Class Notes for InMicro, 2018 Edition

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Instructor’s ManualInMicroFIRSTEDITIONR. Glenn HubbardAnthony Patrick O’Brien

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ContentsChapter 1:Economics: Foundations and Models1Appendix: Using Graphs and Formulas12Chapter 2:Trade-offs, Comparative Advantage, and the Market System14Chapter 3:Where Prices Come From: The Interaction of Demand and Supply22Chapter 4:Economic Efficiency, Government Price Setting, and Taxes34Appendix: Quantitative Demand and Supply Analysis42Chapter 5:Externalities, Environmental Policy, and Public Goods45Chapter 6:Elasticity: The Responsiveness of Demand and Supply56Chapter 7:The Economics of Health Care69Chapter 8:Firms, the Stock Market, and Corporate Governance79Appendix: Tools to Analyze Firms’ Financial Information90Chapter 9:Comparative Advantage and the Gains from International Trade93Chapter 10:Consumer Choice and Behavioral Economics109Appendix:Using Indifference Curves and Budget Lines to UnderstandConsumer Behavior119Chapter 11:Technology, Production, and Costs122Appendix: Using Isoquants and IsocostLines to Understand Production and Cost137

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Chapter 12:Firms in Perfectly Competitive Markets141Chapter 13:Monopolistic Competition: The Competitive Model in a MoreRealistic Setting156Chapter 14:Oligopoly: Firms in Less Competitive Markets171Chapter 15:Monopoly and Antitrust Policy188Chapter 16:Pricing Strategy202Chapter 17:The Markets for Labor and Other Factors of Production208Chapter 18:Public Choice, Taxes, and the Distribution of Income222PrefaceFeatures of this Instructor’s ManualEach 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, keyterm definitions, and teaching tip boxes.The teaching tip boxes include recommendationson how tointegrate key figures.ExtraSolved Problems:Each chapter of the main coursehas aSolved Problemto support two of thechapter’s learning objectives. This Instructor’s Manual includesextraSolved Problemsthat youcanassign as homework or present during classroom lectures.ExtraEconomics inYour Life:Each chapter of thecourseopens and closes with a special feature entitledEconomics inYour Lifethatemphasizes the connection between the material and the students’ personalexperiences and questions. This Instructor’s Manual includes an extraEconomics in Your Lifefor eachchapter to present in class.ExtraApply the Concept:Each chapter of the coursehas two or moreApply the Conceptfeatures toprovide real-world reinforcement of key concepts. This Instructor’s Manual includes extraApply theConceptto present in class.

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Organizing Your SyllabusThe Instructor’s Manual can be a valuable resource for both experienced and first-time instructors. BoththeRevel courseand Instructor’s Manual provide comprehensive coverage of economic theory, policy,and real-world applications.Thiscoursecoversrelatively 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 forLabor and Other Factors of Production”). The authors include business applications in each chapter andhave a dedicated chapter on firms, the stock market, and corporate governance (Chapter 8, “Firms, theStock Market, and Corporate Governance”). The comprehensive coverage of microeconomics andbusiness 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, butthose who wish to will find these topics covered in the appendices to Chapter 10, “Consumer Choice andBehavioral Economics,” and Chapter 11, “Technology,Production, and Costs,” respectively. Chapter 14 ofthis instructor’s manual, “Oligopoly: Firms in Less Competitive Markets,” includes coverage of the kinkeddemand curve thatdoes notappear in the main course.First-time users of theRevel courseshould be aware that some topics introduced in one chapter areapplied 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-imposedprice controls. The appendix toChapter 4, “Quantitative Demand and Supply Analysis,” explains in detailhow 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 theeffectof 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:COREPOLICYOPTIONALChapter 1: Economics:Foundationsand ModelsChapter 2: Trade-offs, ComparativeAdvantage, and the MarketSystemChapter 3: Where Prices ComeFrom: The Interaction of Demandand SupplyChapter 6: Elasticity: TheResponsiveness of Demand andSupplyChapter 9: Comparative Advantageand the Gains from InternationalTradeChapter 11: Technology, Production,and CostsChapter 12: Firms in PerfectlyCompetitive MarketsChapter 13: MonopolisticCompetition: TheCompetitiveModel in a MoreRealistic SettingChapter 14: Oligopoly: Firms in LessCompetitive MarketsChapter 15: Monopoly and AntitrustPolicyChapter 4: Economic Efficiency,Government Price Setting, andTaxesChapter 5: Externalities,Environmental Policy, and PublicGoodsThis chapter may be delayed untilafter Chapter 15.Chapter 7: The Economics ofHealth CareChapter 18: Public Choice, Taxes,and the Distribution of IncomeChapter 1 Appendix: Using Graphsand FormulasChapter 4 Appendix: QuantitativeDemand and Supply AnalysisChapter 8: Firms, the Stock Market,and Corporate GovernanceChapter 8Appendix:Tools toAnalyze Firms’ FinancialInformationChapter 10: ConsumerChoiceandBehavioral EconomicsChapter 10Appendix: UsingIndifference Curves and BudgetLines to Understand ConsumerBehaviorChapter 11Appendix:UsingIsoquants and IsocostLinestoUnderstand Production and CostChapter 16: Pricing Strategy

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COREPOLICYOPTIONALMay be covered after chapter 12.Chapter 17: The Markets for Laborand Other Factors of Production

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Other Supplements for Instructors▪Test Item File▪TestGen Computerized Test Program▪PowerPoint Lecture Presentation▪Digital InteractivesTest Item File (inelectronic TestGen format)TheTest Item Fileincludes 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 analysisType:multiple-choice, true/false, short-answer, essayTopic:the term or concept the question supportsLearningoutcomeAACSB(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 skillguidelines found in the AACSB standards.WhatIsthe AACSB?AACSB is a not-for-profit corporation of educational institutions, corporations, and other organizationsdevoted to the promotion and improvement of higher education in business administration andaccounting. A collegiate institution offering degrees in business administration or accounting mayvolunteer for AACSB accreditation review. The AACSB makes initial accreditation decisions and conductsperiodic reviews to promote continuous quality improvement in management education. PearsonEducation is a proud member of the AACSB and is pleased to provide advice to help you apply AACSBLearning Standards.WhatAreAACSB Learning Standards?One of the criteria for AACSB accreditation is the quality of the curricula. Although no specific coursesare 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 KnowledgeThese categories are AACSB Learning Standards. Questions that test skills relevant to these standards aretagged with the appropriate standard. For example, a question testing the moral questions associatedwith 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 withthe AACSB guidelines noted above. In addition, the tagged questions may help instructors identifypotential applications of these skills. This in turn may suggest enrichment activities or other educationalexperiences to help students achieve these skills.TestGenThe 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 existinggraphics and create new graphics; analyze test results; and organize a database of tests and studentresults. This software allows for extensive flexibility and ease of use. It provides many options fororganizing and displaying tests, along with search and sort features. The software and the test banks canbe downloaded from the Instructor’s Resource Center (www.pearsonhighered.com).PowerPointSlidesPowerPoint slides can be used by instructors for class presentations or by students for lecturepreview orreview. These slides include graphs, tables, and equations from the Revel course. They are presented in astep-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 InteractivesFocused on a single core topic and organized in progressive levels, each interactive immerses students inan 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 toolsfor richclassroom discussions.

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CHAPTER1|Economics: Foundationsand ModelsBrief Chapter Summaryand Learning Objectives1.1Three Key Economic IdeasExplain these three keyeconomic ideas:People are rational;people respond toeconomicincentives;and optimal decisions are made at the margin.▪People must make choices as they try to attain their goals. People make choices becauseresources are scarce.1.2The Economic Problem That Every Society Must SolveDiscuss how an economy answers these questions: What goods and services will be produced? Howwill the goods and services be produced? Who will receive the goods and servicesproduced?▪Alimited amount of resourceswillproduce 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.1.3Economic ModelsDescribethe role of models in economic analysis.▪Economists use models—simplified versions of reality—to analyze real-world issues.1.4Microeconomics and MacroeconomicsDistinguish between microeconomics and macroeconomics.1.5A Preview of Important Economic TermsDefineimportant economic terms.Appendix:Using Graphs and FormulasUse graphsand formulas to analyze economic situations.Key TermsAllocative efficiency.Astate of the economy inwhich production is in accordance with consumerpreferences; in particular, every good or service isproduced up to the point where the last unitprovides a marginal benefit to society equal to themarginal cost of producing it.Centrally planned economy.An economy inwhich the government decides how economicresources will be allocated.Economic model.Asimplified versionof reality used to analyze real-world economicsituations.Economic variable.Something measurable thatcan have different values,such as theincomes of doctors.Economics.The study of the choices peoplemake to attain their goals, given their scarceresources.

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2CHAPTER1|Economics: Foundations and ModelsEquity.The fair distribution of economicbenefits.Macroeconomics.The study of the economy asa whole, including topics such as inflation,unemployment, and economic growth.Marginal analysis.Analysis that involvescomparing marginal benefits and marginal costs.Market.Agroup of buyers and sellers of a goodor service and the institution or arrangement bywhich they come together to trade.Market economy.An economy in whichthedecisions of households and firms interacting inmarkets allocateeconomicresources.Microeconomics.The study of how householdsand firms make choices, how they interact inmarkets, and how the government attempts toinfluence their choices.Mixed economy.An economy in which mosteconomic decisions result from the interaction ofbuyers and sellers in markets but in which thegovernment plays a significant role in theallocation of resources.Normative analysis.Analysis concerned withwhat ought to be.Opportunity cost.The highest-valuedalternative that must be given up to engage in anactivity.Positive analysis.Analysis concerned with whatis.Productive efficiency.Asituation in which agood or service is produced at the lowestpossible cost.Scarcity.Asituation in which unlimited wantsexceed the limited resources available to fulfillthose wants.Trade-off.The idea that,because of scarcity,producing more of one good or service meansproducing less of another good or service.Voluntary exchange.Asituation that occurs inmarkets when both the buyer andtheseller of aproduct are made better off by the transaction.Chapter OutlineWill Smart Devices Revolutionize Health Care?Scanadu,aCalifornia-based firm,developed asmall disk that when pressed against someone’s head canread the person’s blood pressure, heart rate and temperature.Apple and other firmsalsohave developednew consumer medical devices.These firms reacted to several trends. More people have become healthconscious, as the population ages, more people are experiencing medical problems,and technologicalprogress has made it possible for small electronic devices to monitor blood pressure and perform othertasks.These firms are responding totheeconomic incentives that a market system provides.New andimproved goods and services increase the standard of living of the average person.

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CHAPTER1|Economics: Foundations and Models3Teaching TipsThere arespecialfeaturesinthecourse:1.Theintroduction, or chapter opener, uses a real-world businessexampleto preview the economicissuesdiscussed inthe chapter.2.Aboxedfeature titled Economics inYour Lifecomplements the business example that opens thechapter.Economics inYour Lifeposes questions that help students make a personal connection with thechapter theme.At the end of the chapter, the authors use the concepts described in the chapter to answerthese questions.ExtraEconomics in Your Lifefeaturesareincluded in the Instructor’s Manuals.3.Don’t Let This Happen to Youis a box feature that alerts students to common pitfalls covered in thatchapter.4.There are between twoandfourApply the Conceptfeaturesin each chapterthat provide real worldreinforcement of key concepts by citing news stories that focus on business and policy issues.ExtraApply the Conceptfeatures appear in the Instructor’s Manual.5.Solved Problemsuseastep-by-step process forsolving economic problemsrelated to a chapterlearning objective.ExtraSolved Problemsare included in the Instructor’s Manual.Youcanusethesefeaturesasthebasisforclassroomdiscussion,homeworkassignments,andexamination questions.People must make choices as they try to attain their goals.The choices people make represent the trade-offs made necessary by scarcity.Scarcityis a situation in which unlimited wants exceed the limitedresources available to fulfill those wants.Economicsis the study of the choices people make to attaintheir goals, given their scarce resources. Aneconomic modelis a simplified version of reality used toanalyze real-world economic situations.TeachingTipsStudentswill better understand what scarcity means if you give them examples of things that arenotscarce.Suggestexamples of“free”resources—sand on a beach, fresh air, etc.—and askyourstudents tocontributetheir ownexamples; they will soonrealizethat the list of free resources is much shorter thanthe list of scarce resources.1.1Three Key Economic IdeasLearning Objective: Explain these three key economic ideas: People are rational;people respond to economic incentives; and optimal decisions are made at the margin.Amarketis a group of buyers and sellers of a good or service and the institution or arrangement bywhich they come together to trade.A.PeopleAre RationalRational individuals weigh the benefits and costs of each action,and chooseanaction if the benefitsoutweigh the costs.B.PeopleRespond toEconomicIncentivesEconomists emphasize that consumers and firms consistently respond to economic incentives.

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4CHAPTER1|Economics: Foundations and ModelsC.Optimal Decisions Are Made at the MarginEconomists use the word marginal to meananextra or additional benefit orcost frommakinga decision.The optimal decision is to continue any activity to the point where the marginal benefit equals the marginalcost.Marginal analysisis analysis thatinvolves comparing marginal benefits and marginal costs.ExtraSolved Problem 1.1ADoctorMakes a Decision at the MarginA doctor receives complaints from patients that her office isn’t open enough hours. So the doctor asks heroffice manager to analyze the effect of keeping her office open 9 hours per day rather than 8 hours. Thedoctor’s office manager tells her:“Keeping the office open an extra hour is a good idea because therevenue 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 todecide whether the doctor should keep her office open an additional hour per day?Solving the ProblemStep 1:Review the chapter material.This problem is about making decisions, so you may want to review the section“OptimalDecisions 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 isequal to the marginal cost. In this case, the doctor should keep her office open up to the pointwhere the additional revenue she receives from seeing more patients is equal to the marginal costof keeping her office open an additional hour. The office manager has provided information onmarginal revenue but not on marginal cost. So the office manager has not provided enoughinformation 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 remainingopen an extra hour per day. The marginal cost would include the additional salary to be paidto the office staff, any additional medical supplies that would be used, as well as anyadditional electricity or other utilities. The doctor would also need to take into account thenonmonetary cost of spending another hour working rather than spending time with herfamily and friends or in other leisure activities. The marginal revenue would depend on howmany more patients the doctor can see in the extra hour. The doctor should keep her officeopen 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 tokeep her office open for 8 hours.TeachingTipsYoudon’t need tospend a lot of class time with explanationsof the material in this section;subsequentchapters will reinforce students’understandingofmarkets and the“three key economic ideas.”

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CHAPTER1|Economics: Foundations and Models5Everysociety faces the economic problem that it has only a limited amount of economic resources,soitcan produce only a limited amount of goods and services.Society faces trade-offs.Atrade-offis the ideathat,because of scarcity, producing more of one good or service means producing less of another good orservice.Every activity has anopportunity cost:The highest-valued alternative that must be given up toengage in an activity.Trade-offs force society to answer three fundamental questions:1.Whatgoods and services will be produced?2.Howwill the goods and services be produced?3.Whowill receive the goods and servicesproduced?A.What Goods and Services Will Be Produced?The answer to this question is determined by the choicesconsumers, 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 oftenface trade-offsbetween using more workersormore machines.C.Who Will Receive the Goods and Services Produced?In the United States, who receives thegoods and services produced depends largely on how income isdistributed.An important policy question is whether the government should intervene to make thedistribution of income more equal.D.Centrally PlannedEconomiesversus Market EconomiesSocieties organize their economies in two main ways.Acentrally planned economyis an economy inwhich the government decides how economic resources will be allocated.Amarket economyis aneconomy in which the decisions of households and firms interacting in markets allocate economicresources.Today,onlya few small countries, such as Cuba and North Korea, still have completelycentrally planned economies.In a market economy,theincomeof an individualis determined by thepaymentshereceivesfor whathesells.Generally, the more extensive the traininga person has receivedandthelonger thehoursthe personworks, the higherhisincome will be.E.The Modern“Mixed”EconomyThe high rates of unemployment and business bankruptciesduringthe Great Depressionof the 1930scaused a dramatic increase in government intervention in the economy in the United States and othermarketeconomies.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 suchastheprotection of the environment,the promotion of civil rights, and the provision of medical care tolow-income people and the elderly.1.2The Economic Problem That Every Society Must SolveLearning Objective: Discuss how an economy answers these questions: What goods andservices will be produced? How will the goods and services be produced? Who willreceive the goods and services produced?

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6CHAPTER1|Economics: Foundations and ModelsSome economists argue thatthe extent ofgovernment intervention makes it more accurate to refer to theeconomies of theUnited States, Canada and Western Europeas mixed economies rather thanpuremarketeconomies.Amixed economyis an economyin whichmost economic decisions result from theinteraction of buyers and sellers in markets butin whichthe government plays a significant role in theallocation of resources.F.Efficiencyand EquityMarket economies tend to be more efficient thancentrallyplanned economies.There are two types ofefficiency.Productive efficiencyisasituation in which a good or service is produced at the lowest possiblecost.Allocative efficiencyis a state of the economy in which production is in accordance with consumerpreferences; in particular, every good or service is produced up to the point where the last unit provides amarginal benefit to society equal to the marginal cost of producing it.Voluntary exchangeisasituationthat occurs in markets when both the buyer andtheseller of a product are made better off by the transaction.Inefficiencyarises from various sources.Sometimesgovernments reduce efficiency by interfering withvoluntary exchange in markets.The production of some goods damagesthe environment when firmsignore the costs of environmental damage.In this case, government intervention can increase efficiency.Societymay not findanefficient economic outcome to be desirable.Many people prefer economicoutcomes that they consider fair or equitable even if these outcomes are less efficient.Equityis the fairdistribution of economic benefits.There is often a trade-off between efficiency and equity.TeachingTipsAsk students for examples of government regulation of private markets in the United States. Responsesmayinclude:making the saleof cocaine and other addictive drugsillegal; minimum age requirements forthe purchase of alcoholic beveragesand cigarettes; the prohibition of the sale of new drugs before theireffectivenessis demonstrated through government supervised tests.Ask students whether one of theseexamplesof government regulationpromotes equity or fairness. The difficultyindefining equity willbeapparent.To show how students may value equity less than they claim, an economics teacher at a college inWestern New York once told her students at the beginning of her course that their grades would beauctioned to the highest bidders.Becausegrades are typically normally distributed, she offered to sell afew A grades, a few more B grades,and so on.Although the announcement produced shock andgrumbling, the auction proceeded,withfrenzied 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 studentbid on several such grades in the belief that those who lost out on getting an A or B would have to buytheir C grades from him—for a higher price than he paid!After about a week, the instructor informed theclass the auction was intended only as an economics lesson; they would have to earn their grades the old-fashioned way.ExtraSolved Problem1.2Advising New Government LeadersSuppose that acountry experiencesa change in government leadership. Prior to this change,thecountryhada centrally planned economy. The new leaders are willing to try a different system ifthey can becanbeconvincedthat it will yield better results. They hire an economist from acountrywith a marketeconomy to advise them and will order their citizens to follow theeconomist’s recommendations for

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CHAPTER1|Economics: Foundations and Models7change. The economist suggests that a market economy replace central planning to answer the nation’seconomic questions (what,how,andwho?).What will the economist suggest the leaders order their citizens to doin order to change from a centrallyplanned economy to a market economy?Are there reasons whythe leadersof this country might notaccept the economist’s suggestions?Brieflyexplain.Solving the ProblemStep 1:Review the chapter material.The problemis aboutdifferent types ofeconomic systems, so you may wantto review the section“Centrally Planned Economiesversus 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 goodsand services based on self-interest and allow privatelyowned firms to produce goods andservices based on their self-interests. Therefore, the economist would advise the leaders of thecountry to not issue any orders. Government officials should have no influence overindividual decisions made in markets.Step 3:Are there reasons why theleadersof this countrymight notaccept the economist’ssuggestions?Even democratically elected leadersmayfind it difficult to accept the new system. They maywonder how self-interested individuals will produce and distribute goods and services so as topromote the welfare of the entirecountry.This new system requires a significant reduction ingovernment influence in people’s lives, buthistory has shown thatmostgovernment officialsare reluctant to give up this influence. Acceptance is most likely when the leaders have someknowledge and experience with the successful operation of a market economy in othercountries. Ordinary citizens are more likely to accept the economist’s suggestionsbecausetheywouldhave more freedom to pursue their own economic goals.1.3Economic ModelsLearning 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 datawell.5.Retain the revised model to help answer similar economic questions in the future.A.The Role of Assumptions in Economic ModelsModels are based on making assumptions because models must be simplified to be useful.When usingmodels economists make behavioral assumptions about the motives of consumers and firms. Economists

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8CHAPTER1|Economics: Foundations and Modelsassume consumers will buy goods and services that will maximize their satisfactionandfirmswillact tomaximize their profits.B.Forming and Testing Hypotheses in Economic ModelsAneconomic variableis something measurable that can have different values, such as the incomes ofdoctors.A hypothesis in an economic model is a statement that may be correct or incorrect about aneconomic variable.To test a hypothesis,we analyze statistics on the relevant economic variables.Economists accept and use an economic model ifit leads to hypotheses that are confirmed by statisticalanalysis.C.Positive andNormative AnalysisPositive analysisis analysis concerned with what is.Normative analysisis analysis concerned with whatought to be.Economics is about positive analysis, which measures the costs and benefits of differentcourses of action.D.Economics as a Social ScienceBecause economics studies the actions of individuals, it is a social science.Economics considers humanbehavior in every context, not just in the context of business.Economists have played an important role informulating government policies in areas such as the environment, health care, and poverty.ExtraSolved Problem 1.3Sunspot Activity andthe Market for Natural GasSunspots are sites of strong magnetic fields that appear as dark regions on the surface of the sun. Thenumber of sunspots varies over an eleven-year cycle.Scientists have found that the Earth’s temperaturedeclines when the number of sunspots decreases, so when the number of sunspots declinesthereisanexpectation that a period of lower temperatureswillfollow.British economist William Stanley Jevons(1835–1882)developed a modelof economic growth based on the occurrence of sunspots.Jevonshypothesized that when the earth’s temperature varied throughout the sunspot cycle,agricultural outputwould change too.Today, most economists attribute changes in economic growth to factors other thansunspots.But some analysts believe that changes in sunspot activity could result in changes in the demandand price for natural gas in the United States.The development of new technologyhasresulted in a largeincrease in the production of natural gas in the U.S. in thetwenty-firstcentury. As a result, natural gas hasreplaced other sources of energy for businesses and households and lower temperatures could lead to anincrease in the demand for natural gas.How can we developamodel that teststhe relationship between sunspot activity and the market fornatural gas?Source:Simon Constable,“As‘Sun Spots’Cool Down, Natural-Gas Market Heats Up,”Wall Street Journal, July 1, 2013.Solving the ProblemStep 1:Review the chapter material.The problem is about how to use models to analyze economic issues, so you may want toreview the section“Economic Models.”

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CHAPTER1|Economics: Foundations and Models9Step 2:To develop and test a model of the relationship between sunspot activity and themarket for natural gas, follow these steps:1.Decide on the assumptions to use in developing the model. Two assumptions ofthemodel are: (a) Changes in the earth’s temperature are related tochanges inthe amount ofsunspot activity, and (b)Changes in the earth’s temperature cause variationsin thedemand for natural gas, which is an energy source for homes and businesses.2.Formulate a testable hypothesis.All else equal, thedemand for natural gas and the priceof natural gas will be higher in years when there islower than average sunspot activity.All else equal, thedemand for natural gas and the price of natural gas will be lower inyears when there is higher than average sunspot activity.3.Use economic data to test the hypothesis. Compare changes in sunspot activity withchangesin 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 ofgreater-than-average sunspot activity shouldbe years of relatively low sales and pricesfor natural gas,while years of lower-than-average sunspot activity should beyears ofhigher sales and prices for natural gas.4.Revise the model if it fails to explain theeconomicdatawell. The model could failbecausefactors other than sunspot activitycanhave a significant effectthe market fornatural gas. These factors include: changes in the prices of other energy sources,changesin the cost of production for natural gasandchanges ingovernment policiestowardsenergy markets. A revised model would examine the separate influence of sunspots andthese other factors.The model could also fail if factors other than sunspot activity, suchas an increase in the amount of“greenhouse gases”in the atmosphere, affect the Earth’stemperature.5.Retain the revised model to help answer similar economic questions in the future.If thedata support the model, one can assume that there is a relationship between sunspotactivity and the market for natural gas.But tests of the model with data from differenttime periods could either support or refute these results.Acceptance of a model is alwaystentative pending the acquisition of new data or additional statistical analysis.1.4Microeconomics and MacroeconomicsLearning Objective: Distinguish between microeconomics and macroeconomics.Microeconomicsis the study of how households andfirms make choices, how they interact in markets,and how the government attempts to influence their choices.Macroeconomicsisthestudyoftheeconomyasawhole,includingtopicssuchasinflation,unemployment, and economic growth.ExtraSolved Problem1.4Microeconomic and Macroeconomic ViewsSports fans are used towatching eventson television from different camera angles.For popular eventssuch as the Olympics,theWorld Series, andtheSuper Bowl, network coverage captures action fromground level as well as higher locations.Blimpsare frequently flownabovethestadiumswhere the eventstake place.The aerial viewof the blimp’s camera isvisually appealing but is never broadcast for verylongbecausethe athletesare barely visible.Coverage ofgamesincludes a view from a mobile or

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10CHAPTER1|Economics: Foundations and Models“sideline”camera that can zoom in on individual players or fans sitting in the stands, a degree of detailmuch greater than thatprovided by the aerial view.How do the different camera angles help to explain the difference between microeconomics andmacroeconomics?Solving the ProblemStep 1:Review the chapter material.The problem concerns the differences between microeconomics and macroeconomics, so youmay 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 theyinteract in markets, and how the government attempts to influence their choices.This focus issimilar to that of a sideline camera at a footballor baseballgame.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 madeby individuals but the consequences ofthe actions of all decisionmakers in an economy. Thisis similar to the blimp’s aerial view of the venue where a sports event occurs.One can see theentire venue, but the blimp’s point of view is too far away to see any individual player or fan.ExtraApplythe ConceptMacroeconomic and Microeconomic AnalysisEconomists 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 beviewed 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 onehour of work—is a microeconomic topic. Labor productivity increases when a firm invests in capital orexperiences an improvement in technology. Increased labor productivity allows a firm to earn higherprofits andpay its workers higher wages.But macroeconomists also study labor productivity because itdetermines the standard of living a country can achieve for its citizens. An increase in productivity isbeneficial in the long run, but it can slow the growth of jobs in the short run. Following the recessions of2001 and 2007–2009, many economists were concerned that the unemployment rate did not decrease asquickly as it did following previous recessions. One reason for this was an increase in productivity.TheBureau of Labor Statistics reported that output per hour worked of all persons rose by over 3 percent inboth 2009 and 2010.Because workers were more productive, firms did not have to hire new workers toproduce the same amount of goods and services. But productivity growth slowed toabout1 percent orless from 2011 to 2014.Some economistsattribute the slowdown in productivity growth to a decline in investments in research byU.S. firms from the high levels reached after 1995, which resulted in advancements incomputer-relatedapplications.Othereconomistsclaimthatmanyrecentimprovementsinproductivityescapemeasurement.Google Inc.’s chief economist Hal Varian has argued that many innovations—such as apps

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CHAPTER1|Economics: Foundations and Models11that can be used via cell phones to track locations or hailing taxis—lead to improvements in productivity“But I doubt that gets measuredanywhere.”Sources:Department of Labor (Bureau of Labor Statistics);andTimothy Aeppel,“Silicon Valley Doesn’t Believe U.S.ProductivityIs Down,”Wall Street Journal,July16, 2015.1.5A Preview of Important Economic TermsLearning Objective: Define important economic terms.This section provides a brief definition and preview of terms students will see throughout thecourse:firm(company, or business),entrepreneur, innovation,technology,goods, services, revenue, profit, household,factors of production(economic resourcesor inputs),capital,andhuman capital.ExtraEconomics in Your Life:Is Cheating aRational Decision?In their best-selling bookFreakonomics, Steven D. Levitt and Stephen J. Dubnerstated:“Who cheats?Well, just about anyone, if the stakes are right . . . . Cheating . . . is a prominent feature in just about everyhuman endeavor.”Evidencethatsomepeoplecheatsurfacedinthesummerof2011whenthesuperintendent of the board of the Atlanta school district resigned after a report documented widespreadcheating on standardized tests that implicated officials from about 80 percent of Atlanta’s elementary andmiddle 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—arerational. They compare the benefits and costs of their options and make choices for which the expectedbenefits 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 performwell on standardized tests. New technology has made it easier for high school and college students tocheat. The widespread use of cell phones and Internet access makes it easier (less costly) to share examanswers and buy term papers.Sources:Steven D. Levitt and Stephen J. Dubner,FreakonomicsNew York: HarperCollins 2005, pages24–25;Patrik Jonsson,“America’s biggest teacher and principal cheating scandal unfolds in Atlanta,”Christian Science Monitor, July 5, 2011; MaryBeth 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 circumstancesare students in generalmore or less likelyto cheat on an economics examination?Answer:Your economics instructor will be pleased if you would never cheat under any circumstances.But cheating ismore likelywhen: (a) the positive consequences of receiving a high grade aresignificant(for example, a high grade is necessary to maintain a scholarship, gain admittance to medicalschool, orget a good job offer), and/or (b) the probability of getting caught is low (the instructor gives the samemultiple-choice exam to all students in a large classroom with no supervision). Reducing the benefit andincreasing the cost of getting caught will reduce the incidence of cheating. If appeals to personal integrityare not enough to convince students not to cheat, a more effective deterrent may be for potentialemployers to let students know that theyfire dishonest employees.

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12CHAPTER1|Economics: Foundations and ModelsAppendixUsingGraphsand FormulasLearning Objective:Usegraphsandformulasto analyze economic situations.Graphssimplifyeconomic ideas and maketheideas more concreteso they can be applied toreal-worldproblems.Graphs of One VariableFigure 1A.1 displays examples of two common types of graphs:bar graphsand pie charts.The height ofthe bars in the bar graph represents the market shares of automobile firms.The pie chart shows the sameinformation withthemarket sharesof each group of firmsrepresentedby the size ofitsslice of thepie.Information on economic variables can also be displayed in time-series graphs.These graphs aredisplayed on a coordinate grid.The vertical axis (y-axis) of a coordinate grid measures the value of onevariable.The point where the vertical axis intersects the horizontal axis is the origin.The horizontal axisof a coordinate grid measures the value of another variable.The points in a coordinate grid represent thevalues of the two variables.Figure 1A.2 illustrates examplesof time-series graphs.Graphs of Two VariablesWe oftenuse graphsto show the relationship between two variables.Figure 1A.3 illustrates the graph of alinear or straight-line demand curve where price is measured along the vertical axis and quantity ismeasured along the horizontal axis.A.Slopes of LinesThe slope of a straight line indicates how much the variable measured along they-axis changes as thevariable measured along thex-axis changes.Slope can be measured between any two points on thelinebecausethe slope of a straight line has a constant value.The slope canbeexpressed as the changein the value measured on the vertical axis divided by the change in the value measured on thehorizontal axis;slope can alsobeexpressed using the Greek letter delta (Δ) to stand for the change ina variable (slope = Δy/Δx).The slope is also referred to as therise over the run.Change in value on the vertical axisRiseSlopeChange in the value on the horizontal axisRunyx===B.Takinginto Account More Than Two Variables on a GraphThe demand curve in Figure 1A.4 shows the relationship between the price of pizza and the quantity ofpizza sold,but the quantity of any good sold depends on more than just the price of the good.Allowingother variables to change will cause the position of the demand curve in the graph to change.The table inFigure 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 RelationshipsSometimes the relationship between two variables is negative, as in the case with the price of pizza andthe quantity of pizza demanded.The relationship between two variables can be positive, as inFigure1A.6which shows values fordisposable personalincome and consumption spendingin the United Statesfor2011–2014.

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CHAPTER1|Economics: Foundations and Models13D.Determining Cause and EffectInferring cause and effect relationships by observing graphs can lead to incorrect conclusions. One reasonfor this is that there may be an omitted variable that is not accounted for in the graph.A related problemin determining cause and effect is reverse causality; this occurs when we conclude that changes invariableXcause changes in variableY,when changes in variableYcause changes in variableX.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. Feweconomic relationships are actually linear.However, it is often useful to approximate a nonlinearrelationship with a linear relationship.F.Slopes of Nonlinear CurvesTo measure the slope of a nonlinear curve at a particular point, we must measure the slope of a tangent tothe curve at that point. A tangent line touches the curve at only one point. The slope of a tangent ismeasured in the same way as the slope of any straight line.FormulasThis section reviews several useful formulas and showshow to use them.A.Formula for a Percentage ChangeThe formula for a percentage change between two variables for any two periodsis:Percentage changeValue in the second periodValue in the first period100Value in the first period−=B.Formulas for the Areas of a Rectangle and a TriangleThe formula for the area of a rectangle isBase×Height.The formula for the area of a triangle is½×Base×Height.C.Summary of Using FormulasFollow these steps when usinga 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 TipsYou can assign the appendix as“onyourown”reading.But don’t assume students will understand theformulasfor computing a slope or a percentage change.Reviewing these formulas in class will be time wellspent, either at this point in the course or when these formulas are first applied.In particular, students willneedto use graphs of two variables and percentage changesoftenthroughout the remainder of thecourse.

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CHAPTER2|Trade-offs, ComparativeAdvantage,and theMarket SystemBrief Chapter Summaryand Learning Objectives2.1Production Possibilities Frontiers and Opportunity CostsUse a production possibilities frontier to analyze opportunity costs and trade-offs.▪The model of the production possibilities frontier is used to analyze the opportunity costsand trade-offs that individuals, firms, or countries face.2.2Comparative Advantage and TradeDescribecomparative advantage and explain how itserves asthe basis for trade.▪Comparative advantageis the ability of an individual, firm, or country to produce a goodor service at a lower opportunity cost than other producers.2.3The Market SystemExplain the basicsof how a market system works.▪Marketsenable buyers and sellers of goods and services to come together to trade.Key TermsAbsolute advantage.The ability of anindividual, a firm, or a country to produce moreof a good or service than competitors, using thesame amount of resources.Circular-flow diagram.Amodel that illustrateshow participants in markets are linked.Comparative advantage.The ability of anindividual,a firm, or a country to produce agood or service at a lower opportunity cost thancompetitors.Economic growth. The ability of the economyto increase the productionof goods and services.Entrepreneur. Someone who operates abusiness, bringing together the factors ofproduction—labor, capital, and naturalresources—to produce goods and services.Factor market.A market for the factors ofproduction, such as labor, capital, naturalresources, and entrepreneurial ability.Factors of production.Labor, capital, naturalresources, and other inputsused to make goodsand services.Freemarket. A market with few governmentrestrictions on how a good or service can beproduced or sold or on how a factor ofproduction can be employed.Market.Agroup of buyers and sellersof a good or service and the institution orarrangement by which they come togetherto trade.

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14CHAPTER2|Trade-offs, Comparative Advantage, and the Market SystemOpportunity cost.The highest-valuedalternative that must be given up to engagein an activity.Product market.A market for goods—such ascomputers—orservices—such as medicaltreatment.Production possibilities frontier (PPF).Acurve showing the maximum attainablecombinations of two products thatcanbeproduced with available resources and currenttechnology.Property rights.The rights individuals or firmshave to the exclusive use of their property,including the right to buy or sell it.Scarcity.A situation in which unlimited wantsexceed the limited resources available to fulfillthose wants.Trade.The act of buyingandselling.Chapter OutlineManagersat Tesla Motors Face Trade-OffsAll-electric cars have struggled in the marketplace because the batteries that power them are costlyandtheyhave to be recharged about every 300 miles.Although sales of all-electric cars made byTesla Motorsrepresented 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 initiallysold 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 Xwas designed to compete with gasoline-powered SUVs but also sold for a veryhigh base price.To gain significant market share Tesla must allocate resources to produce an all-electriccar for about $35,000.Tesla’s managers must also decide howto sell and service the cars the companysells.Teslaonly sells cars online and relies on company-owned service centers for maintenance andrepairs.Tesla will likely face increased competition in future years from Apple and other companies thatare exploring the electric vehicle market.2.1Production Possibilities Frontiers and Opportunity CostsLearning Objective: Use a production possibilities frontier to analyze opportunity costsand trade-offs.A key fact ofeconomic life is that scarcity requires trade-offs.Scarcityis a situation in which unlimitedwants 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.Aproduction possibilities frontier(PPF)is a curve showing the maximum attainable combinations oftwo products thatcanbe produced with available resources and current technology.A.Graphing the Production Possibilities FrontierAll combinations of productslocatedon theproduction possibilitiesfrontier are efficient becauseallavailable resourcesare being used.Combinations inside the frontier are inefficient becausemaximumoutput is not being obtained from available resources.Pointsoutside the frontier are unattainablegiventhe firm’scurrent resources.Opportunity costis the highest-valued alternative that must be given up to engage in an activity.

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CHAPTER2|Trade-offs, Comparative Advantage, and the Market System15B.Increasing Marginal Opportunity CostsAproduction possibilities frontier that is bowed outwardillustrates increasing marginal opportunity costs,whichoccur because some workers, machines, and other resources are better suited to one use thantoanother.Increasing marginal opportunity costs illustrate an important concept:The more resourcesalready devoted to any activity, the smaller the payoff to devoting additional resources to that activity.C.Economic GrowthEconomic growthis the ability of the economy to increasethe productionof goods and services.Economic growth can occur if more resources become available or if a technological advance makesresources more productive. Growth may lead to greater increases in production for one good than another.ExtraApplythe ConceptFacing Trade-offs in Health Care SpendingHouseholds have limited incomes. If the price of health care rises, households have to choose whether tobuy less health care or spend less on other goods and services. The same is true of the federalgovernment’s spending on health care. The government provides health insurance to about 30 percent ofthe population through programs such as Medicare for people over age 65 and Medicaid for low-incomepeople. If the price of health care rises, the government has to either cut back on the services providedthrough 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 thefunds they can borrow are also limited.)About 54 percent of the population has private health insurance, often provided by an employer. Whenthe fees doctors charge, the cost of prescription drugs, and the cost of hospital stays rise, the cost toemployers of providing health insurance increases. As a result, employers will typically increase theamounttheywithholdfromemployees’paycheckstopayfortheinsurance.Someemployers—particularly small firms—will even stop offering health insurance to their employees. In either case, theprice employees pay for health care will rise. How do people respond to rising health care costs? Isn’thealth care a necessity that people continue to consume the same amount of, no matter how much its priceincreases? In fact, studies have shown that rising health care costs cause people to cut back their spendingon medical services, just as people cut back their spending on other goods and services when their pricesrise. One academic study indicates that for every 1 percent increase in the amount employers chargeemployees for insurance, 164,000 people become uninsured. Of course, people without health insurancecan still visit the doctor and obtain prescriptions, but they have to pay higher prices than do people withinsurance. Although the consequences of being uninsured can be severe, particularly if someone developsa serious illness, economists are not surprised that higher prices for health insurance lead to less healthinsurance being purchased: Faced with limited incomes, people have to make choices among the goodsand services they buy.The Congressional Budget Office estimates that as the U.S. population ages and medical costs continue torise, federal government spending on Medicare will more than double over the next 10 years. Manypolicymakers are concerned that this rapid increase in Medicare spending will force a reduction inspending on other government programs. Daniel Callahan, a researcher at the Hastings Center forBioethics, has argued that policymakers should consider taking some dramatic steps, such as havingMedicare stop paying for open-heart surgery and other expensive treatments for people over 80 years ofage. Callahan argues that the costs of open-heart surgery and similar treatments for the very old exceedthe benefits, and the funds would be better spent on treatments for younger patients, where the benefitswould exceed the costs. Spending less on prolonging the lives of the very old in order to save resources

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16CHAPTER2|Trade-offs, Comparative Advantage, and the Market Systemthat 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 andEconomic Outlook,March 2009.Questions & Solutions1.Suppose the U.S. president is attempting to decide whetherthe federal government should spendmore on research to find a cure for heart disease. He asks you, one of his economic advisors, toprepare a report discussing the relevant factors he should consider. Use the concepts of opportunitycost 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 fundingmore research on heart disease is the reduction in funding for research on other diseases.The decisionshould 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—lessdisease and fewer deaths—as the last dollar spent on research for other diseases.If the additional fundingfor research on heart disease comes at the expense of other non-medical research expenditures, then theopportunity 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 theNew York Times:[Cost-effectiveness analysis] seeks to establish which of several alternative strategies capable ofachieving a given therapeutic goal is the least-cost strategy. It seems a sensible form of inquiry ina nation that is dismayed over the rising cost of health care. . . . Opponents of cost-effectivenessanalysis 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 indicatewhether 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, thatincrease by at least a small amount the chances that we will be hurt or killed.If health and life wereliterally priceless, every decision we make would have the sole objective of minimizing the chances ofour being injured or killed. In a broader sense, we do not devote all of our resources to improving healthcare because resources devoted to, say, saving lives through medical researchare not available for otherneeds, such as improving education. We always have to consider the opportunity cost of using resourcesin one way rather than in another.

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CHAPTER2|Trade-offs, Comparative Advantage, and the Market System172.2Comparative Advantage and TradeLearning Objective: Describe comparative advantage and explain how it serves as thebasis for trade.Tradeis the act of buyingandselling.Trade makes it possible for people to become better off byincreasing both their production and their consumption.A.Specialization and Gains from TradePPFs depict the combinations of two goods that can be produced if no trade occurs.We can usePPFs toshow how someone can benefit from trade even if she is better than someone else at producing both goods.B.Absolute Advantageversus Comparative AdvantageAbsolute advantageis the ability of an individual,afirm, oracountry to produce more of a good orservice than competitors,using the same amount of resources.If the two individuals have different opportunity costs for producing two goods, each individual will havea comparative advantage in the production of one of the goods.Comparative advantageis the ability ofan individual,afirm, oracountry to produce a good or service at a lower opportunity cost thancompetitors.Comparing the possible combinations of production and consumption before and afterspecialization and trade occur proves that trade is mutually beneficial.C.Comparative Advantage and the Gains from TradeThe basis for trade is comparative advantage, not absolute advantage.Individuals, firms, and countries arebetter off if they specialize in producing the goods and services for which they have a comparativeadvantage and obtain the other goods and services they need by trading.Teaching TipsEvengoodstudentshavedifficultyunderstandingcomparativeadvantage.Agoodexampleofcomparative advantageis the career of baseball legend Babe Ruth.Before he achieved his greatest fameas a home run hitter and outfielder with the New York Yankees, Ruth was a star pitcher with the BostonRed Sox.Ruth may have been the best left-handed pitcher in the American League during his years withBoston (1914–1919), but he was used more as anoutfielder in his last two years with the team. In fact, heestablished a record for home runs in a season (29) in 1919.The Yankees acquired Ruth in 1920 andmade him a full-time outfielder. The opportunity cost of this decision for the Yankees was the wins hecould have earned as a pitcher. ButbecauseNew York already had skilled pitchers, the opportunity costof replacing him as a pitcher was lower than the cost of replacing Ruth as a hitter.No one else on theYankees could have hit 54 home runs, Ruth’s total in 1920; the next highest total was 11. It can be arguedthat Ruth had an absolute advantage as both a hitter and pitcherfor the Yankeesin 1920, but acomparative advantage only as a hitter.2.3The Market SystemLearning Objective: Explain the basics of how a market system works.In the United States and most other countries, trade is carried out in markets.Amarketis a group ofbuyers and sellers of a good or service and the institution or arrangement by which they come together totrade.Aproduct marketis amarket for goods—such as computers—orservices—such as medicaltreatment.Afactor marketisamarket for the factors of production, such as labor, capital, naturalresources, and entrepreneurial ability.Factors of productionare thelabor, capital, natural resources, andotherinputs used to make goods and services.

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18CHAPTER2|Trade-offs, Comparative Advantage, and the Market SystemA.The Circular Flow of IncomeAcircular-flow diagramis a model that illustrates how participants in markets are linked. The diagramdemonstrates the interaction between firms and households in both product and factor markets.B.The Gains from Free MarketsAfree marketis a market with few government restrictions on how a good or service can be produced orsold or on how a factor of production can be employed.Adam Smith is considered the father of moderneconomics. 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 MechanismA key to understandingAdamSmith’s argument is the assumption that individuals usually act in arational, self-interested way.This assumption underlies nearly all economic analysis.D.The Role of the Entrepreneurin the Market SystemEntrepreneurs are an essential part of a market economy.Anentrepreneuris someone who operates abusiness, bringing together the factors of production—labor, capital, and natural resources—to producegoods and services.Entrepreneurs often risk their own funds to start businesses and organize factors ofproduction to produce those goods and services that consumers want.E.The Legal Basis of a Successful Market SystemThe absence of government intervention is not enough for a market economy to work well. Governmenthas toprovidea legal environment that allows markets to operate efficiently.Property rightsaretherights 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 grantsa patent that gives aninventor–often a firm—theexclusive right to produce and sell a new product for20years from the date thepatentwas filed. Books, films, and software receive copyright protection.Under U.S. law, the creator of a book,film, or piece of music hastheexclusive right to use the creationduring the creator’s lifetime.Thecreator’s heirs retain this right for70yearsafter the death of the creator.Business activity often involves someone agreeing to carry out some action in the future. Theseagreements often take the form of legal contracts.For the market system to work, businesses andindividuals have to rely on these contracts being carried out.Enforcing contracts or property rightsrequires an independent court system and judges who are able to make impartial decisions on the basis ofthe law.If property rights are notwell enforcedfewer goods and services will be produced, leaving theeconomy inside its production possibilities frontier.Teaching TipsTo initiate class discussionregarding 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 toproduceand sell their creative works?3.Should the government fine or prosecute individuals who illegally obtain music, books, movies, andother creative works in violation of property rights laws?

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CHAPTER2|Trade-offs, Comparative Advantage, and the Market System19ExtraSolved Problem 2.3Adam Smith’s“Invisible Hand”Alan Krueger, an economist at Princeton Universitywho served as chair of the Council of EconomicAdvisers in the Obama administration, has argued that Adam Smith“. . .worried that if merchants andmanufacturers pursued their self-interest by seeking government regulation and privilege, the invisiblehand 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 thegovernment?b.How might these regulations and privileges keep the invisible hand from working?Solving the ProblemStep 1:Review the chapter material.This problemis abouthow goods and services are produced and sold and how factors ofproduction are employed in a free market economic system as described by Adam Smith inAn Inquiry into the Nature and Causes of the Wealth of Nations.You may want to review thesection“The Gains from Free Markets.”Step 2:Answerpart a.bydescribingthe economic system in place in Europe in 1776.At the time, governments gave guilds—associations of producers—the authority to controlproduction.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 tohigher prices and fewer choices for consumers. Instead of catering to the wants of consumers,producers soughtfavors fromgovernment officials.Step 3:Answerpart b.by contrasting the behavior of merchants and manufacturers undera guild system and a market system.Because governmentsin a guild systemgave producers the power to control production,producers did not have to respond to consumers’demands for better quality,greatervariety,and lower prices. Under a market system, producers who sell poor quality goods at highprices suffer economic losses; producers who provide better quality goods at low prices arerewarded with profits.Therefore, it is in the self-interest of producers to address consumerwants.This is how theinvisible hand works in a free market economy, but not inmost ofEurope in theeighteenthcentury.ExtraEconomics inYourLife:International Trade and Household IncomeManypeoplebelievethatoutsourcing—firms producing goods and services outside of their home country—harms their nations’economies by increasing domestic unemployment and decreasing incomes.Butmosteconomists believe that free trade policies, including allowing goods and services to be produced inothercountries,benefitdomesticeconomies.InaletterdatedMarch5th2015,14economists(including R. Glenn Hubbard) who served at chairs of the Council of Economic Advisers under sevenRepublican and Democratic presidents, wrote an open letter to congressional leaders expressing their

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20CHAPTER2|Trade-offs, Comparative Advantage, and the Market Systemsupport for the renewal of the Trade Promotion Authorityin orderto reach agreements with U.S. tradingpartners through the Trans-Pacific Partnership (TPP) and the Trans-Atlantic Trade andInvestmentPartnership (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,formerchairman of the Federal Reserve Board, cited a study that examined theeffectofinternationaltrade on income in the United Statessince World War II:“. . .the increase in trade. . .hasboosted U.S. annual incomes on the order of $10,000 per household.The same study found that removingall 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; andBen Bernanke,“Embracing the Challenge of Free Trade: Competing and Prospering in a Global Economy,”The Federal ReserveBoard, May 1, 2007.http://www.federalreserve.gov/boarddocs/speeches/2007/20070501/default.htm.Questions:(a) Should the United Statesaccept the advice of economists and support free trade policiesevenif this increases the risk of some workers losing their jobs to outsourcing?(b) What type of jobwould make you more or less vulnerable to outsourcing?Answers:(a) Given the opposition from firms and workers in industries that would be harmed by freetrade, it is unlikely that the United States would eliminate all trade barriers.Butstudiessuch as the onecited byBen Bernanke show that increased trade cansignificantlyboosttheincomes of U.S. households.(b) Another study Bernankecitedfoundtwenty-oneoccupations that were most vulnerableto outsourcingwere primarily for relatively lower-wage positions.

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