Chapter 1 The Scope And Method Of Econo

PART I

INTRODUCTION TO ECONOMICS

The Scope and
Method of Economics

1

The study of economics should begin with a sense of wonder. Pause for a moment and consider a typical day in your life. It might start with a bagel made in a local bakery with flour produced in Minnesota from wheat grown in Kansas and bacon from pigs raised in Ohio packaged in plastic made in New
Jersey. You spill coffee from
Colombia on your shirt made in
Texas from textiles shipped from
South Carolina.
After class you drive with a friend on an interstate highway that is part of a system that took 20 years and billions of dollars to build. You stop for gasoline refined in Louisiana from Saudi Arabian crude oil brought to the
United States on a supertanker that took 3 years to build at a shipyard in Maine.
Later you log onto the Web with a laptop assembled in Indonesia from parts made in China and Skype with your brother in Mexico City, and you call a buddy on your iPhone with parts from a dozen countries. You use or consume tens of thousands of things, both tangible and intangible, every day: buildings, music, staples, paper, toothpaste, tweezers, pizza, soap, digital watches, fire protection, banks, electricity, eggs, insurance, football fields, buses, rugs, subways, health services, sidewalks, and so forth. Somebody made all these things. Somebody organized men and women and materials to produce and distribute them. Thousands of decisions went into their completion. Somehow they got to you.
In the United States, over 139 million people—almost half the total population—work at hundreds of thousands of different jobs producing over $14 trillion worth of goods and services every year. Some cannot find work; some choose not to work. Some are rich; others are poor.
The United States imports over $200 billion worth of automobiles and parts and about
$300 billion worth of petroleum and petroleum products each year; it exports around $62 billion worth of agricultural products, including food. Every month the United States buys around
$25 billion worth of goods and services from China, while China buys about $5 billion worth from the United States. High-rise office buildings go up in central cities. Condominiums and homes are built in the suburbs. In other places, homes are abandoned and boarded up.
Some countries are wealthy. Others are impoverished. Some are growing. Some are not.
Some businesses are doing well. Others are going bankrupt. As the 10th edition of our text goes to press, the world is beginning to recover from a period during which many people felt the pain of a major economic downturn. In the United States at the beginning of 2010 more than 15 million people who wanted to work could not find a job. Millions around the world found themselves with falling incomes and wealth.
At any moment in time, every society faces constraints imposed by nature and by previous generations. Some societies are handsomely endowed by nature with fertile land, water, sunshine,

CHAPTER OUTLINE

Why Study
Economics?

p. 2

To Learn a Way of
Thinking
To Understand Society
To Understand Global
Affairs
To Be an Informed Citizen

The Scope of
Economics p. 6
Microeconomics and
Macroeconomics
The Diverse Fields of
Economics

The Method of
Economics p. 9
Descriptive Economics and
Economic Theory
Theories and Models
Economic Policy

An Invitation

p. 15

Appendix: How to
Read and Understand
Graphs p. 17

1

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PART I Introduction to Economics

and natural resources. Others have deserts and few mineral resources. Some societies receive much from previous generations—art, music, technical knowledge, beautiful buildings, and productive factories. Others are left with overgrazed, eroded land, cities leveled by war, or polluted natural environments. All societies face limits. economics The study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided. Economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided. The key word in this definition is choose. Economics is a behavioral, or social, science. In large measure, it is the study of how people make choices. The choices that people make, when added up, translate into societal choices.

The purpose of this chapter and the next is to elaborate on this definition and to introduce the subject matter of economics. What is produced? How is it produced? Who gets it? Why? Is the result good or bad? Can it be improved?

Why Study Economics?
There are four main reasons to study economics: to learn a way of thinking, to understand society, to understand global affairs, and to be an informed citizen.

To Learn a Way of Thinking
Probably the most important reason for studying economics is to learn a way of thinking.
Economics has three fundamental concepts that, once absorbed, can change the way you look at everyday choices: opportunity cost, marginalism, and the working of efficient markets.

Opportunity Cost What happens in an economy is the outcome of thousands of individ-

opportunity cost The best alternative that we forgo, or give up, when we make a choice or a decision.

scarce

Limited.

ual decisions. People must decide how to divide their incomes among all the goods and services available in the marketplace. They must decide whether to work, whether to go to school, and how much to save. Businesses must decide what to produce, how much to produce, how much to charge, and where to locate. It is not surprising that economic analysis focuses on the process of decision making.
Nearly all decisions involve trade-offs. A key concept that recurs in analyzing the decisionmaking process is the notion of opportunity cost. The full “cost” of making a specific choice includes what we give up by not making the alternative choice. The best alternative that we forgo, or give up, when we make a choice or a decision is called the opportunity cost of that decision.
When asked how much a movie costs, most people cite the ticket price. For an economist, this is only part of the answer: to see a movie takes not only a ticket but also time. The opportunity cost of going to a movie is the value of the other things you could have done with the same money and time. If you decide to take time off from work, the opportunity cost of your leisure is the pay that you would have earned had you worked. Part of the cost of a college education is the income you could have earned by working full-time instead of going to school. If a firm purchases a new piece of equipment for $3,000, it does so because it expects that equipment to generate more profit. There is an opportunity cost, however, because that $3,000 could have been deposited in an interest-earning account. To a society, the opportunity cost of using resources to launch astronauts on a space shuttle is the value of the private/civilian or other government goods that could have been produced with the same resources.
Opportunity costs arise because resources are scarce. Scarce simply means limited.
Consider one of our most important resources—time. There are only 24 hours in a day, and we must live our lives under this constraint. A farmer in rural Brazil must decide whether it is better to continue to farm or to go to the city and look for a job. A hockey player at the

CHAPTER 1 The Scope and Method of Economics

3

University of Vermont must decide whether to play on the varsity team or spend more time studying.

Marginalism A second key concept used in analyzing choices is the notion of marginalism.
In weighing the costs and benefits of a decision, it is important to weigh only the costs and benefits that arise from the decision. Suppose, for example, that you live in New Orleans and that you are weighing the costs and benefits of visiting your mother in Iowa. If business required that you travel to Kansas City, the cost of visiting Mom would be only the additional, or marginal, time and money cost of getting to Iowa from Kansas City.
Consider the video game business. It has been estimated that to create and produce a complex multiplayer role-playing game like World of Warcraft (WOW) costs as much as $500 million.
Once the game has been developed, however, the cost of selling and delivering it to another player is close to zero. The original investment (by Activision) made to create WOW is considered a sunk cost. Once the game has been developed, Activision cannot avoid these costs because they have already been incurred. Activision’s business decisions about pricing and distributing WOW depend not on the sunk costs of production, but on the incremental or marginal costs of production. For Activision, those costs are close to zero.
There are numerous examples in which the concept of marginal cost is useful. For an airplane that is about to take off with empty seats, the marginal cost of an extra passenger is essentially zero; the total cost of the trip is roughly unchanged by the addition of an extra passenger.
Thus, setting aside a few seats to be sold at big discounts through www.priceline.com or other
Web sites can be profitable even if the fare for those seats is far below the average cost per seat of making the trip. As long as the airline succeeds in filling seats that would otherwise have been empty, doing so is profitable.
Efficient Markets—No Free Lunch Suppose you are ready to check out of a busy grocery store on the day before a storm and seven checkout registers are open with several people in each line. Which line should you choose? Usually, the waiting time is approximately the same no matter which register you choose (assuming you have more than 12 items). If one line is much shorter than the others, people will quickly move into it until the lines are equalized again.
As you will see later, the term profit in economics has a very precise meaning. Economists, however, often loosely refer to “good deals” or risk-free ventures as profit opportunities. Using the term loosely, a profit opportunity exists at the checkout lines when one line is shorter than the others. In general, such profit opportunities are rare. At any time, many people are searching for them; as a consequence, few exist. Markets like this, where any profit opportunities are eliminated almost instantaneously, are said to be efficient markets. (We discuss markets, the institutions through which buyers and sellers interact and engage in exchange, in detail in
Chapter 2.)
The common way of expressing the efficient markets concept is “there’s no such thing as a free lunch.” How should you react when a stockbroker calls with a hot tip on the stock market?
With skepticism. Thousands of individuals each day are looking for hot tips in the market. If a particular tip about a stock is valid, there will be an immediate rush to buy the stock, which will quickly drive up its price. This view that very few profit opportunities exist can, of course, be carried too far. There is a story about two people walking along, one an economist and one not.
The non-economist sees a $20 bill on the sidewalk and says, “There’s a $20 bill on the sidewalk.”
The economist replies, “That is not possible. If there were, somebody would already have picked it up.”
There are clearly times when profit opportunities exist. Someone has to be first to get the news, and some people have quicker insights than others. Nevertheless, news travels fast, and there are thousands of people with quick insights. The general view that large profit opportunities are rare is close to the mark.
The study of economics teaches us a way of thinking and helps us make decisions.

marginalism The process of analyzing the additional or incremental costs or benefits arising from a choice or decision. sunk costs Costs that cannot be avoided because they have already been incurred. efficient market A market in which profit opportunities are eliminated almost instantaneously. 4

PART I Introduction to Economics

To Understand Society

Industrial Revolution The period in England during the late eighteenth and early nineteenth centuries in which new manufacturing technologies and improved transportation gave rise to the modern factory system and a massive movement of the population from the countryside to the cities.

Another reason for studying economics is to understand society better. Past and present economic decisions have an enormous influence on the character of life in a society. The current state of the physical environment, the level of material well-being, and the nature and number of jobs are all products of the economic system.
To get a sense of the ways in which economic decisions have shaped our environment, imagine looking out a top-floor window of an office tower in any large city. The workday is about to begin. All around you are other tall glass and steel buildings full of workers. In the distance, you see the smoke of factories. Looking down, you see thousands of commuters pouring off trains and buses and cars backed up on freeway exit ramps. You see trucks carrying goods from one place to another. You also see the face of urban poverty: Just beyond the freeway is a large public housing project and, beyond that, burned-out and boarded-up buildings. What you see before you is the product of millions of economic decisions made over hundreds of years. People at some point decided to spend time and money building those buildings and factories. Somebody cleared the land, laid the tracks, built the roads, and produced the cars and buses.
Economic decisions not only have shaped the physical environment but also have determined the character of society. At no time has the impact of economic change on a society been more evident than in England during the late eighteenth and early nineteenth centuries, a period that we now call the Industrial Revolution. Increases in the productivity of agriculture, new manufacturing technologies, and development of more efficient forms of transportation led to a massive movement of the British population from the countryside to the city. At the beginning of the eighteenth century, approximately 2 out of 3 people in Great Britain worked in agriculture. By 1812, only 1 in 3 remained in agriculture; by 1900, the figure was fewer than
1 in 10. People jammed into overcrowded cities and worked long hours in factories. England had changed completely in two centuries—a period that in the run of history was nothing more than the blink of an eye.
It is not surprising that the discipline of economics began to take shape during this period. Social critics and philosophers looked around and knew that their philosophies must expand to accommodate the changes. Adam Smith’s Wealth of Nations appeared in 1776. It was followed by the writings of David Ricardo, Karl Marx, Thomas Malthus, and others.
Each tried to make sense out of what was happening. Who was building the factories? Why?
What determined the level of wages paid to workers or the price of food? What would happen in the future, and what should happen? The people who asked these questions were the first economists.
Similar changes continue to affect the character of life in more recent times. In fact, many argue that the late 1990s marked the beginning of a new Industrial Revolution. As we turned the corner into the new millennium, the “e” revolution was clearly having an impact on virtually every aspect of our lives: the way we buy and sell products, the way we get news, the way we plan vacations, the way we communicate with each other, the way we teach and take classes, and on and on. These changes have had and will clearly continue to have profound impacts on societies across the globe, from Beijing to Calcutta to New York.
These changes have been driven by economics. Although the government was involved in the early years of the World Wide Web, private firms that exist to make a profit (such as
Facebook, YouTube, Yahoo!, Microsoft, Google, Monster.com, Amazon.com, and E-Trade) created almost all the new innovations and products. How does one make sense of all this? What will the effects of these innovations be on the number of jobs, the character of those jobs, the family incomes, the structure of our cities, and the political process both in the United States and in other countries?
During the last days of August 2005, Hurricane Katrina slammed into the coasts of Louisiana and Mississippi, causing widespread devastation, killing thousands, and leaving hundreds of thousands homeless. The economic impact of this catastrophic storm was huge. Thinking about various markets involved helps frame the problem.
For example, the labor market was massively affected. By some estimates, over 400,000 jobs were lost as the storm hit. Hotels, restaurants, small businesses, and oil refineries, to name just a

CHAPTER 1 The Scope and Method of Economics

few, were destroyed. All the people who worked in those establishments instantaneously lost their jobs and their incomes. The cleanup and rebuilding process took time to organize, and it eventually created a great deal of employment.
The storm created a major disruption in world oil markets. Loss of refinery capacity sent gasoline prices up immediately, nearly 40 percent to over $4 per gallon in some locations. The price per gallon of crude oil rose to over $70 per barrel. Local governments found their tax bases destroyed, with no resources to pay teachers and local officials. Hundreds of hospitals were destroyed, and colleges and universities were forced to close their doors, causing tens of thousands of students to change their plans.
While the horror of the storm hit all kinds of people, the worst hit were the very poor, who could not get out of the way because they had no cars or other means of escape. The storm raised fundamental issues of fairness, which we will be discussing for years to come.
The study of economics is an essential part of the study of society.

To Understand Global Affairs
A third reason for studying economics is to understand global affairs. News headlines are filled with economic stories. The environmental disaster associated with BP’s oil spill has the potential to affect the future price of oil if deep sea drilling is banned, the price of fish, the extent of tourism, and tourist-related employment in the Gulf and numerous other markets. The discovery in 2010 of major new diamond deposits in Zimbabwe has implications for the future stability of Mugabe’s government, with implications for developments in the rest of the region.
China’s new position as a major trading partner of both the United States and Europe clearly has implications for political interactions among these nations. Greece’s economic struggles in
2010 over its large debt is affecting the enthusiasm of the rest of Europe’s citizens for the
European Union.
In a relatively open, market-oriented world, it is impossible to understand political affairs without a grounding in economics. While there is much debate about whether or not economic considerations dominate international relations, it is clear that they play a role as political leaders seek the economic well-being of their citizenry.
An understanding of economics is essential to an understanding of global affairs.

To Be an Informed Citizen
A knowledge of economics is essential to being an informed citizen. In 2009, most of the world suffered from a major recession, with diminished economic growth and high unemployment.
Millions of people around the world lost their jobs. Governments from China to the United
Kingdom to the United States all struggled to figure out policies to help their economies recover.
Understanding what happens in a recession and what the government can and cannot do to help in a recovery is an essential part of being an informed citizen.
Economics is also essential in understanding a range of other everyday government decisions at the local and federal levels. Why do governments pay for public schools and roads, but not cell phones? In 2010, the federal government under President Obama moved toward universal health care for U.S. citizens. How do you understand the debate of whether this is or is not a good idea?
In some states, scalping tickets to a ball game is illegal. Is this a good policy or not? Some governments control the prices that firms can charge for some goods, especially essentials like milk and bread. Is this a good idea? Every day, across the globe, people engage in political decision making around questions like these, questions that depend on an understanding of economics.
To be an informed citizen requires a basic understanding of economics.

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PART I Introduction to Economics

E C O N O M I C S I N P R AC T I C E

iPod and the World
It is impossible to understand the workings of an economy without first understanding the ways in which economies are connected across borders. The United States was importing goods and services at a rate of over $2 trillion per year in 2007 and was exporting at a rate of over $1.5 trillion per year.
For literally hundreds of years, the virtues of free trade have been the subject of heated debate. Opponents have argued that buying foreign-produced goods costs Americans jobs and hurts American producers. Proponents argue that there are gains from trade—that all countries can gain from specializing in the production of the goods and services they produce best.
In the modern world, it is not always easy to track where products are made. A sticker that says “Made in China” can often be misleading. Recent studies of two iconic U.S. products, the iPod and the
Barbie doll, make this complexity clear.
The Barbie doll is one of Mattel’s best and longest selling products. The Barbie was designed in the United States. It is made of plastic fashioned in Taiwan, which came originally from the Mideast in the form of petroleum. Barbie’s hair comes from Japan, while the cloth for her clothes mostly comes from China. Most of the assembly of the Barbie also is done in China, using, as we see, pieces from across the globe. A doll that sells for $10 in the United States carries an export value when leaving Hong Kong of $2, of which only
35 cents is for Chinese labor, with most of the rest covering transportation and raw materials. Because the Barbie comes to the United
States from assembly in China and transport from Hong Kong, some would count it as being produced in China. Yet, for this Barbie, $8 of its retail value of $10 is captured by the United States!1
The iPod is similar. A recent study by three economists, Greg
Linden, Kenneth Kraemer, and Jason Dedrick, found that once one

includes Apple’s payment for its intellectual property, distribution costs, and production costs for some components, almost 80% of the retail price of the iPod is captured by the United States. 2
Moreover, for some of the other parts of the iPod, it is not easy to tell exactly where they are produced. The hard drive, a relatively expensive component, was produced in Japan by Toshiba, but some of the components of that hard drive were actually produced elsewhere in
Asia. Indeed, for the iPod, which is composed of many small parts, it is almost impossible to accurately tell exactly where each piece was produced without pulling it apart.
So, next time you see a label saying “Made in China” keep in mind that from an economics point of view one often has to dig a little deeper to see what is really going on.
1

For a discussion of the Barbie see Robert Feenstra, “Integration of Trade and
Disintegration of Production in the Global Economy,” Journal of Economic
Perspectives, Fall 1998, 31–50.
2 Greg Linden, Kenneth Kraemer, and Jason Dedrick, “Who Profits from Innovation in Global Value Chains?” Industrial and Corporate Change, 2010: 19(1), 81–116.

The Scope of Economics
Most students taking economics for the first time are surprised by the breadth of what they study.
Some think that economics will teach them about the stock market or what to do with their money. Others think that economics deals exclusively with problems such as inflation and unemployment. In fact, it deals with all those subjects, but they are pieces of a much larger puzzle.
Economics has deep roots in and close ties to social philosophy. An issue of great importance to philosophers, for example, is distributional justice. Why are some people rich and others poor?
And whatever the answer, is this fair? A number of nineteenth-century social philosophers wrestled with these questions, and out of their musings, economics as a separate discipline was born.
The easiest way to get a feel for the breadth and depth of what you will be studying is to explore briefly the way economics is organized. First of all, there are two major divisions of economics: microeconomics and macroeconomics.

Microeconomics and Macroeconomics microeconomics The branch of economics that examines the functioning of individual industries and the behavior of individual decision-making units—that is, firms and households. Microeconomics deals with the functioning of individual industries and the behavior of individual economic decision-making units: firms and households. Firms’ choices about what to produce and how much to charge and households’ choices about what and how much to buy help to explain why the economy produces the goods and services it does.
Another big question addressed by microeconomics is who gets the goods and services that are produced. Wealthy households get more than poor households, and the forces that determine

CHAPTER 1 The Scope and Method of Economics

this distribution of output are the province of microeconomics. Why does poverty exist? Who is poor? Why do some jobs pay more than others?
Think again about what you consume in a day, and then think back to that view over a big city.
Somebody decided to build those factories. Somebody decided to construct the roads, build the housing, produce the cars, and smoke the bacon. Why? What is going on in all those buildings? It is easy to see that understanding individual microdecisions is very important to any understanding of society.
Macroeconomics looks at the economy as a whole. Instead of trying to understand what determines the output of a single firm or industry or what the consumption patterns are of a single household or group of households, macroeconomics examines the factors that determine national output, or national product. Microeconomics is concerned with household income; macroeconomics deals with national income.
Whereas microeconomics focuses on individual product prices and relative prices, macroeconomics looks at the overall price level and how quickly (or slowly) it is rising (or falling).
Microeconomics questions how many people will be hired (or fired) this year in a particular industry or in a certain geographic area and focuses on the factors that determine how much labor a firm or an industry will hire. Macroeconomics deals with aggregate employment and unemployment: how many jobs exist in the economy as a whole and how many people who are willing to work are not able to find work.
To summarize:
Microeconomics looks at the individual unit—the household, the firm, the industry. It sees and examines the “trees.” Macroeconomics looks at the whole, the aggregate. It sees and analyzes the “forest.”
Table 1.1 summarizes these divisions of economics and some of the subjects with which they are concerned.
TABLE 1.1 Examples of Microeconomic and Macroeconomic Concerns
Division of
Economics
Microeconomics

Macroeconomics

Production
Production/output
in individual industries and businesses
How much steel
How much office space How many cars

Prices

National production/output Total industrial output Gross domestic product Growth of output

Aggregate price level
Consumer prices
Producer prices
Rate of inflation

Prices of individual goods and services
Price of medical care Price of gasoline
Food prices
Apartment rents

Income
Distribution of income and wealth
Wages in the auto industry Minimum wage
Executive salaries
Poverty

Employment
Employment by individual businesses and industries
Jobs in the steel industry Number of employees in a firm
Number of accountants National income
Total wages and salaries Total corporate profits Employment and unemployment in the economy Total number of jobs
Unemployment rate

The Diverse Fields of Economics
Individual economists focus their research and study in many diverse areas. Many of these specialized fields are reflected in the advanced courses offered at most colleges and universities. Some are concerned with economic history or the history of economic thought. Others focus on international economics or growth in less developed countries. Still others study the economics of cities (urban economics) or the relationship between economics and law. These fields are summarized in Table 1.2.

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macroeconomics The branch of economics that examines the economic behavior of aggregates—income, employment, output, and so on—on a national scale.

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PART I Introduction to Economics

TABLE 1.2 The Fields of Economics
Behavioral economics

uses psychological theories relating to emotions and social context to help understand economic decision making and policy. Much of the work in behavioral economics focuses on the biases that individuals have that affect the decisions they make.

Comparative economic systems examines the ways alternative economic systems function. What are the advantages and disadvantages of different systems?

Econometrics

applies statistical techniques and data to economic problems in an effort to test hypotheses and theories. Most schools require economics majors to take at least one course in statistics or econometrics.

Economic development

focuses on the problems of low-income countries. What can be done to promote development in these nations? Important concerns of development for economists include population growth and control, provision for basic needs, and strategies for international trade.

Economic history

traces the development of the modern economy. What economic and political events and scientific advances caused the Industrial Revolution? What explains the tremendous growth and progress of post—World War II Japan? What caused the Great Depression of the 1930s?

Environmental economics

studies the potential failure of the market system to account fully for the impacts of production and consumption on the environment and on natural resource depletion. Have alternative public policies and new economic institutions been effective in correcting these potential failures?

Finance

examines the ways in which households and firms actually pay for, or finance, their purchases. It involves the study of capital markets (including the stock and bond markets), futures and options, capital budgeting, and asset valuation.

Health economics

analyzes the health care system and its players: government, insurers, health care providers, and patients. It provides insight into the demand for medical care, health insurance markets, costcontrolling insurance plans (HMOs, PPOs, IPAs), government health care programs (Medicare and Medicaid), variations in medical practice, medical malpractice, competition versus regulation, and national health care reform.

The history of economic thought,

which is grounded in philosophy, studies the development of economic ideas and theories over time, from Adam Smith in the eighteenth century to the works of economists such as Thomas
Malthus, Karl Marx, and John Maynard Keynes. Because economic theory is constantly developing and changing, studying the history of ideas helps give meaning to modern theory and puts it in perspective.

Industrial organization

looks carefully at the structure and performance of industries and firms within an economy. How do businesses compete? Who gains and who loses?

International economics

studies trade flows among countries and international financial institutions. What are the advantages and disadvantages for a country that allows its citizens to buy and sell freely in world markets? Why is the dollar strong or weak?

Labor economics

deals with the factors that determine wage rates, employment, and unemployment. How do people decide whether to work, how much to work, and at what kind of job? How have the roles of unions and management changed in recent years?

Law and economics

analyzes the economic function of legal rules and institutions. How does the law change the behavior of individuals and businesses? Do different liability rules make accidents and injuries more or less likely? What are the economic costs of crime?

Public economics

examines the role of government in the economy. What are the economic functions of government, and what should they be? How should the government finance the services that it provides? What kinds of government programs should confront the problems of poverty, unemployment, and pollution? What problems does government involvement create?

Urban and regional economics

studies the spatial arrangement of economic activity. Why do we have cities? Why are manufacturing firms locating farther and farther from the center of urban areas?

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E C O N O M I C S I N P R AC T I C E

Trust and Gender
As you study economics, you will see that economists study quite a large range of topics. In the experimental area, this seems to be especially true. An interesting recent example is a paper on gender and trust by Nancy Buchan, Rachel Croson, and Sara Solnick.1
While many transactions happen in anonymous markets in which buyers and sellers don’t know one another, there are many other occasions in which markets operate more effectively if individuals develop some trust in one another. Trust in the goodwill of your employer or of the staff of your local day care can make a big difference in the ways in which you transact business. What can economists say about who is or is not trustworthy?
To answer this question, Buchan et al. used a game economists call the Investment Game to explore the behavior of people when they are not being observed. In this game, there are two players, a responder and a sender, and the game begins with each person receiving $10 from the experimenter. The sender and responder are not known to each other and are put in separate rooms. Sender begins and is told he or she can send any or all of the $10 to the responder. Whatever is sent will be tripled by the experimenter. The responder then can send any or all of the money back.
Clearly the sender–responder pair stand to gain the most if the sender sends all $10 and has it tripled by the experimenter. In this way the pair could turn a starting sum of $20 ($10 each) to $40 (the tripled
$10 plus the responder’s original $10). As you will see in Chapter 14, economists who work on game theory expect no money to be sent in either direction: Because the sender doesn’t trust the responder to share, he or she sends nothing in the first place.

What do Buchan et al. find? In experiments run at the University of
Wisconsin and the University of Miami, the experimenters found that almost all subjects sent some money. Perhaps more interestingly, men sent significantly more than women did, but women returned significantly more than men. As the researchers conclude, “We find that men trust more than women, and women are more trustworthy than men.”

1 Nancy Buchan, Rachel Croson, and Sara Solnick. “Trust and Gender: An
Examination of Behavior, Biases, and Beliefs in the Investment Game.” Journal of
Economic Behavior and Organization, 2008: 68(3), 466–476.

Economists also differ in the emphasis they place on theory. Some economists specialize in developing new theories, whereas other economists spend their time testing the theories of others.
Some economists hope to expand the frontiers of knowledge, whereas other economists are more interested in applying what is already known to the formulation of public policies.
As you begin your study of economics, look through your school’s course catalog and talk to the faculty about their interests. You will discover that economics encompasses a broad range of inquiry and is linked to many other disciplines.

The Method of Economics
Economics asks and attempts to answer two kinds of questions: positive and normative.
Positive economics attempts to understand behavior and the operation of economic systems without making judgments about whether the outcomes are good or bad. It strives to describe what exists and how it works. What determines the wage rate for unskilled workers? What would happen if we abolished the corporate income tax? The answers to such questions are the subject of positive economics.
In contrast, normative economics looks at the outcomes of economic behavior and asks whether they are good or bad and whether they can be made better. Normative economics involves judgments and prescriptions for courses of action. Should the government subsidize or regulate the cost of higher education? Should medical benefits to the elderly under Medicare be available only to those with incomes below some threshold? Should the

positive economics An approach to economics that seeks to understand behavior and the operation of systems without making judgments. It describes what exists and how it works. normative economics An approach to economics that analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action.
Also called policy economics.

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PART I Introduction to Economics

United States allow importers to sell foreign-produced goods that compete with U.S.-made products? Should we reduce or eliminate inheritance taxes? Normative economics is often called policy economics.
Of course, most normative questions involve positive questions. To know whether the government should take a particular action, we must know first if it can and second what the consequences are likely to be. (For example, if we lower import fees, will there be more competition and lower prices?)
Some claim that positive, value-free economic analysis is impossible. They argue that analysts come to problems with biases that cannot help but influence their work. Furthermore, even in choosing what questions to ask or what problems to analyze, economists are influenced by political, ideological, and moral views.
Although this argument has some merit, it is nevertheless important to distinguish between analyses that attempt to be positive and those that are intentionally and explicitly normative.
Economists who ask explicitly normative questions should be required to specify their grounds for judging one outcome superior to another.

Descriptive Economics and Economic Theory descriptive economics The compilation of data that describe phenomena and facts.

economic theory A statement or set of related statements about cause and effect, action and reaction.

Positive economics is often divided into descriptive economics and economic theory. Descriptive economics is simply the compilation of data that describe phenomena and facts. Examples of such data appear in the Statistical Abstract of the United States, a large volume of data published by the Department of Commerce every year that describes many features of the U.S. economy.
Massive volumes of data can now be found on the World Wide Web. As an example, look at www. bls.gov (Bureau of Labor Statistics).
Where do these data come from? The Census Bureau collects an enormous amount of raw data every year, as do the Bureau of Labor Statistics, the Bureau of Economic Analysis, and nongovernment agencies such as the University of Michigan Survey Research Center. One important study now published annually is the Survey of Consumer Expenditure, which asks individuals to keep careful records of all their expenditures over a long period of time. Another is the National
Longitudinal Survey of Labor Force Behavior, conducted over many years by the Center for
Human Resource Development at the Ohio State University.
Economic theory attempts to generalize about data and interpret them. An economic theory is a statement or set of related statements about cause and effect, action and reaction. One of the first theories you will encounter in this text is the law of demand, which was most clearly stated by
Alfred Marshall in 1890: When the price of a product rises, people tend to buy less of it; when the price of a product falls, people tend to buy more.
Theories do not always arise out of formal numerical data. All of us have been observing people’s behavior and their responses to economic stimuli for most of our lives. We may have observed our parents’ reaction to a sudden increase—or decrease—in income or to the loss of a job or the acquisition of a new one. We all have seen people standing in line waiting for a bargain. Of course, our own actions and reactions are another important source of data.

Theories and Models model A formal statement of a theory, usually a mathematical statement of a presumed relationship between two or more variables. variable A measure that can change from time to time or from observation to observation. In many disciplines, including physics, chemistry, meteorology, political science, and economics, theorists build formal models of behavior. A model is a formal statement of a theory. It is usually a mathematical statement of a presumed relationship between two or more variables.
A variable is a measure that can change from time to time or from observation to observation. Income is a variable—it has different values for different people and different values for the same person at different times. The rental price of a movie on a DVD is a variable; it has different values at different stores and at different times. There are countless other examples.
Because all models simplify reality by stripping part of it away, they are abstractions. Critics of economics often point to abstraction as a weakness. Most economists, however, see abstraction as a real strength.

CHAPTER 1 The Scope and Method of Economics

The easiest way to see how abstraction can be helpful is to think of a map. A map is a representation of reality that is simplified and abstract. A city or state appears on a piece of paper as a series of lines and colors. The amount of reality that the mapmaker can strip away before the map loses something essential depends on what the map will be used for. If you want to drive from
St. Louis to Phoenix, you need to know only the major interstate highways and roads. You lose absolutely nothing and gain clarity by cutting out the local streets and roads. However, if you need to get around Phoenix, you may need to see every street and alley.
Most maps are two-dimensional representations of a three-dimensional world; they show where roads and highways go but do not show hills and valleys along the way. Trail maps for hikers, however, have “contour lines” that represent changes in elevation. When you are in a car, changes in elevation matter very little; they would make a map needlessly complex and more difficult to read.
However, if you are on foot carrying a 50-pound pack, a knowledge of elevation is crucial.
Like maps, economic models are abstractions that strip away detail to expose only those aspects of behavior that are important to the question being asked. The principle that irrelevant detail should be cut away is called the principle of Ockham’s razor after the fourteenth-century philosopher William of Ockham.
Be careful—although abstraction is a powerful tool for exposing and analyzing specific aspects of behavior, it is possible to oversimplify. Economic models often strip away a good deal of social and political reality to get at underlying concepts. When an economic theory is used to help formulate actual government or institutional policy, political and social reality must often be reintroduced if the policy is to have a chance of working.
The key here is that the appropriate amount of simplification and abstraction depends on the use to which the model will be put. To return to the map example: You do not want to walk around San Francisco with a map made for drivers—there are too many very steep hills.

Ockham’s razor The principle that irrelevant detail should be cut away.

All Else Equal: Ceteris Paribus It is usually true that whatever you want to explain with a model depends on more than one factor. Suppose, for example, that you want to explain the total number of miles driven by automobile owners in the United States. The number of miles driven will change from year to year or month to month; it is a variable. The issue, if we want to understand and explain changes that occur, is what factors cause those changes.
Obviously, many things might affect total miles driven. First, more or fewer people may be driving. This number, in turn, can be affected by changes in the driving age, by population growth, or by changes in state laws. Other factors might include the price of gasoline, the household’s income, the number and age of children in the household, the distance from home to work, the location of shopping facilities, and the availability and quality of public transport.
When any of these variables change, the members of the household may drive more or less. If changes in any of these variables affect large numbers of households across the country, the total number of miles driven will change.
Very often we need to isolate or separate these effects. For example, suppose we want to know the impact on driving of a higher tax on gasoline. This change would raise the price of gasoline at the pump but would not (at least in the short run) affect income, workplace location, number of children, and so on.
To isolate the impact of one single factor, we use the device of ceteris paribus, or all else equal. We ask, “What is the impact of a change in gasoline price on driving behavior, ceteris paribus, or assuming that nothing else changes?” If gasoline prices rise by 10 percent, how much less driving will there be, assuming no simultaneous change in anything else—that is, assuming that income, number of children, population, laws, and so on, all remain constant? Using the device of ceteris paribus is one part of the process of abstraction. In formulating economic theory, the concept helps us simplify reality to focus on the relationships that interest us.

Expressing Models in Words, Graphs, and Equations Consider the following statements: Lower airline ticket prices cause people to fly more frequently. Higher interest rates slow the rate of home sales. When firms produce more output, employment increases. Higher gasoline prices cause people to drive less and to buy more fuel-efficient cars.

11

ceteris paribus, or all else equal A device used to analyze the relationship between two variables while the values of other variables are held unchanged.

12

PART I Introduction to Economics

Each of those statements expresses a relationship between two variables that can be quantified. In each case, there is a stimulus and a response, a cause and an effect. Quantitative relationships can be expressed in a variety of ways. Sometimes words are sufficient to express the essence of a theory, but often it is necessary to be more specific about the nature of a relationship or about the size of a response. The most common method of expressing the quantitative relationship between two variables is graphing that relationship on a two-dimensional plane. In fact, we will use graphic analysis extensively in Chapter 2 and beyond. Because it is essential that you be familiar with the basics of graphing, the appendix to this chapter presents a careful review of graphing techniques.
Quantitative relationships between variables can also be presented through equations. For example, suppose we discovered that over time, U.S. households collectively spend, or consume,
90 percent of their income and save 10 percent of their income. We could then write:

C = .90 Y and S = .10Y where C is consumption spending, Y is income, and S is saving. Writing explicit algebraic expressions like these helps us understand the nature of the underlying process of decision making.
Understanding this process is what economics is all about.

Cautions and Pitfalls In formulating theories and models, it is especially important to avoid two pitfalls: the post hoc fallacy and the fallacy of composition.
The Post Hoc Fallacy Theories often make statements or sets of statements about cause and post hoc, ergo propter hoc
Literally, “after this (in time), therefore because of this.” A common error made in thinking about causation: If
Event A happens before
Event B, it is not necessarily true that A caused B.

effect. It can be quite tempting to look at two events that happen in sequence and assume that the first caused the second to happen. This is not always the case. This common error is called the post hoc, ergo propter hoc (or “after this, therefore because of this”) fallacy.
There are thousands of examples. The Colorado Rockies have won seven games in a row. Last night you went to the game and they lost. You must have jinxed them. They lost because you went to the game.
Stock market analysts indulge in what is perhaps the most striking example of the post hoc fallacy in action. Every day the stock market goes up or down, and every day some analyst on some national news program singles out one or two of the day’s events as the cause of some change in the market: “Today the Dow Jones industrial average rose 5 points on heavy trading; analysts say that the increase was due to progress in talks between Israel and Syria.” Research has shown that daily changes in stock market averages are very largely random. Although major news events clearly have a direct influence on certain stock prices, most daily changes cannot be linked directly to specific news stories.
Very closely related to the post hoc fallacy is the often erroneous link between correlation and causation. Two variables are said to be correlated if one variable changes when the other variable changes. However, correlation does not imply causation. Cities that have high crime rates also have many automobiles, so there is a very high degree of correlation between number of cars and crime rates. Can we argue, then, that cars cause crime? No. The reason for the correlation may have nothing to do with cause and effect. Big cities have many people, many people have many cars; therefore, big cities have many cars. Big cities also have high crime rates for many reasons—crowding, poverty, anonymity, unequal distribution of wealth, and readily available drugs, to mention only a few. However, the presence of cars is probably not one of them.
This caution must also be viewed in reverse. Sometimes events that seem entirely unconnected actually are connected. In 1978, Governor Michael Dukakis of Massachusetts ran for reelection. Still quite popular, Dukakis was nevertheless defeated in the Democratic primary that year by a razor-thin margin. The weekend before, the Boston Red Sox, in the thick of the division championship race, had been badly beaten by the New York Yankees in four straight games. Some very respectable political analysts believe that hundreds of thousands of Boston sports fans vented their anger on the incumbent governor the following Tuesday.

CHAPTER 1 The Scope and Method of Economics

13

The Fallacy of Composition To conclude that what is true for a part is necessarily true for the whole is to fall into the fallacy of composition. Suppose that a large group of cattle ranchers graze their cattle on the same range. To an individual rancher, more cattle and more grazing mean a higher income. However, because its capacity is limited, the land can support only so many cattle. If every cattle rancher increased the number of cattle sent out to graze, the land would become overgrazed and barren; as a result, everyone’s income would fall. In short, theories that seem to work well when applied to individuals or households often break down when they are applied to the whole.

fallacy of composition The erroneous belief that what is true for a part is necessarily true for the whole.

Testing Theories and Models: Empirical Economics In science, a theory is rejected when it fails to explain what is observed or when another theory better explains what is observed. The collection and use of data to test economic theories is called empirical economics.
Numerous large data sets are available to facilitate economic research. For example, economists studying the labor market can now test behavioral theories against the actual working experiences of thousands of randomly selected people who have been surveyed continuously since the 1960s. Macroeconomists continuously monitoring and studying the behavior of the national economy at the National Bureau of Economic Research (NBER) pass thousands of items of data, collected by both government agencies and private companies, over the Internet.
In the natural sciences, controlled experiments, typically done in the lab, are a standard way of testing theories. In recent years, economics has seen an increase in the use of experiments, both in the field and in the lab, as a tool to test its theories. One economist, John List of Chicago, tested the effect of changing the way an auction was run on bid prices for rare baseball cards with the help of the sports memorabilia dealers in trade show. (The experiment used a standard Cal
Ripkin Jr. card.) Another economist, Keith Chen of Yale, has used experiments with monkeys to investigate the deeper biological roots of human decision making. The Economics in Practice on
p. 9 describes another experiment on trust and gender.

empirical economics The collection and use of data to test economic theories.

Economic Policy
Economic theory helps us understand how the world works, but the formulation of economic policy requires a second step. We must have objectives. What do we want to change? Why? What is good and what is bad about the way the system is operating? Can we make it better?
Such questions force us to be specific about the grounds for judging one outcome superior to another. What does it mean to be better? Four criteria are frequently applied in judging economic outcomes:

1.
2.
3.
4.

Efficiency
Equity
Growth
Stability

Efficiency In physics, “efficiency” refers to the ratio of useful energy delivered by a system to the energy supplied to it. An efficient automobile engine, for example, is one that uses a small amount of fuel per mile for a given level of power.
In economics, efficiency means allocative efficiency. An efficient economy is one that produces what people want at the least possible cost. If the system allocates resources to the production of goods and services that nobody wants, it is inefficient. If all members of a particular society were vegetarians and somehow half of all that society’s resources were used to produce meat, the result would be inefficient. It is inefficient when steel beams lie in the rain and rust because somebody fouled up a shipping schedule. If a firm could produce its product using
25 percent less labor and energy without sacrificing quality, it too is inefficient.
The clearest example of an efficient change is a voluntary exchange. If you and I each want something that the other has and we agree to exchange, we are both better off and no

efficiency In economics, allocative efficiency. An efficient economy is one that produces what people want at the least possible cost.

14

PART I Introduction to Economics

one loses. When a company reorganizes its production or adopts a new technology that enables it to produce more of its product with fewer resources, without sacrificing quality, it has made an efficient change. At least potentially, the resources saved could be used to produce more of something.
Inefficiencies can arise in numerous ways. Sometimes they are caused by government regulations or tax laws that distort otherwise sound economic decisions. Suppose that land in Ohio is best suited for corn production and that land in Kansas is best suited for wheat production. A law that requires Kansas to produce only corn and Ohio to produce only wheat would be inefficient.
If firms that cause environmental damage are not held accountable for their actions, the incentive to minimize those damages is lost and the result is inefficient.

Equity While efficiency has a fairly precise definition that can be applied with some degree of equity Fairness.

rigor, equity (fairness) lies in the eye of the beholder. To many, fairness implies a more equal distribution of income and wealth. Fairness may imply alleviating poverty, but the extent to which the poor should receive cash benefits from the government is the subject of enormous disagreement. For thousands of years, philosophers have wrestled with the principles of justice that should guide social decisions. They will probably wrestle with such questions for thousands of years to come.
Despite the impossibility of defining equity or fairness universally, public policy makers judge the fairness of economic outcomes all the time. Rent control laws were passed because some legislators thought that landlords treated low-income tenants unfairly. Certainly, most social welfare programs are created in the name of equity.

Growth As the result of technological change, the building of machinery, and the acqui-

economic growth An increase in the total output of an economy.

stability A condition in which national output is growing steadily, with low inflation and full employment of resources.

sition of knowledge, societies learn to produce new goods and services and to produce old ones better. In the early days of the U.S. economy, it took nearly half the population to produce the required food supply. Today less than 2.0 percent of the country’s population works in agriculture.
When we devise new and better ways of producing the goods and services we use now and when we develop new goods and services, the total amount of production in the economy increases. Economic growth is an increase in the total output of an economy. If output grows faster than the population, output per capita rises and standards of living increase.
Presumably, when an economy grows, it produces more of what people want. Rural and agrarian societies become modern industrial societies as a result of economic growth and rising per capita output.
Some policies discourage economic growth, and others encourage it. Tax laws, for example, can be designed to encourage the development and application of new production techniques.
Research and development in some societies are subsidized by the government. Building roads, highways, bridges, and transport systems in developing countries may speed up the process of economic growth. If businesses and wealthy people invest their wealth outside their country rather than in their country’s industries, growth in their home country may be slowed.

Stability Economic stability refers to the condition in which national output is growing steadily, with low inflation and full employment of resources. During the 1950s and 1960s, the
U.S. economy experienced a long period of relatively steady growth, stable prices, and low unemployment. Between 1951 and 1969, consumer prices never rose more than 5 percent in a single year, and in only 2 years did the number of unemployed exceed 6 percent of the labor force. From the end of the Gulf War in 1991 to the beginning of 2001, the U.S. economy enjoyed price stability and strong economic growth with rising employment. It was the longest expansion in
American history.
The decades of the 1970s and 1980s, however, were not as stable. The United States experienced two periods of rapid price inflation (over 10 percent) and two periods of severe

CHAPTER 1 The Scope and Method of Economics

15

unemployment. In 1982, for example, 12 million people (10.8 percent of the workforce) were looking for work. The beginning of the 1990s was another period of instability, with a recession occurring in 1990–1991. In 2008–2009 much of the world, including the United States, experienced a large contraction in output and rise in unemployment. This was clearly an unstable period.
The causes of instability and the ways in which governments have attempted to stabilize the economy are the subject matter of macroeconomics.

An Invitation
This chapter has prepared you for your study of economics. The first part of the chapter invited you into an exciting discipline that deals with important issues and questions. You cannot begin to understand how a society functions without knowing something about its economic history and its economic system.
The second part of the chapter introduced the method of reasoning that economics requires and some of the tools that economics uses. We believe that learning to think in this very powerful way will help you better understand the world.
As you proceed, it is important that you keep track of what you have learned in earlier chapters. This book has a plan; it proceeds step-by-step, each section building on the last. It would be a good idea to read each chapter’s table of contents at the start of each chapter and scan each chapter before you read it to make sure you understand where it fits in the big picture.

SUMMARY
1. Economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided.

WHY STUDY ECONOMICS? p. 2

8.

2. There are many reasons to study economics, including (a) to learn a way of thinking, (b) to understand society, (c) to understand global affairs, and (d) to be an informed citizen.
3. The best alternative that we forgo when we make a choice or a decision is the opportunity cost of that decision.

THE SCOPE OF ECONOMICS p. 6

9.
10.

4. Microeconomics deals with the functioning of individual markets and industries and with the behavior of individual decision-making units: business firms and households.
5. Macroeconomics looks at the economy as a whole. It deals with the economic behavior of aggregates—national output, national income, the overall price level, and the general rate of inflation.
6. Economics is a broad and diverse discipline with many special fields of inquiry. These include economic history, international economics, and urban economics.

THE METHOD OF ECONOMICS p.9

7. Economics asks and attempts to answer two kinds of questions: positive and normative. Positive economics attempts to understand behavior and the operation of economies

11.
12.

13.
14.

without making judgments about whether the outcomes are good or bad. Normative economics looks at the results of economic behavior and asks whether they are good or bad and whether they can be improved.
Positive economics is often divided into two parts. Descriptive economics involves the compilation of data that accurately describe economic facts and events. Economic theory attempts to generalize and explain what is observed. It involves statements of cause and effect—of action and reaction.
An economic model is a formal statement of an economic theory. Models simplify and abstract from reality.
It is often useful to isolate the effects of one variable on another while holding “all else constant.” This is the device of ceteris paribus.
Models and theories can be expressed in many ways. The most common ways are in words, in graphs, and in equations.
Because one event happens before another, the second event does not necessarily happen as a result of the first. To assume that “after” implies “because” is to commit the fallacy of post hoc, ergo propter hoc. The erroneous belief that what is true for a part is necessarily true for the whole is the fallacy of composition.
Empirical economics involves the collection and use of data to test economic theories. In principle, the best model is the one that yields the most accurate predictions.
To make policy, one must be careful to specify criteria for making judgments. Four specific criteria are used most often in economics: efficiency, equity, growth, and stability.

16

PART I Introduction to Economics

REVIEW TERMS AND CONCEPTS ceteris paribus, or all else equal, p. 11 descriptive economics, p. 10 economic growth, p. 14 economic theory, p. 10 economics, p. 2 efficiency, p. 13 efficient market, p. 3 empirical economics, p. 13

Ockham’s razor, p. 11 opportunity cost, p. 2 positive economics, p. 9 post hoc, ergo propter hoc, p. 12 scarce, p. 2 stability, p. 14 sunk costs, p. 3 variable, p. 10

equity, p. 14 fallacy of composition, p. 13
Industrial Revolution, p. 4 macroeconomics, p. 7 marginalism, p. 3 microeconomics, p. 6 model, p. 10 normative economics, p. 9

PROBLEMS
All problems are available on www.myeconlab.com

1. One of the scarce resources that constrain our behavior is time.
Each of us has only 24 hours in a day. How do you go about allocating your time in a given day among competing alternatives?
How do you go about weighing the alternatives? Once you choose a most important use of time, why do you not spend all your time on it? Use the notion of opportunity cost in your answer.

2. In the summer of 2007, the housing market and the mortgage market were both in decline. Housing prices in most U.S. cities began to decline in mid-2006. With prices falling and the inventory of unsold houses rising, the production of new homes fell to around 1.5 million in 2007 from 2.3 million in
2005. With new construction falling dramatically, it was expected that construction employment would fall and that this would have the potential of slowing the national economy and increasing the general unemployment rate. Go to www.bls.gov and check out the recent data on total employment and construction employment. Have they gone up or down from their levels in August 2007? What has happened to the unemployment rate? Go to www.fhfa.gov and look at the housing price index. Have home prices risen or fallen since August 2007?
Finally, look at the latest GDP release at www.bea.gov. Look at residential and nonresidential investment (Table 1.1.5) during the last 2 years. Do you see a pattern? Does it explain the employment numbers? Explain your answer.

3. Which of the following statements are examples of positive economic analysis? Which are examples of normative analysis?
a. The inheritance tax should be repealed because it is unfair.
b. Allowing Chile to join NAFTA would cause wine prices in the United States to drop.
c. The first priorities of the new regime in the Democratic
Republic of Congo (DRC, formerly Zaire) should be to rebuild schools and highways and to provide basic health care.

4. Sarita signed up with Netflix for a fixed fee of $16.99 per month.
For this fee, she can receive up to 3 DVDs at a time in the mail and exchange each DVD as often as she likes. She also receives unlimited instant access to movies being streamed from Netflix to her computer or TV. During the average month in 2010, Sarita received and watched 6 movies sent to her through the mail and she watched an additional 13 movies which were streamed to her computer. What is the average cost of a movie to Sarita? What is the marginal cost of an additional movie?

5. A question facing many U.S. states is whether to allow casino gambling. States with casino gambling have seen a substantial increase in tax revenue flowing to state government. This revenue can be used to finance schools, repair roads, maintain social programs, or reduce other taxes.
a. Recall that efficiency means producing what people want at the least cost. Can you make an efficiency argument in favor of allowing casinos to operate?
b. What nonmonetary costs might be associated with gambling? Would these costs have an impact on the efficiency argument you presented in part a?
c. Using the concept of equity, argue for or against the legalization of casino gambling.

6. For each of the following situations, identify the full cost
(opportunity cost) involved:
a. A worker earning an hourly wage of $8.50 decides to cut back to part-time to attend Houston Community College.
b. Sue decides to drive to Los Angeles from San Francisco to visit her son, who attends UCLA.
c. Tom decides to go to a wild fraternity party and stays out all night before his physics exam.
d. Annie spends $200 on a new dress.
e. The Confab Company spends $1 million to build a new branch plant that will probably be in operation for at least 10 years.
f. Alex’s father owns a small grocery store in town. Alex works
40 hours a week in the store but receives no compensation.

7. [Related to the Economics in Practice on p. 6] Log onto www. census.gov. Click on “Foreign Trade, ” then on “Statistics, ” and finally on “State Export Data.” There you will find a list of the products produced in your state and exported to countries around the world. In looking over that list, are you surprised by anything?
Do you know of any firms that produce these items? Search the
Web to find a company that does. Do some research and write a paragraph about your company: what it produces, how many people it employs, and whatever else you can learn about the firm. You might even call the company to obtain the information.

8. Explain the pitfalls in the following statements.
a. Whenever Jeremy decides to wash his car, the next day it usually rain. Since Jeremy’s town is suffering from a severe drought, he decided to wash his car and, just as he expected, the next day the thunderstorms rolled in. Obviously it rained because Jeremy washed his car.

CHAPTER 1 The Scope and Method of Economics

b. The principal of Hamilton High School found that requiring those students who were failing algebra to attend an afterschool tutoring program resulted in a 30 percent average increase in their algebra grades. Based on this success, the principal decided to hire more tutors and require that all students must attend after-school tutoring, so everyone’s algebra grades would improve.
c. People who drive hybrid automobiles recycle their trash more than people who do not drive hybrids. Therefore, recycling trash causes people to drive hybrid automobiles.
9. Explain whether each of the following is an example of a macroeconomic concern or a microeconomic concern.
a. Ford Motor Company is contemplating increasing the production of full-size SUVs based on projected future consumer demand.

17

b. Congress is debating the option of implementing a valueadded tax as a means to cut the federal deficit.
c. The Federal Reserve announces it is increasing the discount rate in an attempt to slow the rate of inflation.
d. The Bureau of Labor Statistics projects a 22.5 percent increase in the number or workers in the healthcare industry from 2008 to 2018.
10. On the Forbes 2010 list of the World’s Billionaires, Mexico’s Carlos
Slim Helu ranks at the top with a net worth of U.S. $53.5 billion.
Does this “richest man in the world” face scarcity, or does scarcity only affect those with more limited incomes and lower net worth?
Source: “The World’s Billionaires,” Forbes, March 10, 2010.

CHAPTER 1 APPENDIX
How to Read and Understand
Graphs

Time Series Graphs

Economics is the most quantitative of the social sciences. If you flip through the pages of this or any other economics text, you will see countless tables and graphs. These serve a number of purposes. First, they illustrate important economic relationships. Second, they make difficult problems easier to understand and analyze. Finally, they can show patterns and regularities that may not be discernible in simple lists of numbers.
A graph is a two-dimensional representation of a set of numbers, or data. There are many ways that numbers can be illustrated by a graph.

It is often useful to see how a single measure or variable changes over time. One way to present this information is to plot the values of the variable on a graph, with each value corresponding to a different time period. A graph of this kind is called a time series graph. On a time series graph, time is measured along the horizontal scale and the variable being graphed is measured along the vertical scale. Figure 1A.1 is a time series graph that presents the total disposable personal

Ĩ FIGURE 1A.1 Total

11,000

Disposable Personal
Income in the United
States: 1975–2009 (in billions of dollars)

10,000

Total disposable personal income

9,000

Source: See Table 1A.1.

8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
1975

1980

1985

1990

1995
Year

2000

2005

18

PART I Introduction to Economics

income in the U.S. economy for each year between 1975 and
2009.1 This graph is based on the data found in Table 1A.1. By displaying these data graphically, we can see that (1) total disposable personal income has increased steadily since 1975 and
(2) during certain periods, income has increased at a faster rate than during other periods.
TABLE 1A.1 Total Disposable Personal Income in the
United States, 1975–2009 (in billions of dollars)

Year
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992

Total
Disposable
Personal
Income
1,187.3
1,302.3
1,435.0
1,607.3
1,790.8
2,002.7
2,237.1
2,412.7
2,599.8
2,891.5
3,079.3
3,258.8
3,435.3
3,726.3
3,991.4
4,254.0
4,444.9
4,736.7

Year
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009

Total
Disposable
Personal
Income
4,921.6
5,184.3
5,457.0
5,759.6
6,074.6
6,498.9
6,803.3
7,327.2
7,648.5
8,009.7
8,377.8
8,889.4
9,277.3
9,915.7
10,403.1
10,806.4
10,923.6

drawn in Figure 1A.2: (4, 2), (2, -1), (-3, 4), (-3, -2). Most, but not all, of the graphs in this book are plots of two variables where both values are positive numbers [such as (4, 2) in Figure 1A.2].
On these graphs, only the upper-right quadrant of the coordinate system (that is, the quadrant in which all X and Y values are positive) will be drawn.

Plotting Income and Consumption Data
For Households
Table 1A.2 presents data collected by the Bureau of Labor
Statistics (BLS). In a recent survey, 5,000 households were asked to keep track of all their expenditures. This table shows average income and average spending for those households,
TABLE 1A.2 Consumption Expenditures and
Income, 2008
Average
Consumption
Expenditures

Average Income
Before Taxes
Bottom fifth
2nd fifth
3rd fifth
4th fifth
Top fifth

$ 10,263
27,442
47,196
74,090
158,652

$22,304
31,751
42,659
58,632
97,003

Source: Consumer Expenditures in 2008, U.S. Bureau of Labor Statistics.

+ Y-axis
(– 3, 4)
4
3

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

(4, 2)

2

Graphing Two Variables on a Cartesian
Coordinate System
More important than simple graphs of one variable are graphs that contain information on two variables at the same time.
The most common method of graphing two variables is the
Cartesian coordinate system. This system is constructed by drawing two perpendicular lines: a horizontal line, or X-axis, and a vertical line, or Y-axis. The axes contain measurement scales that intersect at 0 (zero). This point is called the origin.
On the vertical scale, positive numbers lie above the horizontal axis (that is, above the origin) and negative numbers lie below it. On the horizontal scale, positive numbers lie to the right of the vertical axis (to the right of the origin) and negative numbers lie to the left of it. The point at which the graph intersects the Y-axis is called the Y-intercept. The point at which the graph intersects the X-axis is called the X-intercept.
When two variables are plotted on a single graph, each point represents a pair of numbers. The first number is measured on the
X-axis, and the second number is measured on the Y-axis. For example, the following points (X, Y) are plotted on the set of axes

1
–
–4

–3

–2

–1

1
–1

2

3

+
4 X-axis

(2, –1)

–2

(– 3, – 2)

–3
–4
–

İ FIGURE 1A.2 A Cartesian Coordinate System
A Cartesian coordinate system is constructed by drawing two perpendicular lines: a vertical axis (the Y-axis) and a horizontal axis (the X-axis).
Each axis is a measuring scale.

1 The measure of income presented in Table 1A.1 and in Figure 1A.1 is disposable personal income in billions of dollars. It is the total personal income received by all households in the United States minus the taxes that they pay.

CHAPTER 1 The Scope and Method of Economics

ranked by income. For example, the average income for the top fifth (20 percent) of the households was $158,652. The average spending for the top 20 percent was $97,003.
Figure 1A.3 presents the numbers from Table 1A.2 graphically using the Cartesian coordinate system. Along the horizontal scale, the X-axis, we measure average income.
Along the vertical scale, the Y-axis, we measure average consumption spending. Each of the five pairs of numbers from the table is represented by a point on the graph. Because all numbers are positive numbers, we need to show only the upper right quadrant of the coordinate system.
To help you read this graph, we have drawn a dotted line connecting all the points where consumption and income would be equal. This 45° line does not represent any data. Instead, it represents the line along which all variables on the X-axis correspond exactly to the variables on the Y-axis, for example, (10,000,
10,000), (20,000, 20,000), and (37,000, 37,000). The heavy blue line traces the data; the purpose of the dotted line is to help you read the graph.
There are several things to look for when reading a graph.
The first thing you should notice is whether the line slopes upward or downward as you move from left to right. The blue line in Figure 1A.3 slopes upward, indicating that there seems to be a positive relationship between income and spending:
The higher a household’s income, the more a household tends to consume. If we had graphed the percentage of each group receiving welfare payments along the Y-axis, the line would presumably slope downward, indicating that welfare payments are lower at higher income levels. The income level/welfare payment relationship is thus a negative relationship.

vertical axis) when X (the variable on the horizontal axis) changes. The slope of a line between two points is the change in the quantity measured on the Y-axis divided by the change in the quantity measured on the X-axis. We will normally use
¢ (the Greek letter delta) to refer to a change in a variable. In
Figure 1A.4, the slope of the line between points A and B is ¢Y divided by ¢X. Sometimes it is easy to remember slope as “the rise over the run,” indicating the vertical change over the horizontal change.
To be precise, ¢X between two points on a graph is simply X2 minus X1, where X2 is the X value for the second point and X1 is the X value for the first point. Similarly, ¢Y is defined as Y2 minus Y1, where Y2 is the Y value for the second point and Y1 is the Y value for the first point. Slope is equal to
Y2 - Y1
¢Y
=
¢X
X2 - X1
As we move from A to B in Figure 1A.4(a), both X and Y increase; the slope is thus a positive number. However, as we move from A to B in Figure 1A.4(b), X increases [(X2 - X1) is a positive number], but Y decreases [(Y2 - Y1) is a negative number]. The slope in Figure 1A.4(b) is thus a negative number because a negative number divided by a positive number results in a negative quotient.
To calculate the numerical value of the slope between points A and B in Figure 1A.3, we need to calculate ¢Y and
¢X . Because consumption is measured on the Y-axis, ¢Y is 9,447 [(Y2 - Y1) = (31,751 - 22,304)]. Because income is measured along the X-axis, ¢X is 17,179 [(X2 - X1) = (27,442
- 10,263)]. The slope between A and B is ¢Y/¢X
= 9,447/17,179 = + 0.55.

Slope
The slope of a line or curve is a measure that indicates whether the relationship between the variables is positive or negative and how much of a response there is in Y (the variable on the
Ī FIGURE 1A.3

$

Household
Consumption and
Income

120,000

100,000
45Њ line
Average consumption

A graph is a simple twodimensional geometric representation of data. This graph displays the data from Table 1A.2. Along the horizontal scale (X-axis), we measure household income. Along the vertical scale (Y-axis), we measure household consumption.
Note: At point A, consumption equals $22,304 and income equals $10,263. At point B, consumption equals $31,751 and income equals $27,442.

80,000

60,000

40,000

B
A

20,000

Source: See Table 1A.2.

0

19

20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000
Average income

$

20

PART I Introduction to Economics
b. Negative slope

a. Positive slope
Y

⌬Y

Y

Y2

B

Y1

X2

X1

B

Y2

A

0

A

Y1

⌬Y

X

0

⌬X

X1

X2

X

⌬X

İ FIGURE 1A.4 A Curve with (a) Positive Slope and (b) Negative Slope
A positive slope indicates that increases in X are associated with increases in Y and that decreases in X are associated with decreases in Y. A negative slope indicates the opposite—when X increases, Y decreases; and when X decreases, Y increases.

Another interesting thing to note about the data graphed in Figure 1A.3 is that all the points lie roughly along a straight line. (If you look very closely, however, you can see that the slope declines as you move from left to right; the line becomes slightly less steep.) A straight line has a constant slope. That is, if you pick any two points along it and calculate the slope, you will always get the same number. A horizontal line has a zero

a. Slope: positive and decreasing

slope ( ¢Y is zero); a vertical line has an “infinite” slope because
¢Y is too big to be measured.
Unlike the slope of a straight line, the slope of a curve is continually changing. Consider, for example, the curves in
Figure 1A.5. Figure 1A.5(a) shows a curve with a positive slope that decreases as you move from left to right. The easiest way to think about the concept of increasing or decreasing

c. Slope: negative and increasing

b. Slope: positive and increasing

Y

Y

0

X

Y

0

d. Slope: negative and decreasing

X

0
f. Slope: negative, then positive

e. Slope: positive, then negative

Y

X

Y

Y
A

A
0

X

0

X

0

İ FIGURE 1A.5 Changing Slopes Along Curves

X

CHAPTER 1 The Scope and Method of Economics

slope is to imagine what it is like walking up a hill from left to right. If the hill is steep, as it is in the first part of
Figure 1A.5(a), you are moving more in the Y direction for each step you take in the X direction. If the hill is less steep, as it is further along in Figure 1A.5(a), you are moving less in the Y direction for every step you take in the X direction.
Thus, when the hill is steep, slope ( ¢Y/¢X) is a larger number than it is when the hill is flatter. The curve in
Figure 1A.5(b) has a positive slope, but its slope increases as you move from left to right.
The same analogy holds for curves that have a negative slope. Figure 1A.5(c) shows a curve with a negative slope that increases (in absolute value) as you move from left to right. This time think about skiing down a hill. At first, the descent in Figure 1A.5(c) is gradual (low slope), but as you proceed down the hill (to the right), you descend more quickly (high slope). Figure 1A.5(d) shows a curve with a negative slope that decreases (in absolute value) as you move from left to right.
In Figure 1A.5(e), the slope goes from positive to negative as X increases. In Figure 1A.5(f), the slope goes from negative to positive. At point A in both, the slope is zero.
[Remember, slope is defined as ¢Y/¢X. At point A, Y is not changing ( ¢Y = 0). Therefore, the slope at point A is zero.]

Some Precautions
When you read a graph, it is important to think carefully about what the points in the space defined by the axes represent. Table 1A.3 and Figure 1A.6 present a graph of consumption and income that is very different from the one

TABLE 1A.3 Aggregate National Income and
Consumption for the United States,
1930–2009 (in billions of dollars)
1930
1940
1950
1960
1970
1980
1990
2000
2005
2006
2007
2008
2009

Aggregate National Income
82.9
90.9
263.9
473.9
929.5
2,433.0
5,059.8
8,938.9
11,273.8
12,031.2
12,448.2
12,635.2
12,280.0

Aggregate Consumption
70.1
71.3
192.2
331.8
648.3
1,755.8
3,835.5
6,830.4
8,819.0
9,322.7
9,826.4
10,129.9
10,089.1

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

11,000
2009

10,000
Aggregate consumption (billions of dollars)

2006

9,000

2008
2007

2005

8,000
7,000

45Њ line

2000

6,000
5,000
4,000
1990

3,000
2,000

1930 1970
1,000 1950

0

1980
45Њ

1960
1940

1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 11,000 12,00013,000
Aggregate national income (billions of dollars)

İ FIGURE 1A.6 National Income and Consumption
It is important to think carefully about what is represented by points in the space defined by the axes of a graph. In this graph, we have graphed income with consumption, as in Figure 1A.3, but here each observation point is national income and aggregate consumption in different years, measured in billions of dollars.
Source: See Table 1A.3.

21

22

PART I Introduction to Economics

in Table 1A.2 and Figure 1A.3. First, each point in
Figure 1A.6 represents a different year; in Figure 1A.3, each point represented a different group of households at the same point in time (2008). Second, the points in Figure 1A.6 represent aggregate consumption and income for the whole nation measured in billions of dollars; in Figure 1A.3, the points represented average household income and consumption measured in dollars.

It is interesting to compare these two graphs. All points on the aggregate consumption curve in Figure 1A.6 lie below the
45° line, which means that aggregate consumption is always less than aggregate income. However, the graph of average household income and consumption in Figure 1A.3 crosses the
45° line, implying that for some households, consumption is larger than income.

APPENDIX SUMMARY
1. A graph is a two-dimensional representation of a set of numbers, or data. A time series graph illustrates how a single variable changes over time.
2. The most common method of graphing two variables on one graph is the Cartesian coordinate system, which includes an X (horizontal)-axis and a Y (vertical)-axis. The points at which the two axes intersect is called the origin. The point at which a graph intersects the Y-axis is called the Y-intercept.
The point at which a graph intersects the X-axis is called the
X-intercept.

3. The slope of a line or curve indicates whether the relationship between the two variables graphed on a Cartesian coordinate system is positive or negative and how much of a response there is in Y (the variable on the vertical axis) when
X (the variable on the horizontal axis) changes. The slope of a line between two points is the change in the quantity measured on the Y-axis divided by the change in the quantity measured on the X-axis.

APPENDIX REVIEW TERMS AND CONCEPTS
Cartesian coordinate system A common method of graphing two variables that makes use of two perpendicular lines against which the variables are plotted. p. 18 graph A two-dimensional representation of a set of numbers or data. p. 17 negative relationship A relationship between two variables, X and Y, in which a decrease in X is associated with an increase in Y and an increase in X is associated with a decrease in Y. p. 19 origin On a Cartesian coordinate system, the point at which the horizontal and vertical axes intersect. p. 18

positive relationship A relationship between two variables, X and Y, in which a decrease in X is associated with a decrease in Y, and an increase in X is associated with an increase in Y. p. 19 slope A measurement that indicates whether the relationship between variables is positive or negative and how much of a response there is in Y (the variable on the vertical axis) when X (the variable on the horizontal axis) changes. p. 19 time series graph A graph illustrating how a variable changes over time. p. 17

X-axis On a Cartesian coordinate system, the horizontal line against which a variable is plotted. p. 18
X-intercept The point at which a graph intersects the X-axis. p. 18
Y-axis On a Cartesian coordinate system, the vertical line against which a variable is plotted. p. 18
Y-intercept The point at which a graph intersects the Y-axis. p. 18

APPENDIX PROBLEMS
1. Graph each of the following sets of numbers. Draw a line through the points and calculate the slope of each line.
1
X
1
2
3
4
5

2
Y
5
10
15
20
25

X
1
2
3
4
5

3
Y
25
20
15
10
5

X
0
10
20
30
40

4
Y
0
10
20
30
40

X
0
10
20
30
40

5
Y
40
30
20
10
0

X
0
10
20
30
40

6
Y
0
10
20
10
0

X
0.1
0.2
0.3
0.4
0.5

Y
100
75
50
25
0

2. For each of the graphs in Figure 1, determine whether the curve has a positive or negative slope. Give an intuitive explanation for what is happening with the slope of each curve.
3. For each of the following equations, graph the line and calculate its slope.
a. P = 10 - 2qD (Put qD on the X-axis.)
b. P = 100 - 4qD (Put qD on the X-axis.)
c. P = 50 + 6qS (Put qS on the X-axis.)
d. I = 10,000 - 500r (Put I on the X-axis.)

CHAPTER 1 The Scope and Method of Economics
a.

c.

Mortgage interest rate

Taxes paid

Price per unit

b.

Quantity of apples purchased

Income

0

d.

f.

Fastest time for a 10K race

Days of sunshine

e.

0

Age

0

Home sales

0

Tons of fertilizer per acre

0

23

Bushels of corn per acre

Bushels of corn per acre

0

İ FIGURE 1
4. The following table shows the relationship between the price of a dozen roses and the number of roses sold by Fiona’s Flowers.
a. Is the relationship between the price of roses and the number of roses sold by Fiona’s Flowers a positive relationship or a negative relationship? Explain.
b. Plot the data from the table on a graph, draw a line through the points, and calculate the slope of the line.

5. Calculate the slope of the demand curve at point A and at point B in the following figure.
Price
per unit 34

PRICE PER
DOZEN
$20
50
25
30
40

QUANTITY OF
ROSES (DOZENS)
30
90
40
50
70

MONTH
January
February
March
April
May

A
24

12

B
Demand

5
0

20

45

90

140

Quantity