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Economics, Economic Methods, and Economic Policy
Learning Objectives
By the end of this chapter, you will be able to: • Define economics and recognize the value of studying economics. • Explain the relationship between scarcity and choice, and the role of opportunity costs. • Understand how the production possibilities curve is used to help understand an economic system. • Understand and follow the steps to proper policy analysis.

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Section 1.1 What Is Economics?

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Introduction

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onsider this. . . Why are some people rich and others poor? Why do doctors earn higher salaries than newspaper reporters? Why do Republican congressional representatives attack the economic policy proposals of the Democrats? Why do some companies make lots of profits, while others file for bankruptcy? Why is welfare only temporary? And perhaps most importantly, why can’t you have everything you want—now? These are all important personal, societal, and even global issues. Economics can help you understand the answers to these and many other questions. By the time you finish this chapter, you will have some idea about the way economists address these questions, and by the time you finish this textbook, you will be able to develop answers of your own.

1.1 What Is Economics?

conomics is the study of how people, individually and through institutions, make decisions about producing and consuming goods and services and how they face the problem of scarcity. Scarcity, or the inability to satisfy everyone’s wants, is a fundamental economic problem in a world with limited resources. The study of economics is divided into microeconomics and macroeconomics. Microeconomics focuses on the choices made by individuals and businesses. It describes the interactions of producers and consumers in individual markets, such as the market for cars. It also examines interactions between such markets—for example, the impact of changes in the demand for steel on the price of aluminum. The study of the economy as a whole is called macroeconomics. Macroeconomics is concerned with the aggregate or total effect, determined by adding across many markets. Macroeconomics studies the behavior of variables that describe the whole economy, such as the value of the total output that the economy produces in a given time period (which is called gross domestic product, or GDP). Macroeconomics also examines the behavior of such aggregates as the price level and unemployment. In microeconomics, the most important tools are demand and supply. Demand and supply help to explain prices and outputs in individual markets. These tools also explain the relationship between prices and outputs in different markets. In microeconomics, you may look

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The study of microeconomics focuses on a micro level while the study of macroeconomics focuses on the aggregate level. An analogy can be made to studying flowers: Consider the analysis of all the components of a single flower versus the analysis of the combined impact of all the flowers in a garden together.

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at the demand for the output of a single industry, such as bicycle manufacturing. In macroeconomics, you look at the level of prices and output for the economy as a whole, using aggregate demand and aggregate supply as the main tools. Even though microeconomics and macroeconomics are often studied separately, they are closely related. Economics is a social science. This classification makes economics an academic relative of political science, sociology, psychology, and anthropology. All of these fields look at the behavior of human beings, both individually and in groups. They study different subsets of the actions and interactions of human beings. (For this reason, they are also sometimes termed behavioral sciences.) Economics focuses on the consumption, production, and use of scarce resources by individuals and groups. It is also concerned with the processes by which households and firms make decisions about the use of scarce resources. This definition of economics leads to some overlap with the other social sciences; psychologists and economists share an interest in what leads people to take certain actions. However, economists are primarily interested in actions that are reflected in market activity or in economic decisions made through government. Sociologists are interested in all facets of organized human activity, whereas economists are interested mainly in organized activities that relate to the production and consumption of goods and services.

Check Point: Microeconomics Versus Macroeconomics
• • • • Microeconomics focuses on the choices made by individuals and businesses. The primary tools of microeconomics are demand and supply. Macroeconomics is the study of the economy as a whole. The primary tools of macroeconomics are aggregate demand and aggregate supply.

Economics in Action: What Is Economics?
Economics is not just the study of finance; in fact, economics is another form of social studies. Economics studies people’s desires in a world of limited resources. Find out more with Dr. Mary J. McGlasson’s video at http://www.youtube.com/watch?v=yoVc_S_gd_0.

Why Study Economics?
Economics is a required course for many different majors. You may be wondering why this is so. One reason is that economics interacts with almost all other academic subjects. It affects and is affected by current events. Also, it has a major effect on politics, both domestic and international. A second reason for studying economics is the impact that economic ideas and theories have on world leaders. Much of what political decision makers do is based on economic theory. As John Maynard Keynes, an economist who has had great influence on macroeconomic policy in this century, wrote:

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The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. (Keynes, 1936, p. 383) Keynes was saying that if you want to understand what politicians, great or mad, are trying to do, you must understand the economic theories upon which their actions are based. A third reason for studying economics is that it provides a better understanding of how society functions. Economic theory is very useful in understanding behavior because it allows the development of models with predictive power. As Alfred Marshall, another influential economist, wrote, “Economics is the study of mankind in the ordinary business of life” (1890, p. 323). Finally, economics is incredibly useful. People who are trained in economics find rewarding jobs and careers. If you like to think in a logical fashion, you will enjoy studying economics.

Global Outlook: The Internationalization of Studying Economics
This box, Global Outlook, represents a feature that you will find throughout the book. In Global Outlook boxes, we will examine how an institution, a culture, a product, a policy, or a way of doing business in another country differs from its counterpart in the United States. This chapter is devoted to concepts and ideas that are universal, because scarcity exists in all countries and in all times. Many of the examples in this book are drawn from experiences of people living in the United States. As you read Global Outlook boxes, you will see that some differences in the ways things are done in other countries can be explained by economic incentives. If you travel to Italy, you will be struck by the fact that houses have significantly fewer closets than comparable houses in the United States. Is this because Italians prefer fewer closets than U.S. Americans? What if we went into predominately Italian neighborhoods in New York? Would we find fewer closets in these neighborhoods than we would in an Asian neighborhood in New York? This is a ceteris paribus experiment. So the question is, all things being equal, do Italians prefer fewer closets than U.S. Americans? If we looked around in the United States, we would conclude that, at least in the United States, Italians don’t exhibit any different behavior in building homes with closets than other ethnic groups. We could then ask if Italians in the United States are different from Italians in Italy. This is something a psychologist might do. An economist would expect that there is some government policy driving these choices. The economist would, therefore, look deeper. What the economist would find is that the Italian government (in part) determines the property tax on a home on the basis of the number of closets it has. Therefore, if you do not build closets, but instead buy armoires (an armoire is a piece of furniture that is a stand-alone closet), you can avoid paying taxes—a better explanation than a difference in tastes! As you study economics and as you read these Global Outlook boxes, look for examples of your own. When you learn how to see these economic forces at work, you will be amazed at the analytical power of economic theory.

Section 1.2 Scarcity: Limited Resources, Unlimited Wants

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Check Point: The Direction of Microeconomics
The study of economics • interacts with almost all other academic subjects, • impacts ideas and theories of world leaders, and • is useful in understanding behavior.

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1.2 Scarcity: Limited Resources, Unlimited Wants

hether you are just taking one course or planning a career in economics, the most important single problem you will address is that of scarcity. That is, there are not enough resources to produce all the goods and services people would like to consume. The first tool we will develop is an economic model that is used to explain how any economic system deals with the basic problem of scarcity. Human wants and desires are vast, relative to the resources available to satisfy them. Thus, in every economic system there has to be some method for making choices among alternative actions.

Resources are whatever can be used to produce goods and services for human consumption. We live in a world of limited resources. Some resources, such as oil and coal, are converted to energy and used up in the course of production or consumption. Others are not used up in that sense but are virtually fixed in quantity, like land, diamonds, and copper. At any given time, even the quantity of resources created by people—roads, factories, machines, and skilled labor—cannot be changed quickly or cheaply. Limited resources conflict with unlimited wants. Human wants are said to be unlimited because no matter how much people have, they always want more of something. You may know people who seem perfectly content with what they have. If you questioned them carefully, however, you would probably find that they would like cleaner air, more time to play tennis or golf, or more shelters for the homeless. Since not all wants can be satisfied, individuals have to choose which ones to satisfy with limited available resources. In fact, every society is faced with the problem of scarcity and choice. An example of this is China’s onechild policy. Without scarcity, there would be no need to make choices about which desires or needs to satisfy—and thus no need to study economics.

iStockphoto/Thinkstock

Central planners say the one-child policy has spared China from the pressures of hundreds of millions of additional people.

Section 1.2 Scarcity: Limited Resources, Unlimited Wants

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Opportunity Cost
Every decision to produce or consume something means sacrificing the production or consumption of something else. Economists use the term opportunity cost to denote the full value of the best alternative that is given up, or forgone. For example, the cost of going to a football game includes the value of what is given up in order to attend. Part of the cost of attending the game is the price of the ticket; this price represents the other goods and services you could have purchased with that money instead. However, there is another important part of the cost. This second part is the most valuable alternative use of those 3 hours. The opportunity cost of attending the game consists of both the price of the ticket and the difference in your test grade that three more hours of studying would have produced. Even if the ticket were free, going to the game would still have an opportunity cost. Many people have problems grasping the concept of opportunity cost because they are used to thinking of cost only as the amount of money spent on an item or an activity. In economics, however, the concept of cost is much broader. It includes not only the dollar outlay (the other goods you could have purchased) but also the value of the next best alternative. These alternatives include time cost (the earnings or satisfaction you could have produced for yourself in some other activity) and other sacrifices you might have made. Sometimes it is difficult to place a dollar value on these other costs, but they still play an important role in economic decisions.

Some Applications of Opportunity Cost
Your everyday life provides many illustrations of the concept of opportunity cost. For example, what is the opportunity cost of attaining a college degree? It is not simply the dollar figure. Money spent on books and tuition is certainly one part of the opportunity cost; however, the expense of your room, meals, and clothing is not, because you would have incurred those costs even if you were not in college. Economists do not count them because they are not opportunity costs. One important opportunity cost is the income you could have earned during the years you spend in classes. For most students, that lost income will eventually be made up in higher future earnings. However, right now it is an opportunity cost that should be included. Even if you can earn only $10 an hour, if you have to cut your working hours by 20 hours a week during the 32 weeks a year you are in school, the lost earnings represent a cost of $6,400 a year. For some students, the opportunity cost of going to college is even higher. Suppose you are a talented athlete who could play professionally right after high school, as many baseball and tennis players do. Your college education may cost as much as $200,000 (or more) a year in lost earnings. After 2 or 3 years of college, many football and basketball players face this dilemma. Even if they are straight A students, the opportunity cost of completing a degree in terms of lost income is very high. It is not surprising that many of them choose to turn pro and postpone or abandon getting a degree.

Section 1.2 Scarcity: Limited Resources, Unlimited Wants

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Opportunity Cost and the Choice Curve
We can illustrate the concept of opportunity cost and its relationship to choice using a very simple example. Assume that you have $50 to spend and you have two choices: pizza and cola. Pizzas cost $10 each, and a 20-oz bottle of cola costs $2.50. To keep things simple, we assume that you wish to spend the whole $50. Figure 1.1 shows the various combinations of pizza and cola that you can buy with $50. If you spend the entire $50 on pizza, you can purchase five pizzas and no cola (Point P at the y-intercept). On the other hand, you can buy 20 bottles of cola and no pizza (as shown by Point R at the x-intercept). Other possibilities lie along the line that connects these two intercepts. The line represents all possible combinations of pizza and cola that total $50. It is easy to see that Points A and B represent attainable combinations, because both contain whole numbers of colas and pizzas (for example, Point A represents the combination of three pizzas and eight colas). Connecting all these points with a continuous line implies that you can purchase fractional units of cola and pizza. This is merely a convenient assumption.

Figure 1.1: Choice among alternatives
Pizzas 5 P

4 A

Unattainable Combinations

3

2 B

1

R 0 4 8 12 16 20 Cola (20 oz. bottles)

If a 20-oz bottle of cola costs $2.50 and a pizza costs $10, a person with $50 to spend has many attainable combinations of cola and pizza. The line PR represents the boundary between attainable and unattainable combinations. Along line PR, the opportunity cost of one pizza is four bottles of cola.

Of course, all combinations in the shaded area of Figure 1.1 are also attainable. However, these combinations would not exhaust your entire budget of $50. We have ruled out the possibility of saving part of the $50 because we are assuming only two alternative choices:

Section 1.3 Society’s Choices: The Production Possibilities Curve

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cola and pizza. Combinations above and to the right of the line are not attainable, because they cost more than $50. Figure 1.1 illustrates the array of choices and the concept of opportunity cost. The price of one pizza is the same as the price of four colas. The decision to purchase a pizza means the sacrifice of those colas that could have been purchased. Opportunity cost is measured by the slope of the choice line.

Check Point: Summarizing Opportunity Cost
• The opportunity cost of a decision is the full value of the best alternative that is given up or forgone. • The opportunity cost of consumption or production includes the cost in dollars and the value of the next best alternative. • Opportunity cost is measured by the slope of the choice line.

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1.3 Society’s Choices: The Production Possibilities Curve

rom the perspective of the economy as a whole, the choice is not how to spend income between alternative purchases but how to allocate available productive resources between alternative goods that could be produced. This problem is illustrated by a close relative of the choice curve in Figure 1.1. Society’s choice curve is called a production possibilities curve. This curve shows the various output combinations of two goods or groups of goods that can be produced in an economy with the available resources. This economic model is based on a few assumptions: 1. All of the economy’s productive resources are fully employed. This means that everyone who wants a job has one. Also, factories, land, and other resources are being used to full capacity. 2. There are only two goods (or types of goods) in the economy. 3. The resources used in production are interchangeable. One worker is the same as another, one machine can be substituted for another, and all land is equally useful for producing the two goods. 4. We are looking at the economy at a specific period of time (the short run). During this time period, both the quantity and quality of resources are fixed, and the technology does not change. Given these four assumptions, we can look at an example of a production possibilities curve. These assumptions allow us to consider a simplified model of an economic system. Table 1.1 shows combinations of levees and soybeans that an economy can produce. (Here, levees are used as an example of government-built infrastructure and soybeans represent food supplies.) Figure 1.2 plots the numbers of Table 1.1 on a graph. Line PR in Figure 1.2 is a production possibilities curve. It represents all the combinations of levees and soybeans that can be produced in this economy when the available resources are fully employed. In Figure 1.2, Points A and B represent two different combinations of levees and soybeans that lie on the production possibilities curve. They are both output combinations that can

Section 1.3 Society’s Choices: The Production Possibilities Curve

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be attained in this economy with the available resources. Point C is also attainable. Since it lies inside of line PR, however, production at Point C means that some resources are unemployed. There are points on line PR that have to be better than C because they represent either more levees, more soybeans, or more of both. The economy can do better—that is, can produce more. Therefore, the combination at Point C is inferior to all points on the production possibilities curve from P to R. Table 1.1: Production possibilities curve
Soybeans (tons) 20 16 12 8 4 0 Levees 0 1 2 3 4 5

Figure 1.2: Production possibilities curve
Levees 5 P

4

A Unattainable Combinations C B

3

2 Attainable Combinations 1 R 0 4 8 12 16 20 Soybeans (Tons)

A production possibilities curve shows combinations of two goods that can be produced in an economy, with fixed resources and technology. Points on the curve represent the full employment of resources.

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Line PR in Figure 1.2 can also be used to measure opportunity cost for the economy. It is a straight line; this fact implies that the opportunity cost of one product in terms of the other is constant. That is, the number of levees given up to get another ton of soybeans does not change along line PR. Each time the production of soybeans is increased by 1 ton, one quarter of a levee is sacrificed. The opportunity cost of one more ton of soybeans is one quarter of a levee. Conversely, the opportunity cost of one more levee is 4 tons of soybeans. Opportunity cost of one good in terms of another is constant along line PR in Figure 1.2 because we assume here that all resources are alike for production purposes. That is, any unit of resources is just as good as any other unit in producing either soybeans or levees. This assumption produces a straight-line production possibilities curve. After an economist has constructed a model, the next step is to go back and relax some of the assumptions to see what difference they make. Consider what happens when we drop the third assumption stated earlier—that productive resources are interchangeable. That is, we no longer assume that one unit of labor or land is just as productive as another for producing either good. Table 1.2 shows a different set of combinations of levees and soybeans that can be produced in this economy. These combinations are plotted on the graph in Figure 1.3. At Point A in Figure 1.3, output is 10 levees and 200 tons of soybeans. At Point B, output consists of more levees, 100, but fewer soybeans, only 100 tons. The production possibilities curve in Figure 1.3 is bowed, or curved, instead of being a straight line. This new shape reflects the change in the assumption that resources are alike. Here we are being more realistic and assuming that some resources are better suited to the production of levees and others to the production of soybeans. This change in assumptions produces a model that differs from the first one in what it implies about opportunity cost.

Increasing Opportunity Costs
If the economy is at Point A in Figure 1.3, we can get another 10 levees by shifting resources from soybean production to levee production. In moving from Point A to Point C, we must give up only a small amount of soybeans: 5 tons. But to move from Point B to Point D, producing another 10 levees requires a larger sacrifice of soybeans, 23 tons instead of 5. This curved production possibilities curve illustrates the very important principle of increasing opportunity cost. That is, the more levees that are already being produced, the larger the sacrifice of soybeans that is required to build additional levees. Table 1.2 shows that between Points A and C, 10 more levees cost 5 tons of soybeans. Between Points B and D, however, 10 more levees cost 23 tons of soybeans. Table 1.2: Hypothetical scenario of increasing opportunity cost
Soybeans (tons) 205 200 (Point A) 195 (Point C) 187 Levees 0

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25

10 20 30

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110

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Table 1.2: Hypothetical scenario of increasing opportunity cost (continued)
Soybeans (tons) 179 169 158 146 133 117 100 (Point B) 77 (Point D) 50 0 Levees 40 50 60 70 80 90

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223

100 110 120 130

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110

Figure 1.3: Production possibilities and increasing opportunity costs
Levees 130 110 100 P D B

20 10 0

E

C A R

77 100

195 200 205 Soybeans (Tons)

On this production possibilities curve, the opportunity cost of additional tons of soybeans increases as the economy becomes more specialized in soybeans: Producing each additional ton of soybeans requires a larger sacrifice of levees than before (increasing opportunity cost). If the economy is inside the production possibilities curve at some point, such as E, more of both goods could be produced.

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Increasing opportunity costs are frequently observed in wartime. As more war goods are demanded, civilian sacrifices increase. Initially, as military production expands, additional labor and other resources are used that are relatively more productive for making weapons, like missiles, and relatively less productive for producing other goods. As the switch to missiles continues, however, military production takes resources that are relatively less productive for making missiles, although they were highly productive for other purposes, such as making civilian goods or growing food—for instance, soybeans. Under wartime conditions like these, soybean production falls by larger and larger amounts because more resources are stripped away from soybeans for every extra missile produced. These resources are increasingly those best suited to producing soybeans and least adaptable to missile production.

Unemployment
The production possibilities curve can also illustrate unemployment and the effect of reducing it. Suppose the economy is at Point E in Figure 1.3. This point is inside the production possibilities curve because some workers, factories, land, and machines are unemployed. If the economy could move from Point E to Point C, it would be possible to have more soybeans (195 tons instead of 100) with no sacrifice of levees. Moving from Point E to Point B would mean producing the same amount of soybeans (100 tons) but more levees (100 instead of 20). Finally, at Point E more of both levees and soybeans could be produced. At Point E the opportunity cost of both soybeans and levees is zero, because none of either good has to be sacrificed to increase production of the other. From a macroeconomic perspective, unemployed resources are wasteful. They represent extra production that could be attained simply by putting them to work. The opportunity cost of the goods gained is zero. Thus, economists believe that full employment is an important goal. It is important not just for the individual who needs to work in order to earn income, but also for the aggregate economy. One of the main concerns of macroeconomics is explaining how an economy can find itself inside the production possibilities curve at a point such as E in Figure 1.3. How can an economic system avoid the idleness and waste of unemployed resources? If an economy finds itself at a point such as E, what policies can be implemented to get back on the production possibilities curve? These are important questions in the study of macroeconomics, and the production possibilities curve is a useful technique for identifying them.

Economic Growth
Another macroeconomic issue that can be illustrated by the production possibilities model is economic growth. If technology can improve or the quantity of resources can increase, then output can grow beyond the limits of the production possibilities curve. Better technology or more resources means a change in the fourth assumption stated earlier—that both resources and technology are fixed. As labor becomes more skilled and productive, and as producers acquire new machines and plants embodying the latest technology, the production possibilities curve shifts outward. An outward shift of a production possibilities curve is shown in Figure 1.4. If the economy is at Point A on PR, production consists of D1 tons of soybeans and C1 units of levees. With the shift of the curve to P1R1, it is possible to reach some point, such as Point B, that

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includes more of both soybeans (D2 tons) and levees (C2 units). Other possible combinations on the new production possibilities curve include the same amount of one good and more of the other (such as Point E or F) and less of one good and more of the other (such as Point H or J). No matter which combination is produced, the important thing about an outward shift of a production possibilities curve is that it increases the economy’s capacity to respond to human wants. Added resources, usually labor or capital, are sources of economic growth. New technology can also shift a production possibilities curve outward and account for economic growth. Invention, innovation, discovery of resources, and improvements in productivity all contribute to economic growth and allow us to produce and consume beyond Point A.

Figure 1.4: Shift of the production possibilities curve
Levees P1 P H E C2 C1 Attainable Region B F A J

0

D1 D2 R

R1

Soybeans (Tons)

An outward shift of the production possibilities curve from PR to P1R1 means that the economy can produce more of both soybeans and levees (economic growth).

Check Point: The Production Possibilities Curve
The production possibilities curve shows • • • • attainable combinations (points on the curve), opportunity cost (the slope of the curve), unemployment of resources (points below or inside the curve), and economic growth (a shift of the curve outward).

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Ceteris Paribus
Unlike physical scientists, social scientists rarely have the chance to conduct controlled experiments to validate their models. Thus, economists most often test hypotheses by looking at actual experiences in markets. Such experiments are often referred to by economists as ceteris paribus experiments. Ceteris paribus is a Latin phrase that means “all else being equal.” An economist changes one variable in a theoretical model (for example, the technology for producing levees in the production possibilities model). The economist then predicts what would happen ceteris paribus, or if everything else remained constant. The ceteris paribus assumption is the most common and most important assumption in economic models. If the technology of soybean production improved but there was no change in the technology of producing levees, the production possibilities curve would shift out, as from PR to PR1 in Figure 1.5. The economist would predict an increase in output of both commodities, but a relatively larger increase in the output of soybeans. The economist must then untangle the effects of the change in soybean technology on the mix of output (levees and soybeans) from anything else that changed in the real world in the time period when this model was being tested.

Figure 1.5: Technological change and the production possibilities curve
Levees

P

0

R

R1

Soybeans (Tons)

A change in the technology of producing soybeans shifts the production possibilities curve from PR to PR1. This shows that if all resources were devoted to soybeans, more could be produced. If all resources were devoted to levees, however, no increase in output could occur. Depending on the starting point, increases in both are also possible.

Section 1.4 Basic Elements of the Economic Approach

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In addition to the ceteris paribus assumption, one other assumption is a basic part of most economic models. This assumption is that most people behave in a self-interested way. In general, self-interested behavior consists of people trying to get the most of something they want (to maximize some goal) out of available resources. For consumers, self-interested behavior means maximizing their satisfaction. For owners of productive resources, selfinterest is expressed by seeking to maximize income. For business firms, self-interest means maximizing profits. In the production possibilities model, self-interested behavior will direct the decision as to which combination to produce out of all possible combinations. That combination is the one that maximizes the welfare or satisfaction of consumers. The self-interest assumption has given economics, and economists, a good deal of undeserved bad press. This has occurred because self-interest is often confused with selfishness. Critics of market economies argue that encouraging and rewarding self-interested behavior is a basic flaw in such systems. In fact, concern for others and for the community as a whole is not incompatible with self-interest, because individuals define their own self-interest in terms of what is satisfying to them. Some individuals derive their greatest satisfaction from material possessions, others from leisure or enjoyment of the arts, and still others from helping people and building better communities. Some people may derive satisfaction from all of these! Then self-interested behavior is not inconsistent with volunteer work or charitable contributions. Such unselfish activities are not, by our definition, un-self-interested. This definition of self-interest is broad enough to cover the actions of Albert Schweitzer and Mother Teresa as well as the most unlovable of capitalists. When economists use the self-interest assumption in developing a theory, they are simply saying that they expect behavior to be influenced by costs and benefits. If the cost of a course of action declines or the benefits rise, relative to alternatives, more people will choose that course of action. For example, if the price of soybeans rises relative to that of corn, some farmers will switch production from corn to soybeans, attracted by the higher price. If salaries for public school teachers rise relative to those of accountants, more people are likely to prepare for a teaching career and fewer to study accounting. If the penalty for speeding falls, ceteris paribus, more people are likely to drive faster than the posted speed limit. If the cost of giving to charity rises because it is no longer tax deductible, less will be given to charity. Furthermore, economists do not use the concept of self-interest to predict any one person’s or one firm’s behavior, but rather to predict average or group behavior. Such predictions are similar to the use of attributes of certain groups by insurance companies to predict how often certain events will occur. Insurance companies develop norms for various groups— life expectancies, accident rates, or numbers of house fires—and use them to set prices for policies. These norms say nothing about how likely any particular member of a group is to live past the age of 80, run a car off the road, or have a house burn to the ground.

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1.4 Basic Elements of the Economic Approach his discussion of theories and models suggests that economics is much like other sciences in its methods. What is unique or different about the economic approach? There are a few emphases and ideas that help set economics apart.

Section 1.4 Basic Elements of the Economic Approach

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1. Like the natural sciences, economic theory is positive, or nonnormative. Positive statements are if-then propositions about what is. In contrast, normative statements describe what ought to be. In other words, economic theory strives to be scientific. However, when economists try to apply economic theory to policy questions, they often find it difficult to keep their work positive. Economic theory is value free, but appliers of the theory are often tempted to mix in their values in order to favor a preferred outcome or policy. It is a positive statement to say that production of more levees will require increasing sacrifices of soybeans. It is a normative statement to say that more levees and fewer soybeans should be produced. One easy way to separate the two is to look for words like should or ought to, which identify a normative statement. 2. Economic theory cannot predict the future. It can only explain the effects of certain events. Economic theory consists of statements of the if-A-then-B type. The prediction that B will occur depends on whether or not A happens. (Note that theory does not predict the occurrence of A; economists do not have a crystal ball.) In the production possibilities model, an increase in resources will result in economic growth, ceteris paribus. In this case, part of the ceteris paribus assumption is that the increased resources will be put to work and not left unemployed. There is, however, some difference between what economics is and what many economists actually do. Many economists, especially macroeconomists, spend a great deal of time forecasting future conditions. To do this, they make use of economic theory. In forecasting, an economist guesses the likelihood that A will occur and then uses economic theory to predict the occurrence of B. Sometimes, however, forecasts are wrong. This does not necessarily mean that the theory is incorrect: The forecaster may have been wrong in expecting A to occur. 3. Most economists look first to market processes for solutions to social problems. This market bias reflects a preference for the freedom and efficiency arising from decentralized processes. However, most economic theory is applicable to nonmarket systems as well, even though the legal and political institutions differ. Economists can apply tools developed for analyzing market economies to the workings of socialist economies and to a wide variety of nonmarket behavior. 4. Economists pay a great deal of attention to cost. The emphasis on opportunity cost, scarcity, and choice is fundamental to economics. Nobel Prize winner Milton Friedman underscored the importance of opportunity cost in this famous remark: “There is no such thing as a free lunch” (Kelso & Verjee, 1993). Focusing on the subject of cost often puts economists in conflict with policy makers. Environmentalists do not like to hear economists talk about the opportunity cost of environmental purity in terms of forgone output. College admissions officers seeking students do not like economists reminding students that the opportunity cost of a college education includes income not earned while in college. 5. Economists are very interested in chances to substitute among alternatives. Substitution and cost are closely related because the decision to substitute is based on the costs of the various alternatives. Sometimes substitutes are obvious, such as plastic for aluminum or electric heat for gas. Other substitutes are less apparent. A tree, for example, can substitute for gas or oil as heat, or for aluminum siding on houses. Trees can also substitute for air conditioning or awnings by providing shade. An important task of economic analysis is identifying alternatives that can serve as substitutes and evaluating the costs of substituting one for another. 6. Economists think in terms of marginal analysis. The marginal approach means looking at the effects on other variables of small increases or decreases in one

Section 1.4 Basic Elements of the Economic Approach

CHAPTER 1

important variable. Should we produce one more levee? If we do, what will be the (marginal) cost in terms of soybeans not produced? Most decisions in economics are not all-or-nothing choices but are made at the margin. Decisions about how to spend the next hour, whether to eat another slice of pizza, and whether to hire an extra worker are all marginal decisions. 7. Economists take the individual, rather than the group, the industry, or the community, as the basic decision-making unit. They regard the behavior of individuals as an important influence on public policy and on decisions made in the private sector. The emphasis on individuals rather than groups reflects the importance of incentives in economics. Changes in prices, costs, profits, wages, substitutes, and opportunities are the driving forces behind individual economic decisions. It is the individual, not the group or community, that responds to incentives.

Check Point: Core Values of Economics
• • • • • • • Economic theory is positive. Economic theory cannot predict the future. Economists look to markets for solutions to social problems. Economists emphasize opportunity cost, scarcity, and choice. Economists evaluate the costs of substituting one good or service for another. Economists think on the margin. Economics considers the individual to be the basic decision-making unit.

One of the most important uses of economics is to help to analyze possible solutions to public policy problems and to develop recommendations. Some of the most famous economists in history—Adam Smith, David Ricardo, John Maynard Keynes, Milton Friedman, and Paul Samuelson—became interested in economics because it offered tools with which to develop solutions to policy issues. When economic models are applied to public policy issues, it is difficult to decide when the economist’s task ends and the policy maker takes over. When economic methods are used for policy analysis, there is a five-step process. 1. State the problem. The choice of what problem to consider and how to state it is the task of the policy maker. How a problem is stated often determines what tools the economist applies and what solutions are considered. For example, suppose the problem is illegal parking, such as parking without a permit or in a space not designated for parking. Let us follow that problem through the next four steps. 2. Apply the relevant economic model. The economist turns to the tool kit to select the most useful theoretical model. In this case, there is a fairly simple technique called cost-benefit analysis. This technique simply assumes that people are self-interested, that they are aware of the opportunity costs and benefits of their actions, and that they will choose the course of action that maximizes the excess of benefits over opportunity costs. This simple model predicts that an increase in the opportunity cost of illegal parking or a reduction in benefits will reduce the amount of such parking. 3. Identify solutions. The most common error at this stage is to leave out some alternative solutions. Cost-based solutions to illegal parking might include higher fines. Do you think a person would be less likely to park without a permit if

Section 1.4 Basic Elements of the Economic Approach

CHAPTER 1

the fine were $500 instead of $50? More police officers would raise the cost by increasing the probability of being caught. The city could reduce the benefits of illegal parking by providing more bicycle racks or free bus transportation to and from commuter parking lots. 4. Evaluate solutions. This is the stage where economists are most useful, pointing to costs, substitutes, and incentives. A good economic model predicts how various alternative solutions will affect the amount of illegal parking, who will gain and who will lose, and which solution costs the least to implement. For example, more police officers would be more expensive than higher fines. Bicycle racks are cheaper than shuttle buses. However, racks are not as helpful as buses would be for commuters, unless the commuters live very close to the city center. 5. Choose and implement one or more solutions. This step is not the task of the economist, although it is hard to stop after carrying the process this far. The policy maker (who may have been trained as an economist) takes the economist’s list of possible solutions and the evaluation and makes a policy choice. Most arguments among economists occur when they overstep the boundaries of scientific analysis and advocate a particular solution to an economic problem. Newspapers and television news programs often quote economists who disagree. However, economists agree far more often than they disagree. Disagreements make headlines; agreement is not news. Throughout this book, we will point out where most economists agree and also where and why they disagree. The models we describe represent a broad range of agreement among most economists on how markets work and how individuals respond to incentives.

Check Point: Using Economics to Dictate Policy
• Economics offers tools with which to develop solutions to policy issues. • Economics can be used to develop policy recommendations. • It is up to the policy maker to take the economist’s list of possible solutions and make a policy choice.

Policy Focus: Economists as Policy Advisors
Paul A. Samuelson (1915–2009) and Milton Friedman (1912–2006) were two of the best-known American economists. They were both very active in the major macro and micro policy debates of the past four decades. Both were winners of the Nobel Prize in economics. The two men represented polar extremes with respect to economic policy. Samuelson saw an important role for government in modern industrial society. Friedman advocated a laissez-faire economic policy. He argued that the market economy operates very well and that the interventions supported by Samuelson do more harm than good. Samuelson was a leader of the liberal (policy) school of economics. Friedman represented the conservative or free-market school, which is sometimes called the Chicago School. Samuelson, once a professor at the Massachusetts Institute of Technology, had an undergraduate degree from the University of Chicago and MA and PhD degrees in economics from Harvard University. His PhD dissertation—Foundations of Economic Analysis, written when he was (continued)

Summary

CHAPTER 1

Policy Focus: Economists as Policy Advisors (continued) only 23 years old—was published as a book. It still ranks as a monumental work in the application of mathematics to economics. Graduate students still study it. Many of today’s economists were introduced to economics with Samuelson’s textbook Economics. Samuelson is largely responsible for making the economics department at the Massachusetts Institute of Technology one of the best in the country. Friedman was a professor at the University of Chicago, where he taught for 30 years. He was also a senior research fellow at the Hoover Institution at Stanford University. Friedman received an undergraduate degree from Rutgers, an MA degree from the University of Chicago, and a PhD from Columbia University. He made notable contributions to economic theory. His policy ideas are readily available in three books: Essays in Positive Economics (1953), Capitalism and Freedom (1962), and Free to Choose (1980). Before his passing, Friedman angered some of the conservatives who usually agreed with him by arguing that illegal drugs should be legalized. He argued that legalizing such drugs would reduce both the profits in selling them and the crime and violence among sellers and users.

Bachrach/Archive Photo/Getty Images

George Rose/Getty Images

Paul Samuelson (left) and Milton Friedman (right), were both Nobel Prize–winning economists.

Summary

C

onsider again . . . You now know why you cannot have everything! We live in a world of scarcity. You must make choices, managers of firms must make choices, and leaders of countries must make choices. As we proceed, you will become more adept at understanding the trade-offs involved in making choices—whether for personal consumption, business decisions, or public policy. The policy focus in each chapter will remind you that one of the important functions of economics is to help you understand and improve public policy. Economics is an exciting social science. As you begin to understand the economic way of thinking you will gain insights into an endless array of interesting policy questions. We wish you well. Let’s get on with it!

Key Terms

CHAPTER 1

Key Points
1. Economics is the study of how decisions about producing and consuming goods and services are made and how individuals and groups face the problem of scarcity. Microeconomics looks at the interactions of producers and consumers in individual markets. Macroeconomics is the study of the economy as a whole and is concerned with aggregates, numbers that are determined by adding across many markets. 2. Social or behavioral sciences look at the behavior of human beings, individually and in groups. They study different subsets of the actions and interactions of human beings. Together, macroeconomics and microeconomics make up one of the social sciences. 3. Economics interacts with almost all other academic subjects, and much of what both domestic and international political decision makers do is based on economic theory. Economics also provides an understanding of how society functions. Economics is useful; people who are trained in economics find rewarding jobs and careers. 4. Resources are limited, but human wants are unlimited. This conflict is the basic economic problem of scarcity. People cannot have everything they want, and they must make choices. In order to have more of one good, people must settle for less of another. The cost of extra units of one good is the number of units of the other sacrificed, or the opportunity cost. The principle of increasing opportunity cost says that the more of one good people have, the greater the amount of other goods they must sacrifice to obtain one more unit of that good. 5. The production possibilities curve illustrates the problem of scarcity. The curve shows the various output combinations of two goods or groups of goods that can be produced in an economy with the available resources. Unemployment of resources is shown by a point inside the curve; economic growth is indicated by a shift of the curve to the right. 6. The economic approach is positive and marginal, and cannot be used to predict the future. Economists tend to look to the market for solutions, pay a great deal of attention to cost, are interested in substitution among alternatives, and look at the individual as the decision-making unit. 7. One of the most important uses of economic theory is to develop models that can be used for policy analysis. An issue is analyzed in five steps: State the problem, apply the relevant economic model, identify solutions, evaluate solutions, and choose and implement solutions.

Key Terms ceteris paribus assumption A Latin phrase that means “all else being equal.” It is an important assumption in economic models. increasing opportunity cost The principle that as production of one good rises, larger and larger sacrifices of another are required. normative statements A set of propositions about what ought to be (also called value judgments). opportunity cost The value of the other alternatives given up in order to enjoy a particular good or service.

Critical Thinking and Discussion Questions

CHAPTER 1

positive statements A set of propositions about what is, rather than what ought to be. production possibilities curve A graph that depicts the various combinations of two goods that can be produced in an economy with the available resources. resources Inputs used to produce goods and services.

scarcity The central economic problem that there are not enough resources to produce everything that individuals want. self-interested behavior A basic assumption of economic theory that individual decision makers do what is best for themselves. unlimited wants The needs and desires of human beings, which can never be completely satisfied.

Critical Thinking and Discussion Questions
1. Do you think people exhibit behavior patterns that confirm the self-interest assumption? Does your own behavior confirm this assumption? Is a contribution to charity or volunteer work a contradiction of the self-interest assumption? 2. Why do economists theorize rather than attempt to describe reality exactly? 3. Do assumptions have to be realistic in order for a theory to work? 4. What is the difference between using theory to predict and forecasting? 5. Consider the following simple predictive model: If the speed limit is reduced, fewer highway deaths will occur. What assumptions are being made? What ceteris paribus conditions could change and make this prediction invalid? 6. Which of the following quantities are microeconomic and which are macroeconomic? Which might fall between the two? a. price of shoes b. number of men aged 18 to 24 in the U.S. labor force c. level of interest rates d. unemployment in Tulsa, Oklahoma e. production of agricultural products f. average level of prices g. production of butter h. average price of imported goods i. unemployment in the United States j. total output k. unemployment of carpenters l. number of nurses in the U.S. labor force m. unemployment in the northeastern states 7. What is the opportunity cost of working 10 hours a week flipping burgers while in college? If you worked more hours per week, would you experience increasing or constant opportunity cost? That is, would the extra hours require giving up alternative uses of your time that have the same value or an increasing value? 8. Try developing a simple economic model to predict how students will respond to an increase in dormitory rents. What are your assumptions? What will happen to the number of dormitory spaces rented? What will happen to the number of offcampus apartments rented and their prices?

Chapter 1 Appendix: Economic Relationships and Graphs

E

conomic theories and models are often expressed in the form of mathematical relationships among variables. These relationships can be described by algebraic equations. Economists more often express them visually in the form of graphs. Graphs make it possible to illustrate economic theories and models in ways that make them easier to remember and to apply to the real world. Remember that everything that can be said in graphs can also be said in words. Graphs are only an aid to understanding the theory. Mastering and applying the theory is what you should be trying to achieve. If you can learn to feel comfortable with graphs as visual presentations of economic ideas, reading this textbook and understanding your professor’s lectures will be much easier.

A
1 2 3 4 5 6 7 8 9 10

1.1A Relationship Between Two Variables

relationship between two variables, variable x and variable y, can be expressed in a number of ways. One is a table of values of x and y. For example, Table 1.1A shows the various amounts of fertilizer applied per acre and the corresponding yields of corn per acre. What does this table mean? It means that different amounts of fertilizer were applied to different plots of land and that those plots of land yielded varying amounts of corn.

Table 1.1A: Relationship between two variables x-variable Fertilizer (100 lbs/acre) y-variable Corn (bushels/acre) 1 10 40 80 100 110 115 110 100 70

This relationship could also be expressed in the form of a graph. A graph shows how the quantity of one variable changes when another variable changes. Figure 1.1A shows the system most commonly used for graphing. The vertical line is referred to as the y-axis (or vertical axis). The horizontal line is referred to as the x-axis (or horizontal axis). The x-axis and y-axis divide the graph into four quadrants.

Section 1.1A Relationship Between Two Variables

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Figure 1.1A: Quadrant system
Quadrant II y Quadrant I

E(–3, 5)

H B(2, 4) A(0, 1) 0 G C(0, –6) F(6, 0) x

D(–6, –4)

Quadrant III

Quadrant IV

A four-quadrant system makes it possible to represent combinations of positive and negative values in two dimensions. Point C represents an x-value of 0 and a y-value of –6. The quadrants are labeled I to IV in the counterclockwise direction.

The point where the axes cross (or intersect) is the origin. At the origin, the values of both the x-variable and the y-variable are zero. Above the x-axis, the y-variable has positive values. Below the x-axis, the x-variable has negative values. To the right of the y-axis, the x-variable has positive values. To the left of the y-axis, the x-variable has negative values. Both x and y have positive values in Quadrant I and negative values in Quadrant III. In Quadrant IV, x takes on positive values, and y takes on negative values. In Quadrant II, x has negative values, and y positive values. In this book, most of the graphs will use only Quadrant I because most economic data takes on only positive values. Each point on a graph has a set of coordinates, a pair of numbers representing the x-value and the y-value. For example, Point B on Figure 1.1A represents the value 2 for the x-variable and the value 4 for the y-variable. The x-value is always given first. For example, Point E represents x 5 23, y 5 5. See if you can determine the coordinates of Points G and H. With this background, we can plot the relationship between fertilizer applied and corn output given in Table 1.1A. The first decision to make is which variable goes on which axis. If there is a cause-and-effect relationship, we usually put the “causing” variable on

Section 1.1A Relationship Between Two Variables

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the horizontal axis and the variable being affected on the vertical axis. In mathematics, the causing variable is the independent variable, and the affected variable is the dependent variable. Since we think that fertilizer causes increased corn yields, we plot it on the horizontal axis (x-axis). Corn yield is plotted on the vertical axis (y-axis). The next decision concerns establishing a scale for each axis. The scales can be whatever is convenient and do not need to be the same. In this case, the fertilizer units are hundreds of pounds per acre, and the corn units are bushels per acre. Once a scale is established and the axes are labeled, we can plot the coordinates of the points in Table 1.1A. Then we connect the plotted points with a smooth curve to produce a graph, shown in Figure 1.2A.

Figure 1.2A: Fertilizer and corn output
Corn (Bushels/Acre) 130 120 110 100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 Fertilizer (Hundreds of lbs./Acre)

A graph is usually plotted with the dependent variable on the y-axis and the independent variable on the x-axis. Here, as the independent variable (fertilizer) increases, the dependent variable (corn output) first increases and then decreases.

The value of a graph is that it gives you a visual picture of the mathematical relationship between the variables. In Figure 1.2A, you can easily see that as fertilizer is increased up to 700 pounds per acre, corn output increases. After that level, more fertilizer causes a decrease in output. The corn plants grow too rapidly and don’t produce many ears, or the roots suffer fertilizer burn.

Section 1.1A Relationship Between Two Variables

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Not all relationships produce as tidy a graph as the one for fertilizer and corn yield. Sometimes researchers plot data to see if there is any visual pattern before trying to understand what, if any, is the relationship between the two variables. Such a plot of actual data is called a scatter diagram. Scatter diagrams are useful in searching for possible mathematical relationships between two variables. Figure 1.3A plots data on the rate of inflation (vertical axis) and the rate of unemployment (horizontal axis) for a hypothetical country. In this diagram, there doesn’t seem to be a consistent relationship of any kind between the rate of inflation and the rate of unemployment, at least for the years plotted. Figure 1.4A plots the relationship between the money supply and total output, or GDP. As you can see, there appears to be a more consistent relationship between these two variables.

Figure 1.3A: Inflation and unemployment
Inflation Rate (%) 14 12 10 8 6 4 2

0

5

6

7

8

9 Unemployment Rate (%)

A scatter diagram plots the coordinates for the values of two variables that may or may not have a consistent relationship. This diagram plots a hypothetical country’s unemployment rate and the inflation rate. As you can see, there is no consistent relationship between these two variables.

Section 1.2A Positive and Negative Relationships and Slopes

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Figure 1.4A: GDP and money supply
(Billions) $6,500 $6,000 $5,500 $5,000 $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 1999 2005 2010 Year MI Money Supply GDP

This scatter diagram plots a hypothetical country’s money supply and GDP. Unlike the diagram in Figure 1.3A, this one seems to show a rather consistent relationship between the two variables.

A

1.2A Positive and Negative Relationships and Slopes

graph shows how two variables are related. This relationship may be positive or negative. A positive relationship means that an increase in the value of the x-variable is associated with an increase in the value of the y-variable, as in Figure 1.4A. A negative relationship means that an increase in the value of the x-variable is associated with a decrease in the value of the y-variable. Some relationships in economics, such as the one between fertilizer and corn output plotted in Figure 1.2A, are positive for some values of the x-variable and negative for others.

Section 1.2A Positive and Negative Relationships and Slopes

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Figure 1.5A: Positively sloped lines y B

5 3 1 2

A

0
The slope of a line is the ratio of change in the y-value to the change in the x-value. A line sloping upward to the right has a positive slope, indicating a positive relationship between the two variables.

x

Most of the economic relationships you will encounter in this book are represented by straight lines. A straight line can have a positive slope, as in Figure 1.5A, or a negative slope, as in Figure 1.6A. The slope is a measure of the steepness of the line. It is the ratio of the change in the dependent variable ( y) to the change in the independent variable (x). If the slope is designated by the letter m, then the equation of a straight line can be written as y 5 mx 1 b where b is the value of y when x 5 0. (The value b is also known as the y-intercept, because at this value the line crosses the y-axis.)

Section 1.2A Positive and Negative Relationships and Slopes

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Figure 1.6A: Negatively sloped line y 2 –1

0
A negative slope represents a relationship between the variables in which an increase in the value of the independent variable is associated with a decrease in the value of the dependent variable.

x

Even though both lines in Figure 1.5A are positively sloped, the relationship between the x-variable and the y-variable represented by line A is very different from that represented by line B. The same amount of change in x leads to a larger change in y along line B than it does along line A. In Figure 1.5A, the slope of line A is equal to 11/2 because the y-value changes by one unit for each two-unit change in the x-value. The slope of line B is 11.67. The steeper slope of line B indicates that a larger change in the value of y will result from a given change in the value of x than it will along line A. The sign of the slope is also very important. It indicates whether the relationship between the two variables is positive or negative. A slope with a positive sign designates a positive relationship. A slope with a negative sign, as in Figure 1.6A, indicates a negative relationship. The slope of the line in Figure 1.6A is 21/2.

Section 1.3A Nonlinear Graphs and Maxima and Minima

CHAPTER 1 APPENDIX

A

1.3A Nonlinear Graphs and Maxima and Minima

straight-line graph, such as those in Figures 1.5A and 1.6A, has the same slope along the entire line. The slope of a curved line, on the other hand, varies along the curve. The slope of a curve at a particular point is the slope of the straight line tangent to the curve at that point. A tangent line is a straight line that touches a curve at only one point without crossing it. The slope of the curved line in Figure 1.7A is 11 at Point A and 23/2 at Point C.

Figure 1.7A: Nonlinear graphs: Slope and maximum y y1 A 3 3

B

C –3 2

0

x1

x

On a nonlinear graph, the slope changes along the curve. The slope at any point is the slope of a straight line tangent to the curved line at that point. When the slope is zero, the value of the y-variable is either at a maximum or at a minimum. At Point B, y is at its maximum value, y1, when x has the value x1.

The slope of the curve in Figure 1.7A at Point B is equal to zero. A small change in the value of x results in no change in the value of y along the straight line tangent to the curve at Point B. Point B is a maximum because the y-variable reaches its highest value at that point. The highest value of y, y1, is associated with an x value of x1. Recall that we described self-interested behavior as consumers maximizing satisfaction, resource owners maximizing income, and firms maximizing profit. Being able to find the maximum is very important in economics.

Section 1.4A The 45˚ Line

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Figure 1.8A: Nonlinear graphs: Minimum y y1

B

0

x1

x

This nonlinear graph also has a slope of zero at Point B. In this case, Point B represents the minimum value of y, y1, which is associated with an x-value of x1.

Sometimes a slope of zero is associated with a minimum rather than a maximum, as in Figure 1.8A. The y-variable assumes its lowest value, y1, at Point B in Figure 1.8A. This y-value is associated with an x-value of x1. A firm that is trying to minimize costs, or losses, may be interested in finding a minimum point. It is also important for many kinds of economic questions to determine whether a point of zero slope is a maximum or a minimum.

A

1.4A The 458 Line

geometric construction that proves very useful in economic analysis is a 458 line. This is a straight line through the origin that divides Quadrant I into two equal sections. If both axes are measured in the same units, the values of the x-variable and the y-variable will be equal at any point on the line, and the slope will be 11. A 458 line is shown in Figure 1.9A. Suppose, for example, you want to know whether the value of x is less than, equal to, or greater than the value of y at Point C. A 458 line gives you a quick answer to that question. The value of x is greater than the value of y at Point C because Point C lies below the 458 line.

Section 1.4A The 45˚ Line

CHAPTER 1 APPENDIX

Figure 1.9A: The 458 line y 20

B C

10

A

45 degrees 0 10 20 x

The 458 line drawn in the first quadrant has a slope of 11. If both axes are measured in the same units, the 458 line shows all points where the x-value and the y-value are equal.

Graphs Without Numbers
The graph in Figure 1.2A and the scatter diagrams in Figures 1.3A and 1.4A were constructed from sets of numbers. Other graphs in this section only give a few numerical values from which to calculate slopes. Figures 1.7A and 1.8A have no numbers on them at all. In economics, graphs of theoretical concepts often use no numbers. For example, we might theorize that there is a negative relationship between the price of any good that people consume and the quantity demanded. If price is the y-variable and quantity demanded the x-variable, a negatively sloped line such as the one in Figure 1.6A could represent this theoretical relationship. It doesn’t matter that we don’t have specific coordinates to plot. We have instead graphed an abstract idea. Many graphs in economics are of this abstract type.

Section 1.4A The 45˚ Line

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On graphs without numbers, symbols are used for values, line segments, and areas. For example, Figure 1.10A is similar to graphs you will study in Chapter 3. The y-axis shows the price per loaf of bread, and the x-axis shows the quantity of loaves consumed per week. Particular prices are represented by symbols such as P1. Quantities consumed are represented by symbols such as Q 1, Q 2, and Q 3.

Figure 1.10A: Effects of changes in price on the demand for bread
Price/ Loaf

P1

D2 D1 D3 0 Q3 Q1 Q2 Loaves/Week

Many graphs in economics use symbols rather than numbers on the axes. The symbol P1 represents a hypothetical price, and Q1, Q2, and Q3 represent hypothetical quantities.

In addition to using symbols to represent quantities, we will also make frequent use of the symbol delta, D, to represent changes in a variable. For example, the symbol DQ is a shorthand expression for the change from Q 1 to Q 2 in Figure 1.10A.

Section 1.5A Pie Charts and Bar Charts

CHAPTER 1 APPENDIX

A

1.5A Pie Charts and Bar Charts

ll of the graphs considered so far, except for the scatter diagrams, represent theoretical relationships of one kind or another. Economists also use graphs to describe the real world. Such graphs display descriptive statistics. These include the allocation of government funds between types of programs, the growth of output or the money supply over time, and the different growth rates of imports and exports. Two common types of descriptive graphs encountered in economics are pie charts and bar charts. Pie charts are used to show the division of some whole into parts, usually designated by percentages. Figure 1.11A is a pie chart depicting the sources of hypothetical household income. Pie charts have become very popular because they are easy to create on a personal computer. This visual representation often conveys a clearer sense of the relative sizes of various components than you could obtain from reading a table of numbers.

Figure 1.11A: Pie chart of hypothetical household income
Interest, Rent, and Dividends 16.8% Wages and Salaries 63.6%

Transfer Payments 12.0%

Proprietor’s Income 8.2%
A pie chart depicts the division of a whole into parts (percentages). This pie chart shows that the largest component of a household income is wages and salaries. Transfer payments and interest are much smaller.

Another popular type of descriptive graph is a bar chart, such as Figure 1.12A. This diagram describes the behavior of two variables, hypothetical federal government revenue and expenditures, in a series of “snapshots.” This graph gives a much more vivid impression of how much expenditures have grown relative to revenues than you could derive from a set of numbers.

Section 1.6A Caution: Graphs and Numbers Can Mislead as Well as Inform!

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Figure 1.12A: Bar chart of hypothetical federal revenues and expenditures
(Billions) $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 2008 2009 2010 2011 Federal Revenues Federal Expenditures

A bar chart can be used in a variety of ways to present economic data in a visual manner. This bar chart compares hypothetical federal revenues and expenditures for various years.

Theoretical graphs, such as those in Figures 1.5A through 1.10A, and descriptive graphs, such as Figures 1.11A and 1.12A, are spread throughout this book. Both types are also common in textbooks in social sciences and business, and in popular magazines such as Time and Business Week. Economics is a very visual subject. Be sure that you feel secure with reading and interpreting graphs before proceeding further.

G

1.6A Caution: Graphs and Numbers Can Mislead as Well as Inform!

raphs and statistics can be very informative. They put some concrete, real-world content into abstract models and economic relationships. However, it is very easy to present data in a misleading way. The choice of a scale along an axis can make changes look bigger than they really are. The use of averages conceals a great deal of information about variation. For example, three families with incomes of $24,000, $25,000, and $26,000 have an average income of $25,000. Three incomes of $5,000, $5,000, and $65,000 also average to $25,000. The same average income describes two very different distributions of income.

A classic guide to the use and abuse of numbers and graphs is How to Lie With Statistics, by Darrell Huff and Irving Geis. This book has been through numerous paperback

Key Terms

CHAPTER 1 APPENDIX

editions since it was first published in 1954. It should be required reading for anyone taking courses in the social sciences. It is a useful guide through the pitfalls of the means, medians, averages, bar charts, surveys, samples, and growth rates that are the daily news of the economic and political worlds. Always be very cautious in accepting someone’s graphs or numbers. Consider carefully what that person may be trying to persuade you to think or do and how the statistics could be manipulated to put that position in a more favorable light.

Key Terms
458line A line in the first quadrant, passing through the origin, with a slope of 11, which divides the quadrant in half. If the scales on the axis are the same, the value of the x-variable is equal to the value of the y-variable along the 458line. bar chart A graphic representation that expresses data using columns of different heights. coordinates The values of x and y that define the location of a point in a coordinate system. dependent variable The variable, usually plotted on the vertical axis, that is affected or influenced by the other variable. independent variable The variable, usually plotted on the horizontal axis, that affects or influences the other variable. maximum The point on the graph at which the y-variable, or dependent variable, reaches its highest value. minimum The point on the graph at which the y-variable, or dependent variable, reaches its lowest value. negative relationship A relationship between two variables in which an increase in the value of one is associated with a decrease in the value of the other. origin The intersection of the vertical and horizontal axes of a coordinate system, at which the values of both the x-variable and the y-variable are zero. pie chart A graphic representation in the shape of a pie that expresses actual economic data as parts of a whole. The sizes of the slices of the pie correspond to the percentage shares of the components. positive relationship A relationship between two variables in which an increase in one is associated with an increase in the other and a decrease in one is associated with a decrease in the other. scatter diagram A graph that plots actual pairs of values of two variables to determine whether there appears to be any consistent relationship between them. slope The ratio of the change in the dependent variable (y) and the independent variable (x). tangent line A straight line just touching a curve (nonlinear graphic relationship) at a single point. The slope of the tangent line is equal to the slope of the curve at that point. x-axis The horizontal line in a coordinate system that shows the values of the independent variable; the horizontal axis. y-axis The upright line in a coordinate system that shows the values of the dependent variable; the vertical axis.