Instructor’s Manual to accompany Survey of Economics Seventh Edition by Arthur O’Sullivan Lewis and Clark College Steven M. Sheffrin Tulane University Stephen J. Perez California State University, Sacramento Prepared by Jeff Phillips Colby-Sawyer College iii Contents Chapter 1 Introduction: What Is Economics? 1 Chapter 2 The Key Principles of Economics 12 Chapter 3 Demand, Supply, and Market Equilibrium 25 Chapter 4 Elasticity: A Measure of Responsiveness 43 Chapter 5 Production Technology and Cost 56 Chapter 6 Perfect Competition 67 Chapter 7 Monopoly and Price Discrimination 81 Chapter 8 Market Entry, Monopolistic Competition, and Oligopoly 92 Chapter 9 Market Failure, Imperfect Information, External Benefits, and External Costs 113 Chapter 10 The Labor Market and the Distribution of Income 136 Chapter 11 Measuring a Nation’s Production and Income 150 Chapter 12 Unemployment and Inflation 163 Chapter 13 Why Do Economies Grow? 174 Chapter 14 Aggregate Demand and Aggregate Supply 187 Chapter 15 Fiscal Policy 196 Chapter 16 Money and the Banking System 207 Chapter 17 Monetary Policy and Inflation 218 Chapter 18 International Trade and Public Policy 228 v Preface This Instructor’s Manual was written to be used with Survey of Economics, 7th Edition, by O’Sullivan, Sheffrin, and Perez. A fully integrated teaching and learning package is necessary for today’s classroom. Our supplement package helps you provide new and interesting real-world Applications and assess student understanding of economics. The supplements are coordinated with the main text through the numbering system of the headings in each section. The major sections of the chapters are numbered (1.1, 1.2, 1.3, and so on), and that numbering system is used consistently in the supplements to make it convenient and flexible for instructors to develop assignments. Instructor’s Manual Features Each chapter of the Instructor’s Manual contains the following features: Chapter Summary This overview of the main economic concepts in the chapter shows you how to make connections between the chapters and lists the questions the students should be able to answer when you have finished the chapter. These questions are based on the Applications in the chapter. Approaching the Material This section summarizes a general approach to use to present the concepts in the chapter. Chapter Outline The chapter outline contains the following features: Detailed descriptions of the economic concepts in the chapter. Key term definitions as they appear in the text, allowing you to have the same points of reference as the students. Teaching tips on how to present specific concepts in the chapter. New approaches, classroom activities, and teaching approaches are presented on a topic-by-topic basis. Figure references and tips on how to use them to explain economic concepts. The figures are all available in PowerPoint® format for download from the Instructor’s Resource Center at www.pearsonhighered.com/irc. Application summaries that help you present one of the key features of the book—real-world applications that Answer key questions presented at the start of each chapter. Solutions to end-of-chapter exercises. Several of the exercises support the Applications. Teaching Tips for Economics One of the challenges of teaching principles of economics is that most students bring no prior knowledge of the subject to the classroom. It has been shown that we learn by making connections between prior knowledge and new information. It is easier to make those connections when we see relationships between new information and prior knowledge. The traditional “guns or butter” and “widget factory” approaches to explaining economic principles does little to alleviate this problem. Use strategies that will enable students vi O'Sullivan/Sheffrin/Perez, Survey of Economics, 7e to make connections between what they do know—fast food, concert tickets, cutting classes—and economic principles. The “dismal science” as a description of economics did not originate with principles of economics students. Many would not disagree with that statement, however. Student descriptions of economics range from boring to impossible. One of the reasons that some students have trouble with principles of economics may be the way it is presented. By adjusting the method of delivery as well as improving parts of the lecture, principles of economics instructors may be able to improve outcomes. The First Day of Class The first class meeting sets the tone for the rest of the semester. Students leave the classroom with a perception of how the class is likely to unfold for the semester. Most students in principles of economics classes have not had previous exposure to the study of economics. Given this, most instructors are inclined to give a definition of the study of economics. Invariably, some variation of the following emerges: “…The study of how scarce resources are allocated to satisfy unlimited wants.” A discussion of basic human needs and allocation of natural resources follows. One can almost visualize students sinking into their chairs and the tone for the semester is set. The “dismal” science has begun for another semester. Students without previous exposure to economic principles have nothing to grab onto. Consider this alternative. The instructor begins the first day of class with the following question. “How many of you ate breakfast this morning?” A direct, simple question designed to engage all of the students. The question is effective in a classroom of 20 or 200. Assuming a normal distribution of students, there will be both affirmative and negative answers. Begin by asking those who said no, why not. Invariably, some one will answer, “I didn’t have time.” Now the economics lesson begins. Ask the student if he or she has only 24-hour days. Explain that all of us have the same number of hours in the day, and we have to decide how to use them. Those who did not eat breakfast decided to use the time differently—to sleep, to study, to take a morning jog. The students have made a fundamental economic insight. They have made a decision to allocate a scarce resource—time—to satisfy unlimited needs. The discussion can continue to illustrate other economic concepts. What did they have for breakfast—tastes and preferences? Do they make different decisions on the weekends than during the week? Do Saturday and Sunday have more than 24 hours? Or, is it a different allocation decision? The students have learned about resource allocation. They have used their own experiences to illustrate an economic concept. The students have used something they are very familiar with—the decision to have breakfast or not—to learn a basic economic theory. No mention of guns and butter or widgets. The students may leave the classroom with the idea that maybe economics is not so dismal after all. Keep Them Coming to Class One of the challenges that all instructors face is how to encourage students to do things that you believe will enhance their learning—from class attendance to homework to practice exams. Economics instructors know the answer. People respond to incentives. You must reward whatever behaviors you want from your students. Class attendance is one behavior you want to reward. Here are some strategies to think about: • Mandatory attendance: Take attendance everyday. Students are allowed one or two absences. After that, points are taken off final grade. • Attendance as part of the grade: Slight variation as above, same concept. A certain percentage (10 percent, for example) of the final grade is based on attendance. Establish a scale (1 or 2 classes missed equals a …). • Class participation: Attendance plus. Students need to be there and participate. • Random unannounced quizzes. Give an occasional quiz without prior notice. Those who are not there earn a zero—no makeup. Preface vii • Most important: Make the classes interesting and important. “Interesting” speaks for itself. “Important” means that what goes on in the class appears in the exam. Students will quickly figure out (after the first exam) whether or not the test is straight from the book and class attendance is not necessary. The same strategies apply to any other behavior you want from students. If you want students to do homework, you have to keep track of it and make it part of their grade. The same with practice tests, online visits, or anything else. You have to provide the student with an incentive. Overall Approach The overall approach to teaching economics is to take what students are familiar with and use these settings to explain economic principles. Use the students in class as live participants in your lectures. Economics is a social science that makes predictions about human behavior. The more the instructor can involve students in the presentation of the theory, the more effective student learning can be. Jeff Phillips Colby Sawyer College 1 1 Introduction: What Is Economics? Chapter Summary Chapter 1 provides a basic illustration of what economics is and why it is useful. Economics is the study of the choices people, firms, and governments make when resources are scarce. Economic analysis helps us understand the consequences of these choices. Here are the main points of the chapter: • Most of modern economics is based on positive analysis, which answers the question “What is ?” or “What will be ?” • Economies must answer three questions: What products do we produce? How do we produce the products? Who consumes the products? • Normative analysis answers the question “What ought to be ?” • To think like an economist, we (a) use assumptions, (b) use the notion of ceteris paribus , (c) think in marginal terms, and (d) assume that rational people respond to incentives. • Macroeconomics helps us understand why economies grow and understand economic fluctuations. Microeconomics helps us understand how markets work. Learning Objectives: 1. What is Economics? List the three key economic questions. 2. Economic Analysis and Modern Problems: Discuss the insights from economics for a real-world problem such as congestion. 3. The Economic Way of Thinking: List the four elements of the economic way of thinking. 4. Preview of Coming Attractions—Macroeconomics: List three ways to use macroeconomics. 5. Preview of Coming Attractions—Microeconomics: List three ways to use microeconomics. Approaching the Material The first classes are very important in determining your students’ attitudes towards economics. You have to find out their attitude and use real-world examples that help them understand that economics relates to their lives. Stating to the class that economics is “The study of how scarce resources are allocated to satisfy unlimited wants” is accurate but is also one of the reasons why some people still refer to economics as “the dismal science.” Try the following definition of economics instead: “Economics is the study of how you, your friends, the stores where you shop, and your mayor make choices.” Every student in front of you makes choices everyday—what to wear, what to have for breakfast, or whether to sleep in, whether to study or play video games. Students allocate resources all day long. Time is the one resource that everyone can relate to and everyone has the same amount of. Use what students know to teach them what you want them to know. 2 O’Sullivan/Sheffrin/Perez, Survey of Economics, 7e Chapter Outline 1.1 What Is Economics? A. Scarcity: the resources we use to produce goods and services are limited. Economics is the study of choices when there is scarcity. Š Teaching Tip Students have scarce resources they have to allocate. Ask the class who had breakfast this morning. You should have a room full of both breakfasters and those who did not eat. Ask those who did not eat breakfast why not. Someone is sure to say they did not have the time. Explain that we all have the same amount of time (a scarce resource), but we choose to allocate it differently. (i.e., sleep in, workout, study, eat breakfast). B. Factors of Production Factors of production: the resources used to produce goods and services, also known as production inputs. Natural resources: the resources provided by nature and used to produce goods and services. Labor: the physical and mental effort people use to produce goods and services. Physical capital: the stock of equipment, machines, structures, and infrastructure that is used to produce goods and services. Human capital: the knowledge and skills acquired by a worker through education and experience. Entrepreneurship: the effort used to coordinate the factors of production—natural resources, labor, physical capital, and human capital—to produce and sell products. C. Positive versus Normative Analysis 1. Positive analysis answers the questions “what is?” or “what will be?” a. For example: What is the effect on poverty of a living wage ordinance? Or, What is the effect on a city’s costs of a living wage ordinance? 2. Normative analysis answers questions of “What ought to be?” a. For example: Should a city implement a living wage ordinance? Š Teaching Tip Tell the students that Mr. Alumni Bigbucks has donated 50 million dollars to the university. The following question is an example of positive analysis: Should the donation be used to build a new stadium or a state-of-the art library/technology center? The following question is an example of normative analysis: What do they think should be built and why? D. The Three Key Economic Questions The choices made by individuals, firms, or governments answer three fundamental questions: 1. What goods and services do we produce? 2. How do we produce these goods and services? 3. Who consumes the goods and services that are produced? Chapter 1: Introduction: What Is Economics? 3 Š Teaching Tip Now is a good time to introduce the concept of markets indirectly. Consumers decide what is produced and for whom; businesses decide how the products are produced. . E. Economic Models An economic model is a simplified representation of an economic environment, often employing a graph. For example, economists use the model of a market to analyze the effects of public policy on economic outcomes. 1.2 Economic Analysis and Modern Problems Economic analysis can provide insights into real-world problems such as: A. Economic View of Traffic Congestion: problem is solved by paying tolls. B. Economic View of Poverty in Africa: economic growth helps the poor. C. Economic View of the Current World Recession: policymakers can draw on many years of experience in economic policy to guide the economy during the current times. 1.3 The Economic Way of Thinking A. Use of Assumptions to Simplify and Facilitate Learning B. Isolate Variables— Ceteris Paribus A variable is a measure of something that can take on different values. The ceteris paribus is a Latin expression meaning other variables being held fixed. The assumption is that when we consider changes in one variable, we hold all other variables constant. Š Teaching Tip Ask the students to recall doing experiments in high school science (chemistry) classes. Remind them that in order to obtain reliable results, they had to change only one component while holding other components constant. C. Thinking at the Margin Economists consider small, incremental changes to determine whether or not it is desirable to change the level of economic activity. A small, one-unit change in value is known as a marginal change . For example, should you eat the fourth piece of pizza if you aren’t hungry? D. Rational People Respond to Incentives Š Teaching Tip Self-interest is not the same as selfishness. Ask the students to think about all of the things their parents have done for them over the years. Not selfish but certainly in the parent’s self-interest. E. Example: London Addresses Its Congestion Problem The City of London imposed an $8 per day tax to drive in the city between 7:00 A . M . and 6:30 P . M . The tax reduced the congestion significantly, cutting travel times in half. The city’s economy thrived. 4 O’Sullivan/Sheffrin/Perez, Survey of Economics, 7e Š Teaching Tip Ask the students what other pricing schemes London could have used to reduce congestion—free public transportation, alternative work hours, higher parking rates. Š Teaching Tip Almost every college campus in America lacks enough spaces for those who want to park. Discuss the current parking policy at your university. Ask the students to use economic analysis to come up with alternative policies to solve the parking problem (small groups should work well here). The possible solutions should include raising parking fees, restricting parking by types of parkers (no freshman, faculty/staff only), remote parking with free shuttles, altering class schedules, rewards for car pooling, and expanding parking spaces. Review these key questions and their related Applications: Question 1: How do people respond to incentives? APPLICATION 1: INCENTIVES TO BUY HYBRID VEHICLES Hybrid vehicles are more fuel efficient but also more expensive than gas-powered ones. When gas prices increase, hybrid vehicles become more popular. Another factor influencing the increase hybrid vehicle purchases was the federal subsidy of up to $3,400 per vehicle. The efficiency of the hybrid vehicle subsidy in reducing greenhouse gas carbon dioxide (CO 2 ) is questionable. There are less costly ways to do this, such as building insulation, energy-efficient lighting, and switching to electric power systems. Question 2: What is the role of prices in allocating resources? APPLICATION 2: HOUSING PRICES IN CUBA The Cuban government confiscated most housing in 1960 and did not allow homeowners to sell their property. As a result, the housing stock deteriorated because there was little incentive to repair it. Housing reforms allowed the sale and purchase of homes in Cuba in 2011. These reforms increase incentives and are expected to increase construction of houses. 1.4 Preview of Coming Attractions: Macroeconomics Macroeconomics is the study of the nation’s economy as a whole; it focuses on the issues of inflation, unemployment, and economic growth. A. Why Study Macroeconomics? 1. To understand why economies grow 2. To understand economic fluctuations 3. To make informed business decisions Chapter 1: Introduction: What Is Economics? 5 1.5 Preview of Coming Attractions: Microeconomics Microeconomics is the study of the choices made by households, firms, and the government, and how these choices affect the markets for goods and services. A. Why study microeconomics? 1. To understand markets and predict changes 2. To make personal or managerial decisions 3. To evaluate public policies Additional Applications to Use in Class Question: Does a real estate agent have an incentive to get you the highest price? ADDITIONAL APPLICATION: FREAKONOMICS Source: Motley Fool audio interview with economist Steven Levitt Interviewed by David Gardner “Freakonomics” Summary: Key Points in the Article This audio clip features an interview with one of the authors of the best-selling book Freakonomics . Economist Steven Levitt answers a host of questions typically not tackled by most economists. One of the questions is related to realtors and agency relationships. In other words, do realtors really work for real estate sellers? According to Levitt, it is in the best interest of the realtor to convince sellers to take an offer lower than they would receive if the property remained on the market. Since the percentage of the sales price that real estate salespersons receive from selling a house is a very small fraction, a $10,000 increase in sales price might net a real estate professional another $150 commission for a tremendous amount of additional work. Therefore, it is in the real estate salesperson’s best interest to convince the seller to make the quick sale and take the first reasonable offer. Levitt points toward evidence that real estate professionals tend to leave their own properties on the market longer and receive 2% to 3% more in sales price. Levitt addresses many other issues including market efficiency, horse racing, and drug dealing in this interview. Listen to the clip for Levitt’s economic explanation of numerous topics. Analyzing the News Levitt’s primary contribution is his application of economic thought to a number of topics typically not addressed by economics. As you will hear, economics is truly a social science that can be used to explain quite a bit of human behavior. Thinking Critically Questions 1. What is “freakonomics”? 2. Why would the illustration of “realtors” and not maximizing sales price for sellers be an economic topic? 3. Are the stock markets efficient according to Levitt? 6 O’Sullivan/Sheffrin/Perez, Survey of Economics, 7e Š Teaching Tip This is a great example of how people’s incentives are often not the same. Although the real estate agent works for the seller, their interests regarding holding out for a higher price are not the same. Question: How does a tightening of discretionary income affect luxury industries? ADDITIONAL APPLICATION: SPORTSBIZ: GOLF INDUSTRY GETS HIT HARD Sweet, David “SportsBiz: Golf Industry Gets Hit Hard” Posted 12/3/2008 on MSNBC.com Summary: Key Points in the Article Golf courses are not only on hold in the United States, but also many are being converted to other uses. The 1990s saw tremendous expansion in the sport, which is now being reversed as many people forgo the game due to tight budgets. More courses are closing this year than are opening, and openings are the lowest in 20 years. In addition, many new courses are tied to housing projects that are currently mothballed due to the flagging housing market. Equipment sales are down as well as rounds played. The one bright spot appears to be China. One course designer formerly in high demand in the United States is now focusing on China’s growing appetite for the game. Analyzing the News Golf is a game that consumes discretionary income. As more people look for ways to reduce spending either due to job loss or conservation of cash, golf may be one of the first luxuries to go. It appears that the recession may be impacting all levels of income. You may begin to see a reduction in price as shown in the graph as golf courses attempt to draw customers back to the green. Of course, if the number of golf courses in the United States falls even further, you would see a leftward shift in supply that might help the surviving courses. Thinking Critically Questions 1. What is causing the leftward shift in demand for golf? 2. How do expectations cause demand shifts? 3. Why is China experiencing a golf boom? Question: Should people invest in low-cost health insurance? ADDITIONAL APPLICATION: IS LOW-COST HEALTH INSURANCE WORTH IT? McCormack, Karyn “Is Low-Cost Health Insurance Worth It?” Posted 8/04/2008 on MSNBC.com Businessweek Chapter 1: Introduction: What Is Economics? 7 Summary: Key Points in the Article Some of the low cost health insurance plans currently being pitched on television may not be worth the price. A couple of options limit coverage so that any surgery or hospitalization is capped at less than $1,200. The primary coverage is minor medical instead of major medical. Critics maintain that policies of this nature do little for the insured since any major medical event would result in thousands of dollars of expenses not paid by the plans. However, representatives at one of the companies said that company representatives will negotiate large bills on behalf of their clients. The company, iCan, maintains that their network pricing clout and negotiation will reduce a typical $50,000 bill to around $10,000 to $12,000. Currently, 47 million uninsured Americans may opt for these low cost mini-medical plans. However, even at the low end price of $160 a month for individuals and $260 a month for families these plans may stress a lot of budgets. Analyzing the News Access to medical care is a critical issue in the United States. Does everyone have access to treatment? Probably not equally and many people are forced into bankruptcy every year due to high medical bills. Expect to see continued debate over this issue after the presidential election. Thinking Critically Questions 1. Why is this issue important? 2. What are some options for the government to debate? 3. What forms of nationalized health care currently exist? Appendix A Using Graphs and Percentages 1A.1 Using Graphs A. Graphing Single Variables 1. Pie charts 2. Bar graphs 3. Line graphs Students who are not familiar with graphs will need lots of time here. Give them simple data, and let them create their own pie charts and bar graphs. B. Graphing Two Variables 1. Two variable graphs use both the horizontal and vertical axis. 2. Play “connect the dots” to determine points on the line. Š Teaching Tip Have the students create graphs without numbers. Using concepts they are familiar with (Hours of study, G.P.A.) have them draw the line that shows the general shape of the relationship. 8 O’Sullivan/Sheffrin/Perez, Survey of Economics, 7e Positive relationship: a relationship in which two variables move in the same direction. Negative relationship : a relationship in which two variables move in opposite directions. C. Computing the Slope Slope of the curve is the vertical difference between two points ( the rise ) divided by the horizontal difference (the run ). Š Teaching Tip Most students should be familiar with the concept of slope, but it is worth your time to go step by step for at least a few problems. D. Moving along the Curve versus Shifting the Curve 1. Variables in the graph versus variables not in the graph 2. Changing variables in the graph—movement along the curve 3. Changing variables not in the graph—movement of the curve Emphasize that the Y-intercept represents variables not in the graph. E. Graphing Negative Relationships Illustrate the negative relationship between downloads and CDs purchased. Most students should not have a problem with the concept of a negative relationship. Š Teaching Tip Ask students to come up with three pairs of variables that have a negative relationship. F. Graphing Nonlinear Relationships Show students what a nonlinear relationship looks like. Unless you have an unusual class, you should avoid using calculus to explain nonlinear relationships. An explanation of how there may not be a constant relationship between variables would be useful. 1A.2 Computing Percentage Changes and Using Equations A. Computing Percentage Changes Use the formulas to show students how to compute percentage change. Several examples may be necessary. Š Teaching Tip Most students are shoppers. Use concepts like “20 percent off” sales to help them understand this concept . Chapter 1: Introduction: What Is Economics? 9 Review this key question and the related application: Question 3: How do we compute percentage changes? APPLICATION 3: THE PERILS OF PERCENTAGES This Application explains how in the 1970s the government of Mexico City repainted highway lines to make a four-lane highway into a six-lane highway and then turned it back into a four-lane highway. When reporting on the results of those changes in lanes on the highway, the government incorrectly reported the percentage changes of the effects of re-doing the highway because they used the simple approach to computing percentage changes. This shows that percentage calculations can be inaccurate, if you’re not careful. It’s important to remember that the midpoint formula accurately records percentage changes. B. Using Equations to Compute Missing Values Follow the formulas in the book. As this is basic algebra, students should be well-versed, but a few in-class problems should be helpful. Solutions to End-of-Chapter Exercises Chapter 1 SECTION 1.1: WHAT IS ECONOMICS? 1.1 what, how, who 1.2 natural resources, labor, physical capital, human capital, entrepreneurship 1.3 statement “a.” is TRUE 1.4 a. normative b. positive c. normative d. normative e. positive SECTION 1.2: ECONOMIC ANALYSIS AND MODERN PROBLEMS 2.1 b. 2.2 legal system, regulatory environment SECTION 1.3: THE ECONOMIC WAY OF THINKING 3.1 the earth is flat, the roads are flat 3.2 assumptions, use of ceteris paribus to isolate variables, margin, incentives 3.3 b. 3.4 one fifth 3.5 housing repair and maintenance 3.6 false 10 O’Sullivan/Sheffrin/Perez, Survey of Economics, 7e Chapter 1 Appendix 1. a. b. $5.00, hours/month c. $15.00 d. 6 additional hours 2. $20, $4.00, 10, $60, $80 Chapter 1: Introduction: What Is Economics? 11 3. a. b. –2.0 movies, CD 4. a. Number of Deliveries Total Costs 0 50 5 90 10 130 15 170 20 210 b. $8.00, delivery c. Drivers’ wages and the rental cost of the truck. In addition, the other costs of delivery, such as the price of fuel, insurance, and taxes. d. deliveries e. drivers’ wages, the rental cost of the truck, or the price of fuel 5. along, shifts 6. 10.0%, –2.0%, 6.0% 7. 112, 54, 23 8. 40% = 20/50, 33% = 20/60 12 2 The Key Principles of Economics Chapter Summary Chapter 2 introduces the key principles that are central to all economic theory: • The principle of opportunity cost states that the opportunity cost of something is what you sacrifice to get it. Opportunity costs in production are generally increasing, and thus, the production possibilities curve is bowed outward. • The marginal principle states that any activity should be increased as long as the marginal benefits of the additional activity exceed the marginal costs. • The principle of voluntary exchange states that a voluntary exchange between two people makes both people better off. • The principle of diminishing returns states that, in the short run, if use of one input is increased while all others are held constant, production will eventually increase at a decreasing rate. • The real-nominal principle states that what matters to people is the real value or purchasing power of money or income, not its face or nominal value. Learning Objectives: 1. The Principle of Opportunity Cost: Apply the principle of opportunity cost. 2. The Marginal Principle: Apply the marginal principle. 3. The Principle of Voluntary Exchange: Apply the principle of voluntary exchange. 4. The Principle of Diminishing Returns: Apply the principle of diminishing returns. 5. The Real-Nominal Principle: Apply the real-nominal principle. Approaching the Material Continue the approach you developed in the first chapter, reaching students where they are. The decision to go to college is a great illustration of opportunity costs because students forgo earnings that they would have received from a full-time job. Apply the concept of diminishing returns to hours studying: If a student studies for five hours, will studying one additional hour really benefit him or her? Most of the students will have had jobs, so use the price of a gallon of gas or a burger per hour worked to explain real wages. Most students will have trouble with the marginal principle, so have plenty of examples ready. A seat on a bus or train that is not full is a good example. An extra passenger in a car for a road trip or another person watching a movie will also work. Chapter 2: The Key Principles of Economics 13 Chapter Outline 2.1 The Principle of Opportunity Cost A. Definition 1. The opportunity cost of something is what you sacrifice to get it. 2. What you sacrifice is the next best alternative. 3. For example, if you choose to buy a cup of coffee, you are giving up the money it costs to buy it. What else would you have used the $2.00 for? The opportunity cost of the coffee is the one thing (or next best alternative) that you would buy if not the coffee. Š Teaching Tip Ask the students what they would be doing if they weren’t in class. Answers will range from sleeping, working, watching TV, studying, etc. You can make the point that the alternatives are infinite and computing the cost of them all is impossible. However, since they could only be doing one thing (not all of them) if they were not in class, determining the opportunity cost requires only knowing the one thing they would be doing. B. The Cost of College 1. The classic example of opportunity cost is the costs of going to college. Be sure to illustrate the implicit opportunity cost of forgone income as well as tuition, books, etc. Š Teaching Tip It’s also helpful to have a discussion about whether room and board should be considered a cost of college. If the person has to pay the same amount for room and board whether he/she goes to college or works, it should not be considered a cost of college. C. The Cost of Military Spending D. Opportunity Cost and the Production Possibilities Curve 1. The production possibilities curve : A curve that shows the possible combinations of products that an economy can produce, given that its productive resources are fully employed and efficiently used. 2. Discussion of relevant points on the production possibilities graph a. Points on the curve are efficient and indicate an economy is utilizing all resources. b. Points inside the curve are inefficient and indicate an economy is not utilizing all resources or resources are not used in the least-cost manner. c. Points outside the curve are not feasible given current technologies and resources. 3. Shifts in the Production Possibilities Curve. Show how points outside the PPC are feasible in the future if it shifts out due to increases in resources or technological innovation. It is also useful to discuss what might make the PPC shift in: a natural disaster, the Y2K bug, etc. a. Increased resources b. Technological innovation 14 O’Sullivan/Sheffrin/Perez, Survey of Economics, 7e Š Teaching Tip Use something students are familiar with to construct their first production possibilities curve. Pick two classes, such as Economics and Marketing. Tell them they are going to allocate study time to produce grades in the classes. The choice involves how much study time to allocate for each class. You can start with an all-or-nothing scenario producing an A|F outcome and make adjustments from there. Once they are comfortable, remind them that everything else was held constant. Ask them what would happen to the curve if the professors were better teachers, if students had better study skills, smaller classes, better textbooks, upgraded computers, or more time to study. Review this key question and the related application: Question 1: What is the opportunity cost of running a business? APPLICATION 1: DON’T FORGET THE COSTS OF TIME AND INVESTED FUNDS This Application gives an example of a business to explain how we can use the principle of opportunity cost to compute a business’s costs. In a business, the total costs are affected by the costs of raw materials, the opportunity costs of funds invested, and the opportunity costs of time. This Application shows that we must include not just the costs of materials but also the opportunity cost of funds invested, as well as the opportunity costs of time in computing the true cost of running a business. 2.2 The Marginal Principle A. Definition 1. Marginal benefit is the additional benefit resulting from a small increase in some activity. 2. Marginal cost is the additional cost resulting from a small increase in some activity. 3. Choose a level of the activity such that marginal benefit of the last unit equals the marginal cost of the last unit. B. Using the Marginal Principle: Movie Sequels, Renting College Facilities, Automobile Emissions Standards, Driving Speed and Safety Š Teaching Tip There are several easy-to-understand examples of the Marginal Principle in the world of college students. An easy way to start is with examples where the marginal cost is zero: The amount of food consumed at a particular meal in the cafeteria; Internet minutes in the computer lab; cell phone weekend minutes with some plans. Given that the marginal costs are zero, the student’s decision to consume is based on positive marginal benefits. You can then introduce situations where there are positive marginal costs, such as fast food that needs to be paid for. Chapter 2: The Key Principles of Economics 15 Review this key question and the related application: Question 2: How do people think at the margin? APPLICATION 2: HOW FAST TO SAIL? This Application explains the factors that go into the decision regarding how fast to sail an ocean cargo ship. We can use the marginal principle to see that the increase in a ship’s speed depends on the marginal benefit of delivering more cargo compared to the cost of additional fuel. If the marginal benefit (the increase in revenue from delivered cargo) is greater than the marginal cost (the increase in fuel cost), the ship operator will increase the ship’s speed. 2.3 The Principle of Voluntary Exchange A. The assumption is that people act in their own self-interest . A voluntary exchange between two people makes both better off. Markets work because they are based on the principle of voluntary exchange. Š Teaching Tip College students easily understand the principle of voluntary exchange because they are constantly engaged in voluntary exchanges. Work and consumption are two examples from their world. If they are employed, they voluntarily exchange their time and effort for the money they earn. Nobody kidnaps them and forces them to work. Their employer pays them voluntarily as well. Both the student and employer are better off. Any time individuals purchase anything, they exchange money for a product or a service, making both the buyer and the seller better off. Ask students what they purchased yesterday or today: Coffee or soda? Candy? Newspaper? Why did they purchase it? B. Exchange and Markets 1. A market is an institution or arrangement that allows buyers and sellers to exchange goods and services. Š Teaching Tip Create a market in the classroom. Do the experiment described in the book or in MyEconLab. C. Online Games and Market Exchange 1. Online games such as EverQuest illustrate how markets and exchange develop on their own because of the desire to trade. 16 O’Sullivan/Sheffrin/Perez, Survey of Economics, 7e Review this key question and the related application: Question 3: What is the rationale for specialization and exchange? APPLICATION 3: RORY MCILROY AND WEED-WHACKING Rory McIlroy is one of the best golfers in the world as well as a skillful weed whacker. He can whack down all the weeds on his property in one hour, making him 20 times more productive than the best gardener. Rory should still hire the less productive gardener because of the lower opportunity cost. If he earns $1,000 per hour playing golf, by paying the gardener only $200 ($10 an hour × 20), he would end up saving $800. This shows how the principles of voluntary exchange and specialization are beneficial. 2.4 The Principle of Diminishing Returns A. Principle of Diminishing Returns : Suppose that output is produced with two or more inputs, and we increase one input while holding the others constant. Eventually, output will begin to increase at a decreasing rate. Š Teaching Tip Have the students picture the front end of a fast-food franchise, such as McDonald’s, Burger King, Wendy’s, or another franchise near you. Ask them what would happen if you kept on adding more and more workers at McDonald’s. All the equipment is fixed. The number of workers is the variable input. Ask students what would happen to the number of hamburgers served as you increased the number of workers from 1 to 3 to 5 to 50. Eventually the restaurant would be so crowded that none of the workers would be able to move or serve any hamburgers. (Make sure to point out that this is well beyond the point of diminishing returns.) B. Diminishing Returns from Sharing a Production Facility 1. A good example of diminishing returns is when a company tries to add workers to an existing production facility. Eventually, the facility will become overcrowded, and the additional output resulting from additional workers will fall. Review this key question and the related application: Question 4: Do farmers experience diminishing returns? APPLICATION 4: FERTILIZER AND CROP YIELDS This Application illustrates how the notion of diminishing returns applies to all inputs to the production process. For a farmer, continuously increasing the amount of fertilizer applied to a fixed amount of land eventually reduces the increases in output. The farmer will experience diminishing return because, while even though the amount of fertilizer was not fixed, the other inputs to the production process are fixed. Chapter 2: The Key Principles of Economics 17 Š Teaching Tip A classroom full of urban or suburban students might not relate very well to this example. You can use watering the lawn instead. An excessive amount of water will not help the lawn grow faster. 2.5 The Real-Nominal Principle A. Definition 1. What matters to people is the real value or purchasing power of money or income, not its face value. 2. The nominal value of an amount of money is its face value. The real value is the value of an amount of money in terms of what it can buy. B. The Design of Public Programs C. The Value of the Minimum Wage When the government publishes statistics about the economy, it takes into account the real-nominal principle. For example, the value of “real wages” shows what has happened to the purchasing power of workers over time. The nominal wage shows what has happened to the sum on the worker’s paycheck, but it cannot show what has happened to purchasing power. Š Teaching Tip Ask the students how many of them would be happy to earn $500,000 per year. Most will say yes. Then tell them that a case of soda pop costs $100, a CD costs $250, and a new car costs $500,000. Are they still happy? You can now proceed to explain the difference between nominal and real variables. Review this key question and the related application: Question 5: How does inflation affect lenders and borrowers? APPLICATION 5: REPAYING STUDENT LOANS This Application shows how inflation can impact the value of money paid back over time. Using changes in annual salaries, the Application demonstrates the work time it takes someone to pay back the loan under various inflation assumptions. Š Teaching Tip Another way to illustrate this concept is to ask students if they know their parents’ monthly mortgage payments and when they purchased their homes. Inflation in home prices affects the amount that people will have to borrow. An older home usually will have a smaller nominal mortgage payment. However, your students’ parents’ salaries have presumably risen partly due to inflation. Therefore, inflation has helped those who have been debtors. 18 O’Sullivan/Sheffrin/Perez, Survey of Economics, 7e Additional Applications to Use in Class Question: Has fish production reached the point of diminishing returns? ADDITIONAL APPLICATION: SO LONG SEAFOOD? EXPERTS WARN OF DISASTER MSNBC Staff and News Service Reports “So Long Seafood? Experts Warn of Disaster” Posted on MSNBC.com Financial Times http://www.msnbc.msn.com/id/15532333/ Posted 11/03/2006 Summary: Key Points in the Article According to some experts, overfishing and pollution will virtually wipe out all the world’s fisheries by the year 2050. A team of economists and ecologists arrived at that conclusion by extrapolating current trends. The team warned that unless fisheries management practices radically change, we were in the “last century of wild seafood.” The team spent four years using controlled experiments and existing data to arrive at their conclusions. However, industry professionals do not appear to share the concerns. The National Fisheries Institute issued a statement that said, “Fish stocks naturally fluctuate in population,” and “By developing new technologies that capture target species more efficiently and result in less impact on other species or the environment, we are helping to ensure our industry does not adversely affect surrounding ecosystems or damage native species.” Seafood consumption is up in the United States, with the average American eating 16.6 pounds of seafood in 2004 versus 15.2 pounds in 2002. Fishing accounts for more than $80 billion in revenue worldwide. Analyzing the News Note that the National Fisheries Institute did not deny declining fish stocks. Instead the organization indicated the decline was part of a natural cycle. Could it be that the increasing global demand for seafood has pushed fishing to the point of diminishing returns? Thinking Critically Questions 1. It appears that fish harvests are increasing, but overall fish stocks may be declining. What economic principle is exhibited? 2. How can we increase production? 3. At what point would we cease to add fishing boats? Chapter 2: The Key Principles of Economics 19 Question: How can people invest in themselves? ADDITIONAL APPLICATION: “SHORT ON CASH, SOME PUT A PRICE ON THEMSELVES” Aleccia, JoNel Posted 12/5/2008 on MSNBC.com Summary: Key Points in the Article The shrinking economy has had an impact on people’s willingness to donate plasma, sperm, and fertile eggs. Hair sales are up as well. While the practice of selling most body products is illegal in the United States, there are instances where people are considered “compensated donors.” For example, many plasma centers will pay $20 for donor time and travel. The sudden spike in donor applications begs the question of whether the motives are altruistic or financial. Donating fertile eggs can be lucrative. One nursing student reported being able to graduate from college debt free due to the $28,000 she received for four cycles of fertile eggs donated since February. Viable sperm donors can earn $600 a month for a cycle of ten donations. While the practice can earn some cash, only a small fraction of donors make it through the rigorous medical and life history screens for fertile eggs and sperm. In any case, applications to be donors are up 20 to 30 percent at most clinics with plasma donations up as much as 50 percent in some areas. The uptick appears to be consistent with the recession. Analyzing the News Since “price” appears fixed for these items you simply see an increase in overall quantity. However, this article begs the question of whether body parts and products should be available for sale instead of merely compensation for time and travel. What do you think? Thinking Critically Questions 1. What is driving the increase on “donations” for certain body products? 2. How do clinics compensate donors, since it is illegal to buy plasma? 3. Should this practice be outlawed? Solutions to End-of-Chapter Exercises Chapter 2 SECTION 2.1: THE PRINCIPLE OF OPPORTUNITY COST 1.1 10, 180 1.2 arrow up 1.3 arrow up 1.4 $22,000 1.5 safe drinking water for 5 million people 1.6 outbidding, $1/hectare 1.7 $86,000 per year 20 O’Sullivan/Sheffrin/Perez, Survey of Economics, 7e 1.8 Scientists and engineers will be used to execute the mission, so part of the opportunity cost might be measured in science and engineering education (or any other non-mission-related scientific productivity) forgone. 1.9 The cost of holding wealth in non-interest-bearing form is higher where the interest rate is higher. 1.10 a. The loan cost me the interest I could have earned by investing the $100. b. The opportunity cost is the current market price, not the historical price. c. The cost of the stadium is $50 million plus the forgone earnings from renting the land or the interest that could be earned on the proceeds from sale of the land (whichever is higher). d. The cost would also include the time difference between alternative methods of commuting 1.11 a. b. c. 6, 10 1.12 current value of the furniture, current rate of return on alternative investment(s) SECTION 2.2: THE MARGINAL PRINCIPLE 2.1 Yes, the marginal benefit ($300) is less than the marginal cost ($200). 2.2 Yes, the marginal benefit ($135) exceeds the marginal cost ($125). 2.3 Yes, the marginal benefit ($50 million) exceeds the marginal cost ($30 million). 2.4 marginal, marginal Chapter 2: The Key Principles of Economics 21 2.5 a. Draw MB and MC curves crossing at 40 mph b. Shift MB to the right and show an increase in speed c. Shift MB to the left and show a decrease in speed 22 O’Sullivan/Sheffrin/Perez, Survey of Economics, 7e d. The MC curve should have a kink making it steeper to the right of 35mph. This lowers the speed that he drives. 2.6 a. It made sense if the marginal revenue of $3,100 was greater than the marginal costs b. cost, less, 3,100 2.7 a. yes, marginal revenue 2500 > marginal cost 2000 b. no, marginal revenue 1500< marginal cost 2000 2.8 Three officers should be hired, since the marginal benefit of the third officer ($40,000) equals the constant marginal cost of $40,000, but the marginal benefit of the fourth officer would fall below the constant marginal cost. 2.9 a. 26 b. yes Chapter 2: The Key Principles of Economics 23 2.10 a. Pick 5 pints. b. Pick 3 pints. SECTION 2.3: THE PRINCIPLE OF VOLUNTARY EXCHANGE 3.1 False 3.2 $15, $15 3.3 Up arrow 3.4 softer 3.5 a. No, the cost of forgone surgeries exceeds the benefit of clean drains. b. $1,150 per hour (= ($20 per minute × 60 minutes/hour) – $50 per hour) 3.6 a. 50 fish b. Assign the tribe’s least productive fishermen to build the boat. The cost of the boat decreases to 20 fish. 3.7 The tree-cutter paid the neighbor to compensate for lost shade SECTION 2.4: THE PRINCIPLE OF DIMINISHING RETURNS 4.1 300 4.2 False. Diminishing returns means that output increases at a decreasing rate. 4.3 less than, at least 4.4 inflexible, flexible 4.5 arrow up, arrow down 4.6 This is true, so long as there are no limitations on availability of resources other than soil. 4.7 a. Yes, because employment of some resources is inflexible within a week. b. Possibly not, because employment of all resources used in production of memory chips is likely to be flexible over a period of two years. 4.8 a. No, because of the principle of diminishing returns b. Yes 24 O’Sullivan/Sheffrin/Perez, Survey of Economics, 7e 4.9 2, 154, 48, 11 3, 172, 36, 11 4, 184, 24, 11 5, 190, 12, 11 6, 193, 6, 11 Ted should work five hours, since MB < MC for the sixth hour of work. SECTION 2.5: THE REAL-NOMINAL PRINCIPLE 5.1 $1 in purchasing power 5.2 negative $20 in purchasing power 5.3 down arrow, 3% 5.4 $65,000 5.5 No 5.6 Inflation, since it lowers the real cost of the debt repayment. 5.7 Number of baskets per week: 4.10, 3.05 So the real value of welfare payments decreased 5.8 a. 130.488%, 117.287%, 136.497%, 122.469%, 120.753% b. Wage increases lagged consumer price increase in three of four groups. c. Real wages fell in every sector except professional services. 5.9 a. —, 5 months $5,000, 4 months $2,000, 10 months b. Inflation 5.10 a. 55 tunes, $55, 10% b. 55 tunes, 66 dollars, 32%