Samuelson Nordhaus Chap 1

Basic Concepts

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A. INTRODUCTION

As you begin your studies, you are probably wondering, Why study eco-nomics? In fact, people do it for a number of reasons.

Many study economics because they hope to make money.Some people worry that they will be considered illiterate if they

cannot understand the laws of supply and demand.Others are interested in learning about how comput-

ers and the information revolution are shaping our so-ciety or why inequality in the distribution of income

in the United States has risen so sharply in recentyears.

For Whom the Bell TollsAll these reasons, and many more, make goodsense. Still, as we have come to realize, thereis one overriding reason for learning the ba-sic lessons of economics: All your life—fromcradle to grave and beyond—you will runup against the brutal truths of economics.As a voter, you will make decisions on is-sues that cannot be understood until youhave mastered the rudiments of this sub-ject. Without a study of economics, youcannot be fully informed about interna-tional trade, the economic impact of theInternet, or the trade-off between infla-tion and unemployment.

Choosing your life’s occupation is themost important economic decision you willmake. Your future depends not only on

your own abilities but also on how economicforces beyond your control affect your wages.

Also, your knowledge of economics may helpyou invest the nest egg you save from your

earnings. Of course, studying economics can-not make you a genius. But without economics

the dice of life are loaded against you.There is no need to belabor the point. We

hope you will find that, in addition to being useful,economics is a fascinating field in its own right. Gen-

erations of students, often to their surprise, have discov-ered how stimulating economics can be.

The Fundamentals ofEconomics

The Age of Chivalry is gone; thatof sophisters, economists, and

calculators has succeeded.

Edmund Burke

3

1C H A P T E R

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man desires were fully satisfied, what would be theconsequences? People would not worry aboutstretching out their limited incomes because theycould have everything they wanted; businesses wouldnot need to fret over the cost of labor or health care;governments would not need to struggle over taxesor spending or pollution because nobody would care.Moreover, since all of us could have as much as wepleased, no one would be concerned about the dis-tribution of incomes among different people orclasses.

In such an Eden of affluence, all goods would befree, like sand in the desert or seawater at the beach.All prices would be zero, and markets would be un-necessary. Indeed, economics would no longer be auseful subject.

But no society has reached a utopia of limitlesspossibilities. Ours is a world of scarcity, full of eco-nomic goods. A situation of scarcity is one in whichgoods are limited relative to desires. An objective ob-server would have to agree that, even after two cen-turies of rapid economic growth, production in theUnited States is simply not high enough to meeteveryone’s desires. If you add up all the wants, youquickly find that there are simply not enough goodsand services to satisfy even a small fraction of every-one’s consumption desires. Our national outputwould have to be many times larger before the av-erage American could live at the level of the averagedoctor or big-league baseball player. Moreover, out-side the United States, particularly in Africa and Asia,hundreds of millions of people suffer from hungerand material deprivation.

Given unlimited wants, it is important that aneconomy make the best use of its limited resources.That brings us to the critical notion of efficiency. Efficiency denotes the most effective use of a soci-ety’s resources in satisfying people’s wants and needs.By contrast, consider an economy with uncheckedmonopolies or unhealthy pollution or unwarrantedgovernment interferences. Such an economy mayproduce less than would be possible without thesefactors, or it may produce a disorted bundle of goodsthat leaves consumers worse off than they otherwisecould be—either situation is an inefficient allocationof resources.

In economics, we say that an economy is produc-ing efficiently when it cannot make anyone economi-cally better off without making someone else worse off.

4 CHAPTER 1 THE FUNDAMENTALS OF ECONOMICS

SCARCITY AND EFFICIENCY:THE TWIN THEMES OF ECONOMICS

What is economics? Over the last half-century, thestudy of economics has expanded to include a vastrange of topics. What are the major definitions ofthese growing subjects?1 The important ones are thateconomics

� analyzes how a society’s institutions and technol-ogy affect prices and the allocation of resourcesamong different uses.

� explores the behavior of the financial markets,including interest rates and stock prices.

� examines the distribution of income and suggestsways that the poor can be helped without harm-ing the performance of the economy.

� studies the business cycle and examines howmonetary policy can be used to moderate theswings in unemployment and inflation.

� studies the patterns of trade among nations andanalyzes the impact of trade barriers.

� looks at growth in developing countries and pro-poses ways to encourage the efficient use of re-sources.

� asks how government policies can be used to pur-sue important goals such as rapid economicgrowth, efficient use of resources, full employment,price stability, and a fair distribution of income.

This list is a good one, yet you could extend itmany times over. But if we boil down all these defi-nitions, we find one common theme:

Economics is the study of how societies use scarceresources to produce valuable commodities and dis-tribute them among different people.

Behind this definition are two key ideas in eco-nomics: that goods are scarce and that society mustuse its resources efficiently. Indeed, economics is animportant subject because of the fact of scarcity andthe desire for efficiency.

Consider a world without scarcity. If infinitequantities of every good could be produced or if hu-

1 This list contains several specialized terms from economics.To master the subject, you will need to understand its vo-cabulary. If you are not familiar with a particular word orphrase, you should consult the Glossary at the back of thisbook. The Glossary contains most of the major technical eco-nomic terms used in this book. All terms printed in boldfaceare defined in the Glossary.

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The essence of economics is to acknowledge thereality of scarcity and then figure out how to organ-ize society in a way which produces the most efficientuse of resources. That is where economics makes itsunique contribution.

Microeconomics and MacroeconomicsAdam Smith is usually considered the founder of thefield of microeconomics, the branch of economicswhich today is concerned with the behavior of indi-vidual entities such as markets, firms, and house-holds. In The Wealth of Nations (1776), Smith consid-ered how individual prices are set, studied thedetermination of prices of land, labor, and capital,and inquired into the strengths and weaknesses of themarket mechanism. Most important, he identifiedthe remarkable efficiency properties of markets andsaw that economic benefit comes from the self-inter-ested actions of individuals. These remain importantissues today, and while the study of microeconomicshas surely advanced greatly since Smith’s day, he isstill cited by politicians and economists alike.

The other major branch of our subject is macro-economics, which is concerned with the overall per-formance of the economy. Macroeconomics did noteven exist in its modern form until 1935, when JohnMaynard Keynes published his revolutionary GeneralTheory of Employment, Interest and Money. At the time,England and the United States were still stuck in theGreat Depression of the 1930s, with over one-quar-ter of the American labor force unemployed. In hisnew theory Keynes developed an analysis of whatcauses business cycles, with alternating spells of highunemployment and high inflation. Today, macro-economics examines a wide variety of areas, such ashow total investment and consumption are deter-mined, how central banks manage money and in-terest rates, what causes international financial crises,and why some nations grow rapidly while others stag-nate. Although macroeconomics has progressed farsince his first insights, the issues addressed by Keynesstill define the study of macroeconomics today.

The two branches—microeconomics and macro-economics—converge to form the core of moderneconomics.

THE LOGIC OF ECONOMICS

Economic life is an enormously complicated hive ofactivity, with people buying, selling, bargaining, in-

vesting, persuading, and threatening. The ultimatepurpose of economic science and of this text is tounderstand this complex undertaking. How do econ-omists go about their task?

Economists use the scientific approach to under-stand economic life. This involves observing eco-nomic affairs and drawing upon statistics and the his-torical record. For complex phenomena like theimpacts of budget deficits or the causes of inflation,historical research has provided a rich mine of in-sights.

Often, economics relies upon analyses and the-ories. Theoretical approaches allow economists tomake broad generalizations, such as those con-cerning the advantages of international trade andspecialization or the disadvantages of tariffs andquotas.

In addition, economists have developed a spe-cialized technique known as econometrics, which ap-plies the tools of statistics to economic problems.Using econometrics, economists can sift throughmountains of data to extract simple relationships.

Budding economists must also be alert to com-mon fallacies in economic reasoning. Because eco-nomic relationships are often complex, involvingmany different variables, it is easy to become con-fused about the exact reason behind events or theimpact of policies on the economy. The following aresome of the common fallacies encountered in eco-nomic reasoning:

� The post hoc fallacy. The first fallacy involves theinference of causality. The post hoc fallacy occurswhen we assume that, because one event occurred be-fore another event, the first event caused the secondevent.2 An example of this syndrome occurred inthe Great Depression of the 1930s in the UnitedStates. Some people had observed that periodsof business expansion were preceded or accom-panied by rising prices. From this, they con-cluded that the appropriate remedy for depres-sion was to raise wages and prices. This idea ledto a host of legislation and regulations to propup wages and prices in an inefficient manner. Didthese measures promote economic recovery? Al-most surely not. Indeed, they probably slowed re-covery, which did not occur until total spending

THE LOGIC OF ECONOMICS 5

2 “Post hoc” is shorthand for post hoc, ergo propter hoc. Translatedfrom the Latin, the full expression means “after this, there-fore necessarily because of this.”

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These examples contain no tricks or magic.Rather, they are the results of systems of inter-acting individuals. Often the behavior of the ag-gregate looks very different from the behavior ofindividual people.

We mention these fallacies only briefly in this in-troduction. Later, as we introduce the tools of eco-nomics, we will provide examples of how inattentionto the logic of economics can lead you to false andsometimes costly errors. When you reach the end ofthis book, you can look back to see why each of theseparadoxical examples is true.

COOL HEADS AT THE SERVICE OF WARM HEARTS

Economics has, over the last century, grown from atiny acorn into a mighty oak. Under its spreadingbranches we find explanations of the gains from in-ternational trade, advice on how to reduce unem-ployment and inflation, formulas for investing yourretirement funds, and even proposals for selling therights to pollute. Throughout the world, economistsare laboring to collect data and improve our under-standing of economic trends.

You might well ask, What is the purpose of thisarmy of economists measuring, analyzing, and cal-culating? The ultimate goal of economic science isto improve the living conditions of people in theireveryday lives. Increasing the gross domestic prod-uct is not just a numbers game. Higher incomesmean good food, warm houses, and hot water. Theymean safe drinking water and inoculations againstthe perennial plagues of humanity.

Higher incomes mean even more. They allow gov-ernments to build schools so that young people canlearn to read and develop the skills necessary to inventnew technologies like artificial intelligence. As incomesrise further, nations can afford deep scientific inquiriesinto biology and discover still more vaccines againststill more diseases. With the resources freed up by eco-nomic growth, talented artists have the opportunity towrite poetry and compose music, while others have theleisure time to read, to listen, and to perform. Al-though there is no single pattern of economic devel-opment, and the evolution of culture will differ aroundthe world, freedom from hunger, disease, and the el-ements is a universal human aspiration.


began to rise as the government increased mili-tary spending in preparation for World War II.

� Failure to hold other things constant. A second pit-fall is failure to hold other things constant whenthinking about an issue. For example, we mightwant to know whether raising tax rates will raiseor lower tax revenues. Some people have putforth the seductive argument that we can eat ourfiscal cake and have it too. They argue that cut-ting tax rates will at the same time raise govern-ment revenues and lower the budget deficit. Theypoint to the Kennedy-Johnson tax cuts of 1964,which lowered tax rates sharply and were fol-lowed by an increase in government revenues in1965. Hence, they argue, lower tax rates producehigher revenues.

What is wrong with this reasoning? This ar-gument overlooks the fact that the economygrew from 1964 to 1965. Because people’s in-comes grew during that period, government rev-enues also grew, even though tax rates werelower. Careful studies indicate that revenueswould have been even higher in 1965 had taxrates not been lowered in 1964. Hence, thisanalysis fails to hold other things (namely, totalincomes) constant.

Remember to hold other things constant when youare analyzing the impact of a variable on the economicsystem.

� The fallacy of composition. Sometimes we assumethat what holds true for part of a system alsoholds true for the whole. In economics, however,we often find that the whole is different from thesum of the parts. When you assume that what is truefor the part is also true for the whole, you are commit-ting the fallacy of composition.

Here are some true statements that might sur-prise you if you ignored the fallacy of composi-tion: (1) If one farmer has a bumper crop, shehas a higher income; if all farmers produce arecord crop, farm incomes will fall. (2) If oneperson receives a great deal more money, thatperson will be better off; if everyone receives agreat deal more money, the society is likely to beworse off. (3) If a high tariff is put on the prod-uct of a particular industry, the producers in thatindustry are likely to profit; if high tariffs are puton all industries, most producers and consumerswill be worse off.

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COOL HEADS AT THE SERVICE OF WARM HEARTS 7

But centuries of human history also show thatwarm hearts alone will not feed the hungry or healthe sick. A free and efficient market will not neces-sarily produce a distribution of income that is sociallyacceptable. Determining the best route to economicprogress or an equitable distribution of society’s out-put requires cool heads, ones that objectively weighthe costs and benefits of different approaches, try-ing as hard as humanly possible to keep the analysisfree from the taint of wishful thinking. Sometimes,economic progress will require shutting down an out-moded factory. Sometimes, as when the formerly so-cialist countries adopted market principles, thingsget worse before they get better. Choices are partic-ularly difficult in the field of health care, where lim-ited resources literally involve life and death.

You may have heard the saying, “From each ac-cording to his ability, to each according to his need.”Governments have learned that no society can longoperate solely on this utopian principle. To main-tain a healthy economy, governments must preserveincentives for people to work and to save. Societiescan support the unemployed for a while, but whenunemployment insurance covers too much for toolong, people come to depend upon the governmentand stop looking for work. If they begin to believethat the government owes them a living, this maydull the sharp edge of enterprise. Just because gov-ernment programs derive from lofty purposes doesnot mean that they should be pursued without careand efficiency.

Society must find the right balance between thediscipline of the market and the compassion of gov-ernment social programs. By using cool heads to in-form our warm hearts, economic science can do itspart in ensuring a prosperous and just society.

B. THE THREE PROBLEMS OFECONOMIC ORGANIZATION

Every human society—whether it is an advanced in-dustrial nation, a centrally planned economy, or anisolated tribal nation—must confront and resolvethree fundamental economic problems. Every soci-ety must have a way of determining what commodi-

Positive economics versus normativeeconomicsIn thinking about economic questions, wemust distinguish questions of fact from ques-

tions of fairness. Positive economics describesthe facts of an economy, while normative eco-

nomics involves value judgments.Positive economics deals with questions such as:

Why do doctors earn more than janitors? Does free traderaise or lower the wages of most Americans? What is theimpact of computers on productivity? Although these aredifficult questions to answer, they can all be resolved by

ties are produced, how these goods are made, and forwhom they are produced.

Indeed, these three fundamental questions ofeconomic organization—what, how, and for whom—are as crucial today as they were at the dawn of hu-man civilization. Let’s look more closely at them:

� What commodities are produced and in whatquantities? A society must determine how muchof each of the many possible goods and servicesit will make and when they will be produced.Will we produce pizzas or shirts today? A fewhigh-quality shirts or many cheap shirts? Will weuse scarce resources to produce many con-sumption goods (like pizzas)? Or will we pro-duce fewer consumption goods and more in-vestment goods (like pizza-making machines),which will boost production and consumptiontomorrow.

� How are goods produced? A society must deter-mine who will do the production, with what re-sources, and what production techniques theywill use. Who farms and who teaches? Is elec-tricity generated from oil, from coal, or from thesun? Will factories be run by people or robots?

� For whom are goods produced? Who gets to eatthe fruit of economic activity? Is the distributionof income and wealth fair and equitable? How isthe national product divided among differenthouseholds? Are many people poor and a fewrich? Do high incomes go to teachers or athletesor autoworkers or Internet entrepreneurs? Willsociety provide minimal consumption to thepoor, or must people work if they are to eat?

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government keeps its hands off economic decisions,is called a laissez-faire economy.

By contrast, a command economy is one in whichthe government makes all important decisions aboutproduction and distribution. In a command econ-omy, such as the one which operated in the SovietUnion during most of the twentieth century, the gov-ernment owns most of the means of production (landand capital); it also owns and directs the operationsof enterprises in most industries; it is the employerof most workers and tells them how to do their jobs;and it decides how the output of the society is to bedivided among different goods and services. In short,in a command economy, the government answers themajor economic questions through its ownership ofresources and its power to enforce decisions.

No contemporary society falls completely into ei-ther of these polar categories. Rather, all societies aremixed economies, with elements of market and com-mand. There has never been a 100 percent marketeconomy (although nineteenth-century Englandcame close).

Today most decisions in the United States aremade in the marketplace. But the government playsan important role in overseeing the functioning ofthe market; governments pass laws that regulate eco-nomic life, produce educational and police services,and control pollution. Most societies today operatemixed economies.

C. SOCIETY’S TECHNOLOGICALPOSSIBILITIES

Every gun that is made, every warshiplaunched, every rocket fired signifies, inthe final sense, a theft from those who

hunger and are not fed.

President Dwight D. Eisenhower

Each economy has a stock of limited resources—labor, technical knowledge, factories and tools, land,energy. In deciding what and how things should beproduced, the economy is in reality deciding how to


MARKET, COMMAND, AND MIXED ECONOMIES

What are the different ways that a society can answerthe questions of what, how, and for whom? Differentsocieties are organized through alternative economicsystems, and economics studies the various mecha-nisms that a society can use to allocate its scarce re-sources.

We generally distinguish two fundamentally dif-ferent ways of organizing an economy. At one ex-treme, government makes most economic decisions,with those on top of the hierarchy giving economiccommands to those further down the ladder. At theother extreme, decisions are made in markets, whereindividuals or enterprises voluntarily agree to ex-change goods and services, usually through pay-ments of money. Let’s briefly examine each of thesetwo forms of economic organization.

In the United States and most democratic coun-tries, most economic questions are solved by the mar-ket. Hence their economic systems are called marketeconomies. A market economy is one in which indi-viduals and private firms make the major decisionsabout production and consumption. A system ofprices, of markets, of profits and losses, of incentivesand rewards determines what, how, and for whom.Firms produce the commodities that yield the high-est profits (the what) by the techniques of produc-tion that are least costly (the how). Consumption isdetermined by individuals’ decisions about how tospend the wages and property incomes generated bytheir labor and property ownership (the for whom).The extreme case of a market economy, in which the

reference to analysis and empirical evidence. That putsthem in the realm of positive economics.

Normative economics involves ethical preceptsand norms of fairness. Should poor people be required towork if they are to get government assistance? Should un-employment be raised to ensure that price inflation doesnot become too rapid? Should the United States break upMicrosoft because it has violated the antitrust laws? Thereare no right or wrong answers to these questions becausethey involve ethics and values rather than facts. They canbe resolved only by political debate and decisions, not byeconomic analysis alone.

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allocate its resources among the thousands of dif-ferent possible commodities and services. Howmuch land will go into growing wheat? Or into hous-ing the population? How many factories will pro-duce computers? How many will make pizzas? Howmany children will grow up to play professionalsports or to be professional economists or to pro-gram computers?

Faced with the undeniable fact that goods arescarce relative to wants, an economy must decide howto cope with limited resources. It must choose amongdifferent potential bundles of goods (the what), se-lect from different techniques of production (thehow), and decide in the end who will consume thegoods (the for whom).

INPUTS AND OUTPUTS

To answer these three questions, every society mustmake choices about the economy’s inputs and out-puts. Inputs are commodities or services that areused to produce goods and services. An economyuses its existing technology to combine inputs to pro-duce outputs. Outputs are the various useful goodsor services that result from the production processand are either consumed or employed in furtherproduction. Consider the “production” of pizza. Wesay that the eggs, flour, heat, pizza oven, and chef’sskilled labor are the inputs. The tasty pizza is the out-put. In education, the inputs are the time of the fac-ulty, the laboratories and classrooms, the textbooks,and so on, while the outputs are informed, produc-tive, and well-paid citizens.

Another term for inputs is factors of production.These can be classified into three broad categories:land, labor, and capital.

� Land—or, more generally, natural resources—represents the gift of nature to our productiveprocesses. It consists of the land used for farm-ing or for underpinning houses, factories, androads; the energy resources that fuel our cars andheat our homes; and the nonenergy resourceslike copper and iron ore and sand. In today’s con-gested world, we must broaden the scope of nat-ural resources to include our environmental re-sources, such as clean air and drinkable water.

� Labor consists of the human time spent in pro-duction—working in automobile factories, tilling

the land, teaching school, or baking pizzas. Thou-sands of occupations and tasks, at all skill levels,are performed by labor. It is at once the most fa-miliar and the most crucial input for an advancedindustrial economy.

� Capital resources form the durable goods of aneconomy, produced in order to produce yetother goods. Capital goods include machines,roads, computers, hammers, trucks, steel mills,automobiles, washing machines, and buildings.As we will see later, the accumulation of special-ized capital goods is essential to the task of eco-nomic development.

Restating the three economic problems in terms ofinputs and outputs, a society must decide (1) whatoutputs to produce, and in what quantity; (2) how toproduce them—that is, by what techniques inputsshould be combined to produce the desired outputs;and (3) for whom the outputs should be producedand distributed.

THE PRODUCTION-POSSIBILITYFRONTIER

Societies cannot have everything they want. They arelimited by the resources and the technology availableto them. Take defense spending as an example.Countries must decide how much of their limited re-sources goes to their military and how much goesinto other activities (such as new factories or educa-tion). Some countries, like Japan, allocate only 1 per-cent of their national output to their military. TheUnited States spends 4 percent of its national outputon defense, while a fortress economy like North Ko-rea spends up to 20 percent of its national output onthe military. The more output that goes for defense,the less there is available for consumption and in-vestment.

Let us dramatize this choice by considering aneconomy which produces only two economic goods,guns and butter. The guns, of course, represent mil-itary spending, and the butter stands for civilianspending. Suppose that our economy decides tothrow all its energy into producing the civilian good,butter. There is a maximum amount of butter thatcan be produced per year. The maximal amount ofbutter depends on the quantity and quality of theeconomy’s resources and the productive efficiency

INPUTS AND OUTPUTS 9

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produce 15,000 guns of a certain kind if no butteris produced.

These are two extreme possibilities. In betweenare many others. If we are willing to give up somebutter, we can have some guns. If we are willing togive up still more butter, we can have still more guns.

A schedule of possibilities is given in Table 1-1.Combination F shows the extreme, where all butterand no guns are produced, while A depicts the op-posite extreme, where all resources go into guns. Inbetween—at E, D, C, and B—increasing amounts ofbutter are given up in return for more guns.

How, you might well ask, can a nation turn but-ter into guns? Butter is transformed into guns notphysically but by the alchemy of diverting the econ-omy’s resources from one use to the other.

We can represent our economy’s production possibilities more vividly in the diagram shown in


Alternative Production PossibilitiesButter Guns

Possibilities (millions of pounds) (thousands)

A 0 15B 1 14C 2 12D 3 9E 4 5F 5 0

TABLE 1-1. Limitation of Scarce Resources Implies theGuns-Butter Tradeoff

Scarce inputs and technology imply that the production ofguns and butter is limited. As we go from A to B . . . to F, weare transferring labor, machines, and land from the gun in-dustry to butter and can thereby increase butter production.

Gun

s (t

hous

ands

)

15

12

9

6

3

1 2 3 4 5Butter (millions of pounds)

AB

C

D

E

F

0

FIGURE 1-1. The Production Possibilities in a Graph

This figure displays the alternative combinations of pro-duction pairs from Table 1-1.

with which they are used. Suppose 5 million poundsof butter is the maximum amount that can be pro-duced with the existing technology and resources.

At the other extreme, imagine that all resourcesare instead devoted to the production of guns.Again, because of resource limitations, the econ-omy can produce only a limited quantity of guns.For this example, assume that the economy can

The Production-Possibility Frontier

Gun

s (t

hous

ands

)

15

12

9

6

3

0 1 2 3 4 5Butter (millions of pounds)

A

B

C

D I

E

F

G

B

U

FIGURE 1-2. A Smooth Curve Connects the PlottedPoints of the Numerical Production Possibilities

This frontier shows the schedule along which society canchoose to substitute guns for butter. It assumes a given stateof technology and a given quantity of inputs. Points out-side the frontier (such as point I ) are infeasible or unat-tainable. Any point inside the curve, such as U, indicatesthat the economy has not attained productive efficiency,as is the case, for instance, when unemployment is highduring severe business cycles.

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Figure 1-1. This diagram measures butter along thehorizontal axis and guns along the vertical one. (Ifyou are unsure about the different kinds of graphsor about how to turn a table into a graph, consultthe appendix to this chapter.) We plot point F in Fig-ure 1-1 from the data in Table 1-1 by counting over5 butter units to the right on the horizontal axis andgoing up 0 gun units on the vertical axis; similarly,E is obtained by going 4 butter units to the right andgoing up 5 gun units; and finally, we get A by goingover 0 butter units and up 15 gun units.

If we fill in all intermediate positions with newblue-colored points representing all the differentcombinations of guns and butter we have the con-tinuous blue curve shown as the production-possibilityfrontier, or PPF, in Figure 1-2.

The production-possibility frontier (or PPF )shows the maximum amounts of production that can be obtained by an economy, given its technologi-cal knowledge and quantity of inputs available. The

THE PRODUCTION-POSSIBILITY FRONTIER 11

PPF represents the menu of goods and services avail-able to society.

Putting the PPF to WorkThe PPF in Figure 1-2 was drawn for guns and but-ter, but the same analysis applies to any choice ofgoods. Thus the more resources the government usesto build public goods like highways, the less will beleft to produce private goods like houses; the morewe choose to consume of food, the less we can con-sume of clothing; the more society decides to con-sume today, the less can be its production of capitalgoods to turn out more consumption goods in thefuture.

The graphs in Figures 1-3 to 1-5 present some im-portant applications of PPFs. Figure 1-3 shows the ef-fect of economic growth on a country’s productionpossibilities. An increase in inputs, or improved tech-nological knowledge, enables a country to producemore of all goods and services, thus shifting out the

L

Necessities (food, . . .)

L

(a) Poor Nation

Necessities (food, . . .)

A

F

B

F

(b) High-Income Nation

Lu

xuri

es

(ca

rs,

ste

reo

s, .

. . )

A

Lu

xuri

es

(ca

rs,

ste

reo

s, .

. . )

FIGURE 1-3. Economic Growth Shifts the PPF Outward

(a) Before development, the nation is poor. It must devote almost all its resources to foodand enjoys few comforts. (b) Growth of inputs and technological change shift out the PPF.With economic growth, a nation moves from A to B, expanding its food consumption littlecompared with its increased consumption of luxuries. It can increase its consumption ofboth goods if it desires.

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(a) Frontier Society (b) Urban Society

Private goods (food, . . .)Pr

Pu

Pu

blic

go

od

s (h

igh

way

s, .

. .)

A

B

Pr

Pu

A

Private goods (food, . . .)

Pu

blic

go

od

s (h

igh

way

s, .

. .)

FIGURE 1-4. Economies Must Choose Between Public Goods and Private Goods

(a) A poor frontier society lives from hand to mouth, with little left over for public goodslike highways or public health. (b) A modern urbanized economy is more prosperous andchooses to spend more of its higher income on public goods and government services (roads,environmental protection, and education).

C

A3

A2

A1

Current consumption0

Cap

ital i

nves

tmen

t

(a) Before Investment (b) After Investment

B3

B2

B1

Future consumption0

Country 1

Country 2

Country 3

II

C

Cap

ital i

nves

tmen

t

FIGURE 1-5. Investment for Future Consumption Requires Sacrificing Current Consumption

A nation can produce either current-consumption goods (pizzas and concerts) or investmentgoods (pizza ovens and concert halls). (a) Three countries start out even. They have the samePPF, shown in the panel on the left, but they have different investment rates. Country 1 doesnot invest for the future and remains at A1 (merely replacing machines). Country 2 abstainsmodestly from consumption and invests at A2. Country 3 sacrifices a great deal of current con-sumption and invests heavily. (b) In the following years, countries that invest more heavily forgeahead. Thus thrifty Country 3 has shifted its PPF far out, while Country 1’s PPF has not movedat all. Countries that invest heavily have higher investment and consumption in the future.

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The concept of opportunity cost can be illus-trated using the PPF. Examine the frontier in Fig-ure 1-2, which shows the trade-off between gunsand butter. Suppose the country decides to in-crease its gun purchases from 9000 guns at D to12,000 units at C. What is the opportunity cost ofthis decision? You might calculate the cost in dol-lar terms. But in economics we always need to“pierce the veil” of money to examine the real im-pacts of alternative decisions. On the most funda-mental level, the opportunity cost of moving fromD to C is the butter that must be given up to pro-duce the extra guns. In this example, the oppor-tunity cost of the 3000 extra guns is 1 millionpounds of butter forgone.

Or consider the real-world example of the costof opening a gold mine near Yellowstone NationalPark. The developer argues that the mine will havebut a small cost because Yellowstone’s revenues willhardly be affected. But an economist would answerthat the dollar receipts are too narrow a measure ofcost. We should ask whether the unique and preciousqualities of Yellowstone might be degraded if a goldmine were to operate, with the accompanying noise,water and air pollution, and degradation of amenityvalue for visitors. While the dollar cost might besmall, the opportunity cost in lost wilderness valuesmight be large indeed.

In a world of scarcity, choosing one thing meansgiving up something else. The opportunity cost of adecision is the value of the good or service forgone.

EfficiencyAll of our explanations up to now have implicitly as-sumed that the economy is producing efficiently—that is, it is on, rather than inside, the production-possibility frontier. Remember that efficiency meansthat the economy’s resources are being used as ef-fectively as possible to satisfy people’s needs and de-sires. One important aspect of overall economic ef-ficiency is productive efficiency.

Productive efficiency occurs when an economycannot produce more of one good without produc-ing less of another good; this implies that the econ-omy is on its production-possibility frontier.

Let’s see why productive efficiency requires be-ing on the PPF. Start in the situation shown by point

THE PRODUCTION-POSSIBILITY FRONTIER 13

The trade-off of timeThe production-possibility frontier can alsoshow the crucial economic notion of trade-offs. One of the most important decisions

all people make is how to use their time. Peo-ple have limited time available to pursue differ-

ent activities. For example, as a student, you might have10 hours to study for upcoming tests in both economicsand history. If you study only history, you will get a highgrade there and do poorly in economics, and vice versa.Treating the grades on the two tests as the “output” ofyour studying, sketch out the PPF for grades, given yourlimited time resources. Alternatively, if the two studentcommodities are “grades” and “fun,” how would youdraw this PPF? Where are you on this frontier? Whereare your lazy friends?

PPF. The figure also illustrates that poor countriesmust devote most of their resources to food pro-duction while rich countries can afford more luxu-ries as productive potential increases.

Figure 1-4 depicts the electorate’s choice be-tween private goods (bought at a price) and publicgoods (paid for by taxes). Poor countries can affordlittle of public goods like public health and scientificresearch. But with economic growth, public goods aswell as environmental quality take a larger share ofoutput.

Figure 1-5 portrays an economy’s choice between(a) current-consumption goods and (b) investmentor capital goods (machines, factories, etc.). By sacri-ficing current consumption and producing morecapital goods, a nation’s economy can grow morerapidly, making possible more of both goods (con-sumption and capital) in the future.

Opportunity CostsLife is full of choices. Because resources are scarce,we must always consider how to spend our limitedincomes or time. When you decide whether tostudy economics, buy a car, or go to college, in eachcase you must consider how much the decision willcost in terms of forgone opportunities. The cost ofthe forgone alternative is the opportunity cost of thedecision.

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of the most dramatic declines in production oc-curred during the early 1990s after countries threwoff their socialist planning systems and adopted freemarkets. Because of the disruptions to organizationsand production patterns, output fell and unem-ployment rose as firms responded to changing mar-kets and the new rules of capitalism. No period ofpeacetime history saw such sustained declines in out-put as the “real business cycles” of the postsocialisteconomies.

However, economists expect that this downturnwill be but a temporary setback. Already, theeconomies that have made the most thorough re-forms—such as Poland and the Czech Republic—have turned the corner and are beginning to recover.Their PPFs are once again shifting outward, and theirincomes are likely to surpass the incomes of coun-tries like Ukraine or Belarus, which have been re-luctant reformers.

As we close this introductory chapter, let us re-turn briefly to our opening theme, Why study eco-nomics? Perhaps the best answer to the questionis a famous one given by Keynes in the final linesof The General Theory of Employment, Interest andMoney:

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. Practicalmen, who believe themselves to be quite exemptfrom any intellectual influences, are usually theslaves of some defunct economist. Madmen in authority, who hear voices in the air, are distillingtheir frenzy from some academic scribbler of a fewyears back. I am sure that the power of vested interests is vastly exaggerated compared with thegradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in thefield of economic and political philosophy thereare not many who are influenced by new theoriesafter they are twenty-five or thirty years of age, sothat the ideas which civil servants and politiciansand even agitators apply to current events are notlikely to be the newest. But, soon or late, it isideas, not vested interests, which are dangerous for good or evil.

To understand how the powerful ideas of econom-ics apply to the central issues of human societies—ultimately, this is why we study economics.


D in Figure 1-2. Say the market calls for anothermillion pounds of butter. If we ignored the con-straint shown by the PPF, we might think it possi-ble to produce more butter without reducing gunproduction, say, by moving to point I, to the rightof point D. But point I is outside the frontier, inthe “infeasible” region. Starting from D, we cannotget more butter without giving up some guns.Hence point D displays productive efficiency, whilepoint I is infeasible.

One further point about productive efficiencycan be illustrated using the PPF: Being on the PPFmeans that producing more of one good inevitablyrequires sacrificing other goods. When we producemore guns, we are substituting guns for butter. Sub-stitution is the law of life in a full-employment econ-omy, and the production-possibility frontier depictsthe menu of society’s choices.

Unemployed Resources and Inefficiency. Even ca-sual observers of modern life know that society hasunemployed resources in the form of idle workers,idle factories, and idled land. When there are un-employed resources, the economy is not on its pro-duction-possibility frontier at all but, rather, some-where inside it. In Figure 1-2, point U represents apoint inside the PPF; at U, society is producing only2 units of butter and 6 units of guns. Some re-sources are unemployed, and by putting them towork, we can increase our output of all goods; theeconomy can move from U to D, producing morebutter and more guns, thus improving the econ-omy’s efficiency. We can have our guns and eatmore butter too.

One source of inefficiency occurs during busi-ness cycles. From 1929 to 1933, in the Great De-pression, the total output produced in the UnitedStates declined by almost 25 percent. This occurrednot because the PPF shifted in but because variousshocks reduced spending and pushed the economyinside its PPF. Then the buildup for World War II ex-panded demand, and output grew rapidly as theeconomy pushed back to the PPF. Similar forces wereat work in much of the industrial world between 1990and 1996 as macroeconomic factors pushed Europeand Japan inside their PPFs.

Business-cycle depressions are not the only rea-son why an economy might be inside its PPF. One

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SUMMARY

A. Introduction

1. What is economics? Economics is the study of how so-cieties choose to use scarce productive resources thathave alternative uses, to produce commodities of var-ious kinds, and to distribute them among differentgroups. We study economics to understand not onlythe world we live in but also the many potential worldsthat reformers are constantly proposing to us.

2. Goods are scarce because people desire much morethan the economy can produce. Economic goods arescarce, not free, and society must choose among thelimited goods that can be produced with its availableresources.

3. Microeconomics is concerned with the behavior of in-dividual entities such as markets, firms, and house-holds. Macroeconomics views the performance of theeconomy as a whole. Through all economics, bewareof the fallacy of composition and the post hoc fallacy,and remember to keep other things constant.

B. The Three Problems of Economic Organization

4. Every society must answer three fundamental ques-tions: what, how, and for whom? What kinds and quan-tities are produced among the wide range of all pos-sible goods and services? How are resources used inproducing these goods? And for whom are the goodsproduced (that is, what is the distribution of incomeand consumption among different individuals andclasses)?

5. Societies answer these questions in different ways. Themost important forms of economic organization todayare command and market. The command economy is di-rected by centralized government control; a market

SUMMARY 15

economy is guided by an informal system of prices andprofits in which most decisions are made by private in-dividuals and firms. All societies have different com-binations of command and market; all societies aremixed economies.

C. Society’s Technological Possibilities

6. With given resources and technology, the productionchoices between two goods such as butter and gunscan be summarized in the production-possibility frontier(PPF ). The PPF shows how the production of onegood (such as guns) is traded off against the produc-tion of another good (such as butter). In a world ofscarcity, choosing one thing means giving up some-thing else. The value of the good or service forgone isits opportunity cost.

7. Productive efficiency occurs when production of onegood cannot be increased without curtailing produc-tion of another good. This is illustrated by the PPF.When an economy is on its PPF, it can produce moreof one good only by producing less of another good.

8. Production-possibility frontiers illustrate many basiceconomic processes: how economic growth pushes outthe frontier, how a nation chooses relatively less foodand other necessities as it develops, how a countrychooses between private goods and public goods, andhow societies choose between consumption goods andcapital goods that enhance future consumption.

9. Societies are sometimes inside their production-possi-bility frontier. When unemployment is high or whenrevolution or inefficient government regulations ham-per economic activity, the economy is inefficient andoperates inside its PPF.

CONCEPTS FOR REVIEW

Fundamental Concepts

scarcity and efficiencyfree goods vs. economic goodsmacroeconomics and microeco-

nomicsnormative vs. positive economicsfallacy of composition, post hoc

fallacy“keep other things constant”cool heads, warm hearts

Key Problems of EconomicOrganization

what, how, and for whomalternative economic systems: com-

mand vs. marketlaissez-fairemixed economies

Choice Among ProductionPossibilities

inputs and outputsproduction-possibility frontier (PPF)productive efficiency and inefficiencyopportunity cost

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1. The great English economist Alfred Marshall (1842–1924) invented many of the tools of modern eco-nomics, but he was most concerned with the applica-tion of these tools to the problems of society. In his in-augural lecture, Marshall wrote:

It will be my most cherished ambition to increase thenumbers who Cambridge University sends out into theworld with cool heads but warm hearts, willing to givesome of their best powers to grappling with the socialsuffering around them; resolved not to rest content tillthey have opened up to all the material means of a re-fined and noble life. [Memorials of Alfred Marshall, A. C.Pigou, ed. (MacMillan and Co., London, 1925), p. 174,with minor edits.]

Explain how the cool head might provide the essen-tial positive economic analysis to implement the nor-mative value judgments of the warm heart. Do youagree with Marshall’s view of the role of the teacher?Do you accept his challenge?

2. The late George Stigler, an eminent conservativeChicago economist, wrote as follows:

No thoroughly egalitarian society has ever been able toconstruct or maintain an efficient and progressive eco-nomic system. It has been universal experience that somesystem of differential rewards is necessary to stimulateworkers. [The Theory of Price, 3d ed. (Macmillan, NewYork, 1966), p. 19.]


QUESTIONS FOR DISCUSSION

Are these statements positive or normative econom-ics? Discuss Stigler’s view in light of Alfred Marshall’squote in question 1. Is there a conflict?

3. Define each of the following terms carefully and giveexamples: PPF, scarcity, productive efficiency, inputs,outputs.

4. As people become wealthier, time becomes their ma-jor scarce resource. Suppose that you are very rich buthave only a few hours a week of spare time. Give someexamples of steps you can take to economize on youruse of time. Compare time use of a wealthy person withthat of a poor person.

5. Assume that Econoland produces haircuts and shirtswith inputs of labor. Econoland has 1000 hours of la-bor available. A haircut requires 1/2 hour of labor, whilea shirt requires 5 hours of labor. Construct Econo-land’s production-possibility frontier.

6. Assume that scientific inventions have doubled theproductivity of society’s resources in butter productionwithout altering the productivity of gun manufacture.Redraw society’s production-possibility frontier in Fig-ure 1-2 to illustrate the new trade-off.

7. Many scientists believe that we are rapidly depletingour natural resources. Assume that there are only twoinputs (labor and natural resources) producing twogoods (concerts and gasoline) with no improvementin society’s technology over time. Show what would

FURTHER READING AND INTERNET WEBSITES

Further Reading

Robert Heilbroner, The World Philosophers, Seventh Edition,1999, Touchstone Books provides a lively biography of thegreat economists along with their ideas and impact. Theauthoritative work on the history of economic analysis isJoseph Schumpeter, History of Economic Analysis (McGraw-Hill, New York, 1954).

Websites

One of the greatest books of all economics is Adam Smith,The Wealth of Nations (many publishers, 1776). Every eco-nomics student should read a few pages to get the flavorof his writing. The Wealth of Nations can be found at www.bibliomania.com/NonFiction/Smith/Wealth/index.html.

Log onto one of the Internet reference sites for econom-ics such as Resources for Economists on the Internet(www.rfe.org or rfe.wustl.edu/EconFAQ.html). Browsethrough some of the sections to familiarize yourself withthe site. You might want to look up your college or uni-versity, look at recent news in a newspaper or magazine,or check some economic data.

Two sites for excellent analyses of public policy issues ineconomics are those of the Brookings Institution(www.brook.edu) and of the American Enterprise Institute(www.aei.org and www.aei.org/eo/eofront.htm). Each ofthese publishes books and has policy briefs on line.

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happen to the PPF over time as natural resources areexhausted. How would invention and technologicalimprovement modify your answer? On the basis of thisexample, explain why it is said that “economic growthis a race between depletion and invention.”

8. Say that Diligent has 10 hours to study for upcomingtests in economics and history. Draw a PPF for grades,

given Diligent’s limited time resources. If Diligent stud-ies inefficiently by listening to loud music and chattingwith friends, where will Diligent’s grade “output” berelative to the PPF? What will happen to the grade PPFif Diligent increases study inputs from 10 hours to 15hours?

QUESTIONS FOR DISCUSSION 17

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18

A picture is worth a thousandwords.

Chinese Proverb

Before you can master economics, you must have aworking knowledge of graphs. They are as indis-pensable to the economist as a hammer is to a car-penter. So if you are not familiar with the use of di-agrams, invest some time in learning how to readthem—it will be time well spent.

What is a graph? It is a diagram showing how twoor more sets of data or variables are related to oneanother. Graphs are essential in economics because,among other reasons, they allow us to analyze eco-nomic concepts and examine historical trends.

You will encounter many different kinds ofgraphs in this book. Some graphs show how variableschange over time (see, for example, the inside of thefront cover); other graphs show the relationship be-tween different variables (such as the example wewill turn to in a moment). Each graph in the bookwill help you understand an important economic re-lationship or trend.

THE PRODUCTION-POSSIBILITYFRONTIER

The first graph that you encountered in this text wasthe production-possibility frontier. As we showed inthe body of this chapter, the production-possibilityfrontier, or PPF, represents the maximum amountsof a pair of goods or services that can both be pro-duced with an economy’s given resources, assumingthat all resources are fully employed.

Let’s follow up an important application, thatof choosing between food and machines. The es-sential data for the PPF are shown in Table 1A-1,which is very much like the example in Table 1-1.Recall that each of the possibilities gives one levelof food production and one level of machine pro-duction. As the quantity of food produced in-creases, the production of machines falls. Thus, ifthe economy produced 10 units of food, it couldproduce a maximum of 140 machines, but whenthe output of food is 20 units, only 120 machinescan be manufactured.

Production-Possibility Graph. The datashown in Table 1A-1 can also be pre-

sented as a graph. To construct the graph,we represent each of the table’s pairs of data

by a single point on a two-dimensional plane. Fig-ure 1A-1 displays in a graph the relationship between

Appendix 1

HOW TO READ GRAPHS

Alternative Production PossibilitiesPossibilities Food Machines

A 0 150B 10 140C 20 120D 30 90E 40 50F 50 0

TABLE 1A-1. The Pairs of Possible Outputs of Food andMachines

The table shows six potential pairs of outputs that can beproduced with the given resources of a country. The coun-try can choose one of the six possible combinations.

Mac

hine

s

150

120

90

60

30

10 20 30 40 50Food

AB

C

D

E

F

0

FIGURE 1A-1. Six Possible Pairs of Food-Machines Production Levels

This figure shows the data of Table 1A-1 in graphical form.The data are exactly the same, but the visual display pre-sents the data more vividly.

sam14885_ch01_018 10/18/00 12:40 AM

HOW TO READ GRAPHS 19

change in machinery production that would takeplace. Slope is an exact numerical measure of the rela-tionship between the change in Y and the change in X.

We can use Figure 1A-3 to show how to measurethe slope of a straight line, say, the slope of the linebetween points B and D. Think of the movementfrom B to D as occurring in two stages. First comesa horizontal movement from B to C indicating a 1-unit increase in the X value (with no change in Y ).Second comes a compensating vertical movement upor down, shown as s in Figure 1A-3. (The movementof 1 horizontal unit is purely for convenience. Theformula holds for movements of any size.) The two-step movement brings us from one point to anotheron the straight line.

Because the BC movement is a 1-unit increase inX, the length of CD (shown as s in Figure 1A-3) in-dicates the change in Y per unit change in X. On agraph, this change is called the slope of the line ABDE.

Often slope is defined as “the rise over the run.”The rise is the vertical distance; in Figure 1A-3, therise is the distance from C to D. The run is the horizontal distance; it is BC in Figure 1A-3. The riseover the run in this instance would be CD over BC.Thus the slope of BD is CD/BC.

the food and machines outputs shown in Table 1A-1. Each pair of numbers is represented by a singlepoint in the graph. Thus the row labeled “A” in Table1A-1 is graphed as point A in Figure 1A-1, and simi-larly for points B, C, and so on.

In Figure 1A-1, the vertical line at left and thehorizontal line at bottom correspond to the two vari-ables—food and machines. A variable is an item ofinterest that can be defined and measured and thattakes on different values at different times or places.Important variables studied in economics are prices,quantities, hours of work, acres of land, dollars of in-come, and so forth.

The horizontal line on a graph is referred to asthe horizontal axis, or sometimes the X axis. In Fig-ure 1A-1, food output is measured on the black hor-izontal axis. The vertical line is known as the verticalaxis, or Y axis. In Figure 1A-1, it measures the num-ber of machines produced. Point A on the verticalaxis stands for 150 machines. The lower left-handcorner, where the two axes meet, is called the origin.It signifies 0 food and 0 machines in Figure 1A-1.

A Smooth Curve. In most economic relationships,variables can change by small amounts as well as by thelarge increments shown in Figure 1A-1. We thereforegenerally draw economic relationships as continuouscurves. Figure 1A-2 shows the PPF as a smooth curvein which the points from A to F have been connected.

By comparing Table 1A-1 and Figure 1A-2, we cansee why graphs are so often used in economics. Thesmooth PPF reflects the menu of choice for the econ-omy. It is a visual device for showing what types ofgoods are available in what quantities. Your eye cansee at a glance the relationship between machine andfood production.

Slopes and Lines. Figure 1A-2 depicts the relationshipbetween maximum food and machine production.One important way to describe the relationship be-tween two variables is by the slope of the graph line.

The slope of a line represents the change in onevariable that occurs when another variable changes.More precisely, it is the change in the variable Y onthe vertical axis per unit change in the variable X onthe horizontal axis. For example, in Figure 1A-2, saythat food production rose from 25 to 26 units. Theslope of the curve in Figure 1A-2 tells us the precise

The Production-Possibility Frontier

Mac

hine

s

150

120

90

60

30

0 10 20 30 40 50Food

A

B

C

D

E

F

FIGURE 1A-2. A Production-Possibility Frontier

A smooth curve fills in between the plotted pairs of points,creating the production-possibility frontier.

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20 APPENDIX 1 HOW TO READ GRAPHS

Y

A

B

D

C1

s

E

Y

X

E

B

D

C1

s

A

X

(a) Inverse Relation (b) Direct Relation

FIGURE 1A-3. Calculation of Slope for Straight Lines

It is easy to calculate slopes for straight lines as “rise over run.” Thus in both (a) and (b),the numerical value of the slope is rise/run � CD/BC � s/1 � s. Note that in (a), CD is neg-ative, indicating a negative slope, or an inverse relationship between X and Y.

The key points to understand about slopes arethe following:

1. The slope can be expressed as a number. It meas-ures the change in Y per unit change in X, or“the rise over the run.”

2. If the line is straight, its slope is constant every-where.

3. The slope of the line indicates whether the rela-tionship between X and Y is direct or inverse. Di-rect relationships occur when variables move in the

2

1

Y

(a) (b)

2

1

Y

X1 2 3 4

X0 10 2 3 4

FIGURE 1A-4. Steepnessis not the Same as Slope

Note that even though (a)looks steeper than (b),they display the same re-lationship. Both have aslope of 1/2 but the X axishas been stretched out in(b).

same direction (that is, they increase or decreasetogether); inverse relationships occur when thevariables move in opposite directions (that is, oneincreases as the other decreases).

Thus a negative slope indicates the X-Y relationis inverse, as it is in Figure 1A-3(a). Why? Because anincrease in X calls for a decrease in Y.

People sometimes confuse slope with the ap-pearance of steepness. This conclusion is often butnot always valid. The steepness depends on the scale

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of the graph. Panels (a) and (b) in Figure 1A-4 bothportray exactly the same relationship. But in (b),the horizontal scale has been stretched out com-pared with (a). If you calculate carefully, you willsee that the slopes are exactly the same (and areequal to 1/2).

Slope of a Curved Line. A curved or nonlinear lineis one whose slope changes. Sometimes we want toknow the slope at a given point, such as point B in Fig-ure 1A-5. We see that the slope at point B is positive,but it is not obvious exactly how to calculate the slope.

To find the slope of a smooth curved line at apoint, we calculate the slope of the straight line thatjust touches, but does not cross, the curved line atthe point in question. Such a straight line is called atangent to the curved line. Put differently, the slopeof a curved line at a point is given by the slope ofthe straight line that is tangent to the curve at thegiven point. Once we draw the tangent line, we findthe slope of the tangent line with the usual right-angle measuring technique discussed earlier.

To find the slope at point B in Figure 1A-5, wesimply construct straight line FBJ as a tangent to thecurved line at point B. We then calculate the slopeof the tangent as NJ/MN. Similarly, the tangent lineGH gives the slope of the curved line at point D.

Another example of the slope of a nonlinear lineis shown in Figure 1A-6. This shows a typical micro-economics curve, which is dome-shaped and has amaximum at point C. We can use our method ofslopes-as-tangents to see that the slope of the curveis always positive in the region where the curve is rising and negative in the falling region. At the peakor maximum of the curve, the slope is exactly zero.A zero slope signifies that a tiny movement in the Xvariable around the maximum has no effect on thevalue of the Y variable.1

Y

XA

F

BG

DE

HNM

J

FIGURE 1A-5. Tangent as Slope of Curved Line

By constructing a tangent line, we can calculate the slopeof a curved line at a given point. Thus the line FBMJ is tan-gent to smooth curve ABDE at point B. The slope at B iscalculated as the slope of the tangent line, that is, asNJ/MN.

1 For those who enjoy algebra, the slope of a line can be re-membered as follows: A straight line (or linear relationship)is written as Y � a � bX. For this line, the slope of the curveis b, which measures the change in Y per unit change in X.

A curved line or nonlinear relationship is one involvingterms other than constants and the X term. An example of anonlinear relationship is the quadratic equation Y � (X � 2)2.You can verify that the slope of this equation is negative for X < 2 and positive for X > 2. What is its slope for X � 2?

For those who know calculus: A zero slope comes wherethe derivative of a smooth curve is equal to zero. For exam-ple, plot and use calculus to find the zero-slope point of acurve defined by the function Y � (X � 2)2.

Y

X

Zero slope

Posi

tive

slop

e Negative

slope

C

B D

A E

FIGURE 1A-6. Different Slopes of Nonlinear Curves

Many curves in economics first rise, then reach a maxi-mum, then fall. In the rising region from A to C the slopeis positive (see point B). In the falling region from C to Ethe slope is negative (see point D). At the curve’s maxi-mum, point C, the slope is zero. (What about a U-shapedcurve? What is the slope at its minimum?)

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curve, while in the second case (from D to G) we seea shift of the curve.

Some Special Graphs. The PPF is one of the mostimportant graphs of economics, one depicting therelationship between two economic variables (suchas food and machines or guns and butter). You willencounter other types of graphs in the pages thatfollow.

Time Series. Some graphs show how a particularvariable has changed over time. Look, for example,at the graphs on the inside front cover of this text.The left-hand graph shows a time series, since theAmerican Revolution, of a significant macroeco-nomic variable, the ratio of the federal governmentdebt to total gross domestic product, or GDP — thisratio is the debt-GDP ratio. Time-series graphs havetime on the horizontal axis and variables of interest(in this case, the debt-GDP ratio) on the vertical axis.This graph shows that the debt-GDP ratio has risensharply during every major war.

Scatter Diagrams. Sometimes individual pairs ofpoints will be plotted, as in Figure 1A-1. Often, com-binations of variables for different years will be plot-ted. An important example of a scatter diagram frommacroeconomics is the consumption function, shownin Figure 1A-8. This scatter diagram shows the na-tion’s total disposable income on the horizontal axisand total consumption (spending by households ongoods like food, clothing, and housing) on the ver-tical axis. Note that consumption is very closelylinked to income, a vital clue for understandingchanges in national income and output.

Diagrams with More Than One Curve. Often it isuseful to put two curves in the same graph, thus ob-taining a “multicurve diagram.” The most importantexample is the supply-and-demand diagram, shown inChapter 3 (see page 47). Such graphs can show twodifferent relationships simultaneously, such as howconsumer purchases respond to price (demand) andhow business production responds to price (supply).By graphing the two relationships together, we candetermine the price and quantity that will hold in amarket.

22 APPENDIX 1 HOW TO READ GRAPHSM

achi

nes

210

180

150

120

90

60

30

100 20 30 40 50 60 70Food

D

G

E

1990

2000

FIGURE 1A-7. Shift of Curves Versus Movement AlongCurves

In using graphs, it is essential to distinguish movement alonga curve (such as from high-investment D to low-investmentE ) from a shift of a curve (as from D in an early year to Gin a later year).

Shifts of and Movement Along Curves. An importantdistinction in economics is that between shifts ofcurves and movement along curves. We can exam-ine this distinction in Figure 1A-7. The inner pro-duction-possibility frontier reproduces the PPF inFigure 1A-2. At point D society chooses to produce30 units of food and 90 units of machines. If societydecides to consume more food with a given PPF, thenit can move along the PPF to point E. This movementalong the curve represents choosing more food andfewer machines.

Suppose that the inner PPF represents society’sproduction possibilities for 1990. If we return to thesame country in 2000, we see that the PPF has shiftedfrom the inner 1990 curve to the outer 2000 curve.(This shift would occur because of technologicalchange or because of an increase in labor or capitalavailable.) In the later year, society might choose tobe at point G, with more food and machines than ateither D or E.

The point of this example is that in the first case(moving from D to E) we see movement along the

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graphs in this book, and in other areas, can be bothfun and instructive.

This concludes our brief excursion into graphs.Once you have mastered these basic principles, the

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Disposible income (billions of 1996 dollars)

FIGURE 1A-8. Scatter Di-agram of ConsumptionFunction Shows Impor-tant Macroeconomic Law

Observed points of con-sumption spending fallnear the CC line, whichdisplays average behaviorover time. Thus, the blue-colored point for 1999 isso near the CC line that itcould have been quite ac-curately predicted fromthat line even before theyear was over. Scatter dia-grams allow us to see howclose the relationship isbetween two variables.

SUMMARY TO APPENDIX

1. Graphs are an essential tool of modern economics.They provide a convenient presentation of data or ofthe relationships among variables.

2. The important points to understand about a graph are:What is on each of the two axes (horizontal and ver-tical)? What are the units on each axis? What kind ofrelationship is depicted in the curve or curves shownin the graph?

3. The relationship between the two variables in a curveis given by its slope. The slope is defined as “the riseover the run,” or the increase in Y per unit increase

in X. If it is upward- (or positively) sloping, the twovariables are directly related; they move upward ordownward together. If the curve has a downward (ornegative) slope, the two variables are inversely related.

4. In addition, we sometimes see special types of graphs:time series, which show how a particular variablemoves over time; scatter diagrams, which show obser-vations on a pair of variables; and multicurve diagrams,which show two or more relationships in a singlegraph.

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24 APPENDIX 1 HOW TO READ GRAPHS

QUESTIONS FOR DISCUSSION

1. Consider the following problem: After your 8 hours aday of sleep, you have 16 hours a day to divide betweenleisure and study. Let leisure hours be the X variableand study hours be the Y variable. Plot the straight-line relationship between all combinations of X and Yon a blank piece of graph paper. Be careful to labelthe axes and mark the origin.

2. In question 1, what is the slope of the line showing therelationship between study and leisure hours? Is it astraight line?

3. Let us say that you absolutely need 6 hours of leisureper day, no more, no less. On the graph, mark the

point that corresponds to 6 hours of leisure. Now con-sider a movement along the curve: Assume that you de-cide that you need only 4 hours of leisure a day. Plotthe new point.

4. Next show a shift of the curve: You find that you needless sleep, so you have 18 hours a day to devote toleisure and study. Draw the new (shifted) curve.

5. Keep a record of your leisure and study for a week.Plot a time-series graph of the hours of leisure andstudy each day. Next plot a scatter diagram of hoursof leisure and hours of study. Do you see any rela-tionship between the two variables?

CONCEPTS FOR REVIEW

Elements of Graphs

horizontal, or X, axisvertical, or Y, axisslope as “rise over run”slope (negative, positive, zero)tangent as slope of curved line

Examples of Graphs

time-series graphsscatter diagramsmulticurve graphs

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Samuelson Nordhaus Chap 1

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