for solving economic problems related to a chapter
learning objective. Extra Solved Problems are included in the Instructor’s Manual.
You can use these features as the basis for classroom discussion, homework assignments, and
examination questions.
People must make choices as they try to attain their goals. The choices people make represent the trade-
offs made necessary by scarcity. Scarcity is a situation in which unlimited wants exceed the limited
resources available to fulfill those wants. Economics is the study of the choices people make to attain
their goals, given their scarce resources. An economic model is a simplified version of reality used to
analyze real-world economic situations.
Teaching Tips
Students will better understand what scarcity means if you give them examples of things that are not
scarce. Suggest examples of “free” resources—sand on a beach, fresh air, etc.—and ask your students to
contribute their own examples; they will soon realize that the list of free resources is much shorter than
the list of scarce resources.
1.1
Three Key Economic Ideas
Learning Objective: Explain these three key economic ideas: People are rational;
people respond to economic incentives; and optimal decisions are made at the margin.
A market is a group of buyers and sellers of a good or service and the institution or arrangement by
which they come together to trade.
A. People Are Rational
Rational individuals weigh the benefits and costs of each action, and choose an action if the benefits
outweigh the costs.
B. People Respond to Economic Incentives
Economists emphasize that consumers and firms consistently respond to economic incentives.

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4 CHAPTER 1 | Economics: Foundations and Models
C. Optimal Decisions Are Made at the Margin
Economists use the word marginal to mean an extra or additional benefit or cost from making a decision.
The optimal decision is to continue any activity to the point where the marginal benefit equals the marginal
cost. Marginal analysis is analysis that involves comparing marginal benefits and marginal costs.
Extra Solved Problem 1.1
A Doctor Makes a Decision at the Margin
A doctor receives complaints from patients that her office isn’t open enough hours. So the doctor asks her
office manager to analyze the effect of keeping her office open 9 hours per day rather than 8 hours. The
doctor’s office manager tells her: “Keeping the office open an extra hour is a good idea because the
revenue from your practice will increase by $300,000 per year when the office is open 9 hours per day.”
Do you agree with the office manager’s reasoning? What, if any, additional information do you need to
decide whether the doctor should keep her office open an additional hour per day?
Solving the Problem
Step 1: Review the chapter material.
This problem is about making decisions, so you may want to review the section “Optimal
Decisions Are Made at the Margin.”
Step 2: Explain whether you agree with the office manager’s reasoning.
We have seen that any activity should be continued to the point where the marginal benefit is
equal to the marginal cost. In this case, the doctor should keep her office open up to the point
where the additional revenue she receives from seeing more patients is equal to the marginal cost
of keeping her office open an additional hour. The office manager has provided information on
marginal revenue but not on marginal cost. So the office manager has not provided enough
information to make a decision, and you should not agree with the office manager’s reasoning.
Step 3: Explain what additional information you need.
To make a correct decision, you would need information on the marginal cost of remaining
open an extra hour per day. The marginal cost would include the additional salary to be paid
to the office staff, any additional medical supplies that would be used, as well as any
additional electricity or other utilities. The doctor would also need to take into account the
nonmonetary cost of spending another hour working rather than spending time with her
family and friends or in other leisure activities. The marginal revenue would depend on how
many more patients the doctor can see in the extra hour. The doctor should keep her office
open an additional hour if the marginal revenue of doing so is greater than the marginal cost.
If the marginal cost is greater than the marginal revenue, then the doctor should continue to
keep her office open for 8 hours.
Teaching Tips
You don’t need to spend a lot of class time with explanations of the material in this section; subsequent
chapters will reinforce students’ understanding of markets and the “three key economic ideas.”

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CHAPTER 1 | Economics: Foundations and Models 5
Every society faces the economic problem that it has only a limited amount of economic resources, so it
can produce only a limited amount of goods and services. Society faces trade-offs. A trade-off is the idea
that, because of scarcity, producing more of one good or service means producing less of another good or
service. Every activity has an opportunity cost: The highest-valued alternative that must be given up to
engage in an activity. Trade-offs force society to answer three fundamental questions:
1. What goods and services will be produced?
2. How will the goods and services be produced?
3. Who will receive the goods and services produced?
A. What Goods and Services Will Be Produced?
The answer to this question is determined by the choices consumers, firms, and the government make.
Each choice made comes with an opportunity cost.
B. How Will the Goods and Services Be Produced?
Firms choose how to produce the goods and services they sell. For example, firms often face trade-offs
between using more workers or more machines.
C. Who Will Receive the Goods and Services Produced?
In the United States, who receives the goods and services produced depends largely on how income is
distributed. An important policy question is whether the government should intervene to make the
distribution of income more equal.
D. Centrally Planned Economies versus Market Economies
Societies organize their economies in two main ways. A centrally planned economy is an economy in
which the government decides how economic resources will be allocated. A market economy is an
economy in which the decisions of households and firms interacting in markets allocate economic
resources. Today, only a few small countries, such as Cuba and North Korea, still have completely
centrally planned economies. In a market economy, the income of an individual is determined by the
payments he receives for what he sells. Generally, the more extensive the training a person has received
and the longer the hours the person works, the higher his income will be.
E. The Modern “Mixed” Economy
The high rates of unemployment and business bankruptcies during the Great Depression of the 1930s
caused a dramatic increase in government intervention in the economy in the United States and other
market economies. Some government intervention is designed to raise the incomes of the elderly, the sick,
and people with limited skills. In recent years, government intervention has expanded to meet goals such
as the protection of the environment, the promotion of civil rights, and the provision of medical care to
low-income people and the elderly.
1.2
The Economic Problem That Every Society Must Solve
Learning Objective: Discuss how an economy answers these questions: What goods and
services will be produced? How will the goods and services be produced? Who will
receive the goods and services produced?

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6 CHAPTER 1 | Economics: Foundations and Models
Some economists argue that the extent of government intervention makes it more accurate to refer to the
economies of the United States, Canada and Western Europe as mixed economies rather than pure market
economies. A mixed economy is an economy in which most economic decisions result from the
interaction of buyers and sellers in markets but in which the government plays a significant role in the
allocation of resources.
F. Efficiency and Equity
Market economies tend to be more efficient than centrally planned economies. There are two types of
efficiency. Productive efficiency is a situation in which a good or service is produced at the lowest possible
cost. Allocative efficiency is a state of the economy in which production is in accordance with consumer
preferences; in particular, every good or service is produced up to the point where the last unit provides a
marginal benefit to society equal to the marginal cost of producing it. Voluntary exchange is a situation
that occurs in markets when both the buyer and the seller of a product are made better off by the transaction.
Inefficiency arises from various sources. Sometimes governments reduce efficiency by interfering with
voluntary exchange in markets. The production of some goods damages the environment when firms
ignore the costs of environmental damage. In this case, government intervention can increase efficiency.
Society may not find an efficient economic outcome to be desirable. Many people prefer economic
outcomes that they consider fair or equitable even if these outcomes are less efficient. Equity is the fair
distribution of economic benefits. There is often a trade-off between efficiency and equity.
Teaching Tips
Ask students for examples of government regulation of private markets in the United States. Responses
may include: making the sale of cocaine and other addictive drugs illegal; minimum age requirements for
the purchase of alcoholic beverages and cigarettes; the prohibition of the sale of new drugs before their
effectiveness is demonstrated through government supervised tests. Ask students whether one of these
examples of government regulation promotes equity or fairness. The difficulty in defining equity will be
apparent.
To show how students may value equity less than they claim, an economics teacher at a college in
Western New York once told her students at the beginning of her course that their grades would be
auctioned to the highest bidders. Because grades are typically normally distributed, she offered to sell a
few A grades, a few more B grades, and so on. Although the announcement produced shock and
grumbling, the auction proceeded, with frenzied bidding for A grades. As prices for A grades rose,
bidding switched to B grades. Because few students bothered to bid for C grades, one enterprising student
bid on several such grades in the belief that those who lost out on getting an A or B would have to buy
their C grades from him—for a higher price than he paid! After about a week, the instructor informed the
class the auction was intended only as an economics lesson; they would have to earn their grades the old-
fashioned way.
Extra Solved Problem 1.2
Advising New Government Leaders
Suppose that a country experiences a change in government leadership. Prior to this change, the country
had a centrally planned economy. The new leaders are willing to try a different system if they can be can
be convinced that it will yield better results. They hire an economist from a country with a market
economy to advise them and will order their citizens to follow the economist’s recommendations for

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CHAPTER 1 | Economics: Foundations and Models 7
change. The economist suggests that a market economy replace central planning to answer the nation’s
economic questions (what, how, and who?).
What will the economist suggest the leaders order their citizens to do in order to change from a centrally
planned economy to a market economy?
Are there reasons why the leaders of this country might not accept the economist’s suggestions? Briefly
explain.
Solving the Problem
Step 1: Review the chapter material.
The problem is about different types of economic systems, so you may want to review the section
“Centrally Planned Economies versus Market Economies.”
Step 2: What will the economist suggest the leaders order their citizens to do?
Market economies allow members of households to select occupations and purchase goods
and services based on self-interest and allow privately owned firms to produce goods and
services based on their self-interests. Therefore, the economist would advise the leaders of the
country to not issue any orders. Government officials should have no influence over
individual decisions made in markets.
Step 3: Are there reasons why the leaders of this country might not accept the economist’s
suggestions?
Even democratically elected leaders may find it difficult to accept the new system. They may
wonder how self-interested individuals will produce and distribute goods and services so as to
promote the welfare of the entire country. This new system requires a significant reduction in
government influence in people’s lives, but history has shown that most government officials
are reluctant to give up this influence. Acceptance is most likely when the leaders have some
knowledge and experience with the successful operation of a market economy in other
countries. Ordinary citizens are more likely to accept the economist’s suggestions because they
would have more freedom to pursue their own economic goals.
1.3 Economic Models
Learning Objective: Describe the role of models in economic analysis.
Models are simplified versions of reality used to analyze real-world situations. To develop a model,
economists generally follow five steps.
1. Decide on the assumptions to use in developing the model.
2. Formulate a testable hypothesis.
3. Use economic data to test the hypothesis.
4. Revise the model if it fails to explain the economic data well.
5. Retain the revised model to help answer similar economic questions in the future.
A. The Role of Assumptions in Economic Models
Models are based on making assumptions because models must be simplified to be useful. When using
models economists make behavioral assumptions about the motives of consumers and firms. Economists

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8 CHAPTER 1 | Economics: Foundations and Models
assume consumers will buy goods and services that will maximize their satisfaction and firms will act to
maximize their profits.
B. Forming and Testing Hypotheses in Economic Models
An economic variable is something measurable that can have different values, such as the incomes of
doctors. A hypothesis in an economic model is a statement that may be correct or incorrect about an
economic variable. To test a hypothesis, we analyze statistics on the relevant economic variables.
Economists accept and use an economic model if it leads to hypotheses that are confirmed by statistical
analysis.
C. Positive and Normative Analysis
Positive analysis is analysis concerned with what is. Normative analysis is analysis concerned with what
ought to be. Economics is about positive analysis, which measures the costs and benefits of different
courses of action.
D. Economics as a Social Science
Because economics studies the actions of individuals, it is a social science. Economics considers human
behavior in every context, not just in the context of business. Economists have played an important role in
formulating government policies in areas such as the environment, health care, and poverty.
Extra Solved Problem 1.3
Sunspot Activity and the Market for Natural Gas
Sunspots are sites of strong magnetic fields that appear as dark regions on the surface of the sun. The
number of sunspots varies over an eleven-year cycle. Scientists have found that the Earth’s temperature
declines when the number of sunspots decreases, so when the number of sunspots declines there is an
expectation that a period of lower temperatures will follow. British economist William Stanley Jevons
(1835–1882) developed a model of economic growth based on the occurrence of sunspots. Jevons
hypothesized that when the earth’s temperature varied throughout the sunspot cycle, agricultural output
would change too. Today, most economists attribute changes in economic growth to factors other than
sunspots. But some analysts believe that changes in sunspot activity could result in changes in the demand
and price for natural gas in the United States. The development of new technology has resulted in a large
increase in the production of natural gas in the U.S. in the twenty-first century. As a result, natural gas has
replaced other sources of energy for businesses and households and lower temperatures could lead to an
increase in the demand for natural gas.
How can we develop a model that tests the relationship between sunspot activity and the market for
natural gas?
Source: Simon Constable, “As ‘Sun Spots’ Cool Down, Natural-Gas Market Heats Up,” Wall Street Journal, July 1, 2013.
Solving the Problem
Step 1: Review the chapter material.
The problem is about how to use models to analyze economic issues, so you may want to
review the section “Economic Models.”

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CHAPTER 1 | Economics: Foundations and Models 9
Step 2: To develop and test a model of the relationship between sunspot activity and the
market for natural gas, follow these steps:
1. Decide on the assumptions to use in developing the model. Two assumptions of the
model are: (a) Changes in the earth’s temperature are related to changes in the amount of
sunspot activity, and (b) Changes in the earth’s temperature cause variations in the
demand for natural gas, which is an energy source for homes and businesses.
2. Formulate a testable hypothesis. All else equal, the demand for natural gas and the price
of natural gas will be higher in years when there is lower than average sunspot activity.
All else equal, the demand for natural gas and the price of natural gas will be lower in
years when there is higher than average sunspot activity.
3. Use economic data to test the hypothesis. Compare changes in sunspot activity with
changes in sales and the price of natural gas. Because sunspot activity varies in eleven-
year cycles, data should cover at least one of these cycles. For the United States, years of
greater-than-average sunspot activity should be years of relatively low sales and prices
for natural gas, while years of lower-than-average sunspot activity should be years of
higher sales and prices for natural gas.
4. Revise the model if it fails to explain the economic data well. The model could fail
because factors other than sunspot activity can have a significant effect the market for
natural gas. These factors include: changes in the prices of other energy sources, changes
in the cost of production for natural gas and changes in government policies towards
energy markets. A revised model would examine the separate influence of sunspots and
these other factors. The model could also fail if factors other than sunspot activity, such
as an increase in the amount of “greenhouse gases” in the atmosphere, affect the Earth’s
temperature.
5. Retain the revised model to help answer similar economic questions in the future. If the
data support the model, one can assume that there is a relationship between sunspot
activity and the market for natural gas. But tests of the model with data from different
time periods could either support or refute these results. Acceptance of a model is always
tentative pending the acquisition of new data or additional statistical analysis.
1.4 Microeconomics and Macroeconomics
Learning Objective: Distinguish between microeconomics and macroeconomics.
Microeconomics is the study of how households and firms make choices, how they interact in markets,
and how the government attempts to influence their choices.
Macroeconomics is the study of the economy as a whole, including topics such as inflation,
unemployment, and economic growth.
Extra Solved Problem 1.4
Microeconomic and Macroeconomic Views
Sports fans are used to watching events on television from different camera angles. For popular events
such as the Olympics, the World Series, and the Super Bowl, network coverage captures action from
ground level as well as higher locations. Blimps are frequently flown above the stadiums where the events
take place. The aerial view of the blimp’s camera is visually appealing but is never broadcast for very
long because the athletes are barely visible. Coverage of games includes a view from a mobile or

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10 CHAPTER 1 | Economics: Foundations and Models
“sideline” camera that can zoom in on individual players or fans sitting in the stands, a degree of detail
much greater than that provided by the aerial view.
How do the different camera angles help to explain the difference between microeconomics and
macroeconomics?
Solving the Problem
Step 1: Review the chapter material.
The problem concerns the differences between microeconomics and macroeconomics, so you
may want to review the section “Microeconomics and Macroeconomics.”
Step 2: Compare the focus of microeconomics with television coverage of a sports event.
Microeconomics focuses on how individual households and firms make choices, how they
interact in markets, and how the government attempts to influence their choices. This focus is
similar to that of a sideline camera at a football or baseball game.
Step 3: Compare the focus of macroeconomics with the television coverage of a sports event.
Macroeconomics is the study of the economy as a whole, including topics such as inflation,
unemployment, and economic growth. Macroeconomics does not study the decisions made
by individuals but the consequences of the actions of all decision makers in an economy. This
is similar to the blimp’s aerial view of the venue where a sports event occurs. One can see the
entire venue, but the blimp’s point of view is too far away to see any individual player or fan.
Extra Apply
the Concept Macroeconomic and Microeconomic Analysis
Economists separate the study of how households and firms make choices and interact in markets
(microeconomics) from the study of the economy as a whole (macroeconomics). But some issues can be
viewed from both perspectives. Labor productivity is one such issue.
Labor productivity—the quantity of goods and services that can be produced by one worker or by one
hour of work—is a microeconomic topic. Labor productivity increases when a firm invests in capital or
experiences an improvement in technology. Increased labor productivity allows a firm to earn higher
profits and pay its workers higher wages. But macroeconomists also study labor productivity because it
determines the standard of living a country can achieve for its citizens. An increase in productivity is
beneficial in the long run, but it can slow the growth of jobs in the short run. Following the recessions of
2001 and 2007–2009, many economists were concerned that the unemployment rate did not decrease as
quickly as it did following previous recessions. One reason for this was an increase in productivity. The
Bureau of Labor Statistics reported that output per hour worked of all persons rose by over 3 percent in
both 2009 and 2010. Because workers were more productive, firms did not have to hire new workers to
produce the same amount of goods and services. But productivity growth slowed to about 1 percent or
less from 2011 to 2014.
Some economists attribute the slowdown in productivity growth to a decline in investments in research by
U.S. firms from the high levels reached after 1995, which resulted in advancements in computer-related
applications. Other economists claim that many recent improvements in productivity escape
measurement. Google Inc.’s chief economist Hal Varian has argued that many innovations—such as apps

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CHAPTER 1 | Economics: Foundations and Models 11
that can be used via cell phones to track locations or hailing taxis—lead to improvements in productivity
“But I doubt that gets measured anywhere.”
Sources: Department of Labor (Bureau of Labor Statistics); and Timothy Aeppel, “Silicon Valley Doesn’t Believe U.S.
Productivity Is Down,” Wall Street Journal, July 16, 2015.
1.5 A Preview of Important Economic Terms
Learning Objective: Define important economic terms.
This section provides a brief definition and preview of terms students will see throughout the course: firm
(company, or business), entrepreneur, innovation, technology, goods, services, revenue, profit, household,
factors of production (economic resources or inputs), capital, and human capital.
Extra Economics in Your Life:
Is Cheating a Rational Decision?
In their best-selling book Freakonomics, Steven D. Levitt and Stephen J. Dubner stated: “Who cheats?
Well, just about anyone, if the stakes are right . . . . Cheating . . . is a prominent feature in just about every
human endeavor.” Evidence that some people cheat surfaced in the summer of 2011 when the
superintendent of the board of the Atlanta school district resigned after a report documented widespread
cheating on standardized tests that implicated officials from about 80 percent of Atlanta’s elementary and
middle schools. In 2015, an Atlanta jury convicted 11 teachers as a result of the cheating scandal.
Steven Levitt and other economists assume that decision-makers—students and non-students alike—are
rational. They compare the benefits and costs of their options and make choices for which the expected
benefits exceed the expected costs. The benefits of (successful) cheating may be monetary; for example,
K-12 teachers in some states are eligible for bonus payments of up to $25,000 if their students perform
well on standardized tests. New technology has made it easier for high school and college students to
cheat. The widespread use of cell phones and Internet access makes it easier (less costly) to share exam
answers and buy term papers.
Sources: Steven D. Levitt and Stephen J. Dubner, Freakonomics New York: HarperCollins 2005, pages 24–25; Patrik Jonsson,
“America’s biggest teacher and principal cheating scandal unfolds in Atlanta,” Christian Science Monitor, July 5, 2011; Mary
Beth McCauley, “Atlanta school cheating: When teachers cheat, what do you tell the kids?” Christian Science Monitor,
September 5, 2013; and Valerie Strauss, “How and Why Convicted Teachers Cheated on Standardized Tests,” Washington Post,
April 1, 2015.
Question: For the sake of argument, let’s assume that you would never cheat. Under what circumstances
are students in general more or less likely to cheat on an economics examination?
Answer: Your economics instructor will be pleased if you would never cheat under any circumstances.
But cheating is more likely when: (a) the positive consequences of receiving a high grade are significant
(for example, a high grade is necessary to maintain a scholarship, gain admittance to medical school, or
get a good job offer), and/or (b) the probability of getting caught is low (the instructor gives the same
multiple-choice exam to all students in a large classroom with no supervision). Reducing the benefit and
increasing the cost of getting caught will reduce the incidence of cheating. If appeals to personal integrity
are not enough to convince students not to cheat, a more effective deterrent may be for potential
employers to let students know that they fire dishonest employees.

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12 CHAPTER 1 | Economics: Foundations and Models
Appendix
Using Graphs and Formulas
Learning Objective: Use graphs and formulas to analyze economic situations.
Graphs simplify economic ideas and make the ideas more concrete so they can be applied to real-world
problems.
Graphs of One Variable
Figure 1A.1 displays examples of two common types of graphs: bar graphs and pie charts. The height of
the bars in the bar graph represents the market shares of automobile firms. The pie chart shows the same
information with the market shares of each group of firms represented by the size of its slice of the pie.
Information on economic variables can also be displayed in time-series graphs. These graphs are
displayed on a coordinate grid. The vertical axis (y-axis) of a coordinate grid measures the value of one
variable. The point where the vertical axis intersects the horizontal axis is the origin. The horizontal axis
of a coordinate grid measures the value of another variable. The points in a coordinate grid represent the
values of the two variables. Figure 1A.2 illustrates examples of time-series graphs.
Graphs of Two Variables
We often use graphs to show the relationship between two variables. Figure 1A.3 illustrates the graph of a
linear or straight-line demand curve where price is measured along the vertical axis and quantity is
measured along the horizontal axis.
A. Slopes of Lines
The slope of a straight line indicates how much the variable measured along the y-axis changes as the
variable measured along the x-axis changes. Slope can be measured between any two points on the
line because the slope of a straight line has a constant value. The slope can be expressed as the change
in the value measured on the vertical axis divided by the change in the value measured on the
horizontal axis; slope can also be expressed using the Greek letter delta (Δ) to stand for the change in
a variable (slope = Δy/Δx). The slope is also referred to as the rise over the run.Change in value on the vertical axis Rise
Slope Change in the value on the horizontal axis Run
y
x

= = =

B. Taking into Account More Than Two Variables on a Graph
The demand curve in Figure 1A.4 shows the relationship between the price of pizza and the quantity of
pizza sold, but the quantity of any good sold depends on more than just the price of the good. Allowing
other variables to change will cause the position of the demand curve in the graph to change. The table in
Figure 1A.5 shows the effect of a change in the price of hamburgers on the quantity of pizza demanded.
By shifting the demand curve we take into account the effect of changes in a third variable.
C. Positive and Negative Relationships
Sometimes the relationship between two variables is negative, as in the case with the price of pizza and
the quantity of pizza demanded. The relationship between two variables can be positive, as in Figure 1A.6
which shows values for disposable personal income and consumption spending in the United States for
2011–2014.

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CHAPTER 1 | Economics: Foundations and Models 13
D. Determining Cause and Effect
Inferring cause and effect relationships by observing graphs can lead to incorrect conclusions. One reason
for this is that there may be an omitted variable that is not accounted for in the graph. A related problem
in determining cause and effect is reverse causality; this occurs when we conclude that changes in
variable X cause changes in variable Y, when changes in variable Y cause changes in variable X.
E. Are Graphs of Economic Relationships Always Straight Lines?
The relationship between two variables is linear when it can be represented by a straight line. Few
economic relationships are actually linear. However, it is often useful to approximate a nonlinear
relationship with a linear relationship.
F. Slopes of Nonlinear Curves
To measure the slope of a nonlinear curve at a particular point, we must measure the slope of a tangent to
the curve at that point. A tangent line touches the curve at only one point. The slope of a tangent is
measured in the same way as the slope of any straight line.
Formulas
This section reviews several useful formulas and shows how to use them.
A. Formula for a Percentage Change
The formula for a percentage change between two variables for any two periods is:
Percentage changeValue in the second period Value in the first period 100
Value in the first period
−
= 
B. Formulas for the Areas of a Rectangle and a Triangle
The formula for the area of a rectangle is Base × Height. The formula for the area of a triangle is
½ × Base × Height.
C. Summary of Using Formulas
Follow these steps when using a formula:
1. Make sure you understand the economic concept the formula represents.
2. Make sure you are using the correct formula for the problem you are solving.
3. Make sure the number you calculate using the formula is economically reasonable.
Teaching Tips
You can assign the appendix as “on your own” reading. But don’t assume students will understand the
formulas for computing a slope or a percentage change. Reviewing these formulas in class will be time well
spent, either at this point in the course or when these formulas are first applied. In particular, students will
need to use graphs of two variables and percentage changes often throughout the remainder of the course.

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CHAPTER 2 | Trade-offs, Comparative
Advantage, and the
Market System
Brief Chapter Summary and Learning Objectives
2.1 Production Possibilities Frontiers and Opportunity Costs
Use a production possibilities frontier to analyze opportunity costs and trade-offs.
▪ The model of the production possibilities frontier is used to analyze the opportunity costs
and trade-offs that individuals, firms, or countries face.
2.2 Comparative Advantage and Trade
Describe comparative advantage and explain how it serves as the basis for trade.
▪ Comparative advantage is the ability of an individual, firm, or country to produce a good
or service at a lower opportunity cost than other producers.
2.3 The Market System
Explain the basics of how a market system works.
▪ Markets enable buyers and sellers of goods and services to come together to trade.
Key Terms
Absolute advantage. The ability of an
individual, a firm, or a country to produce more
of a good or service than competitors, using the
same amount of resources.
Circular-flow diagram. A model that illustrates
how participants in markets are linked.
Comparative advantage. The ability of an
individual, a firm, or a country to produce a
good or service at a lower opportunity cost than
competitors.
Economic growth. The ability of the economy
to increase the production of goods and services.
Entrepreneur. Someone who operates a
business, bringing together the factors of
production—labor, capital, and natural
resources—to produce goods and services.
Factor market. A market for the factors of
production, such as labor, capital, natural
resources, and entrepreneurial ability.
Factors of production. Labor, capital, natural
resources, and other inputs used to make goods
and services.
Free market. A market with few government
restrictions on how a good or service can be
produced or sold or on how a factor of
production can be employed.
Market. A group of buyers and sellers
of a good or service and the institution or
arrangement by which they come together
to trade.

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14 CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System
Opportunity cost. The highest-valued
alternative that must be given up to engage
in an activity.
Product market. A market for goods—such as
computers—or services—such as medical
treatment.
Production possibilities frontier (PPF). A
curve showing the maximum attainable
combinations of two products that can be
produced with available resources and current
technology.
Property rights. The rights individuals or firms
have to the exclusive use of their property,
including the right to buy or sell it.
Scarcity. A situation in which unlimited wants
exceed the limited resources available to fulfill
those wants.
Trade. The act of buying and selling.
Chapter Outline
Managers at Tesla Motors Face Trade-Offs
All-electric cars have struggled in the marketplace because the batteries that power them are costly and
they have to be recharged about every 300 miles. Although sales of all-electric cars made by Tesla Motors
represented only 0.1 percent of the U.S. car market in 2015, the company planned to introduce a new,
lower-priced model that would appeal to people who had bought gasoline-powered cars. Tesla initially
sold its Model S sedan for a base price of $75,000. It began selling a second automobile—the Model X—
in late 2015. The Model X was designed to compete with gasoline-powered SUVs but also sold for a very
high base price. To gain significant market share Tesla must allocate resources to produce an all-electric
car for about $35,000. Tesla’s managers must also decide how to sell and service the cars the company
sells. Tesla only sells cars online and relies on company-owned service centers for maintenance and
repairs. Tesla will likely face increased competition in future years from Apple and other companies that
are exploring the electric vehicle market.
2.1 Production Possibilities Frontiers and Opportunity Costs
Learning Objective: Use a production possibilities frontier to analyze opportunity costs
and trade-offs.
A key fact of economic life is that scarcity requires trade-offs. Scarcity is a situation in which unlimited
wants exceed the limited resources available to fulfill those wants. Goods and services and the resources,
or factors of production, that are used to make goods and services, are scarce.
A production possibilities frontier (PPF) is a curve showing the maximum attainable combinations of
two products that can be produced with available resources and current technology.
A. Graphing the Production Possibilities Frontier
All combinations of products located on the production possibilities frontier are efficient because all
available resources are being used. Combinations inside the frontier are inefficient because maximum
output is not being obtained from available resources. Points outside the frontier are unattainable given
the firm’s current resources.
Opportunity cost is the highest-valued alternative that must be given up to engage in an activity.

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 15
B. Increasing Marginal Opportunity Costs
A production possibilities frontier that is bowed outward illustrates increasing marginal opportunity costs,
which occur because some workers, machines, and other resources are better suited to one use than to
another. Increasing marginal opportunity costs illustrate an important concept: The more resources
already devoted to any activity, the smaller the payoff to devoting additional resources to that activity.
C. Economic Growth
Economic growth is the ability of the economy to increase the production of goods and services.
Economic growth can occur if more resources become available or if a technological advance makes
resources more productive. Growth may lead to greater increases in production for one good than another.
Extra Apply
the Concept Facing Trade-offs in Health Care Spending
Households have limited incomes. If the price of health care rises, households have to choose whether to
buy less health care or spend less on other goods and services. The same is true of the federal
government’s spending on health care. The government provides health insurance to about 30 percent of
the population through programs such as Medicare for people over age 65 and Medicaid for low-income
people. If the price of health care rises, the government has to either cut back on the services provided
through Medicare and Medicaid or cut spending in another part of the government’s budget. (Of course,
both households and the government can borrow to pay for some of their spending, but ultimately the
funds they can borrow are also limited.)
About 54 percent of the population has private health insurance, often provided by an employer. When
the fees doctors charge, the cost of prescription drugs, and the cost of hospital stays rise, the cost to
employers of providing health insurance increases. As a result, employers will typically increase the
amount they withhold from employees’ paychecks to pay for the insurance. Some employers—
particularly small firms—will even stop offering health insurance to their employees. In either case, the
price employees pay for health care will rise. How do people respond to rising health care costs? Isn’t
health care a necessity that people continue to consume the same amount of, no matter how much its price
increases? In fact, studies have shown that rising health care costs cause people to cut back their spending
on medical services, just as people cut back their spending on other goods and services when their prices
rise. One academic study indicates that for every 1 percent increase in the amount employers charge
employees for insurance, 164,000 people become uninsured. Of course, people without health insurance
can still visit the doctor and obtain prescriptions, but they have to pay higher prices than do people with
insurance. Although the consequences of being uninsured can be severe, particularly if someone develops
a serious illness, economists are not surprised that higher prices for health insurance lead to less health
insurance being purchased: Faced with limited incomes, people have to make choices among the goods
and services they buy.
The Congressional Budget Office estimates that as the U.S. population ages and medical costs continue to
rise, federal government spending on Medicare will more than double over the next 10 years. Many
policymakers are concerned that this rapid increase in Medicare spending will force a reduction in
spending on other government programs. Daniel Callahan, a researcher at the Hastings Center for
Bioethics, has argued that policymakers should consider taking some dramatic steps, such as having
Medicare stop paying for open-heart surgery and other expensive treatments for people over 80 years of
age. Callahan argues that the costs of open-heart surgery and similar treatments for the very old exceed
the benefits, and the funds would be better spent on treatments for younger patients, where the benefits
would exceed the costs. Spending less on prolonging the lives of the very old in order to save resources

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16 CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System
that can be used for other purposes is a very painful trade-off to consider. But in a world of scarcity,
trade-offs of some kind are inevitable.
Sources: Daniel Callahan, “The Economic Woes of Medicare,” The New York Times, November 13, 2008; Ezekiel J. Emanuel,
“The Cost–Coverage Trade-off,” Journal of the American Medical Association, Vol. 299, No. 8, February 27, 2008, pp. 947–949;
and Congressional Budget Office, A Preliminary Analysis of the President’s Budget and an Update of CBO’s Budget and
Economic Outlook, March 2009.
Questions & Solutions
1. Suppose the U.S. president is attempting to decide whether the federal government should spend
more on research to find a cure for heart disease. He asks you, one of his economic advisors, to
prepare a report discussing the relevant factors he should consider. Use the concepts of opportunity
cost and trade-offs to discuss some of the main issues you would deal with in your report.
Solution:
If the federal government has a fixed budget for medical research, then the opportunity cost of funding
more research on heart disease is the reduction in funding for research on other diseases. The decision
should be made at the margin: to maximize the benefits from government spending on medical research,
the last dollar devoted to research on heart disease should result in the same marginal benefit—less
disease and fewer deaths—as the last dollar spent on research for other diseases. If the additional funding
for research on heart disease comes at the expense of other non-medical research expenditures, then the
opportunity cost will be different, but a similar analysis should be conducted.
2. Uwe Reinhardt, an economist at Princeton University, wrote the following in a column in the
New York Times:
[Cost-effectiveness analysis] seeks to establish which of several alternative strategies capable of
achieving a given therapeutic goal is the least-cost strategy. It seems a sensible form of inquiry in
a nation that is dismayed over the rising cost of health care. . . . Opponents of cost-effectiveness
analysis include individuals who sincerely believe that health and life are “priceless.”
Are health and life priceless? Are there any decisions you make during your everyday life that indicate
whether you consider health and life to be priceless?
Source: Uwe E. Reinhardt, “‘Cost-Effectiveness Analysis’ and U.S. Health Care,” The New York Times, March 13, 2009.
Solution:
Nothing is priceless. Every day we makes decisions, such as driving a car or flying in a plane, that
increase by at least a small amount the chances that we will be hurt or killed. If health and life were
literally priceless, every decision we make would have the sole objective of minimizing the chances of
our being injured or killed. In a broader sense, we do not devote all of our resources to improving health
care because resources devoted to, say, saving lives through medical research are not available for other
needs, such as improving education. We always have to consider the opportunity cost of using resources
in one way rather than in another.

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 17
2.2 Comparative Advantage and Trade
Learning Objective: Describe comparative advantage and explain how it serves as the
basis for trade.
Trade is the act of buying and selling. Trade makes it possible for people to become better off by
increasing both their production and their consumption.
A. Specialization and Gains from Trade
PPFs depict the combinations of two goods that can be produced if no trade occurs. We can use PPFs to
show how someone can benefit from trade even if she is better than someone else at producing both goods.
B. Absolute Advantage versus Comparative Advantage
Absolute advantage is the ability of an individual, a firm, or a country to produce more of a good or
service than competitors, using the same amount of resources.
If the two individuals have different opportunity costs for producing two goods, each individual will have
a comparative advantage in the production of one of the goods. Comparative advantage is the ability of
an individual, a firm, or a country to produce a good or service at a lower opportunity cost than
competitors. Comparing the possible combinations of production and consumption before and after
specialization and trade occur proves that trade is mutually beneficial.
C. Comparative Advantage and the Gains from Trade
The basis for trade is comparative advantage, not absolute advantage. Individuals, firms, and countries are
better off if they specialize in producing the goods and services for which they have a comparative
advantage and obtain the other goods and services they need by trading.
Teaching Tips
Even good students have difficulty understanding comparative advantage. A good example of
comparative advantage is the career of baseball legend Babe Ruth. Before he achieved his greatest fame
as a home run hitter and outfielder with the New York Yankees, Ruth was a star pitcher with the Boston
Red Sox. Ruth may have been the best left-handed pitcher in the American League during his years with
Boston (1914–1919), but he was used more as an outfielder in his last two years with the team. In fact, he
established a record for home runs in a season (29) in 1919. The Yankees acquired Ruth in 1920 and
made him a full-time outfielder. The opportunity cost of this decision for the Yankees was the wins he
could have earned as a pitcher. But because New York already had skilled pitchers, the opportunity cost
of replacing him as a pitcher was lower than the cost of replacing Ruth as a hitter. No one else on the
Yankees could have hit 54 home runs, Ruth’s total in 1920; the next highest total was 11. It can be argued
that Ruth had an absolute advantage as both a hitter and pitcher for the Yankees in 1920, but a
comparative advantage only as a hitter.
2.3 The Market System
Learning Objective: Explain the basics of how a market system works.
In the United States and most other countries, trade is carried out in markets. A market is a group of
buyers and sellers of a good or service and the institution or arrangement by which they come together to
trade. A product market is a market for goods—such as computers—or services—such as medical
treatment. A factor market is a market for the factors of production, such as labor, capital, natural
resources, and entrepreneurial ability. Factors of production are the labor, capital, natural resources, and
other inputs used to make goods and services.

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18 CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System
A. The Circular Flow of Income
A circular-flow diagram is a model that illustrates how participants in markets are linked. The diagram
demonstrates the interaction between firms and households in both product and factor markets.
B. The Gains from Free Markets
A free market is a market with few government restrictions on how a good or service can be produced or
sold or on how a factor of production can be employed. Adam Smith is considered the father of modern
economics. His book, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776,
was an influential argument for the free market system.
C. The Market Mechanism
A key to understanding Adam Smith’s argument is the assumption that individuals usually act in a
rational, self-interested way. This assumption underlies nearly all economic analysis.
D. The Role of the Entrepreneur in the Market System
Entrepreneurs are an essential part of a market economy. An entrepreneur is someone who operates a
business, bringing together the factors of production—labor, capital, and natural resources—to produce
goods and services. Entrepreneurs often risk their own funds to start businesses and organize factors of
production to produce those goods and services that consumers want.
E. The Legal Basis of a Successful Market System
The absence of government intervention is not enough for a market economy to work well. Government
has to provide a legal environment that allows markets to operate efficiently. Property rights are the
rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.
To protect intellectual property rights, the federal government grants a patent that gives an inventor –
often a firm—the exclusive right to produce and sell a new product for 20 years from the date the patent
was filed. Books, films, and software receive copyright protection. Under U.S. law, the creator of a book,
film, or piece of music has the exclusive right to use the creation during the creator’s lifetime. The
creator’s heirs retain this right for 70 years after the death of the creator.
Business activity often involves someone agreeing to carry out some action in the future. These
agreements often take the form of legal contracts. For the market system to work, businesses and
individuals have to rely on these contracts being carried out. Enforcing contracts or property rights
requires an independent court system and judges who are able to make impartial decisions on the basis of
the law. If property rights are not well enforced fewer goods and services will be produced, leaving the
economy inside its production possibilities frontier.
Teaching Tips
To initiate class discussion regarding intellectual property rights, ask students these questions:
1. How many of you have downloaded music via the Internet?
2. Should the government have the right to grant exclusive rights to musicians and other artists to
produce and sell their creative works?
3. Should the government fine or prosecute individuals who illegally obtain music, books, movies, and
other creative works in violation of property rights laws?

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 19
Extra Solved Problem 2.3
Adam Smith’s “Invisible Hand”
Alan Krueger, an economist at Princeton University who served as chair of the Council of Economic
Advisers in the Obama administration, has argued that Adam Smith “. . . worried that if merchants and
manufacturers pursued their self-interest by seeking government regulation and privilege, the invisible
hand would not work its magic . . . .”
Source: Alan B. Krueger, “Rediscovering the Wealth of Nations,” New York Times, August 16, 2001.
a. What types of regulation and privilege might merchants and manufacturers seek from the
government?
b. How might these regulations and privileges keep the invisible hand from working?
Solving the Problem
Step 1: Review the chapter material.
This problem is about how goods and services are produced and sold and how factors of
production are employed in a free market economic system as described by Adam Smith in
An Inquiry into the Nature and Causes of the Wealth of Nations. You may want to review the
section “The Gains from Free Markets.”
Step 2: Answer part a. by describing the economic system in place in Europe in 1776.
At the time, governments gave guilds—associations of producers—the authority to control
production. The production controls limited the output of goods such as shoes and clothing,
as well as the number of producers of these items. Limiting production and competition led to
higher prices and fewer choices for consumers. Instead of catering to the wants of consumers,
producers sought favors from government officials.
Step 3: Answer part b. by contrasting the behavior of merchants and manufacturers under
a guild system and a market system.
Because governments in a guild system gave producers the power to control production,
producers did not have to respond to consumers’ demands for better quality, greater variety,
and lower prices. Under a market system, producers who sell poor quality goods at high
prices suffer economic losses; producers who provide better quality goods at low prices are
rewarded with profits. Therefore, it is in the self-interest of producers to address consumer
wants. This is how the invisible hand works in a free market economy, but not in most of
Europe in the eighteenth century.
Extra Economics in Your Life:
International Trade and Household Income
Many people believe that outsourcing—firms producing goods and services outside of their home country
—harms their nations’ economies by increasing domestic unemployment and decreasing incomes. But
most economists believe that free trade policies, including allowing goods and services to be produced in
other countries, benefit domestic economies. In a letter dated March 5th 2015, 14 economists
(including R. Glenn Hubbard) who served at chairs of the Council of Economic Advisers under seven
Republican and Democratic presidents, wrote an open letter to congressional leaders expressing their

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20 CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System
support for the renewal of the Trade Promotion Authority in order to reach agreements with U.S. trading
partners through the Trans-Pacific Partnership (TPP) and the Trans-Atlantic Trade and Investment
Partnership (TTIP). The letter read, in part: “International trade is fundamentally good for the U.S.
economy, beneficial to American families over time, and consonant with our domestic priorities.”
Ben Bernanke, former chairman of the Federal Reserve Board, cited a study that examined the effect of
international trade on income in the United States since World War II: “. . . the increase in trade . . . has
boosted U.S. annual incomes on the order of $10,000 per household. The same study found that removing
all remaining barriers to trade would raise incomes anywhere from $4,000 to $12,000 per household.”
Source: N. Gregory Mankiw, “Economists Actually Agree on This: The Wisdom of Free Trade,” New York Times, April 24, 2015; and
Ben Bernanke, “Embracing the Challenge of Free Trade: Competing and Prospering in a Global Economy,” The Federal Reserve
Board, May 1, 2007. http://www.federalreserve.gov/boarddocs/speeches/2007/20070501/default.htm.
Questions: (a) Should the United States accept the advice of economists and support free trade policies
even if this increases the risk of some workers losing their jobs to outsourcing? (b) What type of job
would make you more or less vulnerable to outsourcing?
Answers: (a) Given the opposition from firms and workers in industries that would be harmed by free
trade, it is unlikely that the United States would eliminate all trade barriers. But studies such as the one
cited by Ben Bernanke show that increased trade can significantly boost the incomes of U.S. households.
(b) Another study Bernanke cited found twenty-one occupations that were most vulnerable to outsourcing
were primarily for relatively lower-wage positions.

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