Solution Manual for Essentials of Economics, 7th Edition

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Essentials of Economics
Seventh Edition
R. Glenn Hubbard
Anthony Patrick O’Brien
Instructor’s Resource Manual
for
Essentials of Economics
Edward Scahill
and Eva Dziadula

Contents
Part 1: Introduction
Chapter 1 Economics: Foundations and Models 1
Appendix: Using Graphs and Formulas 25
Chapter 2 Trade-offs, Comparative Advantage, and the Market System 27
Chapter 3 Where Prices Come From: The Interaction of Demand and Supply 47
Part 2: Markets in Action: Policy and Applications
Chapter 4 Market Efficiency and Market Failure 79
Chapter 5 The Economics of Health Care 110
Part 3: Microeconomic Foundations: Consumers and Firms
Chapter 6 Firms, the Stock Market, and Corporate Governance 129
Online Appendix: Using Present Value 149
Online Appendix: Income Statements and Balance Sheets 151
Chapter 7 Consumer Choice and Elasticity 154
Chapter 8 Technology, Production, and Costs 190
Part 4: Market Structure and Firm Strategy
Chapter 9 Firms in Perfectly Competitive Markets 227
Chapter 10 Monopoly and Antitrust Policy 257
Chapter 11 Monopolistic Competition and Oligopoly 291
Part 5: Macroeconomic Foundations
Chapter 12 GDP: Measuring Total Production and Income 326

Contents v
Chapter 13 Unemployment and Inflation 349
Part 6: Long-Run Economic Growth and Short-Run Fluctuations
Chapter 14 Economic Growth, the Financial System, and Business Cycles 382
Chapter 15 Aggregate Demand and Aggregate Supply Analysis 397
Appendix: Macroeconomic Schools of Thought 407
Part 7: Monetary and Fiscal Policy
Chapter 16 Money, Banks, and the Federal Reserve System 425
Chapter 17 Monetary Policy 454
Chapter 18 Fiscal Policy 486
Chapter 19 Comparative Advantage, International Trade, and Exchange Rates 523

Preface
Features of this Instructor’s Manual
Each chapter of this Instructor’s Manual contains the following elements:
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 text chapter.
Chapter Outline with Teaching Tips: Detailed descriptions of the economic concepts in the book, key
term definitions, and teaching tip boxes. The teaching tip boxes include recommendations on how to
integrate key figures.
Extra Solved Problems: Each chapter of the main text has a Solved Problem to support two of the chapter’s
learning objectives. This Instructor’s Manual includes extra Solved Problems that you can assign as
homework or present during classroom lectures.
Extra Economics in Your Life: Each chapter of the book opens and closes with a special feature entitled
Economics in Your Life that emphasizes the connection between the material and the students’ personal
experiences and questions. This Instructor’s Manual includes an extra Economics in Your Life for each
chapter to present in class.
Extra Apply the Concepts: Each chapter of the main text has two or more Apply the Concept features to
provide real-world reinforcement of key concepts. This Instructor’s Manual includes extra Apply the
Concepts to present in class.
Solutions to Review Questions and Problems and Applications: Each chapter of this Instructor’s
Manual includes solutions to all questions and problems in the main text:
▪ Solutions to the two Thinking Critically questions that accompany the An Inside Look newspaper
feature located at the end of Chapters 1, 2, 3, and 4
▪ Solutions to the end-of-chapter Review Questions
▪ Solutions to the end-of-chapter Problems and Applications
▪ Solutions to the end-of-chapter Real-Time-Data Exercises

Preface v
Digital Assets Located in MyLab Economics
MyLab Economics is a unique online course management, testing, and tutorial resource. It is included
with the complete eText as well as these additional online resources to accompany the eighth edition.
• Videos. There are more than 80 Apply the Concept features in the book that provide real-world
reinforcement of key concepts. Each feature is accompanied by a two- or three-minute video of the
author explaining the key point of that Apply the Concept. Related assessment is included with each
video, so students can test their understanding. The goal of these videos is to summarize key content
and bring the applications to life. In our experience, many students benefit from this type of online
learning and assessment.
• Concept Checks. Each section of each learning objective concludes with an online Concept Check
that contains one or two multiple-choice, true/false, or fill-in questions. These checks act as “speed
bumps” that encourage students to stop and check their understanding of fundamental terms and
concepts before moving on to the next section. The goal of this digital resource is to help students
assess their progress on a section-by-section basis, so they can be better prepared for homework,
quizzes, and exams.
• Animations of Figures. Graphs are the backbone of introductory economics, but many students
struggle to understand and work with them. Each of the more than 160 numbered figures in the text
has a supporting animated version online. The goal of this digital resource is to help students
understand shifts in curves, movements along curves, and changes in equilibrium values. Having an
animated version of a graph helps students who have difficulty interpreting the static version in the
printed text. Graded practice exercises are included with the animations. In our experience, many
students benefit from this type of online learning.
• Whiteboard Solved Problem Videos. Many students have difficulty applying economic concepts to
solving problems. Each chapter includes between one and three Solved Problems that show students
how to break an economic problem down step by step. Several of these Solved Problems are also
available as whiteboard videos. The goals of the feature and whiteboard videos are to help students
build skills they can use to analyze real-world economic issues they hear and read about in the news
and also to help students apply basic problem-solving skills to homework, quizzes, and exams. Each
Solved Problem in the book and in video format includes at least one additional graded practice
exercise for students.
• Graphs Updated with Real-Time Data from FRED. Select graphs are continuously updated online
with the latest available data from FRED (Federal Reserve Economic Data), which is a
comprehensive, up-to-date data set maintained by the Federal Reserve Bank of St. Louis. Students
can display a pop-up graph that shows new data plotted in the graph. The goal of this digital feature is
to help students understand how to work with data and understand how including new data affects
graphs.
• Interactive Problems and Exercises Updated with Real-Time Data from FRED. The end-of-
chapter problems in select chapters include Real-Time Data Exercises that use the latest data from
FRED. The goals of this digital feature are to help students become familiar with this key data source,
learn how to locate data, and develop skills in interpreting data.

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vi Preface
Organizing Your Syllabus
The Instructor’s Manual can be a valuable resource for both experienced and first-time instructors. Both
the textbook and Instructor’s Manual provide comprehensive coverage of economic theory, monetary
policy, fiscal policy, and real-world applications.
Microeconomic Chapters
The microeconomics chapters cover relatively new developments in the field, such as the economics of
information (Chapter 5, “The Economics of Health Care”). The authors include business applications in
each chapter and have a dedicated chapter on firms, the stock market, and corporate governance (Chapter
6, “Firms, the Stock Market, and Corporate Governance”). The comprehensive coverage of
microeconomics and business topics allows instructors to select chapters for diverse groups of students.
First-time users of the textbook should be aware that some topics introduced in one chapter are applied in
a later chapter. Chapter 4, “Market Efficiency and Market Failure,” introduces consumer, producer and
economic surplus to describe the impact of government-imposed price controls. Chapter 19, “Comparative
Advantage, International Trade, and Exchange Rates” uses the same tools to measure the effect of tariffs
and quotas on international trade.
Macroeconomic Chapters
Chapter 12, “GDP: Measuring Total Production and Income,” and Chapter 13, “Unemployment and
Inflation” carefully provide definitions of macroeconomic statistics such as GDP, CPI, and payroll
employment, that dominate news headlines.
The comprehensive coverage of macroeconomic models and policy issues allows instructors with
somewhat different course objectives the flexibility to choose different chapter sequences. The authors
provide an overview of issues of long-run growth, business cycles, and the financial system in Chapter 14,
“Economic Growth, the Financial System, and Business Cycles.”
Chapter 15, “Aggregate Demand and Aggregate Supply Analysis,” carefully develops the AD-AS model
and then makes the model dynamic in an optional section to account better for actual movements in real
GDP and the price level. Instructors may safely omit the sections on the dynamic AD-AS model in Chapter
17, “Monetary Policy” and in Chapter 18, “Fiscal Policy,” without any loss in continuity to the discussion
of macroeconomic theory and policy.

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Preface vii
Other Supplements
Supplements Available to
Instructors for Download at
www.pearsonhighered.com Features of the Supplement
Test Bank
Authored by Randy Methenitis
of Richland College
• 4,000 multiple-choice, true/false, short-answer, and graphing
questions.
• Test questions are annotated with the following categories:
Difficulty—1 for straight recall, 2 for some analysis, and 3 for
complex analysis
Type—multiple-choice, true/false, short-answer, essay
Topic—the term or concept the question supports
Learning outcome
Page number in the main book
Special feature in the main book
The Association to Advance Collegiate Schools of Business
(AACSB) Guidelines, which propose learning experiences in
the following categories of Assurance of Learning Standards:
Written and Oral Communication; Ethical Understanding and
Reasoning; Analytical Thinking; Information Technology;
Interpersonal Relations and Teamwork, Diverse and
Multicultural Work; Reflective Thinking; and Application of
Knowledge
Computerized TestGen • Allows instructors to customize, save, and generate classroom
tests.
• Instructors can edit, add, or delete questions from the Test
Banks; analyze test results; and organize a database of tests
and student results.
• Many options are available for organizing and displaying tests,
along with search and sort features.
• The software and the Test Banks can be downloaded from
www.pearsonhighered.com.

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viii Preface
Supplements Available to
Instructors for Download at
www.pearsonhighered.com Features of the Supplement
PowerPoint Lecture
Presentations
Authored by Paul Holmes of
Ashland University
• A comprehensive set of PowerPoint slides can be used by
instructors for class presentations or by students for lecture
preview or review. These slides include all the graphs, tables,
and equations in the textbook. Two versions are available: step-
by-step mode, in which you can build graphs as you would on a
blackboard, and automated mode, in which you use a single
click per slide.
• Student versions of the PowerPoint slides are available as .pdf
files. This version allows students to print the slides and bring
them to class for note taking.

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CHAPTER 1 | Economics: Foundations
and Models
Brief Chapter Summary and Learning Objectives
1.1 Three Key Economic Ideas (pages 4–7)
Explain these three key economic ideas: People are rational, people respond to economic
incentives, and optimal decisions are made at the margin.
▪ Because resources are scarce, people must make choices to attain their goals.
1.2 The Economic Problem That Every Society Must Solve (pages 8–11)
Discuss how an economy answers these questions: What goods and services will be produced?
How will the goods and services be produced? Who will receive the goods and services
produced?
▪ Because of scarcity, producing more of one good or service means that less of some other good
or service will be produced.
1.3 Economic Models (pages 11–15)
Explain how economists use models to analyze economic events and government policies.
▪ Economists use models—simplified versions of reality—to analyze real-world issues.
1.4 Microeconomics and Macroeconomics (page 15-16)
Distinguish between microeconomics and macroeconomics.
1.5 Economic Skills and Economics as a Career (pages 16–17)
Describe economics as a career and the key skills you can gain from studying economics.
1.6 A Preview of Important economic Terms (pages 17–19)
Define important economic terms.
Appendix: Using Graphs and Formulas (pages 27–39)
Use graphs and formulas to analyze economic situations.
Key Terms
Allocative efficiency, p. 10. A state of the
economy in which production is in accordance
with consumer preferences; in particular, every
good or service is produced up to the point
where the last unit provides a marginal benefit to
consumers equal to the marginal cost of
producing it.

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2 CHAPTER 1 | Economics: Foundations and Models
Centrally planned economy, p. 9. An economy
in which the government decides how economic
resources will be allocated.
Economic model, p. 11. A simplified version
of reality used to analyze real-world economic
situations.
Economic variable, p. 12. Something
measurable that can have different values, such
as the number of people employed in
manufacturing.
Economics, p. 4. The study of the choices
people make to attain their goals, given their
scarce resources.
Equity, p. 11. The fair distribution of economic
benefits.
Macroeconomics, p. 15. The study of the
economy as a whole, including topics such as
inflation, unemployment, and economic growth.
Marginal analysis, p. 6. Analysis that involves
comparing marginal benefits and marginal costs.
Market, p. 4. A group of buyers and sellers of a
good or service and the institution or
arrangement by which they come together to
trade.
Market economy, p. 9. An economy in which
the decisions of households and firms as they
interact in markets determine the allocation of
economic resources.
Microeconomics, p. 15. The study of how
households and firms make choices, how they
interact in markets, and how the government
attempts to influence their choices.
Mixed economy, p. 10. An economy in which
most economic decisions result from the
interaction of buyers and sellers in markets but
in which the government plays a significant role
in the allocation of resources.
Normative analysis, p. 13. Analysis concerned
with what ought to be.
Opportunity cost, p. 8. The highest-valued
alternative that must be given up to engage in an
activity.
Positive analysis, p. 13. Analysis concerned
with what is.
Productive efficiency, p. 10. A situation in
which a good or service is produced at the
lowest possible cost.
Scarcity, p. 4. A situation in which unlimited
wants exceed the limited resources available to
fulfill those wants.
Trade-off, p. 8. The idea that, because of
scarcity, producing more of one good or service
means producing less of another good or service.
Voluntary exchange, p. 10. A situation that
occurs in markets when both the buyer and the
seller of a product are made better off by the
transaction.
Chapter Outline
Does Apple Manufacture the iPhone in the United States?
Although Apple designs the iPhone at its headquarters in Cupertino, California, most iPhones are assembled
in China. Many products that were once manufactured in the United States are now manufactured overseas.
The Trump administration imposed tariffs on Chinese imports in 2019. Tariffs lead to higher prices for
imported goods, making it more likely that U.S. and foreign companies will manufacture goods in the
United States. The Trump administration also hoped that the tariffs would convince other countries to
reduce restrictions on U. S. imports. In a market system, firms respond to economic incentives. In in case
of Apple, lower wages earned by Chinese workers reduce the costs of assembling iPhones. Technological

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CHAPTER 1 | Economics: Foundations and Models 3
progress often creates incentives for firms to change how they produce goods and services. Firms also
respond to changes in consumer tastes and to changes in government policy. In 2019, many firms awaited
the outcome of trade negotiations between China and the United Stated before deciding in which country
to expand their operations.
Teaching Tips
There are special features in the textbook:
1. The introduction, or chapter opener, uses a real-world business example to preview the economic issues
discussed in the chapter.
2. At the end of each of the first four textbook chapters is a feature titled An Inside Look that consists of
a recent news article plus analysis and questions. The article links back to a topic discussed in the
chapter opener. Visit MyLabEconomics for additional current An Inside Look news articles.
3. A boxed feature titled Economics in Your Life & Career complements the business example that opens
the chapter. Economics in Your Life and Career poses questions that help students make a personal
connection with the chapter theme. At the end of the chapter, the authors use the concepts described in
the chapter to answer these questions. Extra Economics in Your Life & Career features are included in
the Instructor’s Manual.
4. Don’t Let This Happen to You is a box feature that alerts students to common pitfalls covered in that
chapter.
5. There are between two and four Analyze the Concept features in each chapter that provide real world
reinforcement of key concepts by citing news stories that focus on business and policy issues. Extra
Analyze the Concept features appear in the Instructor’s Manual.
6. Solved Problems use a step-by-step process for solving economic problems related to a chapter’s
learning objectives. Extra Solved Problems are included in the Instructor’s Manual.
7. Real-Time Data Exercises (RTDA) are included with problems at the end of macroeconomics chapters.
These problems refer to data and graphs that students will find at the web site of the Federal Reserve
Bank of St. Louis (FRED). Many RTDA require more elaborate calculations than other problems and
the use of Excel spreadsheets.
You can use these features as the basis for classroom discussion, homework assignments, and examination
questions.
People must make choices as they try to attain their goals. The choices people make represent the trade-
offs made necessary by scarcity. Scarcity is a situation in which unlimited wants exceed the limited
resources available to fulfill those wants. Economics is the study of the choices people make to attain their
goals, given their scarce resources.
Teaching Tips
Students will better understand what scarcity means if given examples of things that are not scarce. Suggest
examples of “free” resources—sand on a beach, fresh air, etc.—and ask your students to contribute their
own examples; they will soon realize that the list of free resources is much shorter than the list of scarce
resources.

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4 CHAPTER 1 | Economics: Foundations and Models
1.1
Three Key Economic Ideas (pages 4–7)
Learning Objective: Explain these three key economic ideas: People are rational, people
respond to economic incentives, and optimal decisions are made at the margin.
A market is a group of buyers and sellers of a good or service and the institution or arrangement by which
they come together to trade.
A. People Are Rational
Rational consumers and firms use all available information as they act to achieve their goals. Although not
everyone behaves rationally all the time, the assumption of rational behavior is useful in explaining most
of the choices people make.
B. People Respond to Economic Incentives
Economists emphasize that individuals and firms consistently respond to economic incentives.
C. Optimal Decisions Are Made at the Margin
Economists use the word marginal to mean an extra or additional benefit or cost from making a decision.
The optimal decision is to continue any activity to the point where the marginal benefit equals the marginal
cost. Marginal analysis is analysis that involves comparing marginal benefits and marginal costs.
Extra Solved Problem 1.1
A Doctor Makes a Decision at the Margin
A doctor receives complaints from patients that her office isn’t open enough hours. In response, the doctor
asks her office manager to analyze the effect of keeping her office open 9 hours per day rather than 8 hours.
The doctor’s office manager tells her: “Keeping the office open an extra hour is a good idea because the
revenue from your practice will increase by $300,000 per year when the office is open 9 hours per day.”
Do you agree with the office manager’s reasoning? What, if any, additional information would you need to
decide whether the doctor should keep her office open an additional hour per day?
Solving the Problem
Step 1: Review the chapter material.
This problem is about making decisions, so you may want to review the section “Optimal
Decisions Are Made at the Margin” in the textbook.
Step 2: Explain whether you agree with the office manager’s reasoning.
We have seen that any activity should be continued to the point where the marginal benefit is
equal to the marginal cost. In this case, the doctor should keep her office open up to the point
where the additional revenue she receives from seeing more patients is equal to the marginal
cost of keeping her office open an additional hour. The office manager has provided
information on marginal revenue but not on marginal cost. The office manager has not provided
enough information to make a decision, and you should not agree with the office manager’s
reasoning.

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CHAPTER 1 | Economics: Foundations and Models 5
Step 3: Explain what additional information you need.
To make a correct decision, you would need information on the marginal cost of remaining
open an extra hour per day. The marginal cost would include the additional salary to be paid to
the office staff, any additional medical supplies that would be used, as well as any additional
electricity or other utilities. The doctor would also need to take into account the nonmonetary
cost of spending another hour working rather than spending time with her family and friends
or in other leisure activities. The marginal revenue would depend on how many more patients
the doctor can see in the extra hour. The doctor should keep her office open an additional hour
if the marginal revenue of doing so is greater than the marginal cost. If the marginal cost is
greater than the marginal revenue, then the doctor should continue to keep her office open for
8 hours.
Extra Analyze
the Concept Does Health Insurance Give People an Incentive to Become
Obese?
Obesity is a factor in a variety of diseases, including heart disease, stroke, diabetes, and hypertension,
making it a significant health problem in the United States. Body mass index (BMI) is a measurement of a
person’s weight relative to the person’s height. According to the U.S. Centers for Disease Control and
Prevention (CDC), an adult with a body mass index (BMI) of 30 or greater is considered obese. For
example, a 5'6" adult with a BMI of 30 is 40 pounds overweight.
The following two maps show the dramatic increase in obesity between 1994 and 2015. In 1994, in a
majority of states only between 10 percent and 14 percent of the adult population was obese, and in no state
was more than 20 percent of the adult population obese.
By 2015, in every state, at least 20 percent of the adult population was obese, and in 44 states, at least 25
percent of the adult population was obese. Many people who suffer from obesity have underlying medical
conditions. For these people, obesity is a medical problem that they cannot control. The fact that obesity
has increased, though, indicates that for some people, obesity is the result of diet and lifestyle choices.
Potential explanations for the increase in obesity include greater intake of high-calorie fast foods,
insufficient exercise, and a decline in the physical activity associated with many jobs. The CDC
recommends that teenagers get a minimum of 60 minutes of aerobic exercise per day, a standard that only
15 percent of high school students meet. In 1960, 50 percent of jobs in the United States required at least

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6 CHAPTER 1 | Economics: Foundations and Models
moderate physical activity. Today, only 20 percent of jobs do. As a result, a typical worker today who may
work at a computer is burning off about 130 fewer calories per workday than a worker in the 1960s who
was more likely to have worked in a manufacturing plant.
In addition to eating too much and not exercising enough, could having health insurance be a cause of
obesity? Obese people tend to suffer more medical problems and so incur higher medical costs. Obese
people with health insurance that will reimburse them for only part of their medical bills, or who have no
health insurance, must pay some or all of these higher medical bills themselves. People with health
insurance that covers most of their medical bills will not suffer as large a monetary cost from being obese.
In other words, by reducing some of the costs of obesity, health insurance may give people an economic
incentive to gain weight.
At first glance, this argument may seem implausible. Some people suffer from medical conditions that can
make physical activity difficult or that can cause weight gain even with moderate eating, so they may
become obese, regardless of which type of health insurance they have. The people who are obese because
of poor eating habits or lack of exercise probably don’t consider health insurance when deciding whether
to have a slice of chocolate cake or to watch Netflix instead of going to the gym. But if economists are
correct about the importance of economic incentives, then we would expect that if we hold all other personal
characteristics—such as age, gender, and income—constant, people with health insurance will be more
likely to be overweight than people without health insurance.
Jay Bhattacharya and Kate Bundorf of Stanford University, Noemi Pace of the University of Venice, and
Neeraj Sood of the University of Southern California, have analyzed the effects of health insurance on
weight. Using a sample that followed nearly 80,000 people from 1989 to 2004, they found that after
controlling for factors including age, gender, income, education, and race, people with health insurance
were significantly more likely to be overweight than people without health insurance. Having private health
insurance increased BMI by 1.3 points. Having public health insurance, such as Medicaid, which is a
program under which the government provides health care to low-income people, increased BMI by 2.3
points. These findings suggest that people respond to economic incentives even when making decisions
about what they eat and how much they exercise.
Note: The exact formula for the body mass index is BMI = (Weight in pounds/Height in inches2) x 703.
Sources: Centers for Disease Control and Prevention, “Prevalence of Self-Reported Obesity among U.S. Adults,” www.cdc. gov;
Katherine M. Flegal, Margaret D. Carroll, Cynthia L. Ogden, and Lester R. Curtin, “Prevalence and Trends in Obesity among U.S.
Adults, 1999–2008,” Journal of the American Medical Association, Vol. 303, No. 3, January 20, 2010, pp. 235–241; Jay
Bhattacharya, Kate Bundorf, Noemi Pace, and Neeraj Sood, “Does Health Insurance Make You Fat?” in Michael Grossman and
Naci H. Mocan, eds., Economic Aspects of Obesity, Chicago: University of Chicago Press, 2011; and Tara Parker-Pope, “Less
Active at Work, Americans Have Packed on Pounds,” New York Times, May 25, 2011.
Teaching Tips
You don’t need to spend a lot of class time explaining the material in this section; subsequent chapters will
reinforce students’ understanding of markets and the “three key economic ideas.”
1.2
The Economic Problem That Every Society Must Solve (pages 8–11)
Learning Objective: Discuss how an economy answers these questions: What goods and
services will be produced? How will the goods and services be produced? Who will receive
the goods and services produced?
Every society faces the economic problem that it has only a limited amount of economic resources, so it
can produce only a limited amount of goods and services. Every society faces trade-offs. A trade-off is the

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CHAPTER 1 | Economics: Foundations and Models 7
idea that, because of scarcity, producing more of one good or service means producing less of another good
or service. Every activity has an opportunity cost: The highest-valued alternative that must be given up to
engage in an activity. Trade-offs force society to answer three fundamental questions:
1. What goods and services will be produced?
2. How will the goods and services be produced?
3. Who will receive the goods and services produced?
A. What Goods and Services Will Be Produced?
The answer to this question is determined by the choices consumers, managers of firms, and government
policymakers make. Each choice made has an opportunity cost.
B. How Will the Goods and Services Be Produced?
Firms choose how to produce the goods and services they sell. For example, firms often face trade-offs
between using more workers or more machines.
C. Who Will Receive the Goods and Services Produced?
In the United States, who receives the goods and services produced depends largely on how income is
distributed. An important policy question is whether the government should intervene to make the
distribution of income more equal.
D. Centrally Planned Economies versus Market Economies
Societies organize their economies in two main ways. A centrally planned economy is an economy in
which the government decides how economic resources will be allocated. A market economy is an
economy in which the decisions of households and firms interacting in markets determine the allocation of
economic resources. Today, only North Korea has a completely centrally planned economy. In a market
economy, the income of an individual is determined by the payments he or she receives for what he or she
sells. Generally, the more extensive the training a person has received and the longer the hours the person
works, the higher his income will be.
E. The Modern “Mixed” Economy
The high rates of unemployment and business bankruptcies during the Great Depression of the 1930s caused
a dramatic increase in government intervention in the economy in the United States and other market
economies. Some government intervention is designed to raise the incomes of the elderly, the sick, and
people with limited skills. In recent years, government intervention has expanded to meet goals such as
protection of the environment, promotion of civil rights, and increased access to medical care.
Some economists argue that the extent of government intervention makes it more accurate to refer to the
economies of the United States, Canada, Japan and Western Europe as mixed economies rather than pure
market economies. A mixed economy is an economy in which most economic decisions result from the
interaction of buyers and sellers in markets but in which the government plays a significant role in the
allocation of resources.
F. Efficiency and Equity
Market economies tend to be more efficient than centrally planned economies. There are two types of
efficiency. Productive efficiency is a situation in which a good or service is produced at the lowest possible
cost. Allocative efficiency is a state of the economy in which production is in accordance with consumer
preferences; in particular, every good or service is produced up to the point where the last unit provides a
marginal benefit to consumers equal to the marginal cost of producing it. Voluntary exchange is a situation
that occurs in markets when both the buyer and the seller of a product are made better off by the transaction.

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8 CHAPTER 1 | Economics: Foundations and Models
Inefficiency arises from various sources. Sometimes governments reduce efficiency by interfering with
voluntary exchange in markets. The production of some goods damages the environment when firms ignore
the costs of environmental damage. In this case, government intervention can increase efficiency.
Society may not find an efficient economic outcome to be desirable. Many people prefer economic
outcomes they consider fair or equitable even if these outcomes are less efficient. Equity is the fair
distribution of economic benefits. There is often a trade-off between efficiency and equity.
Teaching Tips
Ask students for examples of government regulation of private markets in the United States. Responses
may include: making the sale of cocaine and other addictive drugs illegal; minimum age requirements for
the purchase of alcoholic beverages and cigarettes; the prohibition of the sale of new drugs before their
effectiveness is demonstrated through government supervised tests. Ask students whether one of these
examples of government regulation promotes equity or fairness. The difficulty in defining equity will be
apparent.
To show how students may value equity less than they claim, an economics teacher at a college in
Western New York once told her students at the beginning of her course that their grades would be
auctioned to the highest bidders. Because grades are usually normally distributed, she offered to sell a few
A grades, a few more B grades, and so on. Although the announcement produced shock and grumbling, the
auction proceeded, with frenzied bidding for A grades. As prices for A grades rose, bidding switched to B
grades. Because few students bothered to bid for C grades, one enterprising student bid on several such
grades in the belief that those who lost out on getting an A or B would have to buy their C grades from
him—for a higher price than he paid! After about a week, the instructor informed the class the auction was
intended only as an economics lesson; they would have to earn their grades the old-fashioned way.
Extra Solved Problem 1.2
Advising New Government Leaders
Suppose a country experiences a change in government leadership. Prior to this change, this country had a
centrally planned economy. The new leaders are willing to try a different system if they can be convinced
that it will yield better results. They hire an economist from a country with a market economy to advise
them and will order their citizens to follow the economist’s recommendations for change. The economist
suggests that a market economy replace central planning to answer the nation’s economic questions (what,
how, and who?).
What will the economist suggest the leaders order their citizens to do in order to change from a centrally
planned economy to a market economy?
Are there reasons why the leaders of this country might not accept the economist’s suggestions? Briefly
explain.
Solving the Problem
Step 1: Review the chapter material.
The problem is about different types of economic systems, so you may want to review the
section “Centrally Planned Economies versus Market Economies” in the textbook.
Step 2: What will the economist suggest the leaders order their citizens to do?

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CHAPTER 1 | Economics: Foundations and Models 9
Market economies allow members of households to select occupations and purchase goods and
services based on self-interest and allow privately owned firms to produce goods and services
based on their self-interests. Therefore, the economist would advise the leaders of the country
to not issue any orders. Government officials should have no influence over individual
decisions made in markets.
Step 3: Are there reasons why the leaders of this country might not accept the economist’s
suggestions?
Even democratically elected leaders may find it difficult to accept the economist’s suggestions.
They may wonder how self-interested individuals will produce and distribute goods and
services so as to promote the welfare of the entire country. This new system requires a
significant reduction in government influence in people’s lives, but history has shown that most
government officials are reluctant to give up this influence. Acceptance is most likely when the
leaders have some knowledge and experience with the successful operation of a market
economy in other countries. Ordinary citizens are more likely to accept the economist’s
suggestions because they would have more freedom to pursue their own economic goals.
Extra Analyze
the Concept It’s Saturday Afternoon: Why Aren’t You at the Game?
For many students, attending college football games is an enjoyable way to spend Saturday afternoons in
the fall. However, some colleges have experienced a decline in the number of students attending their
games. In 2016, average attendance at the 130 schools that make up the Division I Football Bowl
Subdivision (43,106) was the lowest since 2000 (42,631).
What explains the decrease in the number of students willing to attend football games? Rising ticket
prices are one reason for the decline. One student at the University of Michigan was quoted as saying:
“People are looking to trim costs, and for a lot of folks, football is an easy thing to cut. It’s not essential to
going to college.”
Remember that the opportunity cost of engaging in an activity is the value of the best alternative that
must be given up to engage in that activity. The opportunity cost of attending a college football game is not
just the price of a ticket. If the price of a ticket to a game is $50, your opportunity cost is the ticket price
plus the value you place on what else you could do if you don’t attend the game. At one time, relatively
few college football games were televised, but today multiple cable networks broadcast games. If you attend
your college’s games, you miss the opportunity to watch the games being broadcast at the same time—in
high-definition with replays shown from multiple camera angles and expert commentary to clarify what is
happening. When watching games in your room or at a sports restaurant, you can also post to Facebook,
Instagram, or Twitter, read e-mail, surf the Web, and take or receive phone calls. Wi-Fi and cellular
reception are often poor in college stadiums, making these activities difficult.
So the opportunity cost of attending college football games has increased in recent years, not just
because ticket prices have risen but because the number of alternative activities that students value highly
has also increased. We expect that when the opportunity cost of engaging in an activity increases, people
will engage in that activity less, as we’ve seen with student attendance at college football games.
Colleges have responded to declining student attendance by reducing ticket prices, improving Wi-Fi
and cellular service, and installing high-definition video boards that show replays as they appear on

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10 CHAPTER 1 | Economics: Foundations and Models
television. Whether these attempts to lower the opportunity cost of attending college football games enough
to increase attendance at games remains to be seen.
Sources: Jon Solomon, “College Attendance in 2016: Crowds Decline for the Sixth Straight Year,” CBSSports.com, December 16,
2016; Adam Rittenberg, “Attendance Challenges Big Deal for B1G,” espn.com, February 14, 2014; and Ben Cohen, “At College
Football Games, Student Sections Likely to Have Empty Seats,” Wall Street Journal, August 27, 2014.
1.3
Economic Models (pages 11–15)
Learning Objective: Explain how economists use models to analyze economic events and
government policies.
An economic model is simplified version of reality used to analyze real-world situations. To develop a
model, economists generally follow five steps.
1. Decide on the assumptions to use.
2. Formulate a testable hypothesis.
3. Use economic data to test the hypothesis.
4. Revise the model if it fails to explain the economic data well.
5. Retain the revised model to help answer similar economic questions in the future.
A. The Role of Assumptions in Economic Models
Models are based on making assumptions because models must be simplified to be useful. When using
models, economists make behavioral assumptions about the motives of consumers and firms. Economists
assume consumers will buy goods and services that will maximize their satisfaction and firms will act to
maximize their profits.
B. Forming and Testing Hypotheses in Economic Models
An economic variable is something measurable that can have different values, such as the number of
people employed in manufacturing. A hypothesis in an economic model is a statement that may be correct
or incorrect about an economic variable. To test a hypothesis, we analyze statistics on the relevant economic
variables. Economists accept and use an economic model if it leads to hypotheses that are confirmed by
statistical analysis.
C. Positive and Normative Analysis
Positive analysis is analysis concerned with what is. Normative analysis is analysis concerned with what
ought to be. Economics is about positive analysis, which measures the costs and benefits of different courses
of action.
D. Economics as a Social Science
Because economics studies the actions of individuals, it is a social science. Economics considers human
behavior in every context, not just in the context of business. Economists have played an important role in
formulating government policies in areas such as the environment, health care, and poverty.

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CHAPTER 1 | Economics: Foundations and Models 11
Extra Solved Problem 1.3
Snowfalls and Skiing
Marsha Shawn is a college student and downhill skier who lives near The Ski Chalet, a ski resort located
in Vermont. For a course project Marsha and four other students are required to develop an economic
model. Marsha suggests that their model test the impact of snowfalls on the sale of ski equipment (skis,
boots, poles) and snowboards at the six ski shops located within a ten-mile radius of The Ski Chalet.
Marsha and the other students in her group agree that to have an impact on equipment sales a snowfall
would have to result in at least four inches of new snow. How would you recommend that Marsha and the
other students develop their model? Suggest an alternative model for Marsha in the event that the model
fails to explain the data she uses to test her model.
Solving the Problem
Step 1: Review the chapter material.
The problem is about how to use models to analyze economic issues, so you may want to review
the section “Economic Models” in the textbook.
Step 2: To develop and test a model of the relationship between snowfall and sales of ski
equipment the students in Marsha’s group should follow these steps:
1. Decide on the assumptions to use in developing the model. For example: sales of ski
equipment and snowboards are greater after snowfalls (four or more inches) than are sales
at other times during the period that The Ski Chalet is open.
2. Formulate a testable hypothesis. Sales of ski equipment and snowboards at the six ski
shops located near the Ski Chalet are higher (for example, by 5 percent or more) within
one week following snowfalls of four or more inches than other weeks that The Ski Chalet
is open.
3. Use economic data to test the hypothesis. Marsha’s group must obtain sales data from the
six Vermont ski shops and agree on the number of observations (including the number of
times a snowfall of at least four inches is observed) required to test the hypothesis.
4. Revise the model if it fails to explain the economic data well. Suggest an alternative model.
The model could fail if large numbers of skiers and snowboard owners buy their equipment
prior to the months that The Ski Chalet is open, or if large numbers rent, rather than
purchase, their equipment. One alternative model would compare the sales of lift tickets
or rental equipment in weeks following snowfalls of four or more inches and other weeks
during the time The Ski Chalet is open.
5. Retain the revised model to help answer similar economic questions in the future. If the
data support the model, one can assume that there is a relationship between snowfalls and
equipment sales. Tests of the model with data from different time periods or in different
locations could either support or refute these results. Acceptance of a model is always
tentative pending the acquisition of new data or additional statistical analysis.
1.4 Microeconomics and Macroeconomics (page 15-16)
Learning Objective: Distinguish between microeconomics and macroeconomics.
Microeconomics is the study of how households and firms make choices, how they interact in markets,
and how the government attempts to influence their choices.

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12 CHAPTER 1 | Economics: Foundations and Models
Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment,
and economic growth.
Extra Solved Problem 1.4
Microeconomic and Macroeconomic Views
Sports fans are used to watching events on television from different camera angles. For popular events such
as the Olympics, the World Series, and the Super Bowl, network coverage captures action from ground
level as well as higher locations. Blimps are frequently flown above the stadiums and ballparks where the
events take place. The aerial view of the blimp’s camera is visually appealing but is never broadcast for
very long because the athletes are barely visible. Coverage of games includes a view from a mobile or
“sideline” camera that can zoom in on individual players or fans sitting in the stands, a degree of detail
much greater than that provided by the aerial view.
How do the different camera angles help to explain the difference between microeconomics and
macroeconomics?
Solving the Problem
Step 1: Review the chapter material.
The problem concerns the differences between microeconomics and macroeconomics, so you
may want to review the section “Microeconomics and Macroeconomics” in the textbook.
Step 2: Compare the focus of microeconomics with television coverage of a sports event.
Microeconomics focuses on how individual households and firms make choices, how they
interact in markets, and how the government attempts to influence their choices. This focus is
similar to that of a sideline camera at a football game.
Step 3: Compare the focus of macroeconomics with the television coverage of a sports event.
Macroeconomics is the study of the economy as a whole, including topics such as inflation,
unemployment, and economic growth. Macroeconomics does not study the decisions made by
individuals but the consequences of actions taken by all decision makers in an economy. This
is similar to the blimp’s aerial view of the venue where a sports event occurs. One can see the
entire venue, but the blimp’s point of view is too far away to see any individual player or fan.
Extra Analyze
the Concept Macroeconomic and Microeconomic Analysis
Economists separate the study of how households and firms make choices and interact in markets
(microeconomics) from the study of the economy as a whole (macroeconomics). But some issues can be
viewed from both perspectives. Labor productivity is one such issue.
Labor productivity—the quantity of goods and services that can be produced by one worker or by one hour
of work—is a microeconomic topic. Labor productivity increases when a firm invests in capital or
experiences an improvement in technology. Increased labor productivity allows a firm to earn higher profits

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CHAPTER 1 | Economics: Foundations and Models 13
and pay its workers higher wages. But macroeconomists also study labor productivity because it determines
the standard of living a country can achieve for its citizens. An increase in productivity is beneficial in the
long run, but it can slow the growth of jobs in the short run. Following the recessions of 2001 and 2007–
2009, many economists were concerned that the unemployment rate did not decrease as quickly as it did
following previous recessions. One reason for this was an increase in productivity. The Bureau of Labor
Statistics reported that output per hour worked of all persons rose by over 3 percent in both 2009 and 2010.
Because workers were more productive, firms did not have to hire new workers to produce the same amount
of goods and services. Productivity growth slowed to about 1 percent or less from 2011 to 2014.
Some economists attribute the slowdown in productivity growth to a decline in investments in research by
U.S. firms from the high levels reached after 1995, which resulted in advancements in computer-related
applications. Other economists claim that many recent improvements in productivity escape measurement.
Google Inc.’s chief economist Hal Varian has argued that many innovations—such as apps that can be used
via cell phones to track locations or hailing taxis—lead to improvements in productivity “But I doubt that
gets measured anywhere.”
Sources: Department of Labor (Bureau of Labor Statistics); and Timothy Aeppel, “Silicon Valley Doesn’t Believe U.S. Productivity
Is Down,” Wall Street Journal, July 16, 2015.
1.5
Economic Skills and Economics as a Career (pages 16–17)
Learning Objective: Describe economics as a career and the key skills you can gain from
studying economics.
Economists describe how individuals, businesses and governments make choices and analyze the results of
these choices. Many businesses, government agencies and non-profit organizations hire economists.
Students who consider whether to pursue a career in economics may seek an internship with a firm or
agency that employs economists.
1.6 A Preview of Important Economic Terms (pages 17–19)
Learning Objective: Define important economic terms.
This section provides a brief definition and preview of terms students will see throughout the book: firm
(company, or business), entrepreneur, innovation, technology, goods, services, revenue, profit, household,
factors of production (economic resources or inputs), capital, and human capital.
Extra Economics in Your Life and Career:
Is Cheating a Rational Decision?
In their best-selling book Freakonomics, Steven D. Levitt and Stephen J. Dubner stated: “Who cheats?
Well, just about anyone, if the stakes are right…Cheating…is a prominent feature in just about every human
endeavor.” Evidence that some people cheat surfaced in the summer of 2011 when the superintendent of
the board of the Atlanta school district resigned after a report documented widespread cheating on
standardized tests that implicated officials from about 80 percent of Atlanta’s elementary and middle
schools. In 2015, an Atlanta jury convicted 11 teachers as a result of the cheating scandal.
Steven Levitt and other economists assume that decision-makers—students and non-students alike—are
rational. They compare the benefits and costs of their options and make choices for which the expected
benefits exceed the expected costs. The benefits of (successful) cheating may be monetary; for example,

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14 CHAPTER 1 | Economics: Foundations and Models
K-12 teachers in some states are eligible for bonus payments of up to $25,000 if their students perform well
on standardized tests. New technology has made it easier for high school and college students to cheat. The
widespread use of cell phones and Internet access makes it easier (less costly) to share exam answers and
buy term papers.
Sources: Steven D. Levitt and Stephen J. Dubner, Freakonomics New York: HarperCollins 2005, pages 24–25; Patrik Jonsson,
“America’s biggest teacher and principal cheating scandal unfolds in Atlanta,” Christian Science Monitor, July 5, 2011; Mary Beth
McCauley, “Atlanta school cheating: When teachers cheat, what do you tell the kids?” Christian Science Monitor, September 5,
2013; and Valerie Strauss, “How and Why Convicted Teachers Cheated on Standardized Tests,” Washington Post, April 1, 2015.
Question: For the sake of argument, let’s assume that you would never cheat. Under what circumstances
are students in general more or less likely to cheat on an economics examination?
Answer: Your economics instructor will be pleased if you would never cheat under any circumstances. But
cheating is more likely when: (a) the positive consequences of receiving a high grade are significant (for
example, a high grade is necessary to maintain a scholarship, gain admittance to medical school, or get a
good job offer), and/or (b) the probability of getting caught is low (the instructor gives the same multiple-
choice exam to all students in a large classroom with no supervision). Reducing the benefit and increasing
the cost of getting caught will reduce the incidence of cheating. If appeals to personal integrity are not
enough to convince students not to cheat, a more effective deterrent may be for potential employers to let
students know that they fire dishonest employees.
Appendix
Using Graphs and Formulas (pages 27–39)
Learning Objective: Use graphs and formulas to analyze economic situations.
Graphs simplify economic ideas and make the ideas more concrete so they can be applied to real-world
problems.
Graphs of One Variable
Figure 1A.1 in the textbook displays examples of two common types of graphs: bar graphs and pie charts.
The height of the bars in the bar graph represents the market shares of automobile firms. The pie chart
shows the same information with the market shares of each group of firms represented by the size of its
slice of the pie. Information on economic variables can also be displayed in time-series graphs. These graphs
are displayed on a coordinate grid. The vertical axis (y-axis) of a coordinate grid measures the value of one
variable. The point where the vertical axis intersects the horizontal axis is the origin. The horizontal axis of
a coordinate grid measures the value of another variable. The points in a coordinate grid represent the values
of the two variables. Figure 1A.2 illustrates examples of time-series graphs.
Graphs of Two Variables
We often use graphs to show the relationship between two variables. Figure 1A.3 illustrates the graph of a
linear or straight-line demand curve where price is measured along the vertical axis and quantity is measured
along the horizontal axis.
A. Slopes of Lines
The slope of a straight line indicates how much the variable measured along the y-axis changes as the
variable measured along the x-axis changes. Slope can be measured between any two points on the line
because the slope of a straight line has a constant value. The slope can be expressed as the change in the

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CHAPTER 1 | Economics: Foundations and Models 15
value measured on the vertical axis divided by the change in the value measured on the horizontal axis;
slope can also be expressed using the Greek letter delta (Δ) to stand for the change in a variable (slope =
Δy/Δx). The slope is also referred to as the rise divided by the run.
Taking into Account More Than Two Variables on a Graph
The demand curve in Figure 1A.4 shows the relationship between the price of pizza and the quantity of
pizza sold, but the quantity of any good sold depends on more than just the price of the good. Allowing
other variables to change will cause the position of the demand curve in the graph to change. The table in
Figure 1A.5 shows the effect of a change in the price of hamburgers on the quantity of pizza demanded. By
shifting the demand curve, we take into account the effect of changes in a third variable.
A. Positive and Negative Relationships
Sometimes the relationship between two variables is negative, as in the case with the price of pizza and the
quantity of pizza demanded. The relationship between two variables can be positive, as in Figure 1A.6
which shows values for disposable personal income and consumption spending in the United States for
2015–2018.
B. Determining Cause and Effect
Inferring cause and effect relationships by observing graphs can lead to incorrect conclusions. One reason
for this is that there may be an omitted variable that is not accounted for in the graph. A related problem in
determining cause and effect is reverse causality; this occurs when we conclude that changes in variable X
cause changes in variable Y, when changes in variable Y cause changes in variable X.
C. Are Graphs of Economic Relationships Always Straight Lines?
The relationship between two variables is linear when it can be represented by a straight line. Few economic
relationships are actually linear. However, it is often useful to approximate a nonlinear relationship with a
linear relationship.
D. Slopes of Nonlinear Curves
To measure the slope of a nonlinear curve at a particular point we must measure the slope of a tangent to
the curve at that point. A tangent line touches the curve at only one point. The slope of a tangent is measured
in the same way as the slope of any straight line.
Formulas
A. Formula for a Percentage Change
The formula for a percentage change between two variables for any two periods is:
Percentage change
B. Formulas for the Areas of a Rectangle and a Triangle
The formula for the area of a rectangle is Base × Height. The formula for the area of a triangle is
½ × Base × Height.

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16 CHAPTER 1 | Economics: Foundations and Models
C. Summary of Using Formulas
Follow these steps when using a formula:
1. Make sure you understand the economic concept the formula represents.
2. Make sure you are using the correct formula for the problem you are solving.
3. Make sure the number you calculate using the formula is economically reasonable.
Teaching Tips
You can assign the appendix as “on your own” reading. But don’t assume students will understand the
formulas for computing a slope or a percentage change. Reviewing these formulas in class will be time well
spent, either at this point in the course or when these formulas are first applied. In particular, students will
need to use graphs of two variables and percentage changes often throughout the remainder of the text.
Solutions to End-of-Chapter Exercises
Answers to Thinking Critically Questions
1. A tariff is a tax on imports. When a 25 percent tariff is imposed on imports from China, U.S. firms that
import goods from China must pay the U.S. government an amount equal to 25 percent of the price of
the imported goods. These U.S. firms will likely have to increase the price they sell the imported
Chinese-made goods for, which will reduce the sales of the goods in the United States. If these products
were manufactured in the United States, then, of course there would be no tariff. The imposition of the
tariff would therefore become an economic incentive for U.S. companies to return manufacturing jobs
from China to the United States. For some firms, the incentive might not be enough to offset other cost
advantages from producing goods in China.
2. Positive analysis is concerned with what is, while normative analysis is concerned with what ought to
be. Positive economic analysis of the statement could show (1) whether the tariffs are actually
increasing the number of manufacturing jobs in the United States or whether other factors are also
responsible for some of the job creation, and (2) whether increasing the tariffs would likely continue to
increase the number of manufacturing jobs and whether those increases would cause other job losses
(for example, if the tariffs resulted in a company like Apple having to charge higher prices for
smartphones and therefore hire fewer workers in the United States). In other words, the tariffs could
result in both winners and losers in terms of domestic employment.
Should the gains to the winners from increasing tariffs be valued more than the losses to the losers?
The answer to this question involves normative analysis. Positive analysis can show the consequences
of a particular policy such as implementing tariffs, but positive analysis cannot determine whether such
a policy is a “good” or “bad” idea. Whether you agree or disagree with the statement, you are making
a value judgment or a normative statement rather than drawing a conclusion from positive analysis.

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CHAPTER 1 | Economics: Foundations and Models 17
1.1
Three Key Economic Ideas
Learning Objective: Explain these three key economic ideas: People are rational, people
respond to economic incentives, and optimal decisions are made at the margin.
Review Questions
1.1 “People are rational” is the assumption that decision makers explicitly or implicitly weigh the
benefits and costs of each action and then choose an action only if the benefits are expected to
outweigh the costs. “People respond to economic incentives” by changing their behavior in
response to an economic incentive. For example, if the federal government begins to tax firms an
amount equal to government benefits their low-wage employees receive, firms are likely to hire
fewer low-wage workers. “Optimal decisions are made at the margin” means that most decisions
are not “all or nothing,” but involve doing a little more or a little less of an activity. Therefore, the
optimal decision is to continue any activity up to the point where the marginal benefit equals the
marginal cost.
1.2 Scarcity is the situation in which unlimited wants exceed the limited resources available to fulfill
those wants. Economics is the study of the choices consumers, business managers, and government
officials make to attain their goals. Scarcity is central to economics because scarcity requires people
to make choices about how to use their resources to best fulfill their wants. In making choices, we
must give up other opportunities that we value. What we give up (our second-best choice) is called
the opportunity cost of our choice.
Problems and Applications
1.3 Economists assume that people are rational in the sense that they use all available information as
they act to achieve their goals. Rational individuals weigh the benefits and costs of each action, and
they choose an action only if the benefits outweigh the costs. Economists do not assume everyone
is a genius or always makes the “right” decision in every circumstance; rather, economists assume
that the actions of consumers and businesses reflect their attempts to achieve their goals.
1.4 We need information on the losses the typical bank suffers from a robbery and the cost of installing
a bandit barrier or taking other actions, such as hiring a guard, to deter a robbery. The cost of
installing a bandit barrier would include the cost of potentially losing customers who find bandit
barriers off-putting. The fact that not many banks install bandit barriers indicates that these banks
have found that the marginal cost of adding the additional security is greater than the expected
marginal benefit from reducing the expected number of robberies.
1.5 a. Students face a scarcity of time, like everyone else, and respond to the incentives of the
teacher’s grading system. Students have more incentive to put their efforts into the parts of the
course that have the most weight in the grading system.
b. If teachers put too little weight in the grading scale on outside readings, or similar assignments,
students will have little incentive to read and master the material. Students will put less effort
into the parts of the course that have little effect on their grades.
c. Quizzes on assigned readings would give students an incentive to come to class having read
the upcoming material. Some teachers give preparation assignments where students have to
read and answer questions about the upcoming material, and over the course of the semester
students have to successfully complete a certain percentage of the preparation assignments to
qualify for an A, B, or other grade in the course.

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18 CHAPTER 1 | Economics: Foundations and Models
1.6 a. As a result of changes in the federal student loan programs the total amount students borrow
should increase. The changes increase the incentive students have to borrow money under the
programs because they limit the amount of the loans that must be repaid.
b. If in 2016 President Obama was recommending further changes to the student loan program,
then it’s likely that the 2011 changes to the program had results that were not expected. The
most likely unexpected result is that because the 2011 changes required students to pay back
less, students were borrowing more money than the president and his advisers had anticipated.
So, in 2016, it’s likely that President Obama recommended changes that would increase the
loan repayments borrowers would have to make.
c. President Obama and his advisers may have failed to take into account that the 2011 changes
to the program changed the incentives students faced. Because the incentive to increase the
amount borrowed increased, President Obama and his advisers underestimated the increase in
the amount the federal government would have to pay in loan subsidies.
1.7 a. Employees who have health problems incur higher medical costs than healthier employees.
The higher medical costs increase the health insurance premiums that firms must pay
for employer-provided health insurance, which raises the firms’ costs. These higher costs
provide an incentive for universities and corporations to encourage employees to improve and
maintain their health.
b. Health insurance decreases the incentive of employees to improve or maintain their health,
because employees with health insurance do not pay the full cost of their medical bills.
c. A wellness program, if successful, would decrease the premiums that an insurance company
would charge. Healthier employees would have fewer health problems that would be covered
by a university’s or a corporation’s insurance plan.
1.8 a. As stated in the text, under the act, firms whose employees received assistance from
government benefits, including Medicaid and the Supplemental Nutrition Assistance Program
(SNAP), would be required to pay a tax equal to cost of the assistance.
b. Firms that might otherwise have hired a low-wage worker may now be reluctant to do so
because the firms could be liable for paying the tax. In effect, the act would raise the cost of
employing low-income workers who receive government benefits.
c. The sponsors of the legislation may have hoped that firms would raise the wages of low-income
workers, which would make it unnecessary for these workers to apply for government benefits.
The sponsors may also have intended to call attention to the low wages being paid to some
workers and may not have expected that the act would actually become law.
1.9 By “incremental revenue” and “incremental cost,” the author means marginal revenue and marginal
cost. “Incremental” means the same thing as “marginal.” The USPS’s total cost includes such
things as the cost of purchasing delivery trucks and the cost of maintaining post office buildings
and warehouses that are not affected by the number of packages that the USPS delivers. In
determining whether delivering packages for Amazon will increase its overall profit or reduce its
overall loss, the USPS should look only at the marginal (or incremental or additional) revenue and
marginal cost of delivering packages for Amazon. If the marginal revenue exceeds the marginal
cost, the USPS’s profit will increase (or its loss will decrease). If the marginal cost exceeds the
marginal revenue, the USPS’s profit will decrease (or its loss will increase).
1.10 Your friend is failing to think at the margin. It doesn’t matter how much time your friend has
already spent studying psychology. What matters is the marginal benefit to be received from

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CHAPTER 1 | Economics: Foundations and Models 19
studying psychology relative to the marginal cost, where cost is the opportunity cost of lower grades
in other subjects. If the course is required, that may raise the marginal benefit.
1.11 A complete explanation for the connection between majoring in economics and success in business
would involve many factors. But we can say that economics teaches us how to look at the trade-
offs involved in every decision we make. Those who do not make decisions by weighing the costs
of an action against its benefits are unlikely to make good decisions. Climbing the corporate or
governmental ladder requires making a wider and wider array of decisions.
1.2
The Economic Problem That Every Society Must Solve
Learning Objective: Discuss how an economy answers these questions: What goods and
services will be produced? How will the goods and services be produced? Who will receive
the goods and services produced?
Review Questions
2.1 Scarcity implies that every society and every individual faces trade-offs because wants are
unlimited but the ability to satisfy those wants is limited. Societies and individuals cannot have
everything they want, so they have to make choices of what to have and what not to have.
2.2 The three economic questions that every society must answer are (1) What goods and services will
be produced? (2) How will the goods and services be produced? (3) Who will receive the goods
and services produced? In a centrally planned economy, the government makes most of these
decisions. In a pure market economy, almost all of these decisions are made by the decentralized
interaction of households and firms in markets. In a mixed economy, most economic decisions
result from the interaction of buyers and sellers in markets, but government may play a significant
role in the allocation of resources.
2.3 Productive efficiency occurs when a good or service is produced at the lowest possible cost.
Allocative efficiency means that what is produced reflects consumer preferences—every good or
service is produced up to the point at which the last unit provides a marginal benefit to consumers
equal to the marginal cost of producing it.
2.4 Efficiency is concerned with producing the goods and services that people want at the lowest cost.
Equity is “fairness,” a concept that can differ from person to person. Government policymakers
often want to make economic outcomes “fairer,” but doing so usually involves redistributing
income from one group to another. Redistributing income often (but not always) hampers efficiency
because it reduces incentives to produce and drives up production costs.
Problems and Applications
2.5 Yes, even Jeff Bezos faces scarcity because his wants exceed his resources. Bezos has established
a foundation to help homeless families and to establish pre-schools in low-income areas. There are
an unlimited number of other worthy causes that Bezos could fund, so even he faces scarcity.
Further, even Bezos has only 24 hours in a day, so he must make choices about how to spend his
scarce time. Everyone faces scarcity because human desires are virtually unlimited. Your resources
are limited, so the only way not to face scarcity would be to reduce your wants to be no greater
than your resources—not something that most people are capable of doing!
2.6 Spending resources in a way that helps only one poor person is likely to be an ineffective way of
helping poor people. How many poor people could be helped by using another method of helping

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20 CHAPTER 1 | Economics: Foundations and Models
the poor? The opportunity cost of using one method is the number of poor people that could be
helped by using the best available alternative method.
2.7 Although many factors that affect the opportunity cost of attending college football games have
changed over time, some of the most significant changes during the past decade involve technology.
For example, more games are televised, games can be viewed online with enhanced features, and
alternative sources of entertainment, such as streaming television shows and movies or interacting
with friends on social media, have also become available. These changes increase the opportunity
cost of watching football games in person and help to explain the decline in attendance over time.
2.8 Allocative efficiency occurs when production is in accordance with consumer preferences.
Productive efficiency occurs when a good or service is produced at the lowest possible cost. Profit
is the incentive for a firm in a market economy to be allocatively efficient and productively
efficient. If a firm is not allocatively efficient and productively efficient, then it will eventually
suffer losses and go out of business.
2.9 Productive efficiency refers to a situation in which a good or service is produced at the lowest
possible cost. Allocative efficiency is a state in which production is in accordance with consumer
preferences: Every good or service is produced up to the point where the last unit provides a
marginal benefit to society equal to the marginal cost of producing it. The test that Alberto Chong
and his colleagues carried out was not designed to measure how much it would cost to send and
return letters in various countries, but how often–and how quickly–the letters sent were returned.
Each envelope mailed contained one page to limit the possibility that curious postal employees
would be tempted to open the envelope to steal the contents. Written on each envelope was a request
to “please return to sender if undeliverable.” Therefore, it was likely that the letter would either be
returned or discarded. Because the experiment was testing which postal services were best at
properly handling consumers’ letters, it is better viewed as an evaluation of allocative efficiency
rather than productive efficiency.
2.10 Although the federal government’s Food and Drug Administration (FDA) must approve a drug or
medical device before it is offered for sale, privately owned firms produce and sell these products.
It would be more accurate to view markets for drugs and medical devices as characteristic of a
mixed economy: an economy in which most economic decisions result from the interaction of
buyers and sellers in markets but one in which the government plays a significant role in the
allocation of resources.
2.11 As discussed in the chapter, equity, or the fair distribution of benefits, can be difficult to define.
For some people, equity means a more equal distribution of income than would result from an
emphasis on efficiency alone. Raising taxes on people with higher incomes to provide the funds
for programs that aid the poor might increase equity, but may reduce the economic incentive to
work hard, start new businesses, and save. Reducing these activities will reduce economic
efficiency, which illustrates the trade-off between equality and efficiency. An economist can write
an entire book on the subject because equality can be difficult to define and because it can be
difficult to measure the extent to which efforts to promote equality can reduce efficiency. The trade-
off involves complicated normative and positive issues.
2.12 If all of an economic system’s resources were devoted to providing health care, there would be
other important goods and services, such as food, housing, clothing, and education that the
economy could not provide. An economic system that provided its citizens with state-of-the-art
health care but so little food that most were on the verge of starvation, no housing so that many
were sleeping in streets and fields, and no schooling so most people were illiterate, would generally
be regarded as inefficient and treating the population unfairly by depriving them of such important
goods and services. A market economy restricts access to health care, just as it restricts access to

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CHAPTER 1 | Economics: Foundations and Models 21
all goods and services, by charging a price at which less than an unlimited quantity of health care
is demanded.
2.13 a. The groups of students most likely to get the tickets will be those for whom the expected
marginal benefit of going to the athletic department office on Monday morning is greater than
the expected marginal cost. These would include students who have a relatively low
opportunity cost of their time, such as those who have no Monday morning classes. Other
students who are likely to stand in line are those who would have a large benefit from having
the tickets: Those who love football and those who hope to sell their tickets (“scalpers”).
b. The major opportunity cost of distributing the tickets this way is the cost to those students who
attempt to get the tickets, such as: The activities the students can’t do while standing in line,
and the costs to students who stand in line but find that all the tickets are sold before their turn
comes. There’s also the cost of the lost revenue to the college from giving away the tickets
instead of selling them.
c. This isn’t an efficient way to distribute the tickets because of the high cost in wasted time. It
would be more efficient to sell the tickets to those willing to pay the highest prices
d. Equity is hard to define. Some people will see this way of distributing tickets as equitable
because students with low incomes can still get tickets, provided they are willing to pay the
opportunity cost of waiting in line. Some people will see this way of distributing the tickets as
equitable because only those with the greatest desire to watch the game in person will put up
with the hassle of getting the tickets. Some people might argue that this system is equitable
because students are more deserving than nonstudent recipients of the tickets. Others may
disagree, saying that students with a strong desire to obtain the tickets, but who are unable to
be at the athletic department office at the designated time, would have no chance to get the
tickets. Still others could argue that the system was not equitable because this way of
distributing tickets generates no revenue for the athletic department, which could use the
revenue to cover some of the costs of administering the college’s athletic programs.
1.3
Economic Models
Learning Objective: Explain how economists use models to analyze economic events and
government policies.
Review Questions
3.1 Economists use models for the same reason that other scientists do—to make a complicated world
simple enough that problems can be understood and analyzed and questions can be accurately
answered. Useful models will generate testable predictions. If these predictions are consistent with
economic data, the model isn’t rejected and can be used to understand the economy. Testing models
with data can be very difficult, however, because the economy is always changing, and it is difficult
to conduct controlled economic experiments.
3.2 Economists can create a useful model by following these five steps: (1) decide the assumptions to
be used; (2) formulate a testable hypothesis; (3) use economic data to test the hypothesis;
(4) revise the model if it fails to explain the economic data well; and (5) retain the revised model
to help answer similar economic questions in the future.
3.3 Positive economic analysis is concerned with what is; that is, it deals with how the economy
actually behaves. Normative economic analysis is concerned with what ought to be. Economics is

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22 CHAPTER 1 | Economics: Foundations and Models
mainly concerned with positive analysis—conceptualizing and measuring the costs and benefits of
different courses of action. Decision makers, including voters and government officials, can use
the trade-offs and costs and benefits identified by positive economic analysis to normatively decide
what course of action they should take.
Problems and Applications
3.4 The economist should revise the model in light of its failure to explain or predict real world events.
3.5 The problem with Dr. Strangelove’s theory is that it cannot be tested unless we can devise a way
to measure the emission of these subatomic particles, which is impossible because such testing
methods don’t exist. Because we cannot test the model’s predictions, we have no way of knowing
if the theory might be true; therefore, the theory is not very useful.
3.6 a. This statement represents positive analysis, analysis concerned with “what is.” Positive
analysis would use an economic model to measure the effect a tax on cigarettes has on
teenagers’ purchases of cigarettes.
b. This statement represents normative analysis, analysis concerned with “what ought to be.”
Whether the federal government should or should not spend more on research to reduce opioid
addiction cannot be determined based on positive analysis alone, but requires a normative
judgment, or opinion.
c. This statement represents positive analysis. This statement can be tested to determine whether
it is correct.
d. This statement represents normative analysis because it is an opinion or belief that the price of
Starbucks coffee is too high.
3.7 Lowery is making a normative judgment regarding the policy: She believes that the federal
government should guarantee everyone financial security. Normative analysis concerns what one
person believes ought to be. You can agree or disagree with her opinion depending on your own
views of the issue. There is no way to demonstrate that Lowery’s opinion is correct.
3.8 To evaluate the positive elements of this debate, it would be useful to have statistics on the effect
similar import tariffs on other goods have had on sales of those imported goods and on employment
in import-competing firms. It would also be useful to have forecasts of the likely effect a tariff
imposed on imports from China would have on the prices of those goods in the United States and
on employment in the U.S. industries that produce goods that compete with Chinese imports. Even
if this information were available, it is unlikely that the normative issues involved in the debate
would be resolved. People differ on how they evaluate the benefits of saving jobs in a domestic
industry that would be protected by tariffs relative to the cost of the higher prices domestic
consumers will have to pay because of the tariffs.
3.9 a. A tariff on imported steel will raise the prices of those imports making it likely that some U.S.
consumers of steel, such as U.S. automobile firms, will shift from buying imported steel to
buying domestically produced steel. In addition, domestic steel firms, like U.S. Steel, will be
able to raise prices, which will also likely increase their profits.
b. i. The tariff will hurt U.S. automobile firms because steel is an input in the production of
automobiles.

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