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Chapter Outline and Learning Objectives1.1 Three Key Economic Ideas, page 4 Explain these three key economic ideas: People are rational. People respond to incentives. Optimal decisions are made at the margin. The Economic Problem That Every Society Must Solve, page 7 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? Economic Models, page 11 Understand the role of models in economic analysis. Microeconomics and Macroeconomics, page 14 Distinguish between microeconomics and macroeconomics. A Preview of Important Economic Terms, page 15 Become familiar with important economic terms.

1.2

1.3

1.4

1.5

APPENDIX: Using Graphs and Formulas, page 24 Review the use of graphs and formulas.


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>> Microsoft Versus the U.S. Congresson Worker VisasThe number of jobs requiring technical education and training continues to increase. Many U.S. firms, particularly those involved with information technology, have had difficulty filling all their available job openings with U.S. citizens. U.S. law restricts the number of foreign specialty workers who may enter the United States under the H-1B visa program to just 65,000 per year. This visa program covers a very broad range of workersfrom software engineers to fashion models. Bill Gates, chairman of Microsoft, testified before Congress in 2008 that limiting the number of foreign technical workers allowed into the United States was resulting in a critical shortage of scientific talent and hindering the ability of U.S. firms to compete with foreign firms. Gates noted that foreign students make up more than half of enrollments in computer science programs at leading U.S. universities:We provide the worlds best universities . . . and the students are not allowed to stay and work in the country. The . . . smartest people want to come here, and thats a huge advantage to us, and in a sense, were turning them away.

In 2009, though, Congress tightened rather than loosened restrictions on the immigration of technical workers to the United States. As part of the 2009 Recovery and Reinvestment Act, a bill intended to stimulate the U.S. economy during the recession, Congress put strict limits on the ability of banks and other firms receiving government aid to hire foreign workers. Economists and policymakers have debated how restrictions on the immigration of technical workers affect the U.S. economy. In this chapter and the remainder of this book, we will see how economics provides us with tools to analyze many important questions, including the economic effect of the immigration of skilled workers. AN INSIDE LOOK AT POLICY on page 18 discusses arguments for and against restricting the number of H-1B visas for highly skilled workers.Sources: Turning Away Talent, Wall Street Journal, March 10, 2009; Mehul Srivastava, Anger Grows in India over U.S. Visa Rules, BusinessWeek, February 24, 2009; and Grant Gross, Gates Repeats Request for More H-1B Visas, InfoWorld, March 12, 2008.

Economics in YOUR LIFE!Will You Be Competing with Immigrant Workers for Your Next Job? Immigrant workers holding H-1B visas compete with U.S. workers for many high-paying jobs. For example, the average salary of H-1B visa holders working in the social sciencesincluding economicsis over $60,000. Managers with H-1B visas and a professional degree earn $107,500, and computer scientists earn $71,200. Suppose you plan on working as a software engineer, a financial analyst, an accountant, a lawyer, or in another industry where a high level of education is required. Is it likely that during your career, you will be competing for a job with immigrant workers from China, India, or some other foreign country? As you read the chapter, see if you can answer this question. You can check your answer against the one we provide at the end of the chapter.Continued on page 16

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I Scarcity A situation in which unlimited wants exceed the limited resources available to fulfill those wants.

n this book, we use economics to answer questions such as the following:

How are the prices of goods and services determined? How does pollution affect the economy, and how should government policy deal with these effects? Why do firms engage in international trade, and how do government policies affect international trade? Why does government control the prices of some goods and services, and what are the effects of those controls?

Economics The study of the choices people make to attain their goals, given their scarce resources.

Economic model A simplified version of reality used to analyze real-world economic situations.

Economists do not always agree on the answers to every question. In fact, as we will see, economists engage in lively debate on some issues. In addition, new problems and issues are constantly arising. So, economists are always at work developing new methods to analyze economic issues. All the issues we discuss in this book illustrate a basic fact of life: People must make choices as they try to attain their goals. We must make choices because we live in a world of scarcity, which means that although our wants are unlimited, the resources available to fulfill those wants are limited. You might like to own five BMWs and spend three months each summer in five-star European hotels, but unless Bill Gates is a close relative, you probably lack the money to fulfill these dreams. Every day, you make choices as you spend your limited income on the many goods and services available. The finite amount of time you have also limits your ability to attain your goals. If you spend an hour studying for your economics midterm, you have one less hour to study for your history midterm. Firms and the government are in the same situation as you: They also must attain their goals with limited resources. Economics is the study of the choices consumers, business managers, and government officials make to attain their goals, given their scarce resources. We begin this chapter by discussing three important economic ideas that we will return to many times in this book: People are rational, people respond to incentives, and optimal decisions are made at the margin. Then we consider the three fundamental questions that any economy must answer: What goods and services will be produced? How will the goods and services be produced? and Who will receive the goods and services produced? Next, we consider the role of economic models in analyzing economic issues. Economic models are simplified versions of reality used to analyze real-world economic situations. We will explore why economists use models and how they construct them. Finally, we will discuss the difference between microeconomics and macroeconomics, and we will preview some important economic terms.

1.1 LEARNING OBJECTIVEExplain these three key economic ideas: People are rational. People respond to incentives. Optimal decisions are made at the margin. Market A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

Three Key Economic IdeasAs you try to achieve your goals, whether they are buying a new computer or finding a part-time job, you will interact with other people in markets. A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Most of economics involves analyzing what happens in markets. Throughout this book, as we study how people make choices and interact in markets, we will return to three important ideas: 1. People are rational. 2. People respond to economic incentives. 3. Optimal decisions are made at the margin.


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People Are RationalEconomists generally assume that people are rational. This assumption does not mean that economists believe everyone knows everything or always makes the best decision. It means that economists assume that consumers and firms 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. For example, if Microsoft charges a price of $239 for a copy of Windows, economists assume that the managers at Microsoft have estimated that a price of $239 will earn Microsoft the most profit. The managers may be wrong; perhaps a price of $265 would be more profitable, but economists assume that the managers at Microsoft have acted rationally on the basis of the information available to them in choosing the price. Of course, not everyone behaves rationally all the time. Still, the assumption of rational behavior is very useful in explaining most of the choices that people make.

People Respond to Economic IncentivesHuman beings act from a variety of motives, including religious belief, envy, and compassion. Economists emphasize that consumers and firms consistently respond to economic incentives. This fact may seem obvious, but it is often overlooked. For example, according to an article in the Wall Street Journal, the FBI couldnt understand why banks were not taking steps to improve security in the face of an increase in robberies: FBI officials suggest that banks place uniformed, armed guards outside their doors and install bullet-resistant plastic, known as a bandit barrier, in front of teller windows. FBI officials were surprised that few banks took their advice. But the article also reported that installing bullet-resistant plastic costs $10,000 to $20,000, and a well-trained security guard receives $50,000 per year in salary and benefits. The average loss in a bank robbery is only about $1,200. The economic incentive to banks is clear: It is less costly to put up with bank robberies than to take additional security measures. FBI agents may be surprised by how banks respond to the threat of robberiesbut economists are not. In each chapter, the Making the Connection feature discusses a news story or another application related to the chapter material. Read the following Making the Connection for a discussion of whether people respond to economic incentives even when making the decision to have children.

Makingthe

The populations of the United States, Japan, and most European countries are aging as birthrates decline and the average person lives longer. The governments of these countries have programs to pay money to retired workers, such as the Social Security system in the United States. Most of the money for these programs comes from taxes paid by people currently working. As the population ages, there are fewer workers paying taxes relative to the number of retired people receiving government payments. The result is a funding crisis that countries can solve only by either reducing government payments to retired workers or by raising the taxes paid by current workers. In some European countries, birthrates have fallen so low that the total population will soon begin to decline, which will make the funding crisis for government retirement programs even worse. For the population of a country to be stable, the average woman must have 2.1 children, which is enough to replace both parents and account for children who die before reaching adulthood. In recent years, the birthrates in a number of countries, including France, Germany, and Italy, have fallen below this replacement level. The concern about falling birthrates has been particularly strong in the small European country of Estonia. In 2001, the United Nations issued a report in which it forecast that, given its current birthrate, by 2050, the population of Estonia would decline from 1.4 million to only about 700,000. The Estonian government responded by using economic incentives in an attempt to increase the birthrate. Beginning in 2007, the government began paying

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Will Women Have More Babies if the Government Pays Them To?


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working women who take time off after having a baby their entire salary for up to 15 months. Women who have a baby but who do not work receive $200 per month, which is a substantial amount, given that the average income in Estonia is only $650 per month. Will women actually have more babies as a result of this economic incentive? As the graph below shows, the birthrate in Estonia has increased from 1.3 children per woman in the late 1990s to 1.7 children per woman in 2008. This is still below the replacement level birthrate of 2.1 children, and it is too early to tell whether the increased birthrate is due to the economic incentives. But the Estonian government is encouraged by the results and is looking for ways to provide additional economic incentives to raise the birthrate further. And Estonia is not alone; more than 45 other countries in Europe and Asia have taken steps to try to raise their birthrates. These policies suggest that people may respond to economic incentives even when making the very personal decision of how many children to have.Fertility rate (births per woman) 2.4 2.2 2 1.8 1.6 1.4 1.2 1 0 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: Marcus Walker, In Estonia, Paying Women to Have Babies Is Paying Off, Wall Street Journal, October 20, 2006; Sharon Lerner, The Motherhood Experiment, New York Times, March 4, 2007; and Statistics Estonia, Population Reference Bureau.

YOUR TURN: Test your understanding by doing related problem 1.7 on page 21 at the end of thischapter.

Optimal Decisions Are Made at the MarginSome decisions are all or nothing: For instance, when an entrepreneur decides whether to open a new restaurant, he or she either starts the new restaurant or doesnt. When you decide whether to enter graduate school or to take a job, you either enter graduate school or you dont. But rather than being all or nothing, most decisions in life involve doing a little more or a little less. If you are trying to decrease your spending and increase your saving, the decision is not really between saving all the money you earn or spending it all. Rather, many small choices are involved, such as whether to buy a caff mocha at Starbucks every day or just three times per week. Economists use the word marginal to mean extra or additional. Should you watch another hour of TV or spend that hour studying? The marginal benefit (or, in symbols, MB) of watching more TV is the additional enjoyment you receive. The marginal cost (or MC) is the lower grade you receive from having studied a little less. Should Apple produce an additional 300,000 iPhones? Firms receive revenue from selling goods. Apples marginal benefit is the additional revenue it receives from selling 300,000 more iPhones. Apples marginal cost is the additional costfor wages, parts, and so forthof producing 300,000 more iPhones. Economists reason that the optimal decision is to continue any activity up to the point where the marginal benefit equals the


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marginal costin symbols, where MB = MC. Often we apply this rule without consciously thinking about it. Usually you will know whether the additional enjoyment from watching a television program is worth the additional cost involved in not spending that hour studying, without giving the decision a lot of thought. In business situations, however, firms often have to make careful calculations to determine, for example, whether the additional revenue received from increasing production is greater or less than the additional cost of the production. Economists refer to analysis that involves comparing marginal benefits and marginal costs as marginal analysis. In each chapter of this book, you will see the special feature Solved Problem. This feature will increase your understanding of the material by leading you through the steps of solving an applied economic problem. After reading the problem, you can test your understanding by working the related problems that appear at the end of the chapter and in the study guide that accompanies this book. You can also complete Solved Problems on www.myeconlab.com and receive tutorial help.

Marginal analysis Analysis that involves comparing marginal benefits and marginal costs.

Solved Problem

| 1-1idea because we will make a total profit of $500 million if we produce 11 million. Do you agree with her reasoning? What, if any, additional information do you need to decide whether Apple should produce the additional 1 million iPhones?

Apple Computer Makes a Decision at the MarginSuppose Apple is currently selling 10 million iPhones per year. Managers at Apple are considering whether to raise production to 11 million iPhones per year. One manager argues, Increasing production from 10 million to 11 million is a good

SOLVING THE PROBLEMStep 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, which begins on page 6. Remember to think marginal whenever you see the word additional in economics. Step 2: Explain whether you agree with the managers 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, that involves continuing to produce iPhones up to the point where the additional revenue Apple receives from selling more iPhones is equal to the marginal cost of producing them. The Apple manager has not done a marginal analysis, so you should not agree with her reasoning. Her statement about the total profit of producing 11 million iPhones is not relevant to the decision of whether to produce the last 1 million iPhones. Step 3: Explain what additional information you need. You will need additional information to make a correct decision. You will need to know the additional revenue Apple would earn from selling 1 million more iPhones and the additional cost of producing them.YOUR TURN: For more practice, do related problems 1.4, 1.5, and 1.6 on pages 2021 at the endof this chapter.

1.2 LEARNING OBJECTIVE

The Economic Problem That Every Society Must SolveBecause we live in a world of scarcity, any society faces the economic problem that it has only a limited amount of economic resourcessuch as workers, machines, and raw materialsand so can produce only a limited amount of goods and services. Therefore,

Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced?


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Trade-off The idea that because of scarcity, producing more of one good or service means producing less of another good or service. Opportunity cost The highestvalued alternative that must be given up to engage in an activity.

every society faces trade-offs: Producing more of one good or service means producing less of another good or service. In fact, the best way to measure the cost of producing a good or service is the value of what has to be given up to produce it. The opportunity cost of any activitysuch as producing a good or serviceis the highest-valued alternative that must be given up to engage in that activity. The concept of opportunity cost is very important in economics and applies to individuals as much as it does to firms or to society as a whole. Consider the example of someone who could receive a salary of $80,000 per year working as a manager at Microsoft but decides to open her own consulting firm instead. In that case, the opportunity cost of her managerial services to her own firm is the $80,000 she gives up by not working for Microsoft, even if she does not explicitly pay herself a salary. Trade-offs force society to make choices when answering the following 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? Throughout this book, we will return to these questions many times. For now, we briefly introduce each question.

What Goods and Services Will Be Produced?How will society decide whether to produce more economics textbooks or more Bluray players? More daycare facilities or more football stadiums? Of course, society does not make decisions; only individuals make decisions. The answer to the question of what will be produced is determined by the choices that consumers, firms, and the government make. Every day, you help decide which goods and services firms will produce when you choose to buy an iPhone instead of a BlackBerry or a caff mocha rather than a chai tea. Similarly, Apple must choose whether to devote its scarce resources to making more iPhones or more MacBook laptop computers. The federal government must choose whether to spend more of its limited budget on breast cancer research or on homeland security. In each case, consumers, firms, and the government face the problem of scarcity by trading off one good or service for another. And each choice made comes with an opportunity cost, measured by the value of the best alternative given up.

How Will the Goods and Services Be Produced?Firms choose how to produce the goods and services they sell. In many cases, firms face a trade-off between using more workers or using more machines. For example, a local service station has to choose whether to provide car repair services using more diagnostic computers and fewer auto mechanics or more auto mechanics and fewer diagnostic computers. Similarly, movie studios have to choose whether to produce animated films using highly skilled animators to draw them by hand or fewer animators and more computers. In deciding whether to move production offshore to China, firms may need to choose between a production method in the United States that uses fewer workers and more machines and a production method in China that uses more workers and fewer machines.

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. Individuals with the highest income have the ability to buy the most goods and services. Often, people are willing to give up some of their income and, therefore, some of their ability to purchase goods and servicesby donating to charities to increase the incomes of poorer people. Each year, Americans donate more than $300 billion to charity, or an average donation of $2,750 for each household in the country. An important policy question, however, is whether the government should


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intervene to make the distribution of income more equal. Such intervention already occurs in the United States, because people with higher incomes pay a larger fraction of their incomes in taxes and because the government makes payments to people with low incomes. There is disagreement over whether the current attempts to redistribute income are sufficient or whether there should be more or less redistribution.

Centrally Planned Economies versus Market EconomiesTo answer the three questionswhat, how, and whosocieties organize their economies in two main ways. A society can have a centrally planned economy in which the government decides how economic resources will be allocated. Or a society can have a market economy in which the decisions of households and firms interacting in markets allocate economic resources. From 1917 to 1991, the most important centrally planned economy in the world was that of the Soviet Union, which was established when Vladimir Lenin and the Communist Party staged a revolution and took over the Russian Empire. In the Soviet Union, the government decided what goods to produce, how the goods would be produced, and who would receive the goods. Government employees managed factories and stores. The objective of these managers was to follow the governments orders rather than to satisfy the wants of consumers. Centrally planned economies like the Soviet Union have not been successful in producing low-cost, high-quality goods and services. As a result, the standard of living of the average person in a centrally planned economy tends to be low. All centrally planned economies have also been political dictatorships. Dissatisfaction with low living standards and political repression finally led to the collapse of the Soviet Union in 1991. Today, only a few small countries, such as Cuba and North Korea, still have completely centrally planned economies. All the high-income democracies, such as the United States, Canada, Japan, and the countries of western Europe, are market economies. Market economies rely primarily on privately owned firms to produce goods and services and to decide how to produce them. Markets, rather than the government, determine who receives the goods and services produced. In a market economy, firms must produce goods and services that meet the wants of consumers, or the firms will go out of business. In that sense, it is ultimately consumers who decide what goods and services will be produced. Because firms in a market economy compete to offer the highest-quality products at the lowest price, they are under pressure to use the lowest-cost methods of production. For example, in the past 10 years, some U.S. firms, particularly in the electronics and furniture industries, have been under pressure to reduce their costs to meet competition from Chinese firms. In a market economy, the income of an individual is determined by the payments he receives for what he has to sell. If he is a civil engineer, and firms are willing to pay a salary of $85,000 per year for engineers with his training and skills, that is the amount of income he will have to purchase goods and services. If the engineer also owns a house that he rents out, his income will be even higher. One of the attractive features of markets is that they reward hard work. Generally, the more extensive the training a person has received and the longer the hours the person works, the higher the persons income will be. Of course, luckboth good and badalso plays a role here, as elsewhere in life. We can conclude that market economies respond to the question Who receives the goods and services produced? with the answer Those who are most willing and able to buy them.Centrally planned economy An economy in which the government decides how economic resources will be allocated. Market economy An economy in which the decisions of households and firms interacting in markets allocate economic resources.

The Modern Mixed EconomyIn the nineteenth and early twentieth centuries, the U.S. government engaged in relatively little regulation of markets for goods and services. Beginning in the middle of the twentieth century, government intervention in the economy dramatically increased in the United States and other market economies. This increase was primarily caused by the high rates of unemployment and business bankruptcies during the Great Depression of the 1930s. Some government intervention was also intended to raise the incomes of


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Mixed economy An economy in which most economic decisions result from the interaction of buyers and sellers in markets but in which the government plays a significant role in the allocation of resources.

the elderly, the sick, and people with limited skills. For example, in the 1930s, the United States established the Social Security system, which provides government payments to retired and disabled workers, and minimum wage legislation, which sets a floor on the wages employers can pay workers in many occupations. In more recent years, government intervention in the economy has also expanded to meet such goals as protection of the environment and the promotion of civil rights. Some economists argue that the extent of government intervention makes it no longer accurate to refer to the U.S., Canadian, Japanese, and western European economies as pure market economies. Instead, they should be referred to as mixed economies. A mixed economy is still primarily a market economy because most economic decisions result from the interaction of buyers and sellers in markets. However, the government plays a significant role in the allocation of resources. As we will see in later chapters, economists continue to debate the role government should play in a market economy. One of the most important developments in the international economy in recent years has been the movement of China from being a centrally planned economy to being a more mixed economy. The Chinese economy had suffered decades of economic stagnation following the takeover of the government in 1949 by Mao Zedong and the Communist Party. Although China remains a political dictatorship, production of most goods and services is now determined in the market rather than by the government. The result has been rapid economic growth that in the near future may lead to total production of goods and services in China surpassing total production in the United States.

Efficiency and EquityProductive efficiency A situation in which a good or service is produced at the lowest possible cost. Allocative efficiency A state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it. Voluntary exchange A situation that occurs in markets when both the buyer and seller of a product are made better off by the transaction.

Equity The fair distribution of economic benefits.

Market economies tend to be more efficient than centrally planned economies. There are two types of efficiency: productive efficiency and allocative efficiency. Productive efficiency occurs when a good or service is produced at the lowest possible cost. Allocative efficiency occurs when production is in accordance with consumer preferences. Markets tend to be efficient because they promote competition and facilitate voluntary exchange. With voluntary exchange, both the buyer and seller of a product are made better off by the transaction. We know that the buyer and seller are both made better off because, otherwise, the buyer would not have agreed to buy the product or the seller would not have agreed to sell it. Productive efficiency is achieved when competition among firms in markets forces the firms to produce goods and services at the lowest cost. Allocative efficiency is achieved when the combination of competition among firms and voluntary exchange between firms and consumers results in firms producing the mix of goods and services that consumers prefer most. Competition will force firms to continue producing and selling goods and services as long as the additional benefit to consumers is greater than the additional cost of production. In this way, the mix of goods and services produced will match consumer preferences. Although markets promote efficiency, they dont guarantee it. Inefficiency can arise from various sources. To begin with, it may take some time to achieve an efficient outcome. When Blu-ray players were introduced, for example, firms did not instantly achieve productive efficiency. It took several years for firms to discover the lowest-cost method of producing this good. As we will discuss in Chapter 4, governments sometimes reduce efficiency by interfering with voluntary exchange in markets. For example, many governments limit the imports of some goods from foreign countries. This limitation reduces efficiency by keeping goods from being produced at the lowest cost. The production of some goods damages the environment. In this case, government intervention can increase efficiency because without such intervention, firms may ignore the costs of environmental damage and thereby fail to produce the goods at the lowest possible cost. An economically efficient outcome is not necessarily a desirable one. Many people prefer economic outcomes that they consider fair or equitable, even if those outcomes are less efficient. Equity is harder to define than efficiency, but it usually involves a fair distribution of economic benefits. For some people, equity involves a more equal distribution of economic benefits than would result from an emphasis on efficiency alone. For example, some people support taxing people with higher incomes to provide the


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funds for programs that aid the poor. Although governments may increase equity by reducing the incomes of high-income people and increasing the incomes of the poor, efficiency may be reduced. People have less incentive to open new businesses, to supply labor, and to save if the government takes a significant amount of the income they earn from working or saving. The result is that fewer goods and services are produced, and less saving takes place. As this example illustrates, there is often a trade-off between efficiency and equity. Government policymakers often confront this trade-off.

Economic ModelsEconomists rely on economic theories, or models (the words theory and model are used interchangeably), to analyze real-world issues, such as the economic effects of immigration. As mentioned earlier, economic models are simplified versions of reality. Economists are certainly not alone in relying on models: An engineer may use a computer model of a bridge to help test whether it will withstand high winds, or a biologist may make a physical model of a nucleic acid to better understand its properties. One purpose of economic models is to make economic ideas sufficiently explicit and concrete so that individuals, firms, or the government can use them to make decisions. For example, we will see in Chapter 3 that the model of demand and supply is a simplified version of how the prices of products are determined by the interactions among buyers and sellers in markets. Economists use economic models to answer questions. For example, consider the question from the chapter opener: What effect does immigration of technical workers have on the U.S. economy? For a complicated question like this one, economists often use several models to examine different aspects of the issue. For example, they may use a model of how wages are determined to analyze the effect of the immigration of technical workers on wages in particular industries. Economists may use a model of international trade to analyze how labor costs affect the competitiveness of high-technology firms. Sometimes economists use an existing model to analyze an issue, but in other cases, they must develop a new model. To develop a model, economists generally follow these steps: 1. 2. 3. 4. 5. Decide on the assumptions to use in developing the model. Formulate a testable hypothesis. Use economic data to test the hypothesis. Revise the model if it fails to explain well the economic data. Retain the revised model to help answer similar economic questions in the future.

1.3 LEARNING OBJECTIVEUnderstand the role of models in economic analysis.

The Role of Assumptions in Economic ModelsAny model is based on making assumptions because models have to be simplified to be useful. We cannot analyze an economic issue unless we reduce its complexity. For example, economic models make behavioral assumptions about the motives of consumers and firms. Economists assume that consumers will buy the goods and services that will maximize their well-being or their satisfaction. Similarly, economists assume that firms act to maximize their profits. These assumptions are simplifications because they do not describe the motives of every consumer and every firm. How can we know if the assumptions in a model are too simplified or too limiting? We discover this when we form hypotheses based on these assumptions and test these hypotheses using real-world information.

Forming and Testing Hypotheses in Economic ModelsAn economic variable is something measurable that can have different values, such as the wages paid to software programmers. A hypothesis in an economic model is a statement that may be either correct or incorrect about an economic variable. An example of a hypothesis in an economic model is the statement that immigration of technical workers reduces wages paid to software programmers in the United States. An economic hypothesis is usually about a causal relationship; in this case, the hypothesis states that immigration causes, or leads to, lower wages for U.S. software programmers.Economic variable Something measurable that can have different values, such as the wages of software programmers.


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We have to test a hypothesis before we can accept it. To test a hypothesis, we analyze statistics on the relevant economic variables. In our H1-B visas example, we would gather statistics on the wages paid to software programmers and perhaps on other variables as well. Testing a hypothesis can be tricky. For example, showing that the wages paid to software programmers fell at a time when immigration was increasing would not be enough to demonstrate that immigration caused the wage fall. Just because two things are correlatedthat is, they happen at the same timedoes not mean that one caused the other. For example, suppose that the U.S. economy went into a recession at the same time that immigration of software engineers was increasing. In that case, the recession, rather than the immigration of foreign engineers, might have caused the fall in wages paid to software engineers in the United States. Over a period of time, many economic variables change, which complicates the testing of hypotheses. In fact, when economists disagree about a hypothesis, such as the effect of immigration on wages, it is often because of disagreements over interpreting the statistical analysis used to test the hypothesis. Note that hypotheses must be statements that could, in principle, turn out to be incorrect. Statements such as Immigration is good or Immigration is bad are value judgments rather than hypotheses because it is not possible to disprove them. Economists accept and use an economic model if it leads to hypotheses that are confirmed by statistical analysis. In many cases, the acceptance is tentative, however, pending the gathering of new data or further statistical analysis. In fact, economists often refer to a hypothesis having been not rejected, rather than having been accepted, by statistical analysis. But what if statistical analysis clearly rejects a hypothesis? For example, what if a model leads to a hypothesis that immigration lowers wages of U.S. software programmers but the data reject this hypothesis? In that case, the model must be reconsidered. It may be that an assumption used in the model was too simplified or too limiting. For example, perhaps the model used to determine the effect of immigration on wages paid to software programmers assumed that foreign software programmers entering the United States had the same training and experience as software programmers in the United States. If, in fact, U.S. software programmers have more training and experience than immigrant programmers, this difference may explain why the data rejected our hypothesis. The process of developing models, testing hypotheses, and revising models occurs not just in economics but also in disciplines such as physics, chemistry, and biology. This process is often referred to as the scientific method. Economics is a social science because it applies the scientific method to the study of the interactions among individuals.

Normative and Positive AnalysisPositive analysis Analysis concerned with what is. Normative analysis Analysis concerned with what ought to be.

Throughout this book, as we build economic models and use them to answer questions, we need to bear in mind the distinction between positive analysis and normative analysis. Positive analysis is concerned with what is, and normative analysis is concerned with what ought to be. Economics is about positive analysis, which measures the costs and benefits of different courses of action. We can use the federal governments minimum wage law to compare positive and normative analysis. In 2009, under this law, it was illegal for an employer to hire a worker at a wage less than $7.25 per hour. Without the minimum wage law, some firms and some workers would voluntarily agree to a lower wage. Because of the minimum wage law, some workers have difficulty finding jobs, and some firms end up paying more for labor than they otherwise would have. A positive analysis of the federal minimum wage law uses an economic model to estimate how many workers have lost their jobs because of the law, its impact on the costs and profits of businesses, and the gains to workers receiving the minimum wage. After economists complete this positive analysis, the decision as to whether the minimum wage law is a good idea or a bad idea is a normative one and depends on how people evaluate the trade-off involved. Supporters of the law believe that the losses to employers and to workers who are unemployed as a


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Dont Let This Happen to YOU!Dont Confuse Positive Analysis with Normative AnalysisEconomic analysis has shown that the minimum wage law is a bad idea because it causes unemployment. Is this statement accurate? As of 2009, the federal minimum wage law prevents employers from hiring workers at a wage of less than $7.25 per hour. This wage is higher than some employers are willing to pay some workers. If there were no minimum wage law, some workers who currently cannot find any firm willing to hire them at $7.25 per hour would be able to find employment at a lower wage. Therefore, positive economic analysis indicates that the minimum wage law causes unemployment (although economists disagree about how much unemployment the minimum wage causes). But, those workers who still have jobs benefit from the minimum wage because they are paid a higher wage than they otherwise would be. In other words, the minimum wage law creates both losers (the workers who become unemployed and the firms that have to pay higher wages) and winners (the workers who receive higher wages). Should we value the gains to the winners more than we value the losses to the losers? The answer to this question involves normative analysis. Positive economic analysis can show the consequences of a particular policy, but it cannot tell us whether the policy is good or bad. So, the statement at the beginning of this box is inaccurate.

YOUR TURN: Test your understanding by doing relatedproblem 3.9 on page 23 at the end of this chapter.

result of the law are more than offset by the gains to workers who receive higher wages than they would without the law. Opponents of the law believe the losses are greater than the gains. The assessment by any individual depends, in part, on that persons values and political views. The positive analysis an economist provides would play a role in the decision but cant by itself decide the issue one way or the other. In each chapter, you will see a Dont Let This Happen to You! box like the one above. These boxes alert you to common pitfalls in thinking about economic ideas. After reading this box, test your understanding by working the related problem that appears at the end of the chapter.

Economics as a Social ScienceBecause economics studies the actions of individuals, it is a social science. Economics is therefore similar to other social science disciplines, such as psychology, political science, and sociology. As a social science, economics considers human behaviorparticularly decision-making behaviorin every context, not just in the context of business. Economists have studied such issues as how families decide the number of children to have, why people have difficulty losing weight or attaining other desirable goals, and why people often ignore relevant information when making decisions. Economics also has much to contribute to questions of government policy. As we will see throughout this book, economists have played an important role in formulating government policies in areas such as the environment, health care, and poverty.

Makingthe

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Should the Federal Government Have Increased Restrictions on the Immigration of Skilled Workers?

As mentioned in the opener to this chapter, in the 2009 Recovery and Reinvestment Act, Congress put strict limits on the ability of banks and other firms receiving government aid to hire foreign workers under the H-1B visa program. Supporters of the limits argued that firms were hiring foreign workers primarily because their wages were lower than those of domestic workers with the same skills. If firms could not hire foreign workers at lower wages, the firms would have to hire U.S. workers at higher wages. Higher wages for technical jobs would also increase


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Does restricting the immigration of skilled workers affect the employment opportunities of recent U.S. graduates?

the incentives for U.S. high school and college students to obtain the training necessary to qualify for these jobs. Opponents of the new limits on immigration argued that they undermine the ability of U.S. firms to recruit the best available workers, regardless of nationality. By increasing the costs to U.S. firms and by making them less productive, the limits would lead to U.S. firms losing sales to foreign firms. In addition, some U.S. firms might be led to outsource some of their operations to foreign countries where the limits on hiring foreign workers would not apply. For instance, Microsoft relocated some of its software development activity to a new research center in Vancouver, Canada, largely to avoid restrictive U.S. immigration rules. Some U.S. graduate schools also worried that they would be unable to continue to attract top students from around the world if the students would have difficulty being hired for jobs in the United States following graduation. Like many other policy debates, the debate over the immigration of skilled workers has both positive and normative elements. By gathering data and using economic models, it is possible to assess some of the quantitative claims made by each side in the debate: What impact has immigration had on the wages of software engineers and other skilled workers? What effect do limitations on the ability to hire immigrant workers have on the costs of U.S. firms? How will greater restrictions on immigration affect the enrollments of foreign students in U.S. colleges? These are all positive questions, so it is possible to formulate quantitative answers. Ultimately, though, this debate also has a normative element. For instance, some supporters of the restrictions are opposed to unlimited immigration for political or cultural reasons, while some opponents of the restrictions object on philosophical grounds to governments interfering with the free flow of workers and goods between countries. The debate over the immigration of skilled workers demonstrates that economics is often at the center of important policy issues.Source: Paul Danos, Matthew J. Slaughter, and Robert G. Hansen, Its a Terrible Time to Reject Skilled Workers, Wall Street Journal, March 11, 2009.

YOUR TURN: Test your understanding by doing related problem 3.7 on page 22 at the end of thischapter.

1.4 LEARNING OBJECTIVEDistinguish between microeconomics and macroeconomics. Microeconomics The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

Microeconomics and MacroeconomicsEconomic models can be used to analyze decision making in many areas. We group some of these areas together as microeconomics and others as 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. Microeconomic issues include explaining how consumers react to changes in product prices and how firms decide what prices to charge for the products they sell. Microeconomics also involves policy issues, such as analyzing the most efficient way to reduce teenage smoking, analyzing the costs and benefits of approving the sale of a new prescription drug, and analyzing the most efficient way to reduce air pollution. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. Macroeconomic issues include explaining why economies experience periods of recession and increasing unemployment and why, over the long run, some economies have grown much faster than others. Macroeconomics also involves policy issues, such as whether government intervention can reduce the severity of recessions.


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The division between microeconomics and macroeconomics is not hard and fast. Many economic situations have both a microeconomic and a macroeconomic aspect. For example, the level of total investment by firms in new machinery and equipment helps to determine how rapidly the economy growswhich is a macroeconomic issue. But to understand how much new machinery and equipment firms decide to purchase, we have to analyze the incentives individual firms facewhich is a microeconomic issue.

A Preview of Important Economic TermsIn the following chapters, you will encounter certain important terms again and again. Becoming familiar with these terms is a necessary step in learning economics. Here we provide a brief introduction to some of these terms. We will discuss them all in greater depth in later chapters:

1.5 LEARNING OBJECTIVEBecome familiar with important economic terms.

Entrepreneur. An entrepreneur is someone who operates a business. In a market system, entrepreneurs decide what goods and services to produce and how to produce them. An entrepreneur starting a new business puts his or her own funds at risk. If an entrepreneur is wrong about what consumers want or about the best way to produce goods and services, the entrepreneurs funds can be lost. This is not an unusual occurrence: In the United States, about half of new businesses close within four years. Without entrepreneurs willing to assume the risk of starting and operating businesses, economic progress would be impossible in a market system. Innovation. There is a distinction between an invention and innovation. An invention is the development of a new good or a new process for making a good. An innovation is the practical application of an invention. (Innovation may also be used more broadly to refer to any significant improvement in a good or in the means of producing a good.) Much time often passes between the appearance of a new idea and its development for widespread use. For example, the Wright brothers first achieved self-propelled flight at Kitty Hawk, North Carolina, in 1903, but the Wright brothers plane was very crude, and it wasnt until the introduction of the DC-3 by Douglas Aircraft in 1936 that regularly scheduled intercity airline flights became common in the United States. Similarly, the first digital electronic computerthe ENIACwas developed in 1945, but the first IBM personal computer was not introduced until 1981, and widespread use of computers did not have a significant effect on the productivity of U.S. business until the 1990s. Technology. A firms technology is the processes it uses to produce goods and services. In the economic sense, a firms technology depends on many factors, such as the skill of its managers, the training of its workers, and the speed and efficiency of its machinery and equipment. Firm, company, or business. A firm is an organization that produces a good or service. Most firms produce goods or services to earn profits, but there are also nonprofit firms, such as universities and some hospitals. Economists use the terms firm, company, and business interchangeably. Goods. Goods are tangible merchandise, such as books, computers, or Blu-ray players. Services. Services are activities done for others, such as providing haircuts or investment advice. Revenue. A firms revenue is the total amount received for selling a good or service. It is calculated by multiplying the price per unit by the number of units sold. Profit. A firms profit is the difference between its revenue and its costs. Economists distinguish between accounting profit and economic profit. In calculating accounting profit, we exclude the cost of some economic resources that the firm


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does not pay for explicitly. In calculating economic profit, we include the opportunity cost of all resources used by the firm. When we refer to profit in this book, we mean economic profit. It is important not to confuse profit with revenue.

Household. A household consists of all persons occupying a home. Households are suppliers of factors of productionparticularly laborused by firms to make goods and services. Households also demand goods and services produced by firms and governments. Factors of production or economic resources. Firms use factors of production to produce goods and services. The main factors of production are labor, capital, natural resourcesincluding landand entrepreneurial ability. Households earn income by supplying to firms the factors of production. Capital. The word capital can refer to financial capital or to physical capital. Financial capital includes stocks and bonds issued by firms, bank accounts, and holdings of money. In economics, though, capital refers to physical capital, which includes manufactured goods that are used to produce other goods and services. Examples of physical capital are computers, factory buildings, machine tools, warehouses, and trucks. The total amount of physical capital available in a country is referred to as the countrys capital stock. Human capital. Human capital refers to the accumulated training and skills that workers possess. For example, college-educated workers generally have more skills and are more productive than workers who have only high school degrees.

Continued from page 3

Economics in YOUR LIFE!At the beginning of the chapter, we posed the question Is it likely that during your career, you will be competing for a job with immigrant workers from China, India, or some other foreign country? Some information helpful in answering this question appears in the Making the Connection on pages 1314 and in the chapter opener. Supporters of restrictions on H-1B visas for highly skilled workers argue that reducing the ability of firms to hire foreign workers would increase the jobs and wages available to U.S. workers. The chapter opener points out, however, that the total number of H-1B visas is limited to 65,000 per year and that this category of visas covers a broad range of skilled workers, from computer programmers to fashion models. In 2009, Congress placed additional restrictions on the ability of banks and other firms receiving government aid to hire foreign workers. Is 65,000 workers a large number? To put the number in perspective, between June 2007 and June 2008, the U.S. economy created 29.4 million new jobs, even though part of the period was during an economic recession. So, although you may encounter difficulty finding a job and you may lose your job one or more times during your career, competition from foreign workers will probably not be the reason.

ConclusionThe best way to think of economics is as a group of useful ideas about how individuals make choices. Economists have put these ideas into practice by developing economic models. Consumers, business managers, and government policymakers use these models every day to help make choices. In this book, we explore many key economic models and give examples of how to apply them in the real world. Most students taking an introductory economics course do not major in economics or become professional economists. Whatever your major, the economic principles you


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will learn in this book will improve your ability to make choices in many aspects of your life. These principles will also improve your understanding of how decisions are made in business and government. Reading newspapers and other periodicals is an important part of understanding the current business climate and learning how to apply economic concepts to a variety of real-world events. At the end of each chapter, you will see a two-page feature titled An Inside Look. This feature consists of an excerpt of an article that relates to the company or economic issue introduced at the start of the chapter and also to the concepts discussed in the chapter. A summary and an analysis and supporting graphs highlight the key economic points of the article. Read An Inside Look at Policy on the next page to explore arguments for and against restricting or reducing the number of H-1B visas for highly skilled workers. Test your understanding by answering the Thinking Critically about Policy questions.


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AN INSIDE

at Pol icy

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>> Do Immigrants Displaceor Complement Domestic Workers?THE ECONOMIST

Give Me Your Scientists . . .JOE BIDEN, Americas new vicepresident, is prone to gaffes. In 2006 it was the turn of some Americans of Asian descent to take offence at his comment about needing a slight Indian accent to go to a 7-Eleven or a Dunkin Donuts in Delaware. Mr Bidens defence was that he was trying to compliment the immigrant group on its entrepreneurial zeal. Many Americans are less favoura ably disposed towards immigrants. And rising unemployment is hardening attitudes. In the hubbub over the insertion of Buy American provisions into President Obamas fiscal-stimulus package, the Grassley-Sanders amendment was largely overlooked. This restricts the freedom of recipients of federal bail-out money to hire highskilled foreign workers under the governments H-1B visa programme. Some people were delighted at what they saw as a significant, if small, first step in cracking down on those who they fear crowd skilled American workers out of the workplace. But others contend that such restrictions could dull Americas edge in innovation, just when it is needed to help revive the economy. Mr Obama says that part of the solution to Americas economic problems should come from its universities and research laboratories. Yet these institutions in America are now manned disproportionately by immi-

grants, who made up 47% of scientists years between 2000 and 2004. Nearly and engineers in America with PhDs, 40% of patents filed in 2005 by Intel, a according to the 2000 census. Immisilicon-chip maker, were for work done grants accounted for two-thirds of the by people of Chinese or Indian origin. net addition to Americas stock of Some of these patents may have been such workers between 1995 and 2006. awarded to American-born children of Their role in innovation may seem earlier migrants, but Mr Kerr reckons obvious: the more clever people there that most changes over time arise from are, the more ideas are likely to flourfresh immigration. ish, especially if they can be commer- c What of the criticism that these cialised. But although contemporary workers are displacing native scientists theories of growth emphasise the who would have been just as inventive? importance of ideas, they assign no To address this, Mr Kerr and William special role to immigration. EconoLincoln, an economist at the University mists have tended to think of innovaof Michigan, used data on how patents tion as driven by the demand for betresponded to periodic changes in the ter goods, which generates a need for number of H-1B entrants. If immiskilled innovators. Peoples choices of grants were merely displacing natives, career and education should respond increases in the H-1B quota should not to the labour markets demands, have led to increases in innovation. But encouraging more of them to become Messrs Kerr and Lincoln found that innovators if needed. But because when the federal government increased career choices cannot be expected to the number of people allowed in under adjust instantly, there might be scope the programme by 10%, total patentfor skilled immigrants to fill the gap. ing increased by around 2% in the b Addressing these issues requires short run. This was driven mainly by data on just how inventive immigrants more patenting by immigrant scienare, a question that until recently was tists. But even patenting by native scithe province of educated guesswork. entists increased slightly, rather than But William Kerr, an economist at Hardecreasing as proponents of crowding vard Business School, used nameout would have predicted. matching software to identify the ethIf anything, immigrants seemed to nicity of each of the 8m scientists who crowd in native innovation, perhaps had acquired an American patent since because ideas feed off each other. Econ1975. He found that the share of patents omists think of knowledge, unlike awarded to scientists born in America physical goods, as non-rival: use by fell between 1975 and 2004. The share one person does not necessarily preof all patents given to scientists of Chiclude use by others . . . nese and Indian descent living in AmerSource: Give Me Your Scientists. . . , The Econoica more than tripled, from 4.1% in the mist, March 5, 2009. second half of the 1970s to 13.9% in the

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Key Points in the ArticleThis article discusses the possibility that as highly skilled Chinese, Indian, and other immigrants are restricted from working in the United States, U.S. firms will become less competitive with foreign companies. Restricting the number of highly-skilled workers in the United States could undermine economic growth and reduce increases in living standards. The article argues that one strength of the United States is that it attracts the best and brightest from all around the world.

Analyzing the NewsFigure 1 shows that the fraction of scientists and engineers in the United States who are foreign born has been slowly increasing. Figure 2 shows the countries of origin of foreign-born students receiving Ph.D.s in science and engineering. The article states that some people are in favor of restricting the number of H-1B visas for highly skilled workers, while other people would prefer that more of these visas be granted. In this chapter, we learned

a

that people are rational. So, how can rational people come to different conclusions about such a fundamental question? Being rational means that people have goals and pursue actions that further those goals. U.S. firms argue that if more skilled workers are not allowed to immigrate to the United States, the firms will have difficulty competing with foreign companies that do not face restriction on whom they can hire. On the other hand, skilled workers who were born in the United States prefer not to have competition from foreign workers for the jobs that are available. Reduced competition would drive up wages. So, each party to the debate is advocating pursuing policies according to its own interests. b We have seen in this chapter that economists use models to analyze economic questions. When studying an economic question, economists form a hypothesis that can be tested using available data. In this case, the issue is how many innovations are attributed to immigrant scientists and engineers. William Kerr of the Harvard Business School attempted to answer the question by calculating how

many patents had been granted to scientists whose names indicated that they were of Chinese or Indian descent. He discovered that the percentage of innovations discovered by scientists of Chinese and Indian descent increased from 4.1 percent in the late 1970s to 13.9 percent by the early 2000s. c One key aspect of the debate over H1B visas concerns whether new immigrants are displacing native workers or whether they are adding to the productive capacity of the economy by increasing the total amount of innovation. The study by William Kerr and William Lincoln mentioned in the article indicates that new immigrants increase the total amount of innovation, as measured by increases in the number of patents granted. In fact, the authors show that both native workers and foreign workers increase their patenting when the number of H-1B visas increases. This study will not end the debate over the value of immigration. But it does provide some evidence that immigrant scientists appear to be complementing domestic workers rather than displacing them.

Percentage of foreign-born scientists and engineers 41.5% 41.0 40.5 40.0 39.5 39.0 38.5 38.0 37.5 37.0 2000 2005

Others 35.5% Mexico 1.7% Japan 1.7% Iran 1.8% Thailand 1.8% Turkey 2.1% Canada 3.3% India 9.9% 2001 2002 2003 2004 South Korea 10.0% Taiwan 10.1%

China 22.0%

Figure 1 Foreign-Born Scientists and Engineers as a Percentage of All Scientists and Engineers in the United States

Figure 2 Foreign Recipients of U.S. Science and Engineering Doctorates, 19852005

Source: National Science Foundation, Division of Science Resources Statistics, Science and Engineering Indicators: 2008, NSF 08-01 (Arlington, VA, February 2008).

Thinking Critically About Policy1. According to the article, many Americans would like the government to further restrict the number of H-1B work visas. What evidence from the article indicates that further limits on the immigration of

highly-skilled workers would create job vacancies that firms would have difficulty filling using only native-born scientists and engineers? 2. The article points out that when the number of immigrant scientists and engineers increases 10 percent, the number of patents increases by 2 percent and

that both immigrant and native-born scientists and engineers were responsible for this increase. Why would patenting by native-born scientists increase at the same time that the number of foreign-born scientists and engineers was increasing?

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Key TermsAllocative efficiency, p. 10 Centrally planned economy, p. 9 Economic model, p. 4 Economic variable, p. 11 Economics, p. 4 Equity, p. 10 Macroeconomics, p. 14 Marginal analysis, p. 7 Market, p. 4 Market economy, p. 9 Microeconomics, p. 14 Mixed economy, p. 10 Normative analysis, p. 12 Opportunity cost, p. 8 Positive analysis, p. 12 Productive efficiency, p. 10 Scarcity, p. 4 Trade-off, p. 8 Voluntary exchange, p. 10

1.1

Three Key Economic Ideas, pages 47LEARNING OBJECTIVE: Explain these three key economic ideas: People are rational. People respond to incentives. Optimal decisions are made at the margin.

SummaryEconomics is the study of the choices consumers, business managers, and government officials make to attain their goals, given their scarce resources. We must make choices because of scarcity, which means that although our wants are unlimited, the resources available to fulfill those wants are limited. Economists assume that people are rational in the sense that consumers and firms use all available information as they take actions intended to achieve their goals. Rational individuals weigh the benefits and costs of each action and choose an action only if the benefits outweigh the costs. Although people act from a variety of motives, ample evidence indicates that they respond to economic incentives. Economists use the word marginal to mean extra or additional. The optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost.Visit www.myeconlab.com to complete these exercises online and get instant feedback.

bandit barrier. According to a special agent with the FBI, Bandit barriers are a great deterrent. Weve talked to guys who rob banks, and as soon as they see a bandit barrier, they go find another bank. Despite this finding, many banks have been reluctant to install these barriers. Wouldnt banks have a strong incentive to install bandit barriers to deter robberies? Why, then, do so many banks not do so?Source: Richard Cowen, FBI: Banks Are to Blame for Rise in Robberies, NorthJersey.com, March 10, 2009.

1.4 [Related to Solved Problem 1-1 on page 7] During 2009, movie studios began to release a substantial number of films in 3-D format. To show films in this format, theater owners have to invest in 3-D equipment that costs $75,000 for each projector. Typically, theater owners can charge about $3 more for a ticket to a 3-D movie than for a movie in the conventional 2-D format. If you owned a movie theater, discuss how you would go about deciding whether to invest in 3-D equipment.Source: Lauren A. E. Schuker, Can 3-D Save Hollywood? Wall Street Journal, March 20, 2009.

Review Questions1.1 Briefly discuss each of the following economic ideas: People are rational. People respond to incentives. Optimal decisions are made at the margin. 1.2 What is scarcity? Why is scarcity central to the study of economics?

1.5 [Related to Solved Problem 1-1 on page 7] Two students are discussing Solved Problem 1-1: Joe: I think the key additional information you need to know in deciding whether to produce 1 million more iPhones is the amount of profit you are currently making while producing 10 million. Then you can compare the profit earned from selling 11 million iPhones with the profit earned from selling 10 million. This information is more important than the additional revenue and additional cost of the last 1 million iPhones produced. Jill: Actually, Joe, knowing how much profits change when you sell 1 million more iPhones is exactly the same as knowing the additional revenue and the additional cost. Briefly evaluate their arguments.

Problems and Applications1.3 Bank robberies are on the rise in New Jersey, and according to the FBI, this increase has little to do with the economic downturn. The FBI claims that banks have allowed themselves to become easy targets by refusing to install clear acrylic partitions, called bandit barriers, which separate bank tellers from the public. Of the 193 banks robbed in New Jersey in 2008, only 23 had these barriers, and of the 40 banks robbed in the first 10 weeks of 2009, only 1 had a


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1.6 [Related to Solved Problem 1-1 on page 7] Late in the semester, a friend tells you, I was going to drop my psychology course so I could concentrate on my other courses, but I had already put so much time into the course that I decided not to drop it. What do you think of your friends reasoning? Would it make a difference to your answer if your friend has to pass the psychology course at some point to graduate? Briefly explain. 1.7 [Related to the Making the Connection on page 5] The country of Estonia has attempted to increase its birthrate by making payments to women who have babies. According to an article in the Wall Street Journal, Some demographers argue that paying people to have a baby simply makes them have one earlier; it doesnt necessarily make them have more. Reread the description of Estonias programs. Could the program be changed in ways that might make it more likely that Estonian women will have more children rather than simply changing the timing of when they have children? What information would we need to have to resolve the question of whether Estonian women are responding to the gov-

ernments incentives by having more children or simply by having them earlier?Source: Marcus Walker, In Estonia, Paying Women to Have Babies Is Paying Off, Wall Street Journal, October 20, 2006, p. A1.

1.8 In a paper written by Bentley College economists Patricia M. Flynn and Michael A. Quinn, the authors state, We find evidence that Economics is a good choice of major for those aspiring to become a CEO [chief executive officer]. When adjusting for size of the pool of graduates, those with undergraduate degrees in Economics are shown to have had a greater likelihood of becoming an S&P 500 CEO than any other major. A list of famous economics majors published by Marietta College includes business leaders Warren Buffet, Donald Trump, Ted Turner, and Sam Walton, as well as former presidents George H.W. Bush, Gerald Ford, and Ronald Reagan. Why might studying economics be particularly good preparation for being the top manager of a corporation or a leader in government?Sources: Patricia M. Flynn and Michael A. Quinn, Economics: A Good Choice of Major for Future CEOs, Social Science Research Network, November 28, 2006; and Econ 360: Law and Economics, Famous Economics Majors, Marietta College, September 27, 2008.

>>1.2

End Learning Objective 1.1

The Economic Problem That Every Society Must Solve, pages 711LEARNING 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?

SummarySociety faces trade-offs: Producing more of one good or service means producing less of another good or service. The opportunity cost of any activitysuch as producing a good or serviceis the highest-valued alternative that must be given up to engage in that activity. The choices of consumers, firms, and governments determine what goods and services will be produced. Firms choose how to produce the goods and services they sell. In the United States, who receives the goods and services produced depends largely on how income is distributed in the marketplace. In a centrally planned economy, most economic decisions are made by the government. In a market economy, most economic decisions are made by consumers and firms. Most economies, including that of the United States, are mixed economies in which most economic decisions are made by consumers and firms but in which the government also plays a significant role. There are two types of efficiency: productive efficiency and allocative efficiency. Productive efficiency occurs when a good or service is produced at the lowest possible cost. Allocative efficiency occurs when production is in accordance with consumer preferences. Voluntary exchange is a situation that occurs in markets when both the buyer and seller of

a product are made better off by the transaction. Equity is more difficult to define than efficiency, but it usually involves a fair distribution of economic benefits. Government policymakers often face a trade-off between equity and efficiency.Visit www.myeconlab.com to complete these exercises online and get instant feedback.

Review Questions2.1 What are the three economic questions that every society must answer? Briefly discuss the differences in how centrally planned, market, and mixed economies answer these questions. 2.2 What is the difference between productive efficiency and allocative efficiency? 2.3 What is the difference between efficiency and equity? Why do government policymakers often face a tradeoff between efficiency and equity?

Problems and Applications2.4 Does Bill Gates, one of the richest people in the world, face scarcity? Does everyone? Are there any exceptions?


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2.5 Would you expect new and better machinery and equipment to be adopted more rapidly in a market economy or in a centrally planned economy? Briefly explain. 2.6 Centrally planned economies have been less efficient than market economies. a. Has this happened by chance, or is there some underlying reason? b. If market economies are more economically efficient than centrally planned economies, would there ever be a reason to prefer having a centrally planned economy rather than a market economy? 2.7 Leonard Fleck, a philosophy professor at Michigan State University, has written, When it comes to health care in America, we have limited resources for unlimited health care needs. We want everything contemporary medical technology can offer that will improve the length or quality of our lives as we age. But as presently healthy taxpayers, we want costs controlled. Why is it necessary for all economic systems to limit services such as health care? How does a mar-

ket system prevent people from getting as many goods and services as they want?Source: Leonard Fleck, Just Caring: Health Care Rationing and Democratic Deliberation, New York: Oxford University Press, 2009.

2.8 Suppose that your local police department recovers 100 tickets to a big NASCAR race in a drug raid. It decides to distribute these to residents and announces that tickets will be given away at 10 A.M. Monday at City Hall. a. What groups of people will be most likely to try to get the tickets? Think of specific examples and then generalize. b. What is the opportunity cost of distributing the tickets this way? c. Productive efficiency occurs when a good or service (such as the distribution of tickets) is produced at the lowest possible cost. Is this an efficient way to distribute the tickets? If possible, think of a more efficient method of distributing the tickets. d. Is this an equitable way to distribute the tickets? Explain.

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Economic Models, pages 1114LEARNING OBJECTIVE: Understand the role of models in economic analysis.

SummaryEconomists rely on economic models when they apply economic ideas to real-world problems. Economic models are simplified versions of reality used to analyze real-world economic situations. Economists accept and use an economic model if it leads to hypotheses that are confirmed by statistical analysis. In many cases, the acceptance is tentative, however, pending the gathering of new data or further statistical analysis. Economics is a social science because it applies the scientific method to the study of the interactions among individuals. Economics is concerned with positive analysis rather than normative analysis. Positive analysis is concerned with what is. Normative analysis is concerned with what ought to be. Because economics is based on studying the actions of individuals, it is a social science. As a social science, economics considers human behavior in every context of decision making, not just in business.Visit www.myeconlab.com to complete these exercises online and get instant feedback.

with normative analysis or with positive analysis? Briefly explain.

Problems and Applications3.4 Do you agree or disagree with the following assertion: The problem with economics is that it assumes that consumers and firms always make the correct decision. But we know everyones human, and we all make mistakes. 3.5 Suppose an economist develops an economic model and finds that it works great in theory, but it fails in practice. What should the economist do next? 3.6 Dr. Strangeloves theory is that the price of mushrooms is determined by the activity of subatomic particles that exist in another universe parallel to ours. When the subatomic particles are emitted in profusion, the price of mushrooms is high. When subatomic particle emissions are low, the price of mushrooms also is low. How would you go about testing Dr. Strangeloves theory? Discuss whether this theory is useful. 3.7 [Related to the Making the Connection on page 13] The Making the Connection explains that the debate over the immigration of skilled workers has both positive and normative elements. What economic statistics would be most useful in evaluating the positive elements in this debate? Assuming that these statistics are available or could be gathered, are they likely to resolve the normative issues in this debate?

Review Questions3.1 Why do economists use models? How are economic data used to test models? 3.2 Describe the five steps by which economists arrive at a useful economic model. 3.3 What is the difference between normative analysis and positive analysis? Is economics concerned mainly


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3.8 [Related to the Chapter Opener on page 3] Many U.S. firms have had difficulty filling available jobs with U.S. citizens. U.S. law restricts the number of foreign specialty workers who may enter the United States under the H-1B visa program to just 65,000 per year. In 2009, Congress tightened these restrictions even more. a. Why have U.S. firms had difficulty filling available jobs with U.S. citizens? b. What affect might the tightening of restrictions on immigration of foreign workers have on the U.S. economy? 3.9 [Related to the Dont Let This Happen to You! on page 13] Explain which of the following statements represent positive analysis and which represent normative analysis. a. A 50-cent-per-pack tax on cigarettes will lead to a 12 percent reduction in smoking by teenagers. b. The federal government should spend more on AIDS research.

c. Rising paper prices will increase textbook prices. d. The price of coffee at Starbucks is too high.

3.10 In Australia, anyone providing financial advice must be licensed through the Australia Securities and Investment Commission (ASIC). ASIC chairman Jeffrey Lucy reminded consumers of this law after receiving complaints that people were continuing to invest large sums of money with people who were not authorized to provide financial advice. This law applies to financial advice from the Internet in the same way it applies to financial advice in any other medium. a. How would this law help protect consumers? b. How might this law protect financial advisors more than consumers? c. Briefly discuss whether you consider this law to be a good law.Sources: Australian Services and Investment Commission, 06-162: Has your financial adviser got a license? May 24, 2006; and Securities Advice, Oz NetLaw, 2008.

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Microeconomics and Macroeconomics, pages 1415LEARNING OBJECTIVE: Distinguish between microeconomics and macroeconomics.

SummaryMicroeconomics is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.Visit www.myeconlab.com to complete these exercises online and get instant feedback.

a. The effect of higher cigarette taxes on the quantity

of cigarettes soldb. The effect of higher income taxes on the total

amount of consumer spendingc. The reasons for the economies of East Asian coun-

Review Question4.1 Briefly discuss the difference between microeconomics and macroeconomics.

Problems and Applications4.2 Briefly explain whether each of the following is primarily a microeconomic issue or a macroeconomic issue.

tries growing faster than the economies of subSaharan African countries d. The reasons for low rates of profit in the airline industry 4.3 Briefly explain whether you agree with the following assertion: Microeconomics is concerned with things that happen in one particular place, such as the unemployment rate in one city. In contrast, macroeconomics is concerned with things that affect the country as a whole, such as how the rate of teenage smoking in the United States would be affected by an increase in the tax on cigarettes.

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A Preview of Important Economic Terms, pages 1516LEARNING OBJECTIVE: Become familiar with important economic terms.

SummaryBecoming familiar with important terms is a necessary step in learning economics. These important economic terms

include capital, entrepreneur, factors of production, firm, goods, household, human capital, innovation, profit, revenue, and technology.

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AppendixLEARNING OBJECTIVEReview the use of graphs and formulas.

Using Graphs and FormulasGraphs are used to illustrate key economic ideas. Graphs appear not just in economics textbooks but also on Web sites and in newspaper and magazine articles that discuss events in business and economics. Why the heavy use of graphs? Because they serve two useful purposes: (1) They simplify economic ideas, and (2) they make the ideas more concrete so they can be applied to real-world problems. Economic and business issues can be complicated, but a graph can help cut through complications and highlight the key relationships needed to understand the issue. In that sense, a graph can be like a street map. For example, suppose you take a bus to New York City to see the Empire State Building. After arriving at the Port Authority Bus Terminal, you will probably use a map similar to the one shown below to find your way to the Empire State Building. Maps are very familiar to just about everyone, so we dont usually think of them as being simplified versions of reality, but they are. This map does not show much more than the streets in this part of New York City and some of the most important buildings. The names, addresses, and telephone numbers of the people who live and work in the area arent given. Almost none of the stores and buildings those people work and live in are shown either. The map doesnt indicate which streets allow curbside parking and which dont. In fact, the map shows almost nothing about the messy reality of life in this section of New York City, except how the streets are laid out, which is the essential information you need to get from the Port Authority to the Empire State Building.


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Think about someone who says, I know how to get around in the city, but I just cant figure out how to read a map. It certainly is possible to find your destination in a city without a map, but its a lot easier with one. The same is true of using graphs in economics. It is possible to arrive at a solution to a real-world problem in economics and business without using graphs, but it is usually a lot easier if you do use them. Often, the difficulty students have with graphs and formulas is a lack of familiarity. With practice, all the graphs and formulas in this text will become familiar to you. Once you are familiar with them, you will be able to use them to analyze problems that would otherwise seem very difficult. What follows is a brief review of how graphs and formulas are used.

Graphs of One VariableFigure 1A-1 displays values for market shares in the U.S. automobile market, using two common types of graphs. Market shares show the percentage of industry sales accounted for by different firms. In this case, the

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