Ten Principles

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Purpose of Assignment

In Week 1, students are introduced to the ten fundamental principles on which the study of economics is based. Throughout this course, the students will use these ten principles to better develop their understanding of economics and how society manages its scarce resources. Students will see how markets work using supply and demand for a good to determine both the quantity produced and the price at which the good sells. The concepts of equilibrium and elasticity are used to explain the sensitivity of quantity supplied and quantity demanded to changes in economic variables. Students will see how government policies impact prices and quantities in markets.

Assignment Steps

Resources: Principles of Microeconomics, Ch. 1, 2, 3, 4, and 6.

Prepare an 875-word research paper as part of a marketing research committee for your organization about current microeconomic thought and theory.

Identify the fundamental lessons the Ten Principles of Economics teaches regarding:

How people make decisions
How people interact
How the economy works as a whole

Explain the following to help the committee members understand how markets work:

How society manages its scarce resources and benefits from economic interdependence.
Why the demand curve slopes downward and the supply curve slopes upward.
Where the point of equilibrium is and what does it determine?
The impact of price controls, taxes, and elasticity on changes in supply, demand and equilibrium prices.

Format consistent with APA guidelines.

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CHAPTER

6
Supply, Demand, and Government

Policies

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conomists have two roles. As scientists, they develop and test theories to explain the world
around them. As policy advisers, they use their theories to help change the world for the better.

The focus of the preceding two chapters has been scientific. We have seen how supply and demand
determine the price of a good and the quantity of the good sold. We have also seen how various events
shift supply and demand and thereby change the equilibrium price and quantity. And we have
developed the concept of elasticity to gauge the size of these changes.

This chapter offers our first look at policy. Here we analyze various types of government policy
using only the tools of supply and demand. As you will see, the analysis yields some surprising

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insights. Policies often have effects that their architects did not intend or anticipate.
We begin by considering policies that directly control prices. For example, rent-control laws dictate

a maximum rent that landlords may charge tenants. Minimum-wage laws dictate the lowest wage that
firms may pay

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workers. Price controls are usually enacted when policymakers believe that the market price of a
good or service is unfair to buyers or sellers. Yet, as we will see, these policies can generate inequities
of their own.

After discussing price controls, we consider the impact of taxes. Policymakers use taxes to raise
revenue for public purposes and to influence market outcomes. Although the prevalence of taxes in our
economy is obvious, their effects are not. For example, when the government levies a tax on the
amount that firms pay their workers, do the firms or the workers bear the burden of the tax? The
answer is not at all clear—until we apply the powerful tools of supply and demand.

6-1 Controls on Prices
To see how price controls affect market outcomes, let’s look once again at the market for ice cream. As
we saw in Chapter 4, if ice cream is sold in a competitive market free of government regulation, the
price of ice cream adjusts to balance supply and demand: At the equilibrium price, the quantity of ice
cream that buyers want to buy exactly equals the quantity that sellers want to sell. To be concrete, let’s
suppose that the equilibrium price is $3 per cone.

Some people may not be happy with the outcome of this free-market process. The American
Association of Ice-Cream Eaters complains that the $3 price is too high for everyone to enjoy a cone a
day (their recommended daily allowance). Meanwhile, the National Organization of Ice-Cream
Makers complains that the $3 price—the result of “cutthroat competition”—is too low and is
depressing the incomes of its members. Each of these groups lobbies the government to pass laws that
alter the market outcome by directly controlling the price of an icecream cone.

Because buyers of any good always want a lower price while sellers want a higher price, the
interests of the two groups conflict. If the Ice-Cream Eaters are successful in their lobbying, the
government imposes a legal maximum on the price at which ice-cream cones can be sold. Because the
price is not allowed to rise above this level, the legislated maximum is called a price ceiling. By
contrast, if the Ice-Cream Makers are successful, the government imposes a legal minimum on the
price. Because the price cannot fall below this level, the legislated minimum is called a price floor.
Let us consider the effects of these policies in turn.

price ceiling a legal maximum on the price at which a good can be sold
price floor a legal minimum on the price at which a good can be sold

6-1a How Price Ceilings Affect Market Outcomes
When the government, moved by the complaints and campaign contributions of the Ice-Cream Eaters,
imposes a price ceiling on the market for ice cream, two outcomes are possible. In panel (a) of Figure
1, the government imposes a price ceiling of $4 per cone. In this case, because the price that balances
supply and demand ($3) is below the ceiling, the price ceiling is not binding. Market forces naturally
move the economy to the equilibrium, and the price ceiling has no effect on the price or the quantity
sold.

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Panel (b) of Figure 1 shows the other, more interesting, possibility. In this case, the government
imposes a price ceiling of $2 per cone. Because the equilibrium price of $3 is above the price ceiling,
the ceiling is a binding constraint on the market. The forces of supply and demand tend to move the
price toward the equilibrium price, but when the market price hits the ceiling, it cannot, by law, rise
any further. Thus, the market price equals the price ceiling. At this price, the quantity of ice cream
demanded (125 cones in Figure 1) exceeds the quantity supplied (75 cones). There is a shortage: 50
people who want to buy ice cream at the going price are unable to do so.

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FIGURE 1
A Market with a Price Ceiling
In panel (a), the government imposes a price ceiling of $4. Because the price ceiling is above the equilibrium
price of $3, the price ceiling has no effect, and the market can reach the equilibrium of supply and demand. In
this equilibrium, quantity supplied and quantity demanded both equal 100 cones. In panel (b), the government
imposes a price ceiling of $2. Because the price ceiling is below the equilibrium price of $3, the market price
equals $2. At this price, 125 cones are demanded and only 75 are supplied, so there is a shortage of 50 cones.

In response to this shortage, some mechanism for rationing ice cream will naturally develop. The
mechanism could be long lines: Buyers who are willing to arrive early and wait in line get a cone, but
those unwilling to wait do not. Alternatively, sellers could ration ice-cream cones according to their
own personal biases, selling them only to friends, relatives, or members of their own racial or ethnic
group. Notice that even though the price ceiling was motivated by a desire to help buyers of ice cream,
not all buyers benefit from the policy. Some buyers do get to pay a lower price, although they may
have to wait in line to do so, but other buyers cannot get any ice cream at all.

This example in the market for ice cream shows a general result: When the government imposes a
binding price ceiling on a competitive market, a shortage of the good arises, and sellers must ration
the scarce goods among the large number of potential buyers. The rationing mechanisms that develop
under price ceilings are rarely desirable. Long lines are inefficient because they waste buyers’ time.
Discrimination according to seller bias is both inefficient (because the good does not necessarily go to
the buyer who values it most highly) and potentially unfair. By contrast, the rationing mechanism in a
free, competitive market is both efficient and impersonal. When the market for ice cream reaches its
equilibrium, anyone who wants to pay the market price can get a cone. Free markets ration goods with
prices.

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case study Lines at the Gas Pump
As we discussed in Chapter 5, in 1973 the Organization of Petroleum Exporting Countries (OPEC)
raised the price of crude oil in world oil markets. Because crude oil is the major input used to make
gasoline, the higher oil prices reduced the supply of gasoline. Long lines at gas stations became
commonplace, and motorists often had to wait for hours to buy only a few gallons of gas.

What was responsible for the long gas lines? Most people blame OPEC. Surely, if OPEC had not
raised the price of crude oil, the shortage of gasoline would not have occurred. Yet economists
blame U.S. government regulations that limited the price oil companies could charge for gasoline.

Figure 2 shows what happened. As shown in panel (a), before OPEC raised the price of crude oil,
the equilibrium price of gasoline, P1, was below the price ceiling. The price regulation, therefore,
had no effect. When the price of crude oil rose, however, the situation changed. The increase in the
price of crude oil raised the cost of producing gasoline, and this reduced the supply of gasoline. As
panel (b) shows, the supply curve shifted to the left from S1 to S2. In an unregulated market, this
shift in supply would have raised the equilibrium price of gasoline from P1 to P2, and no shortage
would have resulted. Instead, the price ceiling prevented the price from rising to the equilibrium
level. At the price ceiling, producers were

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willing to sell Qs, and consumers were willing to buy QD. Thus, the shift in supply caused a
severe shortage at the regulated price.

FIGURE 2
The Market for Gasoline with a Price Ceiling
Panel (a) shows the gasoline market when the price ceiling is not binding because the equilibrium price, P1,
is below the ceiling. Panel (b) shows the gasoline market after an increase in the price of crude oil (an input
into making gasoline) shifts the supply curve to the left from S1 to S2. In an unregulated market, the price
would have risen from P1 to P2. The price ceiling, however, prevents this from happening. At the binding
price ceiling, consumers are willing to buy QD, but producers of gasoline are willing to sell only Qs. The
difference between quantity demanded and quantity supplied, QD−QS, measures the gasoline shortage.

Eventually, the laws regulating the price of gasoline were repealed. Lawmakers came to
understand that they were partly responsible for the many hours Americans lost waiting in line to
buy gasoline. Today, when the price of crude oil changes, the price of gasoline can adjust to bring
supply and demand into equilibrium.

case study Rent Control in the Short Run and the Long Run
One common example of a price ceiling is rent control. In many cities, the local government places
a ceiling on rents that landlords may charge their tenants. The goal of this policy is to help the poor
by making housing more affordable. Economists often criticize rent control, arguing that it is a
highly inefficient way to help the poor raise their standard of living. One economist called rent
control “the best way to destroy a city, other than bombing.”

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The adverse effects of rent control are less apparent to the general population because these
effects occur over many years. In the short run, landlords have a fixed number of apartments to rent,
and they cannot adjust this number quickly as market conditions change. Moreover, the number of
people searching for housing in a city may not be highly responsive to rents in the short run because
people take time to adjust their housing arrangements. Therefore, the short-run supply and demand
for housing are relatively inelasti

Panel (a) of Figure 3 shows the short-run effects of rent control on the housing market. As with
any binding price ceiling, rent control causes a shortage.

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Yet because supply and demand are inelastic in the short run, the initial shortage caused by rent
control is small. The primary effect in the short run is to reduce rents.

FIGURE 3
Rent Control in the Short Run and in the Long Run
Panel (a) shows the short-run effects of rent control: Because the supply and demand curves for apartments
are relatively inelastic, the price ceiling imposed by a rent-control law causes only a small shortage of
housing. Panel (b) shows the long-run effects of rent control: Because the supply and demand curves for
apartments are more elastic, rent control causes a large shortage.

The long-run story is very different because the buyers and sellers of rental housing respond more
to market conditions as time passes. On the supply side, landlords respond to low rents by not
building new apartments and by failing to maintain existing ones. On the demand side, low rents
encourage people to find their own apartments (rather than living with their parents or sharing
apartments with roommates) and induce more people to move into a city. Therefore, both supply
and demand are more elastic in the long run.

Panel (b) of Figure 3 illustrates the housing market in the long run. When rent control depresses
rents below the equilibrium level, the quantity of apartments supplied falls substantially, and the
quantity of apartments demanded rises substantially. The result is a large shortage of housing.

In cities with rent control, landlords use various mechanisms to ration housing. Some landlords
keep long waiting lists. Others give a preference to tenants without children. Still others
discriminate on the basis of race. Sometimes apartments are allocated to those willing to offer
under-the-table payments to building superintendents. In essence, these bribes bring the total price

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of an apartment closer to the equilibrium price.
To understand fully the effects of rent control, we have to remember one of the Ten Principles of

Economics from Chapter 1: People respond to incentives. In free markets, landlords try to keep their
buildings clean and safe because desirable apartments command higher prices. By contrast, when
rent control creates shortages and waiting lists, landlords lose their incentive to respond to tenants’
concerns. Why should a landlord spend money to maintain and improve the property when people
are waiting to get in as it is? In the end, tenants get lower rents, but they also get lower-quality
housing.

Policymakers often react to the effects of rent control by imposing additional regulations. For
example, various laws make racial discrimination in housing illegal and require landlords to provide
minimally adequate living conditions. These laws, however, are difficult and costly to enforce. By
contrast, when rent control is eliminated and a market for housing is regulated by the forces of
competition, such laws are less necessary. In a free market, the price of housing adjusts to eliminate
the shortages that give rise to undesirable landlord behavior.

6-1b How Price Floors Affect Market Outcomes
To examine the effects of another kind of government price control, let’s return to the market for ice
cream. Imagine now that the government is persuaded by the pleas of the National Organization of
Ice-Cream Makers whose members feel the $3 equilibrium price is too low. In this case, the
government might institute a price floor. Price floors, like price ceilings, are an attempt by the
government to maintain prices at other than equilibrium levels. Whereas a price ceiling places a legal
maximum on prices, a price floor places a legal minimum.

When the government imposes a price floor on the ice-cream market, two outcomes are possible. If
the government imposes a price floor of $2 per cone when the equilibrium price is $3, we obtain the
outcome in panel (a) of Figure 4. In this case, because the equilibrium price is above the floor, the
price floor is not binding. Market forces naturally move the economy to the equilibrium, and the price
floor has no effect.

Panel (b) of Figure 4 shows what happens when the government imposes a price floor of $4 per
cone. In this case, because the equilibrium price of $3 is below the floor, the price floor is a binding
constraint on the market. The forces of supply and demand tend to move the price toward the
equilibrium price, but when the market price hits the floor, it can fall no further. The market price
equals the price floor. At this floor, the quantity of ice cream supplied (120 cones) exceeds the quantity
demanded (80 cones). Some people who want to sell ice cream at the going price are unable to. Thus,
a binding price floor causes a surplus.

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FIGURE 4
A Market with a Price Floor
In panel (a), the government imposes a price floor of $2. Because this is below the equilibrium price of $3, the
price floor has no effect. The market price adjusts to balance supply and demand. At the equilibrium, quantity
supplied and quantity demanded both equal 100 cones. In panel (b), the government imposes a price floor of $4,
which is above the equilibrium price of $3. Therefore, the market price equals $4. Because 120 cones are
supplied at this price and only 80 are demanded, there is a surplus of 40 cones.

Just as the shortages resulting from price ceilings can lead to undesirable rationing mechanisms, so
can the surpluses resulting from price floors. The sellers who appeal to the personal biases of the
buyers, perhaps due to racial or familial ties, may be better able to sell their goods than those who do
not. By contrast, in a free market, the price serves as the rationing mechanism, and sellers can sell all
they want at the equilibrium price.

case study The Minimum Wage
An important example of a price floor is the minimum wage. Minimum-wage laws dictate the
lowest price for labor that any employer may pay. The U.S. Congress first instituted a minimum
wage with the Fair Labor Standards Act of 1938 to ensure workers a minimally adequate standard
of living. In 2012, the minimum wage according to federal law was $7.25 per hour. (Some states
mandate minimum wages above the federal level.) Most European nations have minimum-wage
laws as well, sometimes significantly higher than in the United States. For example, average income
in France is 27 percent lower than

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it is in the United States, but the French minimum wage is 9.40 euros per hour, which is about $12
per hour.

To examine the effects of a minimum wage, we must consider the market for labor. Panel (a) of
Figure 5 shows the labor market, which, like all markets, is subject to the forces of supply and
demand. Workers determine the supply of labor, and firms determine the demand. If the government
doesn’t intervene, the wage normally adjusts to balance labor supply and labor demand.

Panel (b) of Figure 5 shows the labor market with a minimum wage. If the minimum wage is
above the equilibrium level, as it is here, the quantity of labor supplied exceeds the quantity
demanded. The result is unemployment. Thus, the minimum wage raises the incomes of those
workers who have jobs, but it lowers the incomes of workers who cannot find jobs.

To fully understand the minimum wage, keep in mind that the economy contains not a single
labor market but many labor markets for different types of workers. The impact of the minimum
wage depends on the skill and experience of the worker. Highly skilled and experienced workers are
not affected because their equilibrium wages are well above the minimum. For these workers, the
minimum wage is not binding.

The minimum wage has its greatest impact on the market for teenage labor. The equilibrium
wages of teenagers are low because teenagers are among the least skilled and least experienced
members of the labor force. In addition, teenagers are often willing to accept a lower wage in
exchange for on-the-job training. (Some teenagers are willing to work as “interns” for no pay at all.
Because internships pay nothing, however, the minimum wage does not apply to them. If it did,
these jobs might not exist.) As a result, the minimum wage is binding more often for teenagers than
for other members of the labor force.

FIGURE 5
How the Minimum Wage Affects the Labor Market
Panel (a) shows a labor market in which the wage adjusts to balance labor supply and labor demand. Panel
(b) shows the impact of a binding minimum wage. Because the minimum wage is a price floor, it causes a
surplus: The quantity of labor supplied exceeds the quantity demanded. The result is unemployment.

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Many economists have studied how minimum-wage laws affect the teenage labor market. These
researchers compare the changes in the minimum wage over time with the changes in teenage
employment. Although there is some debate about how much the minimum wage affects
employment, the typical study finds that a 10 percent increase in the minimum wage depresses
teenage employment between 1 and 3 percent. In interpreting this estimate, note that a 10 percent
increase in the minimum wage does not raise the average wage of teenagers by 10 percent. A
change in the law does not directly affect those teenagers who are already paid well above the
minimum, and enforcement of minimum-wage laws is not perfect. Thus, the estimated drop in
employment of 1 to 3 percent is significant.

In addition to altering the quantity of labor demanded, the minimum wage alters the quantity
supplied. Because the minimum wage raises the wage that teenagers can earn, it increases the
number of teenagers who choose to look for jobs. Studies have found that a higher minimum wage
influences which teenagers are employed. When the minimum wage rises, some teenagers who are
still attending high school choose to drop out and take jobs. These new dropouts displace other
teenagers who had already dropped out of school and who now become unemployed.

The minimum wage is a frequent topic of debate. Economists are about evenly divided on the
issue. In a 2006 survey of Ph.D. economists, 47 percent favored eliminating the minimum wage,
while 14 percent would maintain it at its current level and 38 percent would increase it.

Advocates of the minimum wage view the policy as one way to raise the income of the working
poor. They correctly point out that workers who earn the minimum wage can afford only a meager
standard of living. In 2012, for instance, when the minimum wage was $7.25 per hour, two adults
working 40 hours a week for every week of the year at minimum-wage jobs had a total annual
income of only $30,160, which was less than two-thirds of the median family income in the United
States. Many advocates of the minimum wage admit that it has some adverse effects, including
unemployment, but they believe that these effects are small and that, all things considered, a higher
minimum wage makes the poor better off.

Opponents of the minimum wage contend that it is not the best way to combat poverty. They note
that a high minimum wage causes unemployment, encourages teenagers to drop out of school, and
prevents some unskilled workers from getting the on-the-job training they need. Moreover,
opponents of the minimum wage point out that it is a poorly targeted policy. Not all minimum-wage
workers are heads of households trying to help their families escape poverty. In fact, fewer than a
third of minimum-wage earners are in families with incomes below the poverty line. Many are
teenagers from middle-class homes working at part-time jobs for extra spending money.

6-1c Evaluating Price Controls
One of the Ten Principles of Economics discussed in Chapter 1 is that markets are usually a good way
to organize economic activity. This principle explains why economists usually oppose price ceilings
and price floors. To economists, prices are not the outcome of some haphazard process. Prices, they
contend, are the result of the millions of business and consumer decisions that lie behind the supply
and demand curves. Prices have the crucial job of balancing supply and demand and, thereby,
coordinating economic activity. When policymakers set prices by legal decree, they obscure the

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signals that normally guide the allocation of society’s resources.

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IN THE NEWS Venezuela versus the Market

This is what happens when political leaders replace market prices with theirThis is what happens when political leaders replace market prices with their
ownown.
With Venezuelan Food Shortages, Some Blame Price Controls
By William Neuman

ARACAS, Venezuela — By 6:30 a.m., a full hour and a half before the store would open,
about two dozen people were already in line. They waited patiently, not for the latest iPhone,

but for something far more basic: groceries.
“Whatever I can get,” said Katherine Huga, 23, a mother of two, describing her shopping list. She

gave a shrug of resignation. “You buy what they have.”
Venezuela is one of the world’s top oil producers at a time of soaring energy prices, yet shortages

of staples like milk, meat and toilet paper are a chronic part of life here, often turning grocery
shopping into a hit or miss proposition.

Some residents arrange their calendars around the once-a-week deliveries made to government-
subsidized stores like this one, lining up before dawn to buy a single frozen chicken before the stock
runs out. Or a couple of bags of flour. Or a bottle of cooking oil.

The shortages affect both the poor and the well-off, in surprising ways. A supermarket in the
upscale La Castellana neighborhood recently had plenty of chicken and cheese—even quail eggs—
but not a single roll of toilet paper. Only a few bags of coffee remained on a bottom shelf.

Asked where a shopper could get milk on a day when that, too, was out of stock, a manager said
with sarcasm, “At Chávez’s house.”

At the heart of the debate is President Hugo Chávez’s socialist-inspired government, which
imposes strict price controls that are intended to make a range of foods and other goods more
affordable for the poor. They are often the very products that are the hardest to find.

“Venezuela is too rich a country to have this,” Nery Reyes, 55, a restaurant worker, said outside a

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government-subsidized store in the working-class Santa Rosalía neighborhood. “I’m wasting my day
here standing in line to buy one chicken and some rice.”

Venezuela was long one of the most prosperous countries in the region, with sophisticated
manufacturing, vibrant agriculture and strong businesses, making it hard for many residents to
accept such widespread scarcities. But amid the prosperity, the gap between rich and poor was
extreme, a problem that Mr. Chávez and his ministers say they are trying to eliminate.

They blame unfettered capitalism for the country’s economic ills and argue that controls are
needed to keep prices in check in a country where inflation rose to 27.6 percent last year, one of the
highest rates in the world. They say companies cause shortages on purpose, holding products off the
market to push up prices. This month, the government required price cuts on fruit juice, toothpaste,

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disposable diapers and more than a dozen other products.
“We are not asking them to lose money, just that they make money in a rational way, that they

don’t rob the people,” Mr. Chávez said recently.
But many economists call it a classic case of a government causing a problem rather than solving

it. Prices are set so low, they say, that companies and producers cannot make a profit. So farmers
grow less food, manufacturers cut back production and retailers stock less inventory. Moreover,
some of the shortages are in industries, like dairy and coffee, where the government has seized
private companies and is now running them, saying it is in the national interest.

In January, according to a scarcity index compiled by the Central Bank of Venezuela, the
difficulty of finding basic goods on store shelves was at its worst level since 2008. While that
measure has eased considerably, many products can still be hard to come by.

Datanálisis, a polling firm that regularly tracks scarcities, said that powdered milk, a staple here,
could not be found in 42 percent of the stores its researchers visited in early March. Liquid milk can
be even harder to find.

Other products in short supply last month, according to Datanálisis, included beef, chicken,
vegetable oil and sugar. The polling firm also says that the problem is most extreme in the
government-subsidized stores that were created to provide affordable food to the poor….

Francisco Rodríguez, an economist with Bank of America Merrill Lynch who studies the
Venezuelan economy, said the government might score some political points with the new round of
price controls. But over time, he argued, they will spell trouble for the economy.

“In the medium to long term, this is going to be a disaster,” Mr. Rodriguez said.
The price controls also mean that products missing from store shelves usually show up on the

black market at much higher prices, a source of outrage for many. For government supporters, that
is proof of speculation. Others say it is the consequence of a misguided policy….

If there is one product that Venezuela should be able to produce in abundance it is coffee, a major
crop here for centuries. Until 2009, Venezuela was a coffee exporter, but it began importing large
amounts of it three years ago to make up for a decline in production.

Farmers and coffee roasters say the problem is simple: retail price controls keep prices close to or
below what it costs farmers to grow and harvest the coffee. As a result, many do not invest in new
plantings or fertilizer, or they cut back on the amount of land used to grow coffee. Making matters
worse, the recent harvest was poor in many areas.

A group representing small- to medium-size roasters said last month that there was no domestic
coffee left on the wholesale market—the earliest time of year that industry leaders could remember
such supplies running out. The group announced a deal with the government to buy imported beans
to keep coffee on store shelves.

Similar problems have played out with other agricultural products under price controls, like lags
in production and rising imports for beef, milk and corn.

Waiting in line to buy chicken and other staples, Jenny Montero, 30, recalled how she could not

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find cooking oil last fall and had to switch from the fried food she prefers to soups and stews.
“It was good for me,” she said drily, pushing her 14-month-old daughter in a stroller. “I lost

several pounds.”

Source: New York Times, April 20, 201

Another one of the Ten Principles of Economics is that governments can sometimes improve market
outcomes. Indeed, policymakers are led to control prices because they view the market’s outcome as
unfair. Price controls are often aimed at helping the poor. For instance, rent-control laws try to make
housing affordable for everyone, and minimum-wage laws try to help people escape poverty.

Yet price controls often hurt those they are trying to help. Rent control may keep rents low, but it
also discourages landlords from maintaining their buildings and makes housing hard to find.
Minimum-wage laws may raise the incomes of some workers, but they also cause other workers to be
unemployed.

Helping those in need can be accomplished in ways other than controlling prices. For instance, the
government can make housing more affordable by paying a fraction of the rent for poor families.
Unlike rent control, such rent subsidies do not reduce the quantity of housing supplied and, therefore,
do not lead to housing shortages. Similarly, wage subsidies raise the living standards of the working
poor without discouraging firms from hiring them. An example of a wage subsidy is the earned
income tax credit, a government program that supplements the incomes of low-wage workers.

Although these alternative policies are often better than price controls, they are not perfect. Rent and
wage subsidies cost the government money and, therefore, require higher taxes. As we see in the next
section, taxation has costs of its own.

Quick Quiz Define price ceiling and price floor and give an example of each. Which leads to a
shortage? Which leads to a surplus? Why?

6-2 Taxes
All governments—from the federal government in Washington, D.C., to the local governments in
small towns—use taxes to raise revenue for public projects, such as roads, schools, and national
defense. Because taxes are such an important policy instrument, and because they affect our lives in
many ways, we return to the

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study of taxes several times throughout this book. In this section, we begin our study of how taxes
affect the economy.

To set the stage for our analysis, imagine that a local government decides to hold an annual ice-
cream celebration—with a parade, fireworks, and speeches by town officials. To raise revenue to pay
for the event, the town decides to place a $0.50 tax on the sale of ice-cream cones. When the plan is
announced, our two lobbying groups swing into action. The American Association of Ice-Cream
Eaters claims that consumers of ice cream are having trouble making ends meet, and it argues that
sellers of ice cream should pay the tax. The National Organization of Ice-Cream Makers claims that its
members are struggling to survive in a competitive market, and it argues that buyers of ice cream
should pay the tax. The town mayor, hoping to reach a compromise, suggests that half the tax be paid
by the buyers and half be paid by the

sellers.

To analyze these proposals, we need to address a simple but subtle question: When the government
levies a tax on a good, who actually bears the burden of the tax? The people buying the good? The
people selling the good? Or if buyers and sellers share the tax burden, what determines how the burden
is divided? Can the government simply legislate the division of the burden, as the mayor is suggesting,
or is the division determined by more fundamental market forces? The term tax incidence refers to
how the burden of a tax is distributed among the various people who make up the economy. As we
will see, some surprising lessons about tax incidence can be learned by applying the tools of supply
and demand.

tax incidence the manner in which the burden of a tax is shared among participants in a market

6-2a How Taxes on Sellers Affect Market Outcomes
We begin by considering a tax levied on sellers of a good. Suppose the local government passes a law
requiring sellers of ice-cream cones to send $0.50 to the government for each cone they sell. How does
this law affect the buyers and sellers of ice cream? To answer this question, we can follow the three
steps in Chapter 4 for analyzing supply and demand: (1) We decide whether the law affects the supply
curve or demand curve. (2) We decide which way the curve shifts. (3) We examine how the shift
affects the equilibrium price and quantity.

Step One The immediate impact of the tax is on the sellers of ice cream. Because the tax is not levied
on buyers, the quantity of ice cream demanded at any given price is the same; thus, the demand curve
does not change. By contrast, the tax on sellers makes the ice-cream business less profitable at any
given price, so it shifts the supply curve.

Step Two Because the tax on sellers raises the cost of producing and selling ice cream, it reduces the
quantity supplied at every price. The supply curve shifts to the left (or, equivalently, upward).

In addition to determining the direction in which the supply curve moves, we can also be precise
about the size of the shift. For any market price of ice cream, the effective price to sellers—the amount
they get to keep after paying the tax—is $0.50 lower. For example, if the market price of a cone
happened to be $2.00, the effective price received by sellers would be $1.50. Whatever the market
price, sellers will supply a quantity of ice cream as if the price were $0.50 lower than it is. Put

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differently, to induce sellers to supply any given quantity, the market price must now be $0.50 higher
to compensate for the effect of the tax. Thus, as shown in Figure 6, the supply curve shifts upward
from S1 to S2 by the exact size of the tax ($0.50).

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FIGURE 6
A Tax on Sellers
When a tax of $0.50 is levied on sellers, the supply curve shifts up by $0.50 from S1 to S2. The equilibrium
quantity falls from 100 to 90 cones. The price that buyers pay rises from $3.00 to $3.30. The price that sellers
receive (after paying the tax) falls from $3.00 to $2.80. Even though the tax is levied on sellers, buyers and
sellers share the burden of the tax.

Step Three Having determined how the supply curve shifts, we can now compare the initial and the
new equilibriums. Figure 6 shows that the equilibrium price of ice cream rises from $3.00 to $3.30,
and the equilibrium quantity falls from 100 to 90 cones. Because sellers sell less and buyers buy less in
the new equilibrium, the tax reduces the size of the ice-cream market.

Implications We can now return to the question of tax incidence: Who pays the tax? Although sellers
send the entire tax to the government, buyers and sellers share the burden. Because the market price
rises from $3.00 to $3.30 when the tax is introduced, buyers pay $0.30 more for each ice-cream cone
than they did without the tax. Thus, the tax makes buyers worse off. Sellers get a higher price ($3.30)
from buyers than they did previously, but what they get to keep after paying the tax is only $2.80
($3.30 − $0.50 = $2.80), compared with $3.00 before the tax was implemented. Thus, the tax also
makes sellers worse off.

To sum up, this analysis yields two lessons:

Taxes discourage market activity. When a good is taxed, the quantity of the good sold is smaller in
the new equilibrium.

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Buyers and sellers share the burden of taxes. In the new equilibrium, buyers pay more for the good,
and sellers receive less.

6-2b How Taxes on Buyers Affect Market Outcomes
Now consider a tax levied on buyers of a good. Suppose that our local government passes a law
requiring buyers of ice-cream cones to send $0.50 to the government for each ice-cream cone they
buy. What are the effects of this law? Again, we apply our three steps.

Step One The initial impact of the tax is on the demand for ice cream. The supply curve is not
affected because, for any given price of ice cream, sellers have the

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same incentive to provide ice cream to the market. By contrast, buyers now have to pay a tax to the
government (as well as the price to the sellers) whenever they buy ice cream. Thus, the tax shifts the
demand curve for ice cream.

Step Two We next determine the direction of the shift. Because the tax on buyers makes buying ice
cream less attractive, buyers demand a smaller quantity of ice cream at every price. As a result, the
demand curve shifts to the left (or, equivalently, downward), as shown in Figure

Once again, we can be precise about the size of the shift. Because of the $0.50 tax levied on buyers,
the effective price to buyers is now $0.50 higher than the market price (whatever the market price
happens to be). For example, if the market price of a cone happened to be $2.00, the effective price to
buyers would be $2.50. Because buyers look at their total cost including the tax, they demand a
quantity of ice cream as if the market price were $0.50 higher than it actually is. In other words, to
induce buyers to demand any given quantity, the market price must now be $0.50 lower to make up for
the effect of the tax. Thus, the tax shifts the demand curve downward from D1 to D2 by the exact size
of the tax ($0.50).

Step Three Having determined how the demand curve shifts, we can now see the effect of the tax by
comparing the initial equilibrium and the new equilibrium. You can see in Figure 7 that the
equilibrium price of ice cream falls from $3.00 to $2.80, and the equilibrium quantity falls from 100 to
90 cones. Once again, the tax on ice cream reduces the size of the ice-cream market. And once again,
buyers and sellers share the burden of the tax. Sellers get a lower price for their product; buyers pay a
lower market price to sellers than they did previously, but the effective price (including the tax buyers
have to pay) rises from $3.00 to $3.30.

FIGURE 7
A Tax on Buyers
When a tax of $0.50 is levied on buyers, the demand curve shifts down by $0.50 from D1 to D2. The
equilibrium quantity falls from 100 to 90 cones. The price that sellers receive falls from $3.00 to $2.80. The
price that buyers pay (including the tax) rises from $3.00 to $3.30. Even though the tax is levied on buyers,
buyers and sellers share the burden of the tax.

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Implications If you compare Figures 6 and 7, you will notice a surprising conclusion: Taxes levied
on sellers and taxes levied on buyers are equivalent. In both cases, the tax places a wedge between the
price that buyers pay and the price that sellers receive. The wedge between the buyers’ price and the
sellers’ price is the same, regardless of whether the tax is levied on buyers or sellers. In either case, the
wedge shifts the relative position of the supply and demand curves. In the new equilibrium, buyers and
sellers share the burden of the tax. The only difference between a tax levied on sellers and a tax levied
on buyers is who sends the money to the government.

The equivalence of these two taxes is easy to understand if we imagine that the government collects
the $0.50 ice-cream tax in a bowl on the counter of each icecream store. When the government levies
the tax on sellers, the seller is required to place $0.50 in the bowl after the sale of each cone. When the
government levies the tax on buyers, the buyer is required to place $0.50 in the bowl every time a cone
is bought. Whether the $0.50 goes directly from the buyer’s pocket into the bowl, or indirectly from
the buyer’s pocket into the seller’s hand and then into the bowl, does not matter. Once the market
reaches its new equilibrium, buyers and sellers share the burden, regardless of how the tax is levied.

case study Can Congress Distribute the Burden of a Payroll
Tax?
If you have ever received a paycheck, you probably noticed that taxes were deducted from the
amount you earned. One of these taxes is called FICA, an acronym for the Federal Insurance
Contributions Act. The federal government uses the revenue from the FICA tax to pay for Social
Security and Medicare, the income support and healthcare programs for the elderly. FICA is an
example of a payroll tax, which is a tax on the wages that firms pay their workers. In 2013, the total
FICA tax for the typical worker was 15.3 percent of earnings.

Who do you think bears the burden of this payroll tax—firms or workers? When Congress passed
this legislation, it tried to mandate a division of the tax burden. According to the law, half of the tax
is paid by firms, and half is paid by workers. That is, half of the tax is paid out of firms’ revenues,
and half is deducted from workers’ paychecks. The amount that shows up as a deduction on your
pay stub is the worker contribution.

Our analysis of tax incidence, however, shows that lawmakers cannot so easily dictate the
distribution of a tax burden. To illustrate, we can analyze a payroll tax as merely a tax on a good,
where the good is labor and the price is the wage. The key feature of the payroll tax is that it places
a wedge between the wage that firms pay and the wage that workers receive. Figure 8 shows the
outcome. When a payroll tax is enacted, the wage received by workers falls, and the wage paid by
firms rises. In the end, workers and firms share the burden of the tax, much as the legislation
requires. Yet this division of the tax burden between workers and firms has nothing to do with the
legislated division: The division of the burden in Figure 8 is not necessarily 50-50, and the same
outcome would prevail if the law levied the entire tax on workers or if it levied the entire tax on
firms.

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FIGURE 8
A Payroll Tax
A payroll tax places a wedge between the wage that workers receive and the wage that firms pay. Comparing
wages with and without the tax, you can see that workers and firms share the tax burden. This division of the
tax burden between workers and firms does not depend on whether the government levies the tax on
workers, levies the tax on firms, or divides the tax equally between the two groups.

This example shows that the most basic lesson of tax incidence is often overlooked in public
debate. Lawmakers can decide whether a tax comes from the buyer’s pocket or from the seller’s, but
they cannot legislate the true burden of a tax. Rather, tax incidence depends on the forces of supply
and demand.

6-2c Elasticity and Tax Incidence
When a good is taxed, buyers and sellers of the good share the burden of the tax. But how exactly is
the tax burden divided? Only rarely will it be shared equally. To see how the burden is divided,
consider the impact of taxation in the two markets in Figure 9. In both cases, the figure shows the
initial demand curve, the initial supply curve, and a tax that drives a wedge between the amount paid
by buyers and the amount received by sellers. (Not drawn in either panel of the figure is the new
supply or demand curve. Which curve shifts depends on whether the tax is levied on buyers or sellers.
As we have seen, this is irrelevant for the incidence of the tax.) The difference in the two panels is the
relative elasticity of supply and demand.

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Panel (a) of Figure 9 shows a tax in a market with very elastic supply and relatively inelastic
demand. That is, sellers are very responsive to changes in the price of the good (so the supply curve is
relatively flat), whereas buyers are not very responsive (so the demand curve is relatively steep). When
a tax is imposed on a market with these elasticities, the price received by sellers does not fall much, so
sellers bear only a small burden. By contrast, the price paid by buyers rises substantially, indicating
that buyers bear most of the burden of the tax.

Panel (b) of Figure 9 shows a tax in a market with relatively inelastic supply and very elastic
demand. In this case, sellers are not very responsive to changes in the price (so the supply curve is
steeper), whereas buyers are very responsive (so the demand curve is flatter). The figure shows that
when a tax is imposed, the price paid by buyers does not rise much, but the price received by sellers
falls substantially. Thus, sellers bear most of the burden of the tax.

The two panels of Figure 9 show a general lesson about how the burden of a tax is divided: A tax
burden falls more heavily on the side of the market that is less elastic. Why is this true? In essence, the
elasticity measures the willingness of buyers or sellers to leave the market when conditions become
unfavorable. A small elasticity of demand means that buyers do not have good alternatives to
consuming this particular good. A small elasticity of supply means that sellers do not have good
alternatives to producing this particular good. When the good is taxed, the side of the market with
fewer good alternatives is less willing to leave the market and must, therefore, bear more of the burden
of the tax.

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FIGURE 9
How the Burden of a Tax Is Divided
In panel (a), the supply curve is elastic, and the demand curve is inelastic. In this case, the price received by
sellers falls only slightly, while the price paid by buyers rises substantially. Thus, buyers bear most of the
burden of the tax. In panel (b), the supply curve is inelastic, and the demand curve is elastic. In this case, the
price received by sellers falls substantially, while the price paid by buyers rises only slightly. Thus, sellers bear
most of the burden of the tax.

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We can apply this logic to the payroll tax discussed in the previous case study. Most labor
economists believe that the supply of labor is much less elastic than the demand. This means that
workers, rather than firms, bear most of the burden

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of the payroll tax. In other words, the distribution of the tax burden is far from the 50-50 split that
lawmakers intended.

case study Who Pays the Luxury Tax?
In 1990, Congress adopted a new luxury tax on items such as yachts, private airplanes, furs, jewelry,
and expensive cars. The goal of the tax was to raise revenue from those who could most easily
afford to pay. Because only the rich could afford to buy such extravagances, taxing luxuries seemed
a logical way of taxing the rich.

Yet, when the forces of supply and demand took over, the outcome was quite different from the
one Congress intended. Consider, for example, the market for yachts. The demand for yachts is
quite elastic. A millionaire can easily not buy a yacht; he can use the money to buy a bigger house,
take a European vacation, or leave a larger bequest to his heirs. By contrast, the supply of yachts is
relatively inelastic, at least in the short run. Yacht factories are not easily converted to alternative
uses, and workers who build yachts are not eager to change careers in response to changing market
conditions.

Our analysis makes a clear prediction in this case. With elastic demand and inelastic supply, the
burden of a tax falls largely on the suppliers. That is, a tax on yachts places a burden largely on the
firms and workers who build yachts because they end up getting a significantly lower price for their
product. The workers, however, are not wealthy. Thus, the burden of a luxury tax falls more on the
middle class than on the rich.

The mistaken assumptions about the incidence of the luxury tax quickly became apparent after
the tax went into effect. Suppliers of luxuries made their congressional representatives well aware of
the economic hardship they experienced, and Congress repealed most of the luxury tax in 1993.

“If this boat were any more expensive, we’d be playing golf.”

Quick Quiz In a supply-and-demand diagram, show how a tax on car buyers of $1,000 per car
affects the quantity of cars sold and the price of cars. In another diagram, show how a tax on car
sellers of $1,000 per car affects the quantity of cars sold and the price of cars. In both of your
diagrams, show the change in the price paid by car buyers and the change in the price received by car

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sellers.

6-3 Conclusion
The economy is governed by two kinds of laws: the laws of supply and demand and the laws enacted
by governments. In this chapter, we have begun to see how these laws interact. Price controls and
taxes are common in various markets in the economy, and their effects are frequently debated in the
press and among policymakers. Even a little bit of economic knowledge can go a long way toward
understanding and evaluating these policies.

In subsequent chapters, we analyze many government policies in greater detail. We examine the
effects of taxation more fully and consider a broader range of policies than we considered here. Yet the
basic lessons of this chapter will not change: When analyzing government policies, supply and
demand are the first and most useful tools of analysis.

Summary

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A price ceiling is a legal maximum on the price of a good or service. An example is rent control. If
the price ceiling is below the equilibrium price, then the price ceiling is binding, and the quantity
demanded exceeds the quantity supplied. Because of the resulting shortage, sellers must in some
way ration the good or service among buyers.
A price floor is a legal minimum on the price of a good or service. An example is the minimum
wage. If the price floor is above the equilibrium price, then the price floor is binding, and the
quantity supplied exceeds the quantity demanded. Because of the resulting surplus, buyers’ demands
for the good or service must in some way be rationed among sellers.
When the government levies a tax on a good, the equilibrium quantity of the good falls. That is, a
tax on a market shrinks the size of the market.
A tax on a good places a wedge between the price paid by buyers and the price received by sellers.
When the market moves to the new equilibrium, buyers pay more for the good and sellers receive
less for it. In this sense, buyers and sellers share the tax burden. The incidence of a tax (that is, the
division of the tax burden) does not depend on whether the tax is levied on buyers or sellers.
The incidence of a tax depends on the price elasticities of supply and demand. Most of the burden
falls on the side of the market that is less elastic because that side of the market cannot respond as
easily to the tax by changing the quantity bought or sold.

Key Concepts
price ceiling, p. 112
price floor, p. 112
tax incidence, p. 122

Questions for Review
1. Give an example of a price ceiling and an example of a price floor.
2. Which causes a shortage of a good—a price ceiling or a price floor? Justify your answer with a

graph.
3. What mechanisms allocate resources when the price of a good is not allowed to bring supply and

demand into equilibrium?
4. Explain why economists usually oppose controls on prices.
5. Suppose the government removes a tax on buyers of a good and levies a tax of the same size on

sellers of the good. How does this change in tax policy affect the price that buyers pay sellers for
this good, the amount buyers are out of pocket (including any tax payments they make), the
amount sellers receive (net of any tax payments they make), and the quantity of the good sold?

6. How does a tax on a good affect the price paid by buyers, the price received by sellers, and the
quantity sold?

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c.
d.

a.
b.

c.
d.

a.
b.
c.
d.

7. What determines how the burden of a tax is divided between buyers and sellers? Why?

Quick Check Multiple Choice
When the government imposes a binding price floor, it causes

the supply curve to shift to the left.
the demand curve to shift to the right.
a shortage of the good to develop.
a surplus of the good to develop.

In a market with a binding price ceiling, an increase in the ceiling will _________ the quantity
supplied, _________ the quantity demanded, and reduce the _________.

increase, decrease, surplus
decrease, increase, surplus
increase, decrease, shortage
decrease, increase, shortage

A $1 per unit tax levied on consumers of a good is equivalent to
a $1 per unit tax levied on producers of the good.
a $1 per unit subsidy paid to producers of the good.
a price floor that raises the good’s price by $1 per unit.
a price ceiling that raises the good’s price by $1 per unit.

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a.
b.
c.
d.

2.
a.

b.
c.
3.
PRINTED BY: marquez007@email.phoenix.edu. Printing is for personal, private use only. No part of this
book may be reproduced or transmitted without publisher’s prior permission. Violators will be prosecuted.

Which of the following would increase quantity supplied, decrease quantity demanded, and
increase the price that consumers pay?

the imposition of a binding price floor
the removal of a binding price floor
the passage of a tax levied on producers
the repeal of a tax levied on producers

Which of the following would increase quantity supplied, increase quantity demanded, and
decrease the price that consumers pay?

the imposition of a binding price floor
the removal of a binding price floor
the passage of a tax levied on producers
the repeal of a tax levied on producers

When a good is taxed, the burden of the tax falls mainly on consumers if
the tax is levied on consumers.
the tax is levied on producers.
supply is inelastic, and demand is elastic.
supply is elastic, and demand is inelastic.

Problems and Applications
Lovers of classical music persuade Congress to impose a price ceiling of $40 per concert ticket. As
a result of this policy, do more or fewer people attend classical music concerts? Explain.
The government has decided that the free-market price of cheese is too low.

Suppose the government imposes a binding price floor in the cheese market. Draw a supply-
and-demand diagram to show the effect of this policy on the price of cheese and the quantity of
cheese sold. Is there a shortage or surplus of cheese?
Producers of cheese complain that the price floor has reduced their total revenue. Is this
possible? Explain.
In response to cheese producers’ complaints, the government agrees to purchase all the surplus
cheese at the price floor. Compared to the basic price floor, who benefits from this new policy?
Who loses?

A recent study found that the demand and supply schedules for Frisbees are as follows:

Price per Frisbee Quantity Demanded Quantity Supplied
$11 1 million Frisbees 15 million Frisbees

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a.
b.
c.
4.
a.
b.
5.
6.
7.

10 2 12
9 4 9
8 6 6
7 8 3
6 10 1

What are the equilibrium price and quantity of Frisbees?
Frisbee manufacturers persuade the government that Frisbee production improves scientists’
understanding of aerodynamics and thus is important for national security. A concerned
Congress votes to impose a price floor $2 above the equilibrium price. What is the new market
price? How many Frisbees are sold?
Irate college students march on Washington and demand a reduction in the price of Frisbees.
An even more concerned Congress votes to repeal the price floor and impose a price ceiling $1
below the former price floor. What is the new market price? How many Frisbees are sold?

Suppose the federal government requires beer drinkers to pay a $2 tax on each case of beer
purchased. (In fact, both the federal and state governments impose beer taxes of some sort.)

Draw a supply-and-demand diagram of the market for beer without the tax. Show the price
paid by consumers, the price received by producers, and the quantity of beer sold. What is the
difference between the price paid by consumers and the price received by producers?
Now draw a supply-and-demand diagram for the beer market with the tax. Show the price paid
by consumers, the price received by producers, and the quantity of beer sold. What is the
difference between the price paid by consumers and the price received by producers? Has the
quantity of beer sold increased or decreased?

A senator wants to raise tax revenue and make workers better off. A staff member proposes raising
the payroll tax paid by firms and using part of the extra revenue to reduce the payroll tax paid by
workers. Would this accomplish the senator’s goal? Explain.
If the government places a $500 tax on luxury cars, will the price paid by consumers rise by more
than $500, less than $500, or exactly $500? Explain.
Congress and the president decide that the United States should reduce air pollution by reducing its
use

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may be reproduced or transmitted without publisher’s prior permission. Violators will be prosecuted.

PART

Introduction

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may be reproduced or transmitted without publisher’s prior permission. Violators will be prosecuted.

CHAPTER

1
Ten Principles of Economics

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he word economy comes from the Greek word oikonomos, which means “one who manages a
household.” At first, this origin might seem peculiar. But in fact, households and economies have

much in common.
A household faces many decisions. It must decide which household members do which tasks and

what each member receives in return: Who cooks dinner? Who does the laundry? Who gets the extra
dessert at dinner? Who gets to drive the car? In short, a household must allocate its scarce resources
(time, dessert, car mileage) among its various members, taking into account each member’s abilities,
efforts, and desires.

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Like a household, a society faces many decisions. It must find some way to decide what jobs will be
done and who will do them. It needs some people to grow food, other people to make clothing, and
still others to design computer software. Once society has allocated people (as well as land, buildings,
and machines) to various jobs, it must also allocate the goods and services

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they produce. It must decide who will eat caviar and who will eat potatoes. It must decide who will
drive a Ferrari and who will take the bus.

The management of society’s resources is important because resources are scarce. Scarcity means
that society has limited resources and therefore cannot produce all the goods and services people wish
to have. Just as each member of a household cannot get everything she wants, each individual in a
society cannot attain the highest standard of living to which she might aspire.

scarcity the limited nature of society’s resources

Economics is the study of how society manages its scarce resources. In most societies, resources are
allocated not by an all-powerful dictator but through the combined choices of millions of households
and firms. Economists, therefore, study how people make decisions: how much they work, what they
buy, how much they save, and how they invest their savings. Economists also study how people
interact with one another. For instance, they examine how the multitude of buyers and sellers of a good
together determine the price at which the good is sold and the quantity that is sold. Finally, economists
analyze forces and trends that affect the economy as a whole, including the growth in average income,
the fraction of the population that cannot find work, and the rate at which prices are rising.

economics the study of how society manages its scarce resources

The study of economics has many facets, but it is unified by several central ideas. In this chapter, we
look at Ten Principles of Economics. Don’t worry if you don’t understand them all at first or if you
aren’t completely convinced. We explore these ideas more fully in later chapters. The ten principles are
introduced here to give you an overview of what economics is all about. Consider this chapter a
“preview of coming attractions.”

1-1 How People Make Decisions
There is no mystery to what an economy is. Whether we are talking about the economy of Los
Angeles, the United States, or the whole world, an economy is just a group of people dealing with one
another as they go about their lives. Because the behavior of an economy reflects the behavior of the
individuals who make up the economy, we begin our study of economics with four principles about
individual decision making.

1-1a Principle 1: People Face Trade-offs
You may have heard the old saying, “There ain’t no such thing as a free lunch.” Grammar aside, there
is much truth to this adage. To get something that we like, we usually have to give up something else
that we also like. Making decisions requires trading off one goal against another.

Consider a student who must decide how to allocate her most valuable resource—her time. She can
spend all of her time studying economics, spend all of it studying psychology, or divide it between the
two fields. For every hour she studies one subject, she gives up an hour she could have used studying

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the other. And for every hour she spends studying, she gives up an hour that she could have spent
napping, bike riding, watching TV, or working at her part-time job for some extra spending money.

Or consider parents deciding how to spend their family income. They can buy food, clothing, or a
family vacation. Or they can save some of the family income for retirement or for children’s college
education. When they choose to spend an extra dollar on one of these goods, they have one less dollar
to spend on some other good.

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When people are grouped into societies, they face different kinds of trade-offs. One classic trade-off
is between “guns and butter.” The more a society spends on national defense (guns) to protect its
shores from foreign aggressors, the less it can spend on consumer goods (butter) to raise the standard
of living at home. Also important in modern society is the trade-off between a clean environment and a
high level of income. Laws that require firms to reduce pollution raise the cost of producing goods and
services. Because of these higher costs, the firms end up earning smaller profits, paying lower wages,
charging higher prices, or some combination of these three. Thus, while pollution regulations yield the
benefit of a cleaner environment and the improved health that comes with it, the regulations come at
the cost of reducing the incomes of the regulated firms’ owners, workers, and customers.

Another trade-off society faces is between efficiency and equality. Efficiency means that society is
getting the maximum benefits from its scarce resources. Equality means that those benefits are
distributed uniformly among society’s members. In other words, efficiency refers to the size of the
economic pie, and equality refers to how the pie is divided into individual slices.

efficiency the property of society getting the most it can from its scarce resources
equality the property of distributing economic prosperity uniformly among the members of society

When government policies are designed, these two goals often conflict. Consider, for instance,
policies aimed at equalizing the distribution of economic well-being. Some of these policies, such as
the welfare system or unemployment insurance, try to help the members of society who are most in
need. Others, such as the individual income tax, ask the financially successful to contribute more than
others to support the government. Though they achieve greater equality, these policies reduce
efficiency. When the government redistributes income from the rich to the poor, it reduces the reward
for working hard; as a result, people work less and produce fewer goods and services. In other words,
when the government tries to cut the economic pie into more equal slices, the pie gets smaller.

Recognizing that people face trade-offs does not by itself tell us what decisions they will or should
make. A student should not abandon the study of psychology just because doing so would increase the
time available for the study of economics. Society should not stop protecting the environment just
because environmental regulations reduce our material standard of living. The poor should not be
ignored just because helping them distorts work incentives. Nonetheless, people are likely to make
good decisions only if they understand the options that are available to them. Our study of economics,
therefore, starts by acknowledging life’s trade-offs.

1-1b Principle 2: The Cost of Something Is What You Give Up to
Get It
Because people face trade-offs, making decisions requires comparing the costs and benefits of
alternative courses of action. In many cases, however, the cost of an action is not as obvious as it
might first appear.

Consider the decision to go to college. The main benefits are intellectual enrichment and a lifetime
of better job opportunities. But what are the costs? To answer this question, you might be tempted to
add up the money you spend on tuition, books, room, and board. Yet this total does not truly represent

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what you give up to spend a year in college.
There are two problems with this calculation. First, it includes some things that are not really costs

of going to college. Even if you quit school, you need a place to sleep and food to eat. Room and
board are costs of going to college only to the extent that they are more expensive at college than
elsewhere. Second, this

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calculation ignores the largest cost of going to college—your time. When you spend a year listening
to lectures, reading textbooks, and writing papers, you cannot spend that time working at a job. For
most students, the earnings they give up to attend school are the single largest cost of their education.

The opportunity cost of an item is what you give up to get that item. When making any decision,
decision makers should be aware of the opportunity costs that accompany each possible action. In fact,
they usually are. College athletes who can earn millions if they drop out of school and play
professional sports are well aware that the opportunity cost of their attending college is very high. It is
not surprising that they often decide that the benefit of a college education is not worth the cost.

opportunity cost whatever must be given up to obtain some item

1-1c Principle 3: Rational People Think at the Margin
Economists normally assume that people are rational. Rational people systematically and
purposefully do the best they can to achieve their objectives, given the available opportunities. As you
study economics, you will encounter firms that decide how many workers to hire and how much of
their product to manufacture and sell to maximize profits. You will also encounter individuals who
decide how much time to spend working and what goods and services to buy with the resulting income
to achieve the highest possible level of satisfaction.

rational people people who systematically and purposefully do the best they can to achieve their
objectives

Rational people know that decisions in life are rarely black and white but usually involve shades of
gray. At dinnertime, the question you face is not “Should I fast or eat like a pig?” More likely, you will
be asking yourself “Should I take that extra spoonful of mashed potatoes?” When exams roll around,
your decision is not between blowing them off and studying twenty-four hours a day but whether to
spend an extra hour reviewing your notes instead of watching TV. Economists use the term marginal
change to describe a small incremental adjustment to an existing plan of action. Keep in mind that
margin means “edge,” so marginal changes are adjustments around the edges of what you are doing.
Rational people often make decisions by comparing marginal benefits and marginal costs.

marginal change a small incremental adjustment to a plan of action

For example, suppose you are considering calling a friend on your cell phone. You decide that
talking with her for 10 minutes would give you a benefit that you value at about $7. Your cell phone
service costs you $40 per month plus $0.50 per minute for whatever calls you make. You usually talk
for 100 minutes a month, so your total monthly bill is $90 ($0.50 per minute times 100 minutes, plus
the $40 fixed fee). Under these circumstances, should you make the call? You might be tempted to
reason as follows: “Because I pay $90 for 100 minutes of calling each month, the average minute on
the phone costs me $0.90. So a 10-minute call costs $9. Because that $9 cost is greater than the $7
benefit, I am going to skip the call.” That conclusion is wrong, however. Although the average cost of
a 10-minute call is $9, the marginal cost—the amount your bill increases if you make the extra call—

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is only $5. You will make the right decision only by comparing the marginal benefit and the marginal
cost. Because the marginal benefit of $7 is greater than the marginal cost of $5, you should make the
call. This is a principle that people innately understand: Cell phone users with unlimited minutes (that
is, minutes that are free at the margin) are often prone to make long and frivolous calls.

Thinking at the margin works for business decisions as well. Consider an airline deciding how much
to charge passengers who fly standby. Suppose that flying a 200-seat plane across the United States
costs the airline $100,000. In this case, the average cost of each seat is $100,000/200, which is $500.
One might be tempted

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to conclude that the airline should never sell a ticket for less than $500. But a rational airline can
increase its profits by thinking at the margin. Imagine that a plane is about to take off with 10 empty
seats and a standby passenger waiting at the gate is willing to pay $300 for a seat. Should the airline
sell the ticket? Of course, it should. If the plane has empty seats, the cost of adding one more
passenger is tiny. The average cost of flying a passenger is $500, but the marginal cost is merely the
cost of the bag of peanuts and can of soda that the extra passenger will consume. As long as the
standby passenger pays more than the marginal cost, selling the ticket is profitable.

“Is the marginal benefit of this call greater than the marginal cost?”

Marginal decision making can help explain some otherwise puzzling economic phenomena. Here is
a classic question: Why is water so cheap, while diamonds are so expensive? Humans need water to
survive, while diamonds are unnecessary; but for some reason, people are willing to pay much more
for a diamond than for a cup of water. The reason is that a person’s willingness to pay for a good is
based on the marginal benefit that an extra unit of the good would yield. The marginal benefit, in turn,
depends on how many units a person already has. Water is essential, but the marginal benefit of an
extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but
because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large.

A rational decision maker takes an action if and only if the marginal benefit of the action exceeds
the marginal cost. This principle explains why people use their cell phones as much as they do, why
airlines are willing to sell tickets below average cost, and why people are willing to pay more for

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diamonds than for water. It can take some time to get used to the logic of marginal thinking, but the
study of economics will give you ample opportunity to practice.

1-1d Principle 4: People Respond to Incentives
An incentive is something (such as a prospect of a punishment or reward) that induces a person to act.
Because rational people make decisions by comparing costs and benefits, they respond to incentives.
You will see that incentives play a central role in the study of economics. One economist went so far
as to suggest that the entire field could be summarized as simply “People respond to incentives. The
rest is commentary.”

incentive something that induces a person to act

Incentives are crucial to analyzing how markets work. For example, when the price of an apple
rises, people decide to eat fewer apples. At the same time, apple orchards decide to hire more workers
and harvest more apples. In other words, a higher price in a market provides an incentive for buyers to
consume less and an incentive for sellers to produce more. As we will see, the influence of prices on
the behavior of consumers and producers is crucial for how a market economy allocates scarce
resources.

Public policymakers should never forget about incentives: Many policies change the costs or
benefits that people face and, as a result, alter their behavior. A tax on gasoline, for instance,
encourages people to drive smaller, more fuel-efficient cars. That is one reason people drive smaller
cars in Europe, where gasoline taxes are high, than in the United States, where gasoline taxes are low.
A higher gasoline tax also encourages people to carpool, take public transportation, and live closer to
where they work. If the tax were larger, more people would be driving hybrid cars, and if it were large
enough, they would switch to electric cars.

When policymakers fail to consider how their policies affect incentives, they often end up with
unintended consequences. For example, consider public policy regarding auto safety. Today, all cars
have seat belts, but this was not true fifty

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years ago. In the 1960s, Ralph Nader’s book Unsafe at Any Speed generated much public concern
over auto safety. Congress responded with laws requiring seat belts as standard equipment on new
cars.

How does a seat belt law affect auto safety? The direct effect is obvious: When a person wears a
seat belt, the probability of surviving an auto accident rises. But that’s not the end of the story because
the law also affects behavior by altering incentives. The relevant behavior here is the speed and care
with which drivers operate their cars. Driving slowly and carefully is costly because it uses the driver’s
time and energy. When deciding how safely to drive, rational people compare, perhaps unconsciously,
the marginal benefit from safer driving to the marginal cost. As a result, they drive more slowly and
carefully when the benefit of increased safety is high. For example, when road conditions are icy,
people drive more attentively and at lower speeds than they do when road conditions are clear.

Consider how a seat belt law alters a driver’s cost-benefit calculation. Seat belts make accidents less
costly because they reduce the likelihood of injury or death. In other words, seat belts reduce the
benefits of slow and careful driving. People respond to seat belts as they would to an improvement in
road conditions—by driving faster and less carefully. The result of a seat belt law, therefore, is a larger
number of accidents. The decline in safe driving has a clear, adverse impact on pedestrians, who are
more likely to find themselves in an accident but (unlike the drivers) don’t have the benefit of added
protection.

At first, this discussion of incentives and seat belts might seem like idle speculation. Yet in a classic
1975 study, economist Sam Peltzman argued that auto-safety laws have had many of these effects.
According to Peltzman’s evidence, these laws produce both fewer deaths per accident and more
accidents. He concluded that the net result is little change in the number of driver deaths and an
increase in the number of pedestrian deaths.

Peltzman’s analysis of auto safety is an offbeat and controversial example of the general principle
that people respond to incentives. When analyzing any policy, we must consider not only the direct
effects but also the less obvious indirect effects that work through incentives. If the policy changes
incentives, it will cause people to alter their behavior.

case study The Incentive Effects of Gasoline Prices
From 2005 to 2008 the price of oil in world oil markets skyrocketed, the result of limited supplies
together with surging demand from robust world growth, especially in China. The price of gasoline
in the United States rose from about $2 to about $4 a gallon. At the time, the news was filled with
stories about how people responded to the increased incentive to conserve— sometimes in obvious
ways, sometimes in less obvious ways.

Here is a sampling of various stories:

“As Gas Prices Soar, Buyers Are Flocking to Small Cars”
“As Gas Prices Climb, So Do Scooter Sales”
“Gas Prices Knock Bicycles Sales, Repairs into Higher Gear”
“Gas Prices Send Surge of Riders to Mass Transit”

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“Camel Demand Up as Oil Price Soars”: Farmers in the Indian state of Rajasthan are
rediscovering the humble camel. As the cost of running gas-guzzling tractors soars, even-toed
ungulates are making a comeback.
“The Airlines Are Suffering, but the Order Books of Boeing and Airbus Are Bulging”: Demand
for new, more fuel-efficient aircraft has never been greater.

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The latest versions of the Airbus A320 and Boeing 737, the single-aisle workhorses for which
demand is strongest, are up to 40 percent cheaper to run than the vintage planes some American
airlines still use.
“Home Buying Practices Adjust to High Gas Prices”: In his hunt for a new home, Demetrius
Stroud crunched the numbers to find out that, with gas prices climbing, moving near an Amtrak
station is the best thing for his wallet.
“Gas Prices Drive Students to Online Courses”: For Christy LaBadie, a sophomore at
Northampton Community College, the 30-minute drive from her home to the Bethlehem, Pa.,
campus has become a financial hardship now that gasoline prices have soared to more than $4 a
gallon. So this semester she decided to take an online course to save herself the trip—and the
money.
“Diddy Halts Private Jet Flights Over Fuel Prices”: Fuel prices have grounded an unexpected
frequent-flyer: Sean “Diddy” Combs…. The hip-hop mogul said he is now flying on commercial
airlines instead of in private jets, which Combs said had previously cost him $200,000 and up for
a roundtrip between New York and Los Angeles. “I’m actually flying commercial,” Diddy said
before walking onto an airplane, sitting in a first-class seat and flashing his boarding pass to the
camera. “That’s how high gas prices are.”

Many of these developments proved transitory. The economic downturn that began in 2008 and
continued into 2009 reduced the world demand for oil, and the price of gasoline declined
substantially. No word yet on whether Mr. Combs has returned to his private jet.

Quick Quiz Describe an important trade-off you recently faced. • Give an example of some action
that has both a monetary and nonmonetary opportunity cost. • Describe an incentive your parents
offered to you in an effort to influence your behavior.

1-2 How People Interact
The first four principles discussed how individuals make decisions. As we go about our lives, many of
our decisions affect not only ourselves but other people as well. The next three principles concern how
people interact with one another.

“For $5 a week you can watch baseball without being nagged to cut the grass!”

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1-2a Principle 5: Trade Can Make Everyone Better Off
You may have heard on the news that the Chinese are our competitors in the world economy. In some
ways, this is true because American and Chinese firms produce many of the same goods. Companies
in the United States and China compete for the same customers in the markets for clothing, toys, solar
panels, automobile tires, and many other items.

Yet it is easy to be misled when thinking about competition among countries. Trade between the
United States and China is not like a sports contest in which one side wins and the other side loses. In
fact, the opposite is true: Trade between two countries can make each country better off.

To see why, consider how trade affects your family. When a member of your family looks for a job,
she competes against members of other families who are looking for jobs. Families also compete
against one another when they go shopping because each family wants to buy the best goods at the
lowest prices. In a sense, each family in an economy competes with all other families.

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Despite this competition, your family would not be better off isolating itself from all other families.
If it did, your family would need to grow its own food, make its own clothes, and build its own home.
Clearly, your family gains much from its ability to trade with others. Trade allows each person to
specialize in the activities she does best, whether it is farming, sewing, or home building. By trading
with others, people can buy a greater variety of goods and services at lower cost.

Countries as well as families benefit from the ability to trade with one another. Trade allows
countries to specialize in what they do best and to enjoy a greater variety of goods and services. The
Chinese, as well as the French and the Egyptians and the Brazilians, are as much our partners in the
world economy as they are our competitors.

1-2b Principle 6: Markets Are Usually a Good Way to Organize
Economic Activity
The collapse of communism in the Soviet Union and Eastern Europe in the 1980s was one of the last
century’s most important changes. Communist countries operated on the premise that government
officials were in the best position to allocate the economy’s scarce resources. These central planners
decided what goods and services were produced, how much was produced, and who produced and
consumed these goods and services. The theory behind central planning was that only the government
could organize economic activity in a way that promoted economic well-being for the country as a
whole.

Most countries that once had centrally planned economies have abandoned the system and are
instead developing market economies. In a market economy, the decisions of a central planner are
replaced by the decisions of millions of firms and households. Firms decide whom to hire and what to
make. Households decide which firms to work for and what to buy with their incomes. These firms and
households interact in the marketplace, where prices and self-interest guide their decisions.

market economy an economy that allocates resources through the decentralized decisions of many
firms and households as they interact in markets for goods and services

At first glance, the success of market economies is puzzling. In a market economy, no one is looking
out for the economic well-being of society as a whole. Free markets contain many buyers and sellers
of numerous goods and services, and all of them are interested primarily in their own well-being. Yet
despite decentralized decision making and self-interested decision makers, market economies have
proven remarkably successful in organizing economic activity to promote overall economic well-
being.

In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist Adam
Smith made the most famous observation in all of economics: Households and firms interacting in
markets act as if they are guided by an “invisible hand” that leads them to desirable market outcomes.
One of our goals in this book is to understand how this invisible hand works its magic.

As you study economics, you will learn that prices are the instrument with which the invisible hand
directs economic activity. In any market, buyers look at the price when determining how much to
demand, and sellers look at the price when deciding how much to supply. As a result of the decisions

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that buyers and sellers make, market prices reflect both the value of a good to society and the cost to
society of making the good. Smith’s great insight was that prices adjust to guide these individual
buyers and sellers to reach outcomes that, in many cases, maximize the well-being of society as a
whole.

Smith’s insight has an important corollary: When a government prevents prices from adjusting
naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the decisions of
the households and firms that make

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up an economy. This corollary explains why taxes adversely affect the allocation of resources: They
distort prices and thus the decisions of households and firms. It also explains the great harm caused by
policies that directly control prices, such as rent control. And it explains the failure of communism. In
communist countries, prices were not determined in the marketplace but were dictated by central
planners. These planners lacked the necessary information about consumers’ tastes and producers’
costs, which in a market economy is reflected in prices. Central planners failed because they tried to
run the economy with one hand tied behind their backs—the invisible hand of the marketplace.

1-2c Principle 7: Governments Can Sometimes Improve Market
Outcomes
If the invisible hand of the market is so great, why do we need government? One purpose of studying
economics is to refine your view about the proper role and scope of government policy.

One reason we need government is that the invisible hand can work its magic only if the
government enforces the rules and maintains the institutions that are key to a market economy. Most
important, market economies need institutions to enforce property rights so individuals can own and
control scarce resources. A farmer won’t grow food if she expects her crop to be stolen; a restaurant
won’t serve meals unless it is assured that customers will pay before they leave; and an entertainment
company won’t produce DVDs if too many potential customers avoid paying by making illegal copies.
We all rely on government-provided police and courts to enforce our rights over the things we produce
—and the invisible hand counts on our ability to enforce our rights.

property rights the ability of an individual to own and exercise control over scarce resources

FYI Adam Smith and the Invisible Hand

t may be only a coincidence that Adam Smith’s great book The Wealth of Nations was published
in 1776, the exact year in which American revolutionaries signed the Declaration of

Independence. But the two documents share a point of view that was prevalent at the time:
Individuals are usually best left to their own devices, without the heavy hand of government guiding
their actions. This political philosophy provides the intellectual basis for the market economy and
for free society more generally.

Why do decentralized market economies work so well? Is it because people can be counted on to

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treat one another with love and kindness? Not at all. Here is Adam Smith’s description of how
people interact in a market economy:

Man has almost constant occasion for the help of his brethren, and it is in vain for him to expect
it from their benevolence only. He will be more likely to prevail if he can interest their self-love in
his favour, and show them that it is for their own advantage to do for him what he requires of them
…. Give me that which I want, and you shall have this which you want, is the meaning of every such
offer; and it is in this manner that we obtain from one another the far greater part of those good
offices which we stand in need of.

Adam Smith

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our
dinner, but from their regard to their own interest. We address ourselves, not to their
humanity but to their self-love, and never talk to them of our own necessities but of their
advantages. Nobody but a beggar chooses to depend chiefly upon the benevolence of his
fellow-citizens ….

Every individual… neither intends to promote the public interest, nor knows how much he
is promoting it…. He intends only his own gain, and he is in this, as in many other cases, led
by an invisible hand to promote an end which was no part of his intention. Nor is it always
the worse for the society that it was no part of it. By pursuing his own interest he frequently
promotes that of the society more effectually than when he really intends to promote it.

Smith is saying that participants in the economy are motivated by self-interest and that the “invisible
hand” of the marketplace guides this self-interest into promoting general economic well-being.

Many of Smith’s insights remain at the center of modern economics. Our analysis in the coming
chapters will allow us to express Smith’s conclusions more precisely and to analyze more fully the
strengths and weaknesses of the market’s invisible hand.

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Yet there is another reason we need government: The invisible hand is powerful, but it is not
omnipotent. There are two broad reasons for a government to intervene in the economy and change the
allocation of resources that people would choose on their own: to promote efficiency or to promote
equality. That is, most policies aim either to enlarge the economic pie or to change how the pie is
divided.

Consider first the goal of efficiency. Although the invisible hand usually leads markets to allocate
resources to maximize the size of the economic pie, this is not always the case. Economists use the
term market failure to refer to a situation in which the market on its own fails to produce an efficient
allocation of resources. As we will see, one possible cause of market failure is an externality, which is
the impact of one person’s actions on the well-being of a bystander. The classic example of an
externality is pollution. When the production of a good pollutes the air and creates health problems for
those who live near the factories, the market left to its own devices may fail to take this cost into
account. Another possible cause of market failure is market power, which refers to the ability of a
single person or firm (or a small group) to unduly influence market prices. For example, if everyone in
town needs water but there is only one well, the owner of the well is not subject to the rigorous
competition with which the invisible hand normally keeps self-interest in check; she may take
advantage of this opportunity by restricting the output of water so she can charge a higher price. In the
presence of externalities or market power, well-designed public policy can enhance economic
efficiency.

market failure a situation in which a market left on its own fails to allocate resources efficiently
externality the impact of one person’s actions on the well-being of a bystander
market power the ability of a single economic actor (or small group of actors) to have a substantial
influence on market prices

Now consider the goal of equality. Even when the invisible hand yields efficient outcomes, it can
nonetheless leave sizable disparities in economic well-being. A market economy rewards people
according to their ability to produce things that other people are willing to pay for. The world’s best
basketball player earns more than the world’s best chess player simply because people are willing to
pay more to watch basketball than chess. The invisible hand does not ensure that everyone has
sufficient food, decent clothing, and adequate healthcare. This inequality may, depending on one’s
political philosophy, call for government intervention. In practice, many public policies, such as the
income tax and the welfare system, aim to achieve a more equal distribution of economic well-being.

To say that the government can improve on market outcomes at times does not mean that it always
will. Public policy is made not by angels but by a political process that is far from perfect. Sometimes
policies are designed simply to reward the politically powerful. Sometimes they are made by well-
intentioned leaders who are not fully informed. As you study economics, you will become a better
judge of when a government policy is justifiable because it promotes efficiency or equality and when it
is not.

Quick Quiz Why is a country better off not isolating itself from all other countries? • Why do we
have markets, and according to economists, what roles should government play in them?

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1-3 How the Economy as a Whole Works

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CHAPTER

4
The Market Forces of Supply and

Demand

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hen a cold snap hits Florida, the price of orange juice rises in supermarkets throughout the
country. When the weather turns warm in New England every summer, the price of hotel

rooms in the Caribbean plummets. When a war breaks out in the Middle East, the price of gasoline in
the United States rises and the price of a used Cadillac falls. What do these events have in common?
They all show the workings of supply and demand.

Supply and demand are the two words economists use most often—and for good reason. Supply and
demand are the forces that make market economies work. They determine the quantity of each good
produced and the price at which it is sold. If you want to know how any event or policy will affect the

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economy, you must think first about how it will affect supply and demand.
This chapter introduces the theory of supply and demand. It considers how buyers and sellers

behave and how they interact with one another.

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It shows how supply and demand determine prices in a market economy and how prices, in turn,
allocate the economy’s scarce resources.

4-1 Markets and Competition
The terms supply and demand refer to the behavior of people as they interact with one another in
competitive markets. Before discussing how buyers and sellers behave, let’s first consider more fully
what we mean by the terms market and competition.

4-1a What Is a Market?
A market is a group of buyers and sellers of a particular good or service. The buyers as a group
determine the demand for the product, and the sellers as a group determine the supply of the product.
market a group of buyers and sellers of a particular good or service

Markets take many forms. Some markets are highly organized, such as the markets for many
agricultural commodities. In these markets, buyers and sellers meet at a specific time and place where
an auctioneer helps set prices and arrange sales.

More often, markets are less organized. For example, consider the market for ice cream in a
particular town. Buyers of ice cream do not meet together at any one time. The sellers of ice cream are
in different locations and offer somewhat different products. There is no auctioneer calling out the
price of ice cream. Each seller posts a price for an ice-cream cone, and each buyer decides how much
ice cream to buy at each store. Nonetheless, these consumers and producers of ice cream are closely
connected. The ice-cream buyers are choosing from the various ice-cream sellers to satisfy their
cravings, and the ice-cream sellers are all trying to appeal to the same ice-cream buyers to make their
businesses successful. Even though it is not as organized, the group of ice-cream buyers and ice-cream
sellers forms a market.

4-1b What Is Competition?
The market for ice cream, like most markets in the economy, is highly competitive. Each buyer knows
that there are several sellers from which to choose, and each seller is aware that his product is similar
to that offered by other sellers. As a result, the price and quantity of ice cream sold are not determined
by any single buyer or seller. Rather, price and quantity are determined by all buyers and sellers as
they interact in the marketplace.

Economists use the term competitive market to describe a market in which there are so many
buyers and so many sellers that each has a negligible impact on the market price. Each seller of ice
cream has limited control over the price because other sellers are offering similar products. A seller
has little reason to charge less than the going price, and if he charges more, buyers will make their
purchases elsewhere. Similarly, no single buyer of ice cream can influence the price of ice cream
because each buyer purchases only a small amount.

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competitive market a market in which there are many buyers and many sellers so that each has a
negligible impact on the market price

In this chapter, we assume that markets are perfectly competitive. To reach this highest form of
competition, a market must have two characteristics: (1) The goods offered for sale are all exactly the
same, and (2) the buyers and sellers are so numerous that no single buyer or seller has any influence
over the market price. Because buyers and sellers in perfectly competitive markets must accept the
price the market determines, they are said to be price takers. At the market price, buyers can buy all
they want, and sellers can sell all they want.

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There are some markets in which the assumption of perfect competition applies perfectly. In the
wheat market, for example, there are thousands of farmers who sell wheat and millions of consumers
who use wheat and wheat products. Because no single buyer or seller can influence the price of wheat,
each takes the market price as given.

Not all goods and services, however, are sold in perfectly competitive markets. Some markets have
only one seller, and this seller sets the price. Such a seller is called a monopoly. Your local cable
television company, for instance, may be a monopoly. Residents of your town probably have only one
company from which to buy cable service. Still other markets fall between the extremes of perfect
competition and monopoly.

Despite the diversity of market types we find in the world, assuming perfect competition is a useful
simplification and, therefore, a natural place to start. Perfectly competitive markets are the easiest to
analyze because everyone participating in the market takes the price as given by market conditions.
Moreover, because some degree of competition is present in most markets, many of the lessons that we
learn by studying supply and demand under perfect competition apply in more complicated markets as
well.

Quick Quiz What is a market? • What are the characteristics of a perfectly competitive market?

4-2 Demand
We begin our study of markets by examining the behavior of buyers. To focus our thinking, let’s keep
in mind a particular good—ice cream.

4-2a The Demand Curve: The Relationship between Price and
Quantity Demanded
The quantity demanded of any good is the amount of the good that buyers are willing and able to
purchase. As we will see, many things determine the quantity demanded of any good, but in our
analysis of how markets work, one determinant plays a central role—the price of the good. If the price
of ice cream rose to $20 per scoop, you would buy less ice cream. You might buy frozen yogurt
instead. If the price of ice cream fell to $0.20 per scoop, you would buy more. This relationship
between price and quantity demanded is true for most goods in the economy and, in fact, is so
pervasive that economists call it the law of demand: Other things being equal, when the price of a
good rises, the quantity demanded of the good falls, and when the price falls, the quantity demanded
rises.

quantity demanded the amount of a good that buyers are willing and able to purchase
law of demand the claim that, other things being equal, the quantity demanded of a good falls when
the price of the good rises

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prices of ice cream. If ice cream is free, Catherine eats 12 cones per month. At $0.50 per cone,
Catherine buys 10 cones each month. As the price rises further, she buys fewer and fewer cones. When
the price reaches $3.00, Catherine doesn’t buy any cones at all. This table is a demand schedule, a
table that shows the relationship between the price of a good and the quantity demanded, holding
constant everything else that influences how much of the good consumers want to buy.

demand schedule a table that shows the relationship between the price of a good and the quantity
demanded

The graph in Figure 1 uses the numbers from the table to illustrate the law of demand. By
convention, the price of ice cream is on the vertical axis, and the quantity of ice cream demanded is on
the horizontal axis. The line relating price and quantity demanded is called the demand curve. The
demand curve slopes downward because, other things being equal, a lower price means a greater
quantity demanded.

demand curve a graph of the relationship between the price of a good and the quantity demanded

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FIGURE 1
Catherine’s Demand Schedule and Demand Curve
The demand schedule is a table that shows the quantity demanded at each price. The demand curve, which
graphs the demand schedule, illustrates how the quantity demanded of the good changes as its price varies.
Because a lower price increases the quantity demanded, the demand curve slopes downward.

4-2b Market Demand versus Individual Demand
The demand curve in Figure 1 shows an individual’s demand for a product. To analyze how markets
work, we need to determine the market demand, the sum of all the individual demands for a particular
good or service.

The table in Figure 2 shows the demand schedules for ice cream of the two individuals in this
market—Catherine and Nicholas. At any price, Catherine’s demand schedule tells us how much ice
cream she buys, and Nicholas’s demand schedule tells us how much ice cream he buys. The market
demand at each price is the sum of the two individual demands.

The graph in Figure 2 shows the demand curves that correspond to these demand schedules. Notice
that we sum the individual demand curves horizontally to obtain the market demand curve. That is, to
find the total quantity demanded at any price, we add the individual quantities, which are found on the
horizontal axis of the individual demand curves. Because we are interested in analyzing how markets
function, we work most often with the market demand curve. The market demand curve shows how
the total quantity demanded of a good varies as the price of the good varies, while all the other factors
that affect how much consumers want to buy are held constant.

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FIGURE 2
Market Demand as the Sum of Individual Demands
The quantity demanded in a market is the sum of the quantities demanded by all the buyers at each price. Thus,
the market demand curve is found by adding horizontally the individual demand curves. At a price of $2.00,
Catherine demands 4 ice-cream cones and Nicholas demands 3 ice-cream cones. The quantity demanded in the
market at this price is 7 cones.

4-2c Shifts in the Demand Curve
Because the market demand curve holds other things constant, it need not be stable over time. If
something happens to alter the quantity demanded at any given price, the demand curve shifts. For
example, suppose the American Medical Association discovered that people who regularly eat ice
cream live longer, healthier lives. The discovery would raise the demand for ice cream. At any given
price, buyers would now want to purchase a larger quantity of ice cream, and the demand curve for ice
cream would shift.

Figure 3 illustrates shifts in demand. Any change that increases the quantity demanded at every
price, such as our imaginary discovery by the American Medical Association, shifts the demand curve
to the right and is called an increase in demand. Any change that reduces the quantity demanded at
every price shifts the demand curve to the left and is called a decrease in demand.

There are many variables that can shift the demand curve. Here are the most important.

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Income What would happen to your demand for ice cream if you lost your job one summer? Most
likely, it would fall. A lower income means that you have less to spend in total, so you would have to
spend less on some—and probably most—goods. If the demand for a good falls when income falls, the
good is called a normal good.

normal good a good for which, other things being equal, an increase in income leads to an increase
in demand

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FIGURE 3
Shifts in the Demand Curve
Any change that raises the quantity that buyers wish to purchase at any given price shifts the demand curve to
the right. Any change that lowers the quantity that buyers wish to purchase at any given price shifts the demand
curve to the left.

Not all goods are normal goods. If the demand for a good rises when income falls, the good is called
an inferior good. An example of an inferior good might be bus rides. As your income falls, you are
less likely to buy a car or take a cab and more likely to ride a bus.

inferior good a good for which, other things being equal, an increase in income leads to a decrease in
demand

Prices of Related Goods Suppose that the price of frozen yogurt falls. The law of demand says that
you will buy more frozen yogurt. At the same time, you will probably buy less ice cream. Because ice
cream and frozen yogurt are both cold, sweet, creamy desserts, they satisfy similar desires. When a fall
in the price of one good reduces the demand for another good, the two goods are called substitutes.
Substitutes are often pairs of goods that are used in place of each other, such as hot dogs and
hamburgers, sweaters and sweatshirts, and movie tickets and DVD rentals.

substitutes two goods for which an increase in the price of one leads to an increase in the demand for
the other

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hot fudge. Yet in this case, you will likely buy more ice cream as well because ice cream and hot fudge
are often used together. When a fall in the price of one good raises the demand for another good, the
two goods are called complements. Complements are often pairs of goods that are used together, such
as gasoline and automobiles, computers and software, and peanut butter and jelly.

complements two goods for which an increase in the price of one leads to a decrease in the demand
for the other

Tastes The most obvious determinant of your demand is your tastes. If you like ice cream, you buy
more of it. Economists normally do not try to explain people’s tastes because tastes are based on
historical and psychological forces that are beyond the realm of economics. Economists do, however,
examine what happens when tastes change.

Expectations Your expectations about the future may affect your demand for a good or service today.
If you expect to earn a higher income next month, you may

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choose to save less now and spend more of your current income buying ice cream. If you expect the
price of ice cream to fall tomorrow, you may be less willing to buy an ice-cream cone at today’s price.

Number of Buyers In addition to the preceding factors, which influence the behavior of individual
buyers, market demand depends on the number of these buyers. If Peter were to join Catherine and
Nicholas as another consumer of ice cream, the quantity demanded in the market would be higher at
every price, and market demand would increase.

Summary The demand curve shows what happens to the quantity demanded of a good when its price
varies, holding constant all the other variables that influence buyers. When one of these other variables
changes, the demand curve shifts. Table 1 lists the variables that influence how much of a good
consumers choose to buy.

If you have trouble remembering whether you need to shift or move along the demand curve, it
helps to recall a lesson from the appendix to Chapter 2. A curve shifts when there is a change in a
relevant variable that is not measured on either axis. Because the price is on the vertical axis, a change
in price represents a movement along the demand curve. By contrast, income, the prices of related
goods, tastes, expectations, and the number of buyers are not measured on either axis, so a change in
one of these variables shifts the demand curve.

TABLE 1
Variables That Influence Buyers
This table lists the variables that affect how much consumers choose to buy of any good. Notice
the special role that the price of the good plays: A change in the good’s price represents a
movement along the demand curve, whereas a change in one of the other variables shifts the
demand curve.

Variable A Change in This Variable…
Price of the good itself Represents a movement along the demand curve
Income Shifts the demand curve
Prices of related goods Shifts the demand curve
Tastes Shifts the demand curve
Expectations Shifts the demand curve
Number of buyers Shifts the demand curve

case study Two Ways to Reduce the Quantity of Smoking
Demanded
Public policymakers often want to reduce the amount that people smoke because of smoking’s
adverse health effects. There are two ways that policy can attempt to achieve this goal.

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One way to reduce smoking is to shift the demand curve for cigarettes and other tobacco
products. Public service announcements, mandatory health warnings on cigarette packages, and the
prohibition of cigarette advertising on television are all policies aimed at reducing the quantity of
cigarettes demanded at any given price. If successful, these policies shift the demand curve for
cigarettes to the left, as in panel (a) of Figure 4.

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FIGURE 4
Shifts in the Demand Curve versus Movements along the Demand Curve
If warnings on cigarette packages convince smokers to smoke less, the demand curve for cigarettes shifts to
the left. In panel (a), the demand curve shifts from D1 to D2. At a price of $2.00 per pack, the quantity
demanded falls from 20 to 10 cigarettes per day, as reflected by the shift from point A to point B. By
contrast, if a tax raises the price of cigarettes, the demand curve does not shift. Instead, we observe a
movement to a different point on the demand curve. In panel (b), when the price rises from $2.00 to $4.00,
the quantity demanded falls from 20 to 12 cigarettes per day, as reflected by the movement from point A to
point C.

Alternatively, policymakers can try to raise the price of cigarettes. If the government taxes the
manufacture of cigarettes, for example, cigarette companies pass much of this tax on to consumers
in the form of higher prices. A higher price encourages smokers to reduce the numbers of cigarettes
they smoke. In this case, the reduced amount of smoking does not represent a shift in the demand
curve. Instead, it represents a movement along the same demand curve to a point with a higher price
and lower quantity, as in panel (b) of Figure

How much does the amount of smoking respond to changes in the price of cigarettes? Economists
have attempted to answer this question by studying what happens when the tax on cigarettes
changes. They have found that a 10 percent increase in the price causes a 4 percent reduction in the
quantity demanded. Teenagers are especially sensitive to the price of cigarettes: A 10 percent
increase in the price causes a 12 percent drop in teenage smoking.

A related question is how the price of cigarettes affects the demand for illicit drugs, such as
marijuana. Opponents of cigarette taxes often argue that tobacco and marijuana are substitutes so
that high cigarette prices encourage marijuana use. By contrast, many experts on substance abuse
view tobacco as a “gateway drug” leading the young to experiment with other harmful substances.

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Most studies of the data are consistent with this latter view: They find that lower cigarette prices are
associated with greater use of marijuana. In other words, tobacco and marijuana appear to be
complements rather than substitutes.

“What is the best way to stop this?”

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Quick Quiz Make up an example of a monthly demand schedule for pizza and graph the implied
demand curve. Give an example of something that would shift this demand curve, and briefly explain
your reasoning. Would a change in the price of pizza shift this demand curve?

4-3 Supply
We now turn to the other side of the market and examine the behavior of sellers. Once again, to focus
our thinking, let’s consider the market for ice cream.

4-3a The Supply Curve: The Relationship between Price and
Quantity Supplied
The quantity supplied of any good or service is the amount that sellers are willing and able to sell.
There are many determinants of quantity supplied, but once again, price plays a special role in our
analysis. When the price of ice cream is high, selling ice cream is profitable, and so the quantity
supplied is large. Sellers of ice cream work long hours, buy many ice-cream machines, and hire many
workers. By contrast, when the price of ice cream is low, the business is less profitable, so sellers
produce less ice cream. At a low price, some sellers may even choose to shut down, and their quantity
supplied falls to zero. This relationship between price and quantity supplied is called the law of
supply: Other things being equal, when the price of a good rises, the quantity supplied of the good
also rises, and when the price falls, the quantity supplied falls as well.

quantity supplied the amount of a good that sellers are willing and able to sell
law of supply the claim that, other things being equal, the quantity supplied of a good rises when the
price of the good rises

The table in Figure 5 shows the quantity of ice-cream cones supplied each month by Ben, an ice-
cream seller, at various prices of ice cream. At a price below $1.00, Ben does not supply any ice cream
at all. As the price rises, he supplies a greater and greater quantity. This is the supply schedule, a table
that shows the relationship between the price of a good and the quantity supplied, holding constant
everything else that influences how much producers of the good want to sell.

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supply schedule a table that shows the relationship between the price of a good and the quantity
supplied

FIGURE 5
Ben’s Supply Schedule and Supply Curve
The supply schedule is a table that shows the quantity supplied at each price. This supply curve, which graphs
the supply schedule, illustrates how the quantity supplied of the good changes as its price varies. Because a
higher price increases the quantity supplied, the supply curve slopes upward.

The graph in Figure 5 uses the numbers from the table to illustrate the law of supply. The curve
relating price and quantity supplied is called the supply curve. The supply curve slopes upward
because, other things being equal, a higher price means a greater quantity supplied.

supply curve a graph of the relationship between the price of a good and the quantity supplied

4-3b Market Supply versus Individual Supply
Just as market demand is the sum of the demands of all buyers, market supply is the sum of the
supplies of all sellers. The table in Figure 6 shows the supply schedules for the two ice-cream
producers in the market—Ben and Jerry. At any price, Ben’s supply schedule tells us the quantity of
ice cream that Ben supplies,

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and Jerry’s supply schedule tells us the quantity of ice cream that Jerry supplies. The market supply is
the sum of the two individual supplies.

FIGURE 6
Market Supply as the Sum of Individual Supplies
The quantity supplied in a market is the sum of the quantities supplied by all the sellers at each price. Thus, the
market supply curve is found by adding horizontally the individual supply curves. At a price of $2.00, Ben
supplies 3 ice-cream cones and Jerry supplies 4 ice-cream cones. The quantity supplied in the market at this
price is 7 cones.

The graph in Figure 6 shows the supply curves that correspond to the supply schedules. As with
demand curves, we sum the individual supply curves horizontally to obtain the market supply curve.
That is, to find the total quantity supplied at any price, we add the individual quantities, which are
found on the horizontal axis of the individual supply curves. The market supply curve shows how the
total quantity supplied varies as the price of the good varies, holding constant all the other factors
beyond price that influence producers’ decisions about how much to sell.

4-3c Shifts in the Supply Curve
Because the market supply curve is drawn holding other things constant, when one of these factors

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changes, the supply curve shifts. For example, suppose the price of sugar falls. Sugar is an input into
the production of ice cream, so the fall in the price of sugar makes selling ice cream more profitable.
This raises the supply of ice cream: At any given price, sellers are now willing to produce a larger
quantity. The supply curve for ice cream shifts to the right.

Figure 7 illustrates shifts in supply. Any change that raises quantity supplied at every price, such as
a fall in the price of sugar, shifts the supply curve to the right and is called an increase in supply.
Similarly, any change that reduces the quantity supplied at every price shifts the supply curve to the
left and is called a decrease in supply.

There are many variables that can shift the supply curve. Here are some of the most important.

Input Prices To produce their output of ice cream, sellers use various inputs: cream, sugar, flavoring,
ice-cream machines, the buildings in which the ice cream is made, and the labor of workers to mix the
ingredients and operate the machines. When the price of one or more of these inputs rises, producing
ice cream is less profitable, and firms supply less ice cream. If input prices rise substantially, a firm

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might shut down and supply no ice cream at all. Thus, the supply of a good is negatively related to the
price of the inputs used to make the good.

FIGURE 7
Shifts in the Supply Curve
Any change that raises the quantity that sellers wish to produce at any given price shifts the supply curve to the
right. Any change that lowers the quantity that sellers wish to produce at any given price shifts the supply curve
to the left.

Technology The technology for turning inputs into ice cream is another determinant of supply. The
invention of the mechanized ice-cream machine, for example, reduced the amount of labor necessary
to make ice cream. By reducing firms’ costs, the advance in technology raised the supply of ice cream.

Expectations The amount of ice cream a firm supplies today may depend on its expectations about
the future. For example, if a firm expects the price of ice cream to rise in the future, it will put some of
its current production into storage and supply less to the market today.

Number of Sellers In addition to the preceding factors, which influence the behavior of individual
sellers, market supply depends on the number of these sellers. If Ben or Jerry were to retire from the
ice-cream business, the supply in the market would fall.

Summary The supply curve shows what happens to the quantity supplied of a good when its price
varies, holding constant all the other variables that influence sellers. When one of these other variables
changes, the supply curve shifts. Table 2 lists the variables that influence how much producers choose

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to sell of a good.
Once again, to remember whether you need to shift or move along the supply curve, keep in mind

that a curve shifts only when there is a change in a relevant variable that is not named on either axis.
The price is on the vertical axis, so a change in price represents a movement along the supply curve.
By contrast, because input prices, technology, expectations, and the number of sellers are not
measured on either axis, a change in one of these variables shifts the supply curve.

Quick Quiz Make up an example of a monthly supply schedule for pizza, and graph the implied
supply curve. Give an example of something that would shift this supply curve, and briefly explain
your reasoning. Would a change in the price of pizza shift this supply curve?

TABLE 2
Variables That Influence Sellers
This table lists the variables that affect how much producers choose to sell of any good. Notice
the special role that the price of the good plays: A change in the good’s price represents a
movement along the supply curve, whereas a change in one of the other variables shifts the
supply curve.

Variable A Change in This Variable …
Price of the good itself Represents a movement along the supply curve
Input prices Shifts the supply curve
Technology Shifts the supply curve
Expectations Shifts the supply curve
Number of sellers Shifts the supply curve

4-4 Supply and Demand Together

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Having analyzed supply and demand separately, we now combine them to see how they determine the
price and quantity of a good sold in a market.

4-4a Equilibrium
Figure 8 shows the market supply curve and market demand curve together. Notice that there is one
point at which the supply and demand curves intersect. This point is called the market’s equilibrium.
The price at this intersection is called the equilibrium price, and the quantity is called the
equilibrium quantity. Here the equilibrium price is $2.00 per cone, and the equilibrium quantity is 7
ice-cream cones.

equilibrium a situation in which the market price has reached the level at which quantity supplied
equals quantity demanded
equilibrium price the price that balances quantity supplied and quantity demanded
equilibrium quantity the quantity supplied and the quantity demanded at the equilibrium price

The dictionary defines the word equilibrium as a situation in which various forces are in balance—
and this also describes a market’s equilibrium. At the equilibrium price, the quantity of the good that
buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to
sell. The equilibrium price is sometimes called the market-clearing price because, at this price,
everyone in the market has been satisfied: Buyers have bought all they want to buy, and sellers have
sold all they want to sell.

The actions of buyers and sellers naturally move markets toward the equilibrium of supply and
demand. To see why, consider what happens when the market price is not equal to the equilibrium
price.

Suppose first that the market price is above the equilibrium price, as in panel (a) of Figure 9. At a
price of $2.50 per cone, the quantity of the good supplied (10 cones) exceeds the quantity demanded (4
cones). There is a surplus of the good: Suppliers are unable to sell all they want at the going price. A
surplus is sometimes called a situation of excess supply. When there is a surplus in the icecream
market, sellers of ice cream find their freezers increasingly full of ice cream they would like to sell but
cannot. They respond to the surplus by cutting their prices. Falling prices, in turn, increase the quantity
demanded and decrease the quantity supplied. These changes represent movements along the supply
and demand curves, not shifts in the curves. Prices continue to fall until the market reaches the
equilibrium.

surplus a situation in which quantity supplied is greater than quantity demanded

FIGURE 8
The Equilibrium of Supply and Demand
The equilibrium is found where the supply and demand curves intersect. At the equilibrium price, the quantity
supplied equals the quantity demanded. Here the equilibrium price is $2.00: At this price, 7 ice-cream cones are

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supplied and 7 icecream cones are demanded.

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FIGURE 9
Markets Not in Equilibrium
In panel (a), there is a surplus. Because the market price of $2.50 is above the equilibrium price, the quantity
supplied (10 cones) exceeds the quantity demanded (4 cones). Suppliers try to increase sales by cutting the
price of a cone, and this moves the price toward its equilibrium level. In panel (b), there is a shortage. Because
the market price of $1.50 is below the equilibrium price, the quantity demanded (10 cones) exceeds the quantity
supplied (4 cones). With too many buyers chasing too few goods, suppliers can take advantage of the shortage
by raising the price. Hence, in both cases, the price adjustment moves the market toward the equilibrium of
supply and demand.

Suppose now that the market price is below the equilibrium price, as in panel (b) of Figure 9. In this
case, the price is $1.50 per cone, and the quantity of the good demanded exceeds the quantity supplied.
There is a shortage of the good: Demanders are unable to buy all they want at the going price. A
shortage is sometimes called a situation of excess demand. When a shortage occurs in the ice-cream
market, buyers have to wait in long lines for a chance to buy one of the few cones available. With too
many buyers chasing too few goods, sellers can respond to the shortage by raising their prices without
losing sales. These price increases cause the quantity demanded to fall and the quantity supplied to
rise. Once again, these changes represent movements along the supply and demand curves, and they
move the market toward the equilibrium.

shortage a situation in which quantity demanded is greater than quantity supplied

Thus, regardless of whether the price starts off too high or too low, the activities of the many buyers
and sellers automatically push the market price toward the equilibrium price. Once the market reaches
its equilibrium, all buyers and sellers are satisfied, and there is no upward or downward pressure on the
price. How quickly equilibrium is reached varies from market to market depending on how quickly
prices adjust. In most free markets, surpluses and shortages are only temporary because prices

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eventually move toward their equilibrium levels. Indeed, this phenomenon is so pervasive that it is
called the law of supply and demand: The price of any good adjusts to bring the quantity supplied
and quantity demanded for that good into balance.

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law of supply and demand the claim that the price of any good adjusts to bring the quantity supplied
and the quantity demanded for that good into balance

4-4b Three Steps to Analyzing Changes in Equilibrium
So far, we have seen how supply and demand together determine a market’s equilibrium, which in turn
determines the price and quantity of the good that buyers purchase and sellers produce. The
equilibrium price and quantity depend on the position of the supply and demand curves. When some
event shifts one of these curves, the equilibrium in the market changes, resulting in a new price and a
new quantity exchanged between buyers and sellers.

When analyzing how some event affects the equilibrium in a market, we proceed in three steps.
First, we decide whether the event shifts the supply curve, the demand curve, or, in some cases, both
curves. Second, we decide whether the curve shifts to the right or to the left. Third, we use the supply-
and-demand diagram to compare the initial and the new equilibrium, which shows how the shift
affects the equilibrium price and quantity. Table 3 summarizes these three steps. To see how this recipe
is used, let’s consider various events that might affect the market for ice cream.

Example: A Change in Market Equilibrium Due to a Shift in Demand Suppose that one summer
the weather is very hot. How does this event affect the market for ice cream? To answer this question,
let’s follow our three steps.

The hot weather affects the demand curve by changing people’s taste for ice cream. That is, the
weather changes the amount of ice cream that people want to buy at any given price. The
supply curve is unchanged because the weather does not directly affect the firms that sell ice
cream.
Because hot weather makes people want to eat more ice cream, the demand curve shifts to the
right. Figure 10 shows this increase in demand as a shift in the demand curve from D1 to D2
This shift indicates that the quantity of ice cream demanded is higher at every price.
At the old price of $2, there is now an excess demand for ice cream, and this shortage induces
firms to raise the price. As Figure 10 shows, the increase in demand raises the equilibrium
price from $2.00 to $2.50 and the equilibrium quantity from 7 to 10 cones. In other words, the
hot weather increases the price of ice cream and the quantity of ice cream sold.

TABLE 3
Three Steps for Analyzing Changes in Equilibrium
1. Decide whether the event shifts the supply or demand curve (or perhaps both).
2. Decide in which direction the curve shifts.
3. Use the supply-and-demand diagram to see how the shift changes the equilibrium price and
quantity.

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FIGURE 10
How an Increase in Demand Affects the Equilibrium
An event that raises quantity demanded at any given price shifts the demand curve to the right. The equilibrium
price and the equilibrium quantity both rise. Here an abnormally hot summer causes buyers to demand more ice
cream. The demand curve shifts from D1 to D2, which causes the equilibrium price to rise from $2.00 to $2.50
and the equilibrium quantity to rise from 7 to 10 cones.

Shifts in Curves versus Movements along Curves Notice that when hot weather increases the
demand for ice cream and drives up the price, the quantity of ice cream that firms supply rises, even
though the supply curve remains the same. In this case, economists say there has been an increase in
“quantity supplied” but no change in “supply.”

Supply refers to the position of the supply curve, whereas the quantity supplied refers to the amount
suppliers wish to sell. In this example, supply does not change because the weather does not alter
firms’ desire to sell at any given price. Instead, the hot weather alters consumers’ desire to buy at any
given price and thereby shifts the demand curve to the right. The increase in demand causes the
equilibrium price to rise. When the price rises, the quantity supplied rises. This increase in quantity
supplied is represented by the movement along the supply curve.

To summarize, a shift in the supply curve is called a “change in supply,” and a shift in the demand
curve is called a “change in demand.” A movement along a fixed supply curve is called a “change in

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1.
2.

the quantity supplied,” and a movement along a fixed demand curve is called a “change in the quantity
demanded.”

Example: A Change in Market Equilibrium Due to a Shift in Supply Suppose that during another
summer, a hurricane destroys part of the sugarcane crop and drives up the price of sugar. How does
this event affect the market for ice cream? Once again, to answer this question, we follow our three
steps.

The change in the price of sugar, an input for making ice cream, affects the supply curve. By
raising the costs of production, it reduces the amount of ice cream that firms produce and sell at
any given price. The demand curve does not change because the higher cost of inputs does not
directly affect the amount of ice cream households wish to buy.

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2.
3.
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The supply curve shifts to the left because, at every price, the total amount that firms are willing
and able to sell is reduced. Figure 11 illustrates this decrease in supply as a shift in the supply
curve from S1 to S2.
At the old price of $2, there is now an excess demand for ice cream, and this shortage causes
firms to raise the price. As Figure 11 shows, the shift in the supply curve raises the equilibrium
price from $2.00 to $2.50 and lowers the equilibrium quantity from 7 to 4 cones. As a result of
the sugar price increase, the price of ice cream rises, and the quantity of ice cream sold falls.

Example: Shifts in Both Supply and Demand Now suppose that a heat wave and a hurricane occur
during the same summer. To analyze this combination of events, we again follow our three steps.

We determine that both curves must shift. The hot weather affects the demand curve because it
alters the amount of ice cream that households want to buy at any given price. At the same time,
when the hurricane drives up sugar prices, it alters the supply curve for ice cream because it
changes the amount of ice cream that firms want to sell at any given price.
The curves shift in the same directions as they did in our previous analysis: The demand curve
shifts to the right, and the supply curve shifts to the left. Figure 12 illustrates these shifts.
As Figure 12 shows, two possible outcomes might result depending on the relative size of the
demand and supply shifts. In both cases, the equilibrium price rises. In panel (a), where demand
increases substantially while supply falls just a little, the equilibrium quantity also rises. By
contrast, in panel (b), where supply falls substantially while demand rises just a little, the
equilibrium quantity falls. Thus, these events certainly raise the price of ice cream, but their
impact on the amount of ice cream sold is ambiguous (that is, it could go either way).

FIGURE 11
How a Decrease in Supply Affects the Equilibrium
An event that reduces quantity supplied at any given price shifts the supply curve to the left. The equilibrium
price rises, and the equilibrium quantity falls. Here an increase in the price of sugar (an input) causes sellers to
supply less ice cream. The supply curve shifts from S1 to S2, which causes the equilibrium price of ice cream
to rise from $2.00 to $2.50 and the equilibrium quantity to fall from 7 to 4 cones.

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FIGURE 12
A Shift in Both Supply and Demand
Here we observe a simultaneous increase in demand and decrease in supply. Two outcomes are possible. In
panel (a), the equilibrium price rises from P1 to P2 and the equilibrium quantity rises from Q1 to Q2. In panel
(b), the equilibrium price again rises from P1 to P2 but the equilibrium quantity falls from Q1 to Q2.

Summary We have just seen three examples of how to use supply and demand curves to analyze a
change in equilibrium. Whenever an event shifts the supply curve, the demand curve, or perhaps both
curves, you can use these tools to predict how the event will alter the price and quantity sold in
equilibrium. Table 4 shows the predicted outcome for any combination of shifts in the two curves. To
make sure you understand how to use the tools of supply and demand, pick a few

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entries in this table and make sure you can explain to yourself why the table contains the prediction
that it does.

TABLE 4
What Happens to Price and Quantity When Supply or Demand Shifts?
As a quick quiz, make sure you can explain at least a few of the entries in this table using a
supply-and-demand diagram.

Quick Quiz On the appropriate diagram, show what happens to the market for pizza if the price of
tomatoes rises. • On a separate diagram, show what happens to the market for pizza if the price of
hamburgers falls.

4-5 Conclusion: How Prices Allocate Resources
This chapter has analyzed supply and demand in a single market. Although our discussion has
centered on the market for ice cream, the lessons learned here apply in most other markets as well.
Whenever you go to a store to buy something, you are contributing to the demand for that item.
Whenever you look for a job, you are contributing to the supply of labor services. Because supply and
demand are such pervasive economic phenomena, the model of supply and demand is a powerful tool
for analysis. We will be using this model repeatedly in the following chapters.

One of the Ten Principles of Economics discussed in Chapter 1 is that markets are usually a good
way to organize economic activity. Although it is still too early to judge whether market outcomes are
good or bad, in this chapter we have begun to see how markets work. In any economic system, scarce
resources have to be allocated among competing uses. Market economies harness the forces of supply
and demand to serve that end. Supply and demand together determine the prices of the economy’s
many different goods and services; prices in turn are the signals that guide the allocation of resources.

For example, consider the allocation of beachfront land. Because the amount of this land is limited,

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not everyone can enjoy the luxury of living by the beach. Who gets this resource? The answer is
whoever is willing and able to pay the price. The price of beachfront land adjusts until the quantity of
land demanded exactly balances the quantity supplied. Thus, in market economies, prices are the
mechanism for rationing scarce resources.

Similarly, prices determine who produces each good and how much is produced. For instance,
consider farming. Because we need food to survive, it is crucial that some people work on farms. What
determines who is a farmer and who is not? In a free society, there is no government planning agency
making this decision and ensuring an adequate supply of food. Instead, the allocation of workers to
farms is based on the job decisions of millions of workers. This decentralized system works well
because these decisions depend on prices. The prices of food and the wages of farmworkers (the price
of their labor) adjust to ensure that enough people choose to be farmers.

If a person had never seen a market economy in action, the whole idea might seem preposterous.
Economies are enormous groups of people engaged in a multitude of interdependent activities. What
prevents decentralized decision making from degenerating into chaos? What coordinates the actions of
the millions of people with their varying abilities and desires? What ensures that what needs to be
done is in fact done? The answer, in a word, is prices. If an invisible hand guides market economies,
as Adam Smith famously suggested, then the price system is the baton that the invisible hand uses to
conduct the economic orchestr

“Two dollars”

“—and seventy-five cents.”

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IN THE NEWS Price Increases after Disasters

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When a disaster such as a hurricane strikes a region, many goods experienceWhen a disaster such as a hurricane strikes a region, many goods experience
an increase in demand or a decrease in supply, putting upward pressure onan increase in demand or a decrease in supply, putting upward pressure on
prices. Policymakers often object to these price hikes, but this opinion pieceprices. Policymakers often object to these price hikes, but this opinion piece
endorses the market’s natural response.endorses the market’s natural response.

Is Price Gouging Reverse Looting?
By John Carney

our dollars for a can of coke. Five hundred dollars a night for a hotel in downtown Brooklyn. A
pair of D-batteries for $6.9

These are just a few of the examples of price hikes I or friends of mine have personally come
across in the run-up and aftermath of hurricane Sandy. Price gouging, as this is often called, is a
common occurrence during emergencies.

Price gouging around natural disasters is one of the things politicians on the left and right agree is
a terrible, no good, very bad thing. New York Attorney General Eric Schneiderman sent out a press
release warning “against price inflation of necessary goods and services during hurricane Sandy.”
New Jersey Governor Chris Christie issued a “forceful reminder” that price gouging “will result in
significant penalties.” Hotlines have been established to allow consumers to report gouging.

New Jersey’s law is very specific. Price increases of more than 10 percent during a declared state
of emergency are considered excessive. A New Jersey gas station paid a $50,000 fine last year for
hiking gasoline prices by 16 percent during tropical storm Irene.

New York’s law may be even stricter. According to AG Schneiderman’s release, all price
increases on “necessary goods and items” count as gouging.

“General Business Law prohibits such increase in costs of essential items like food, water, gas,
generators, batteries and flashlights, and services like transportation, during natural disasters or
other events that disrupt the market,” the NY AG release said.

These laws are built on the quite conventional view that it is unethical for a business to take
advantage of a disaster in pursuit of profits. It just seems wrong for business owners to make money
on the misery of their neighbors. Merchants earning larger profits because of a disaster seem to be

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rewarded for doing nothing more than raising their prices.
“It’s reverse looting,” a neighbor of mine in Brooklyn said about the price of batteries at a local

electronic store.
Unfortunately, ethics runs into economics in a way that can make these laws positively harmful.

Price gouging can occur only when there is a shortage of the goods in demand. If there were no
shortage, normal market processes would prevent sudden price spikes. A deli owner charging $4 for
a can of Pepsi would discover he was just driving customers to the deli a block away, which charges
a buck.

But when everyone suddenly starts buying batteries or bottles of water for fear of a blackout,
shortages can arise. Sometimes

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there simply is not enough of a particular good to satisfy a sharp spike in demand. And so the
question arises: how do we decide which customers get the batteries, the groceries, the gasoline?

We could hold a lottery. Perhaps people could receive a ticket at the grocery store. Winners would
get to shop at the usual prices. Losers would just go hungry. Or, more likely, they would be forced to
buy the food away from the lottery winners—at elevated prices no doubt, since no one would buy
food just to sell it at the same price. So the gouging would just pass from merchant to lottery
winning customer.

Would you pay $4 for this?

We could have some sort of rationing program. Each person could be assigned a portion of the
necessary goods according to their household need. This is something the U.S. resorted to during
World War II. The problem is that rationing requires an immense amount of planning—and an
impossible level of knowledge. The rationing bureaucrat would have to know precisely how much
of each good was available in a given area and how many people would need it. Good luck getting
that in place as a hurricane bears down on your city.

We could simply sell goods on a first come, first serve basis. This is, in fact, what anti-gouging
laws encourage. The result is all too familiar. People hoard goods. Store shelves are emptied. And
you have to wonder, why is a first to the register race a fairer system than the alternative of market
prices? Speed seems a poor proxy for justice.

Allowing prices to rise at times of extreme demand discourages overconsumption. People
consider their purchases more carefully. Instead of buying a dozen batteries (or bottles of water or
gallons of gas), perhaps they buy half that. The result is that goods under extreme demand are
available to more customers. The market process actually results in a more equitable distribution
than the anti-gouging laws.

Once we understand this, it’s easy to see that merchants aren’t really profiting from disaster. They
are profiting from managing their prices, which has the socially beneficial effect of broadening
distribution and discouraging hoarding. In short, they are being justly rewarded for performing an
important public service.

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One objection is that a system of free-floating, legal gouging would allow the wealthy to buy
everything and leave the poor out altogether. But this concern is overrated. For the most part, price
hikes during disasters do not actually put necessary goods and services out of reach of even the
poorest people. They just put the budgets of the poor under additional strain. This is a problem
better resolved through transfer payments to alleviate the household budgetary effects of the prices
after the fact, rather than trying to control the price in the first place….

Instead of cracking down on price gougers, we should be using our experience of shortages
during this time of crisis to spark a reform of our counter-productive laws. Next time disaster
strikes, we should hope for a bit more gouging and a lot fewer empty store shelves.

Source: Courtesy of CNBC.

Summary
Economists use the model of supply and demand to analyze competitive markets. In a competitive
market, there are many buyers and sellers, each of whom has little or no influence on the market
price.
The demand curve shows how the quantity of a good demanded depends on the price. According to
the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand
curve slopes downward.
In addition to price, other determinants of how much consumers want to buy include income, the
prices of substitutes and complements, tastes, expectations, and the number of buyers. If one of
these factors changes, the demand curve shifts.
The supply curve shows how the quantity of a good supplied depends on the price. According to the
law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve
slopes upward.
In addition to price, other determinants of how much producers want to sell include input prices,
technology, expectations, and the number of sellers. If one of these factors changes, the supply
curve shifts.
The intersection of the supply and demand curves determines the market equilibrium. At the
equilibrium price, the quantity demanded equals the quantity supplied.
The behavior of buyers and sellers naturally drives markets toward their equilibrium. When the
market price is above the equilibrium price, there is a surplus of the good, which causes the market
price to fall. When the market price is below the equilibrium price, there is a shortage, which causes
the market price to rise.
To analyze how any event influences a market, we use the supply-and-demand diagram to examine
how the event affects the equilibrium price and quantity. To do this, we follow three steps. First, we
decide whether the event shifts the supply curve or the demand curve (or both). Second, we decide
in which direction the curve shifts. Third, we compare the new equilibrium with the initial
equilibrium.
In market economies, prices are the signals that guide economic decisions and thereby allocate
scarce resources. For every good in the economy, the price ensures that supply and demand are in

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balance. The equilibrium price then determines how much of the good buyers choose to consume
and how much sellers choose to produce.

Key Concepts

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market, p. 66
competitive market, p. 66
quantity demanded, p. 67
law of demand, p. 67
demand schedule, p. 67
demand curve, p. 68
normal good, p. 70
inferior good, p. 70
substitutes, p. 70
complements, p. 70
quantity supplied, p. 73
law of supply, p. 73
supply schedule, p. 74
supply curve, p. 74
equilibrium, p. 77
equilibrium price, p. 77
equilibrium quantity, p. 77
surplus, p. 77
shortage, p. 78
law of supply and demand, p. 79

Questions for Review
1. What is a competitive market? Briefly describe a type of market that is not perfectly competitive.
2. What are the demand schedule and the demand curve, and how are they related? Why does the

demand curve slope downward?
3. Does a change in consumers’ tastes lead to a movement along the demand curve or a shift in the

demand curve? Does a change in price lead to a movement along the demand curve or a shift in the
demand curve? Explain your answers.

4. Popeye’s income declines, and as a result, he buys more spinach. Is spinach an inferior or a normal
good? What happens to Popeye’s demand curve for spinach?

5. What are the supply schedule and the supply curve, and how are they related? Why does the supply
curve slope upward?

6. Does a change in producers’ technology lead to a movement along the supply curve or a shift in the
supply curve? Does a change in price lead to a movement along the supply curve or a shift in the
supply curve?

7. Define the equilibrium of a market. Describe the forces that move a market toward its equilibrium.
8. Beer and pizza are complements because they are often enjoyed together. When the price of beer

rises, what happens to the supply, demand, quantity supplied, quantity demanded, and price in the
market for pizza?

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a.
b.
c.
d.

3.
a.
b.
c.
d.
4.
a.
b.
c.
d.

a.
b.
c.
d.

9. Describe the role of prices in market economies.

Quick Check Multiple Choice
A change in which of the following will NOT shift the demand curve for hamburgers?

the price of hot dogs
the price of hamburgers
the price of hamburger buns
the income of hamburger consumers

An increase in _______ will cause a movement along a given demand curve, which is called a
change in _________

supply, demand
supply, quantity demanded
demand, supply
demand, quantity supplied

Movie tickets and DVDs are substitutes. If the price of DVDs increases, what happens in the
market for movie tickets?

The supply curve shifts to the left.
The supply curve shifts to the right.
The demand curve shifts to the left.
The demand curve shifts to the right.

The discovery of a large new reserve of crude oil will shift the ________ curve for gasoline,
leading to a ________ equilibrium price.

supply, higher
supply, lower
demand, higher
demand, lower

If the economy goes into a recession and incomes fall, what happens in the markets for inferior
goods?

Prices and quantities both rise.
Prices and quantities both fall.
Prices rise, quantities fall.
Prices fall, quantities rise.

Which of the following might lead to an increase in the equilibrium price of jelly and a decrease in
the equilibrium quantity of jelly sold?

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a.
b.
c.
d.
1.

an increase in the price of peanut better, a complement to jelly
an increase in the price of Marshmallow Fluff, a substitute for jelly
an increase in the price of grapes, an input into jelly
an increase in consumers’ incomes, as long as jelly is a normal good

Problems and Applications

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a.
b.
c.
2.
3.

a.
b.
c.
d.
e.

4.
a.

•
•
•

b.
c.
5.
6.
a.
b.
c.
d.
PRINTED BY: marquez007@email.phoenix.edu. Printing is for personal, private use only. No part of this
book may be reproduced or transmitted without publisher’s prior permission. Violators will be prosecuted.

Explain each of the following statements using supply-and-demand diagrams.
“When a cold snap hits Florida, the price of orange juice rises in supermarkets throughout the
country.”
“When the weather turns warm in New England every summer, the price of hotel rooms in
Caribbean resorts plummets.”
“When a war breaks out in the Middle East, the price of gasoline rises and the price of a used
Cadillac falls.”

“An increase in the demand for notebooks raises the quantity of notebooks demanded but not the
quantity supplied.” Is this statement true or false? Explain.
Consider the market for minivans. For each of the events listed here, identify which of the
determinants of demand or supply are affected. Also indicate whether demand or supply increases
or decreases. Then draw a diagram to show the effect on the price and quantity of minivans.

People decide to have more children.
A strike by steelworkers raises steel prices.
Engineers develop new automated machinery for the production of minivans.
The price of sports utility vehicles rises.
A stock market crash lowers people’s wealth.

Consider the markets for DVDs, TV screens, and tickets at movie theaters.
For each pair, identify whether they are complements or substitutes:

DVDs and TV screens
DVDs and movie tickets
TV screens and movie tickets

Suppose a technological advance reduces the cost of manufacturing TV screens. Draw a
diagram to show what happens in the market for TV screens.
Draw two more diagrams to show how the change in the market for TV screens affects the
markets for DVDs and movie tickets.

Over the past 30 years, technological advances have reduced the cost of computer chips. How do
you think this has affected the market for computers? For computer software? For typewriters?
Using supply-and-demand diagrams, show the effect of the following events on the market for
sweatshirts.

A hurricane in South Carolina damages the cotton crop.
The price of leather jackets falls.
All colleges require morning exercise in appropriate attire.
New knitting machines are invented.

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a.
b.
c.
9.

10.
a.

11.

Ketchup is a complement (as well as a condiment) for hot dogs. If the price of hot dogs rises, what
happens to the market for ketchup? For tomatoes? For tomato juice? For orange juice?
The market for pizza has the following demand and supply schedules:

Price Quantity Demanded Quantity Supplied
$4 135 pizzas 26 pizzas
5 104 53
6 81 81
7 68 98
8 53 110
9 39 121

Graph the demand and supply curves. What is the equilibrium price and quantity in this
market?
If the actual price in this market were above the equilibrium price, what would drive the market
toward the equilibrium?
If the actual price in this market were below the equilibrium price, what would drive the market
toward the equilibrium?

Consider the following events: Scientists reveal that eating oranges decreases the risk of diabetes,
and at the same time, farmers use a new fertilizer that makes orange trees produce more oranges.
Illustrate and explain what effect these changes have on the equilibrium price and quantity of
oranges.
Because bagels and cream cheese are often eaten together, they are complements.

We observe that both the equilibrium price of cream cheese and the equilibrium quantity of
bagels have risen. What could be responsible for this pattern—a fall in the price of flour or a
fall in the price of milk? Illustrate and explain your answer.
Suppose instead that the equilibrium price of cream cheese has risen but the equilibrium
quantity of bagels has fallen. What could be responsible for this pattern—a rise in the price of
flour or a rise in the price of milk? Illustrate and explain your answer.

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may be reproduced or transmitted without publisher’s prior permission. Violators will be prosecute

CHAPTER

2
Thinking Like an Economist

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very field of study has its own language and its own way of thinking. Mathematicians talk about
axioms, integrals, and vector spaces. Psychologists talk about ego, id, and cognitive dissonance.

Lawyers talk about venue, torts, and promissory estoppel.
Economics is no different. Supply, demand, elasticity, comparative advantage, consumer surplus,

deadweight loss—these terms are part of the economist’s language. In the coming chapters, you will
encounter many new terms and some familiar words that economists use in specialized ways. At first,
this new language may seem needlessly arcane. But as you will see, its value lies in its ability to
provide you with a new and useful way of thinking about the world in which you live.

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The purpose of this book is to help you learn the economist’s way of thinking. Just as you cannot
become a mathematician, psychologist, or lawyer overnight, learning to think like an economist will
take some time. Yet with

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a combination of theory, case studies, and examples of economics in the news, this book will give
you ample opportunity to develop and practice this skill.

Before delving into the substance and details of economics, it is helpful to have an overview of how
economists approach the world. This chapter discusses the field’s methodology. What is distinctive
about how economists confront a question? What does it mean to think like an economist?

2-1 The Economist as Scientist
Economists try to address their subject with a scientist’s objectivity. They approach the study of the
economy in much the same way a physicist approaches the study of matter and a biologist approaches
the study of life: They devise theories, collect data, and then analyze these data in an attempt to verify
or refute their theories.

To beginners, the claim that economics is a science can seem odd. After all, economists do not work
with test tubes or telescopes. The essence of science, however, is the scientific method—the
dispassionate development and testing of theories about how the world works. This method of inquiry
is as applicable to studying a nation’s economy as it is to studying the earth’s gravity or a species’
evolution. As Albert Einstein once put it, “The whole of science is nothing more than the refinement of
everyday thinking.”

Although Einstein’s comment is as true for social sciences such as economics as it is for natural
sciences such as physics, most people are not accustomed to looking at society through a scientific
lens. Let’s discuss some of the ways in which economists apply the logic of science to examine how an
economy works.

“I’m a social scientist, Michael. That means I can’t explain electricity or anything like that, but if you ever want to
know about people, I’m your man.”

2-1a The Scientific Method: Observation, Theory, and More
Observation

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Isaac Newton, the famous 17th-century scientist and mathematician, allegedly became intrigued one
day when he saw an apple fall from a tree. This observation motivated Newton to develop a theory of
gravity that applies not only to an apple falling to the earth but to any two objects in the universe.
Subsequent testing of Newton’s theory has shown that it works well in many circumstances (although,
as Einstein would later emphasize, not in all circumstances). Because Newton’s theory has been so
successful at explaining observation, it is still taught in undergraduate physics courses around the
world.

This interplay between theory and observation also occurs in economics. An economist might live
in a country experiencing rapidly increasing prices and be moved by this observation to develop a
theory of inflation. The theory might assert that high inflation arises when the government prints too
much money. To test this theory, the economist could collect and analyze data on prices and money
from many different countries. If growth in the quantity of money were completely unrelated to the
rate of price increase, the economist would start to doubt the validity of this theory of inflation. If
money growth and inflation were strongly correlated in international data, as in fact they are, the
economist would become more confident in the theory.

Although economists use theory and observation like other scientists, they face an obstacle that
makes their task especially challenging: In economics, conducting

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experiments is often impractical. Physicists studying gravity can drop many objects in their
laboratories to generate data to test their theories. By contrast, economists studying inflation are not
allowed to manipulate a nation’s monetary policy simply to generate useful data. Economists, like
astronomers and evolutionary biologists, usually have to make do with whatever data the world
happens to give them.

To find a substitute for laboratory experiments, economists pay close attention to the natural
experiments offered by history. When a war in the Middle East interrupts the flow of crude oil, for
instance, oil prices skyrocket around the world. For consumers of oil and oil products, such an event
depresses living standards. For economic policymakers, it poses a difficult choice about how best to
respond. But for economic scientists, the event provides an opportunity to study the effects of a key
natural resource on the world’s economies. Throughout this book, therefore, we consider many
historical episodes. These episodes are valuable to study because they give us insight into the economy
of the past and, more important, because they allow us to illustrate and evaluate economic theories of
the present.

2-1b The Role of Assumptions
If you ask a physicist how long it would take a marble to fall from the top of a ten-story building, he
will likely answer the question by assuming that the marble falls in a vacuum. Of course, this
assumption is false. In fact, the building is surrounded by air, which exerts friction on the falling
marble and slows it down. Yet the physicist will point out that the friction on the marble is so small
that its effect is negligible. Assuming the marble falls in a vacuum simplifies the problem without
substantially affecting the answer.

Economists make assumptions for the same reason: Assumptions can simplify the complex world
and make it easier to understand. To study the effects of international trade, for example, we might
assume that the world consists of only two countries and that each country produces only two goods.
In reality, there are numerous countries, each of which produces thousands of different types of goods.
But by considering a world with only two countries and two goods, we can focus our thinking on the
essence of the problem. Once we understand international trade in this simplified imaginary world, we
are in a better position to understand international trade in the more complex world in which we live.

The art in scientific thinking—whether in physics, biology, or economics—is deciding which
assumptions to make. Suppose, for instance, that instead of dropping a marble from the top of the
building, we were dropping a beach ball of the same weight. Our physicist would realize that the
assumption of no friction is less accurate in this case: Friction exerts a greater force on a beach ball
than on a marble because a beach ball is much larger. The assumption that gravity works in a vacuum
is reasonable for studying a falling marble but not for studying a falling beach ball.

Similarly, economists use different assumptions to answer different questions. Suppose that we want
to study what happens to the economy when the government changes the number of dollars in
circulation. An important piece of this analysis, it turns out, is how prices respond. Many prices in the
economy change infrequently; the newsstand prices of magazines, for instance, change only once
every few years. Knowing this fact may lead us to make different assumptions when studying the
effects of the policy change over different time horizons. For studying the short-run effects of the
policy, we may assume that prices do not

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change much. We may even make the extreme and artificial assumption that all prices are
completely fixed. For studying the long-run effects of the policy however, we may assume that all
prices are completely flexible. Just as a physicist uses different assumptions when studying falling
marbles and falling beach balls, economists use different assumptions when studying the short-run and
long-run effects of a change in the quantity of money.

2-1c Economic Models
High school biology teachers teach basic anatomy with plastic replicas of the human body. These
models have all the major organs—the heart, the liver, the kidneys, and so on—which allow teachers
to show their students very simply how the important parts of the body fit together. Because these
plastic models are stylized and omit many details, no one would mistake one of them for a real person.
Despite this lack of realism—indeed, because of this lack of realism—studying these models is useful
for learning how the human body works.

Economists also use models to learn about the world, but unlike plastic manikins, their models
mostly consist of diagrams and equations. Like a biology teacher’s plastic model, economic models
omit many details to allow us to see what is truly important. Just as the biology teacher’s model does
not include all the body’s muscles and capillaries, an economist’s model does not include every feature
of the economy.

As we use models to examine various economic issues throughout this book, you will see that all
the models are built with assumptions. Just as a physicist begins the analysis of a falling marble by
assuming away the existence of friction, economists assume away many of the details of the economy
that are irrelevant for studying the question at hand. All models—in physics, biology, and economics
—simplify reality to improve our understanding of it.

2-1d Our First Model: The Circular-Flow Diagram
The economy consists of millions of people engaged in many activities—buying, selling, working,
hiring, manufacturing, and so on. To understand how the economy works, we must find some way to
simplify our thinking about all these activities. In other words, we need a model that explains, in
general terms, how the economy is organized and how participants in the economy interact with one
another.

Figure 1 presents a visual model of the economy called a circular-flow diagram. In this model, the
economy is simplified to include only two types of decision makers—firms and households. Firms
produce goods and services using inputs, such as labor, land, and capital (buildings and machines).
These inputs are called the factors of production. Households own the factors of production and
consume all the goods and services that the firms produce.

circular-flow diagram a visual model of the economy that shows how dollars flow through markets
among households and firms

Households and firms interact in two types of markets. In the markets for goods and services,
households are buyers, and firms are sellers. In particular, households buy the output of goods and
services that firms produce. In the markets for the factors of production, households are sellers, and

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firms are buyers. In these markets, households provide the inputs that firms use to produce goods and
services. The circular-flow diagram offers a simple way of organizing the economic transactions that
occur between households and firms in the economy.

The two loops of the circular-flow diagram are distinct but related. The inner loop represents the
flows of inputs and outputs. The households sell the use of their labor, land, and capital to the firms in
the markets for the factors of production. The firms then use these factors to produce goods and
services, which in turn are sold to households in the markets for goods and services. The outer loop of
the diagram represents the corresponding flow of dollars. The households spend money to buy goods
and services from the firms. The firms use some of the revenue from these sales to pay for the factors
of production, such as the wages of their workers. What’s left is the profit of the firm owners, who
themselves are members of households.

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FIGURE 1
The Circular Flow
This diagram is a schematic representation of the organization of the economy. Decisions are made by
households and firms. Households and firms interact in the markets for goods and services (where households
are buyers and firms are sellers) and in the markets for the factors of production (where firms are buyers and
households are sellers). The outer set of arrows shows the flow of dollars, and the inner set of arrows shows the
corresponding flow of inputs and outputs.

Let’s take a tour of the circular flow by following a dollar bill as it makes its way from person to
person through the economy. Imagine that the dollar begins at a household, say, in your wallet. If you
want to buy a cup of coffee, you take the dollar to one of the economy’s markets for goods and
services, such as your local Starbucks coffee shop. There, you spend it on your favorite drink. When
the dollar moves into the Starbucks cash register, it becomes revenue for the firm. The dollar doesn’t
stay at Starbucks for long, however, because the firm uses it to buy inputs in the markets for the factors
of production. Starbucks might use the dollar to pay rent to its landlord for the space it occupies or to
pay the wages of its workers. In either case, the dollar enters the income of some household and, once
again, is back in someone’s wallet. At that point, the story of the economy’s circular flow starts once
again.

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The circular-flow diagram in Figure 1 is a very simple model of the economy. It dispenses with
details that, for some purposes, are significant. A more complex and realistic circular-flow model
would include, for instance, the roles of government and international trade. (A portion of that dollar
you gave to Starbucks might be used to pay taxes or to buy coffee beans from a farmer in Brazil.) Yet

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these details are not crucial for a basic understanding of how the economy is organized. Because of
its simplicity, this circular-flow diagram is useful to keep in mind when thinking about how the pieces
of the economy fit together.

2-1e Our Second Model: The Production Possibilities Frontier
Most economic models, unlike the circular-flow diagram, are built using the tools of mathematics.
Here we use one of the simplest such models, called the production possibilities frontier, to illustrate
some basic economic ideas.

Although real economies produce thousands of goods and services, let’s consider an economy that
produces only two goods—cars and computers. Together, the car industry and the computer industry
use all of the economy’s factors of production. The production possibilities frontier is a graph that
shows the various combinations of output—in this case, cars and computers—that the economy can
possibly produce given the available factors of production and the available production technology
that firms use to turn these factors into output.

production possibilities frontier a graph that shows the combinations of output that the economy can
possibly produce given the available factors of production and the available production technology

Figure 2 shows this economy’s production possibilities frontier. If the economy uses all its resources
in the car industry, it produces 1,000 cars and no computers. If it uses all its resources in the computer
industry, it produces 3,000 computers and no cars. The two endpoints of the production possibilities
frontier represent these extreme possibilities.

More likely, the economy divides its resources between the two industries, producing some cars and
some computers. For example, it can produce 600 cars and 2,200 computers, as shown in Figure 2 by
point A. Or, by moving some of the factors of production to the car industry from the computer
industry, the economy can produce 700 cars and 2,000 computers, represented by point B.

FIGURE 2
The Production Possibilities Frontier
The production possibilities frontier shows the combinations of output—in this case, cars and computers—that
the economy can possibly produce. The economy can produce any combination on or inside the frontier. Points
outside the frontier are not feasible given the economy’s resources. The slope of the production possibilities
frontier measures the opportunity cost of a car in terms of computers. This opportunity cost varies, depending
on how much of the two goods the economy is producing.

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Because resources are scarce, not every conceivable outcome is feasible. For example, no matter
how resources are allocated between the two industries, the economy cannot produce the amount of
cars and computers represented by point C. Given the technology available for manufacturing cars and
computers, the economy does not have enough of the factors of production to support that level of
output. With the resources it has, the economy can produce at any point on or inside the production
possibilities frontier, but it cannot produce at points outside the frontier.

An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has
available. Points on (rather than inside) the production possibilities frontier represent efficient levels of
production. When the economy is producing at such a point, say point A, there is no way to produce
more of one good without producing less of the other. Point D represents an inefficient outcome. For
some reason, perhaps widespread unemployment, the economy is producing less than it could from the
resources it has available: It is producing only 300 cars and 1,000 computers. If the source of the
inefficiency is eliminated, the economy can increase its production of both goods. For example, if the
economy moves from point D to point A, its production of cars increases from 300 to 600, and its
production of computers increases from 1,000 to 2,200.

One of the Ten Principles of Economics discussed in Chapter 1 is that people face trade-offs. The
production possibilities frontier shows one trade-off that society faces. Once we have reached an
efficient point on the frontier, the only way of producing more of one good is to produce less of the
other. When the economy moves from point A to point B, for instance, society produces 100 more cars
but at the expense of producing 200 fewer computers.

This trade-off helps us understand another of the Ten Principles of Economics: The cost of
something is what you give up to get it. This is called the opportunity cost. The production
possibilities frontier shows the opportunity cost of one good as measured in terms of the other good.
When society moves from point A to point B, it gives up 200 computers to get 100 additional cars.
That is, at point A, the opportunity cost of 100 cars is 200 computers. Put another way, the opportunity
cost of each car is two computers. Notice that the opportunity cost of a car equals the slope of the
production possibilities frontier. (If you don’t recall what slope is, you can refresh your memory with
the graphing appendix to this chapter.)

The opportunity cost of a car in terms of the number of computers is not constant in this economy
but depends on how many cars and computers the economy is producing. This is reflected in the shape
of the production possibilities frontier. Because the production possibilities frontier in Figure 2 is
bowed outward, the opportunity cost of a car is highest when the economy is producing many cars and
few computers, such as at point E, where the frontier is steep. When the economy is producing few
cars and many computers, such as at point F, the frontier is flatter, and the opportunity cost of a car is
lower.

Economists believe that production possibilities frontiers often have this bowed shape. When the
economy is using most of its resources to make computers, such as at point F, the resources best suited
to car production, such as skilled autoworkers, are being used in the computer industry. Because these
workers probably aren’t very good at making computers, increasing car production by one unit will
cause only a slight reduction in the number of computers produced.

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At point F, the opportunity cost of a car in terms of computers is small, and the frontier is relatively
flat. By contrast, when the economy is using most of its resources to make cars, such as at point E, the
resources best suited to making cars are already at work in the car industry. Producing an additional
car means moving some of the best computer technicians out of the computer industry and turning
them into autoworkers. As a result, producing an additional car will mean a substantial loss of
computer output. The opportunity cost of a car is high, and the frontier is steep.

The production possibilities frontier shows the trade-off between the outputs of different goods at a
given time, but the trade-off can change over time. For example, suppose a technological advance in
the computer industry raises the number of computers that a worker can produce per week. This
advance expands society’s set of opportunities. For any given number of cars, the economy can now
make more computers. If the economy does not produce any computers, it can still produce 1,000 cars,
so one endpoint of the frontier stays the same. But if the economy devotes some of its resources to the
computer industry, it will produce more computers from those resources. As a result, the production
possibilities frontier shifts outward, as in Figure

This figure illustrates what happens when an economy grows. Society can move production from a
point on the old frontier to a point on the new frontier. Which point it chooses depends on its
preferences for the two goods. In this example, society moves from point A to point G, enjoying more
computers (2,300 instead of 2,200) and more cars (650 instead of 600).

The production possibilities frontier simplifies a complex economy to highlight some basic but
powerful ideas: scarcity, efficiency, trade-offs, opportunity cost, and economic growth. As you study
economics, these ideas will recur in various forms. The production possibilities frontier offers one
simple way of thinking about them.

FIGURE 3
A Shift in the Production Possibilities Frontier
A technological advance in the computer industry enables the economy to produce more computers for any
given number of cars. As a result, the production possibilities frontier shifts outward. If the economy moves
from point A to point G, then the production of both cars and computers increases.

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2-1f Microeconomics and Macroeconomics

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PRINTED BY: marquez007@email.phoenix.edu. Printing is for personal, private use only. No part of this book
may be reproduced or transmitted without publisher’s prior permission. Violators will be prosecuted.

Many subjects are studied on various levels. Consider biology, for example. Molecular biologists
study the chemical compounds that make up living things. Cellular biologists study cells, which are
made up of many chemical compounds and, at the same time, are themselves the building blocks of
living organisms. Evolutionary biologists study the many varieties of animals and plants and how
species change gradually over the centuries.

Economics is also studied on various levels. We can study the decisions of individual households
and firms. Or we can study the interaction of households and firms in markets for specific goods and
services. Or we can study the operation of the economy as a whole, which is the sum of the activities
of all these decision makers in all these markets.

The field of economics is traditionally divided into two broad subfields. Microeconomics is the
study of how households and firms make decisions and how they interact in specific markets.
Macroeconomics is the study of economy-wide phenomena. A microeconomist might study the
effects of rent control on housing in New York City, the impact of foreign competition on the U.S. auto
industry, or the effects of compulsory school attendance on workers’ earnings. A macroeconomist
might study the effects of borrowing by the federal government, the changes over time in the
economy’s rate of unemployment, or alternative policies to promote growth in national living
standards.

microeconomics the study of how households and firms make decisions and how they interact in
markets
macroeconomics the study of economy-wide phenomena, including inflation, unemployment, and
economic growth

Microeconomics and macroeconomics are closely intertwined. Because changes in the overall
economy arise from the decisions of millions of individuals, it is impossible to understand
macroeconomic developments without considering the associated microeconomic decisions. For
example, a macro-economist might study the effect of a federal income tax cut on the overall
production of goods and services. But to analyze this issue, he must consider how the tax cut affects
households’ decisions about how much to spend on goods and services.

Despite the inherent link between microeconomics and macroeconomics, the two fields are distinct.
Because they address different questions, each field has its own set of models, which are often taught
in separate courses.

Quick Quiz In what sense is economics like a science? • Draw a production possibilities frontier
for a society that produces food and clothing. Show an efficient point, an inefficient point, and an
infeasible point. Show the effects of a drought. • Define microeconomics and macroeconomics.

2-2 The Economist as Policy Adviser
Often, economists are asked to explain the causes of economic events. Why, for example, is
unemployment higher for teenagers than for older workers? Sometimes, economists are asked to

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recommend policies to improve economic outcomes. What, for instance, should the government do to
improve the economic well-being of teenagers? When economists are trying to explain the world, they
are scientists. When they are trying to help improve it, they are policy advisers.

2-2a Positive versus Normative Analysis

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may be reproduced or transmitted without publisher’s prior permission. Violators will be prosecuted.

To help clarify the two roles that economists play, let’s examine the use of language. Because scientists
and policy advisers have different goals, they use language in different ways.

For example, suppose that two people are discussing minimum-wage laws. Here are two statements
you might hear:

Polly: Minimum-wage laws cause unemployment.
Norm: The government should raise the minimum wage.

Ignoring for now whether you agree with these statements, notice that Polly and Norm differ in what
they are trying to do. Polly is speaking like a scientist: She is making a claim about how the world
works. Norm is speaking like a policy adviser: He is making a claim about how he would like to
change the world.

In general, statements about the world come in two types. One type, such as Polly’s, is positive.
Positive statements are descriptive. They make a claim about how the world is. A second type of
statement, such as Norm’s, is normative. Normative statements are prescriptive. They make a claim
about how the world ought to be.

positive statements claims that attempt to describe the world as it is
normative statements claims that attempt to prescribe how the world should be

A key difference between positive and normative statements is how we judge their validity. We can,
in principle, confirm or refute positive statements by examining evidence. An economist might
evaluate Polly’s statement by analyzing data on changes in minimum wages and changes in
unemployment over time. By contrast, evaluating normative statements involves values as well as
facts. Norm’s statement cannot be judged using data alone. Deciding what is good or bad policy is not
just a matter of science. It also involves our views on ethics, religion, and political philosophy.

Positive and normative statements are fundamentally different, but they are often intertwined in a
person’s set of beliefs. In particular, positive views about how the world works affect normative views
about what policies are desirable. Polly’s claim that the minimum wage causes unemployment, if true,
might lead her to reject Norm’s conclusion that the government should raise the minimum wage. Yet
normative conclusions cannot come from positive analysis alone; they involve value judgments as
well.

As you study economics, keep in mind the distinction between positive and normative statements
because it will help you stay focused on the task at hand. Much of economics is positive: It just tries to
explain how the economy works. Yet those who use economics often have normative goals: They want
to learn how to improve the economy. When you hear economists making normative statements, you
know they are speaking not as scientists but as policy advisers.

2-2b Economists in Washington
President Harry Truman once said that he wanted to find a one-armed economist. When he asked his
economists for advice, they always answered, “On the one hand,…. On the other hand,….”

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Truman was right in realizing that economists’ advice is not always straight-forward. This tendency
is rooted in one of the Ten Principles of Economics: People face trade-offs. Economists are aware that
trade-offs are involved in most policy decisions. A policy might increase efficiency at the cost of
equality. It might help future generations but hurt current generations. An economist who says that all
policy decisions are easy or clear-cut is an economist not to be trusted.

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Truman was not the only president who relied on the advice of economists. Since 1946, the
president of the United States has received guidance from the Council of Economic Advisers, which
consists of three members and a staff of a few dozen economists. The council, whose offices are just a
few steps from the White House, has no duty other than to advise the president and to write the annual
Economic Report of the President, which discusses recent developments in the economy and presents
the council’s analysis of current policy issues.

“Let’s switch. I’ll make the policy, you implement it, and he’ll explain it.”

The president also receives input from economists in many administrative departments. Economists
at the Office of Management and Budget help formulate spending plans and regulatory policies.
Economists at the Department of the Treasury help design tax policy. Economists at the Department of
Labor analyze data on workers and those looking for work to help formulate labor-market policies.
Economists at the Department of Justice help enforce the nation’s antitrust laws.

Economists are also found outside the administrative branch of government. To obtain independent
evaluations of policy proposals, Congress relies on the advice of the Congressional Budget Office,
which is staffed by economists. The Federal Reserve, the institution that sets the nation’s monetary
policy, employs hundreds of economists to analyze economic developments in the United States and
throughout the world.

The influence of economists on policy goes beyond their role as advisers: Their research and
writings often affect policy indirectly. Economist John Maynard Keynes offered this observation:

The ideas of economists and political philosophers, both when they are right and when they are
wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little
else. Practical men, who believe themselves to be quite exempt from intellectual influences, are
usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air,
are distilling their frenzy from some academic scribbler of a few years back.

These words were written in 1935, but they remain true today. Indeed, the “academic scribbler” now
influencing public policy is often Keynes himself.

2-2c Why Economists’ Advice Is Not Always Followed
Any economist who advises presidents or other elected leaders knows that his recommendations are
not always heeded. Frustrating as this can be, it is easy to understand. The process by which economic

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policy is actually made differs in many ways from the idealized policy process assumed in economics
textbooks.

Throughout this text, whenever we discuss economic policy, we often focus on one question: What
is the best policy for the government to pursue? We act as if policy were set by a benevolent king.
Once the king figures out the right policy, he has no trouble putting his ideas into action.

In the real world, figuring out the right policy is only part of a leader’s job, sometimes the easiest
part. After a president hears from his economic advisers about what policy is best from their
perspective, he turns to other advisers for related input. His communications advisers will tell him how
best to explain the proposed policy to the public, and they will try to anticipate any misunderstandings
that might make the challenge more difficult. His press advisers will tell him how the news media will
report on his proposal and what opinions will likely be expressed on the nation’s editorial pages. His
legislative affairs advisers will

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tell him how Congress will view the proposal, what amendments members of Congress will suggest,
and the likelihood that Congress will pass some version of the president’s proposal into law. His
political advisers will tell him which groups will organize to support or oppose the proposed policy,
how this proposal will affect his standing among different groups in the electorate, and whether it will
affect support for any of the president’s other policy initiatives. After hearing and weighing all this
advice, the president then decides how to proceed.

Making economic policy in a representative democracy is a messy affair—and there are often good
reasons why presidents (and other politicians) do not advance the policies that economists advocate.
Economists offer crucial input into the policy process, but their advice is only one ingredient of a
complex recipe.

Quick Quiz Give an example of a positive statement and an example of a normative statement that
somehow relates to your daily life. • Name three parts of government that regularly rely on advice
from economists.

2-3 Why Economists Disagree
“If all economists were laid end to end, they would not reach a conclusion.” This quip from George
Bernard Shaw is revealing. Economists as a group are often criticized for giving conflicting advice to
policymakers. President Ronald Reagan once joked that if the game Trivial Pursuit were designed for
economists, it would have 100 questions and 3,000 answers.

Why do economists so often appear to give conflicting advice to policymakers? There are two basic
reasons:

Economists may disagree about the validity of alternative positive theories about how the world
works.
Economists may have different values and therefore different normative views about what
government policy should aim to accomplish.

Let’s discuss each of these reasons.

2-3a Differences in Scientific Judgments
Several centuries ago, astronomers debated whether the earth or the sun was at the center of the solar
system. More recently, meteorologists have debated whether the earth is experiencing global warming
and, if so, why. Science is an ongoing search to understand the world around us. It is not surprising
that as the search continues, scientists sometimes disagree about the direction in which truth lies.

Economists often disagree for the same reason. Economics is a young science, and there is still
much to be learned. Economists sometimes disagree because they have different hunches about the
validity of alternative theories or about the size of important parameters that measure how economic
variables are related.

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For example, economists disagree about whether the government should tax a household’s income
or its consumption (spending). Advocates of a switch from the current income tax to a consumption
tax believe that the change would encourage households to save more because income that is saved
would not be taxed. Higher saving, in turn, would free resources for capital accumulation, leading to
more rapid growth in productivity and living standards. Advocates of the current income tax system
believe that household saving would not respond

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much to a change in the tax laws. These two groups of economists hold different normative views
about the tax system because they have different positive views about saving’s responsiveness to tax
incentives.

2-3b Differences in Values
Suppose that Peter and Paula both take the same amount of water from the town well. To pay for
maintaining the well, the town taxes its residents. Peter has income of $100,000 and is taxed $10,000,
or 10 percent of his income. Paula has income of $20,000 and is taxed $4,000, or 20 percent of her
income.

Is this policy fair? If not, who pays too much and who pays too little? Does it matter whether Paula’s
low income is due to a medical disability or to her decision to pursue an acting career? Does it matter
whether Peter’s high income is due to a large inheritance or to his willingness to work long hours at a
dreary job?

These are difficult questions on which people are likely to disagree. If the town hired two experts to
study how the town should tax its residents to pay for the well, we would not be surprised if they
offered conflicting advice.

This simple example shows why economists sometimes disagree about public policy. As we know
from our discussion of normative and positive analysis, policies cannot be judged on scientific grounds
alone. Sometimes, economists give conflicting advice because they have different values. Perfecting
the science of economics will not tell us whether Peter or Paula pays too much.

2-3c Perception versus Reality
Because of differences in scientific judgments and differences in values, some disagreement among
economists is inevitable. Yet one should not overstate the amount of disagreement. Economists agree
with one another to a much greater extent than is sometimes understood.

Table 1 contains twenty propositions about economic policy. In surveys of professional economists,
these propositions were endorsed by an overwhelming majority of respondents. Most of these
propositions would fail to command a similar consensus among the publi

The first proposition in the table is about rent control, a policy that sets a legal maximum on the
amount landlords can charge for their apartments. Almost all economists believe that rent control
adversely affects the availability and quality of housing and is a costly way of helping the neediest
members of society. Nonetheless, many city governments ignore the advice of economists and place
ceilings on the rents that landlords may charge their tenants.

The second proposition in the table concerns tariffs and import quotas, two policies that restrict
trade among nations. For reasons we discuss more fully later in this text, almost all economists oppose
such barriers to free trade. Nonetheless, over the years, presidents and Congress have chosen to restrict
the import of certain goods.

Why do policies such as rent control and trade barriers persist if the experts are united in their
opposition? It may be that the realities of the political process stand as immovable obstacles. But it
also may be that economists have not yet convinced enough of the public that these policies are

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undesirable. One purpose of this book is to help you understand the economist’s view of these and
other subjects and, perhaps, to persuade you that it is the right one.

Quick Quiz Why might economic advisers to the president disagree about a question of policy?

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7.
8.

10.

11.

12.

13.
14.

15.
16.
17.
18.

19.

TABLE 1
Propositions about Which Most Economists Agree
Proposition (and percentage of economists who agree)

A ceiling on rents reduces the quantity and quality of housing available. (93%)
Tariffs and import quotas usually reduce general economic welfare. (93%)
Flexible and floating exchange rates offer an effective international monetary
arrangement. (90%)
Fiscal policy (e.g., tax cut and/or government expenditure increase) has a significant
stimulative impact on a less than fully employed economy. (90%)
The United States should not restrict employers from outsourcing work to foreign
countries. (90%)
Economic growth in developed countries like the United States leads to greater levels of
well-being. (88%)
The United States should eliminate agricultural subsidies. (85%)
An appropriately designed fiscal policy can increase the long-run rate of capital
formation. (85%)
Local and state governments should eliminate subsidies to professional sports franchises.
(85%)
If the federal budget is to be balanced, it should be done over the business cycle rather
than yearly. (85%)
The gap between Social Security funds and expenditures will become unsustainably large
within the next 50 years if current policies remain unchanged. (85%)
Cash payments increase the welfare of recipients to a greater degree than do transfers-in-
kind of equal cash value. (84%)
A large federal budget deficit has an adverse effect on the economy. (83%)
The redistribution of income in the United States is a legitimate role for the government.
(83%)
Inflation is caused primarily by too much growth in the money supply. (83%)
The United States should not ban genetically modified crops. (82%)
A minimum wage increases unemployment among young and unskilled workers. (79%)
The government should restructure the welfare system along the lines of a “negative
income tax.” (79%)
Effluent taxes and marketable pollution permits represent a better approach to pollution
control than the imposition of pollution ceilings. (78%)

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20. Government subsidies on ethanol in the United States should be reduced or eliminated.
(78%)

Source: Richard M.Alston, J. R. Kearl, and Michael B. Vaughn, “Is There Consensus among Economists in the
1990s?” American Economic Review (May 1992): 203–209; Dan Fuller and Doris Geide-Stevenson, “Consensus
among Economists Revisited,” Journal of Economics Education (Fall 2003): 369–387; Robert Whaples, “Do
Economists Agree on Anything? Yes!” Economists’ Voice (November 2006): 1–6; Robert Whaples, “The Policy Views
of American Economic Association Members: The Results of a New Survey,” Econ Journal Watch (September 2009):
337–348.

IN THE NEWS Actual Economists and Virtual Realities

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For professional economists, video games may be the next frontier.For professional economists, video games may be the next frontier.

The Economics of Video Games
By Brad Plumer

nflation can be a headache for any central banker. But it takes a certain type of economist to know
what to do when a belligerent spaceship fleet attacks an interstellar trading post, causing mineral

prices to surge across the galaxy.
Eyjólfur Guŏmundsson is just that economist. Working for the Icelandic company CCP Games,

he oversees the virtual economy of the massively multiplayer video game Eve Online. Within this
world, players build their own spaceships and traverse a galaxy of 7,500 star systems. They buy and
sell raw materials, creating their own fluctuating markets. They speculate on commodities. They
form trade coalitions and banks.

It’s a sprawling economy, with more than 400,000 players participating in its virtual market—
more people, in fact, than live in Iceland. Inflation, deflation and even recessions can occur. Which
is why, from his office in Reykjavik, Guômundsson leads a team of eight analysts poring over reams
of data to make sure everything in Eve Online is running smoothly. His job bears more than a
passing resemblance to that of Ben Bernanke, who oversees the U.S. economy from the Federal
Reserve.

“For all intents and purposes, this is an economy that has activity equal to a small country in real
life,” Guômundsson says. “There’s nothing ‘virtual’ about this world.”

Nowadays, many massively multiplayer online video games have become so complex that game
companies are turning to economists for help. Without oversight, the games’ economies can go
badly awry—as when a gambling ban triggered a virtual bank run in the online world of Second
Life in 2007, with one bank alone costing players $750,000 in real-life money.

But there’s a flip side, too. Just as video game designers are in dire need of economic advice,
many academic economists are keen on studying video games. A virtual world, after all, allows
economists to study concepts that rarely occur in real life, such as full-reserve banking, a popular
libertarian alternative to the current banking system that cropped up in Eve Online. The data is
richer. And it’s easier to run economy-wide experiments in a video game—experiments that, for

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obvious reasons, can’t be run on countries.
That ability to experiment on a massive scale, academics say, could revolutionize economics.
“Economic theory has come to a dead end—the last real breakthroughs were in the 1960s,” says

Yanis Varoufakis, a Greek economist recently hired by the video-game company Valve. “But that’s
not because we stopped being clever. We came up against a hard barrier. The future is going to be in
experimentation and simulation—and video game communities give us a chance to do all that.”

At least, that’s the dream. The reality, as always, is more complicated. Game companies are often
wary of meddling economists trying to conduct experiments that suck the fun out of their virtual
worlds. And some academics scoff at the notion that there’s anything to learn from universes filled
with warlocks and starfleets. Game companies and economists may need each other. Now if only
they could learn to share the controller.

In June, Varoufakis announced on his blog that he had been hired as an in-house economist by
Valve, the maker of the popular Half-Life games. Varoufakis wasn’t an obscure number-cruncher.
From his perch at the University of Athens, he had become famous for his trenchant analyses of
Greece’s debt woes and the euro crisis.

It was clear why Valve was interested. The company oversees a network of games such as Team
Fortress 2 that run on its online gaming platform, called Steam.

Valve wanted to link different Steam games together so players could trade virtual items. As Gabe
Newell, the chief executive of Valve, explained in an e-mail to Varoufakis: “We are discussing an
issue of linking economies in two virtual environments (creating a shared currency), and wrestling
with some of the thornier problems of balance of payments.”

Whom better to ask, Newell figured, than an expert on the difficulties that Germany and Greece
faced after joining the euro?

To date, only two companies—CCP and Valve—have gone so far as to hire in-house economists.
But several academics who study virtual worlds say they have consulted with game designers.

“If you’re creating a game with 100,000 users, with things that they can buy and sell, you need an
economist just to help you tweak that system so that it doesn’t spin out of control,” says Robert
Bloomfield, an economist who studies virtual worlds at Cornell’s Johnson School of Management.

Source: The Washington Post, September 28, 2012.

2-4 Let’s Get Going

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The first two chapters of this book have introduced you to the ideas and methods of economics. We are
now ready to get to work. In the next chapter, we start learning in more detail the principles of
economic behavior and economic policy.

As you proceed through this book, you will be asked to draw on many of your intellectual skills.
You might find it helpful to keep in mind some advice from the great economist John Maynard
Keynes:

The study of economics does not seem to require any specialized gifts of an unusually high
order. Is it not… a very easy subject compared with the higher branches of philosophy or pure
science? An easy subject, at which very few excel! The paradox finds its explanation, perhaps,
in that the master-economist must possess a rare combination of gifts. He must be
mathematician, historian, statesman, philosopher—in some degree. He must understand
symbols and speak in words. He must contemplate the particular in terms of the general, and
touch abstract and concrete in the same flight of thought. He must study the present in the light
of the past for the purposes of the future. No part of man’s nature or his institutions must lie
entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood; as
aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.

This is a tall order. But with practice, you will become more and more accustomed to thinking like an
economist.

Summary
Economists try to address their subject with a scientist’s objectivity. Like all scientists, they make
appropriate assumptions and build simplified models to understand the world around them. Two
simple economic models are the circular-flow diagram and the production possibilities frontier.
The field of economics is divided into two subfields: microeconomics and macroeconomics.
Microecono-mists study decision making by households and firms and the interaction among
households and firms in the marketplace. Macroeconomists study the forces and trends that affect
the economy as a whole.
A positive statement is an assertion about how the world is. A normative statement is an assertion
about how the world ought to be. When economists make normative statements, they are acting
more as policy advisers than as scientists.
Economists who advise policymakers sometimes offer conflicting advice either because of
differences in scientific judgments or because of differences in values. At other times, economists
are united in the advice they offer, but policymakers may choose to ignore the advice because of the
many forces and constraints imposed by the political process.

Key Concepts
circular-flow diagram, p. 22
production possibilities frontier, p. 24
microeconomics, p. 27

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macroeconomics, p. 27
positive statements, p. 28
normative statements, p. 28

Questions for Review

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c.
d.

2.
a.
b.
c.
d.

3.
a.
b.
c.
d.

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book may be reproduced or transmitted without publisher’s prior permission. Violators will be prosecuted.

How is economics a science?
2. Why do economists make assumptions?
3. Should an economic model describe reality exactly?
4. Name a way that your family interacts in the factor market and a way that it interacts in the product

market.
5. Name one economic interaction that isn’t covered by the simplified circular-flow diagram.
6. Draw and explain a production possibilities frontier for an economy that produces milk and

cookies. What happens to this frontier if disease kills half of the economy’s cows?
7. Use a production possibilities frontier to describe the idea of “efficiency.”
8. What are the two subfields into which economics is divided? Explain what each subfield studies.
9. What is the difference between a positive and a normative statement? Give an example of each.

10. Why do economists sometimes offer conflicting advice to policymakers?

Quick Check Multiple Choice
An economic model is

a mechanical machine that replicates the functioning of the economy.
a fully detailed, realistic description of the economy.
a simplified representation of some aspect of the economy.
a computer program that predicts the future of the economy.

The circular-flow diagram illustrates that, in markets for the factors of production,
households are sellers, and firms are buyers.
households are buyers, and firms are sellers.
households and firms are both buyers.
households and firms are both sellers.

A point inside the production possibilities frontier is
efficient, but not feasible.
feasible, but not efficient.
both efficient and feasible.
neither efficient nor feasible.

An economy produces hot dogs and hamburgers. If a discovery of the remarkable health benefits of
hot dogs were to change consumers’ preferences, it would

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a.
b.
c.
d.

5.
a.
b.
c.
d.

6.
a.
b.
c.
d.

1.
a.
b.
c.
d.
2.
a.
b.

expand the production possibilities frontier.
contract the production possibilities frontier.
move the economy along the production possibilities frontier.
move the economy inside the production possibilities frontier.

All of the following topics fall within the study of microeconomics EXCEPT
the impact of cigarette taxes on the smoking behavior of teenagers.
the role of Microsoft’s market power in the pricing of software.
the effectiveness of antipoverty programs in reducing homelessness.
the influence of the government budget deficit on economic growth.

Which of the following is a positive, rather than a normative, statement?
Law X will reduce national income.
Law X is a good piece of legislation.
Congress ought to pass law X.
The president should veto law X.

Problems and Applications
Draw a circular-flow diagram. Identify the parts of the model that correspond to the flow of goods
and services and the flow of dollars for each of the following activities.

Selena pays a storekeeper $1 for a quart of milk.
Stuart earns $4.50 per hour working at a fast-food restaurant.
Shanna spends $30 to get a haircut.
Salma earns $10,000 from her 10 percent ownership of Acme Industrial.

Imagine a society that produces military goods and consumer goods, which we’ll call “guns” and
“butter.”

Draw a production possibilities frontier for guns and butter. Using the concept of opportunity
cost, explain why it most likely has a bowed-out shape.

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c.
d.
3.
4.
a.

•
•
•
•

b.
c.
d.

5.
a.
b.
c.
d.
e.

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this book may be reproduced or transmitted without publisher’s prior permission. Violators will be
prosecuted.

Show a point that is impossible for the economy to achieve. Show a point that is feasible but
inefficient.
Imagine that the society has two political parties, called the Hawks (who want a strong
military) and the Doves (who want a smaller military). Show a point on your production
possibilities frontier that the Hawks might choose and a point that the Doves might choose.
Imagine that an aggressive neighboring country reduces the size of its military. As a result,
both the Hawks and the Doves reduce their desired production of guns by the same amount.
Which party would get the bigger “peace dividend,” measured by the increase in butter
production? Explain.

The first principle of economics discussed in Chapter 1 is that people face trade-offs. Use a
production possibilities frontier to illustrate society’s trade-off between two “goods”—a clean
environment and the quantity of industrial output. What do you suppose determines the shape and
position of the frontier? Show what happens to the frontier if engineers develop a new way of
producing electricity that emits fewer pollutants.
An economy consists of three workers: Larry, Moe, and Curly. Each works 10 hours a day and can
produce two services: mowing lawns and washing cars. In an hour, Larry can either mow one lawn
or wash one car; Moe can either mow one lawn or wash two cars; and Curly can either mow two
lawns or wash one car.

Calculate how much of each service is produced under the following circumstances, which we
label A, B, C, and D:

All three spend all their time mowing lawns. (A)
All three spend all their time washing cars. (B)
All three spend half their time on each activity. (C)
Larry spends half his time on each activity, while Moe only washes cars and Curly only
mows lawns. (D)

Graph the production possibilities frontier for this economy. Using your answers to part (a),
identify points A, B, C, and D on your graph.
Explain why the production possibilities frontier has the shape it does.
Are any of the allocations calculated in part (a) inefficient? Explain.

Classify the following topics as relating to microeconomics or macroeconomics.
a family’s decision about how much income to save
the effect of government regulations on auto emissions
the impact of higher national saving on economic growth
a firm’s decision about how many workers to hire
the relationship between the inflation rate and changes in the quantity of money

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6.
a.
b.
c.
d.
e.

Classify each of the following statements as positive or normative. Explain.
Society faces a short-run trade-off between inflation and unemployment.
A reduction in the rate of money growth will reduce the rate of inflation.
The Federal Reserve should reduce the rate of money growth.
Society ought to require welfare recipients to look for jobs.
Lower tax rates encourage more work and more saving.

Go to CengageBrain.com to purchase access to the proven, critical Study Guide to accompany this
text, which features additional notes and context, practice tests, and much more.

Appendix
Graphing: A Brief Review

http://cengagebrain.com/

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Many of the concepts that economists study can be expressed with numbers—the price of bananas, the
quantity of bananas sold, the cost of growing bananas, and so on. Often, these economic variables are
related to one another: When the price of bananas rises, people buy fewer bananas. One way of
expressing the relationships among variables is with graphs.

Graphs serve two purposes. First, when developing economic theories, graphs offer a way to
visually express ideas that might be less clear if described with equations or words. Second, when
analyzing economic data, graphs provide a powerful way of finding and interpreting patterns. Whether
we are working with theory or with data, graphs provide a lens through which a recognizable forest
emerges from a multitude of trees.

Numerical information can be expressed graphically in many ways, just as there are many ways to
express a thought in words. A good writer chooses words that will make an argument clear, a
description pleasing, or a scene dramatic. An effective economist chooses the type of graph that best
suits the purpose at hand.

In this appendix, we discuss how economists use graphs to study the mathematical relationships
among variables. We also discuss some of the pitfalls that can arise in the use of graphical methods.

Graphs of a Single Variable
Three common graphs are shown in Figure A-1. The pie chart in panel (a) shows how total income in
the United States is divided among the sources of income, including compensation of employees,
corporate profits, and so on. A slice of the pie represents each source’s share of the total. The bar
graph in panel (b) compares income for four countries. The height of each bar represents the average

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income in each country. The time-series graph in panel (c) traces the rising productivity in the U.S.
business sector over time. The height of the line shows output per hour in each year. You have
probably seen similar graphs in newspapers and magazines.

FIGURE A-1
Types of Graphs
The pie chart in panel (a) shows how the U.S. national income in 2011 was derived from various sources. The
bar graph in panel (b) compares the 2011 average income in four countries. The time-series graph in panel (c)
shows the productivity of labor in U.S. businesses from 1950 to 2010.

Graphs of Two Variables: The Coordinate System
The three graphs in Figure A-1 are useful in showing how a variable changes over time or across
individuals, but they are limited in how much they can tell us. These graphs display information only
about a single variable. Economists are often concerned with the relationships between variables.
Thus, they need to display two variables on a single graph. The coordinate system makes this possible.

Suppose you want to examine the relationship between study time and grade point average. For
each student in your class, you could record a pair of numbers: hours per week spent studying and
grade point average. These numbers could then be placed in parentheses as an ordered pair and appear
as a single point on the graph. Albert E., for instance, is represented by the ordered pair (25
hours/week, 3.5 GPA), while his “what-me-worry?” classmate Alfred E. is represented by the ordered
pair (5 hours/week, 2.0 GPA).

We can graph these ordered pairs on a two-dimensional grid. The first number in each ordered pair,
called the x-coordinate, tells us the horizontal location of the point. The second number, called the y-
coordinate, tells us the vertical location of the point. The point with both an x-coordinate and a y-
coordinate of zero is known as the origin. The two coordinates in the ordered pair tell us where the
point is located in relation to the origin: x units to the right of the origin and y units above it.

Figure A-2 graphs grade point average against study time for Albert E., Alfred E., and their

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classmates. This type of graph is called a scatterplot because it plots scattered points. Looking at this
graph, we immediately notice that points farther to the right (indicating more study time) also tend to
be higher (indicating a better grade point average). Because study time and grade point average
typically move in the same direction, we say that these two variables have a positive correlation.

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By contrast, if we were to graph party time and grades, we would likely find that higher party time
is associated with lower grades; because these variables typically move in opposite directions, we say
that they have a negative correlation. In either case, the coordinate system makes the correlation
between the two variables easy to see.

FIGURE A-2
Using the Coordinate System
Grade point average is measured on the vertical axis and study time on the horizontal axis. Albert E., Alfred E.,
and their classmates are represented by various points. We can see from the graph that students who study more
tend to get higher grades.

Curves in the Coordinate System
Students who study more do tend to get higher grades, but other factors also influence a student’s
grades. Previous preparation is an important factor, for instance, as are talent, attention from teachers,
even eating a good breakfast. A scatterplot like Figure A-2 does not attempt to isolate the effect that
studying has on grades from the effects of other variables. Often, however, economists prefer looking
at how one variable affects another, holding everything else constant.

To see how this is done, let’s consider one of the most important graphs in economics: the demand
curve. The demand curve traces out the effect of a good’s price on the quantity of the good consumers
want to buy. Before showing a demand curve, however, consider Table A-1, which shows how the
number of novels that Emma buys depends on her income and on the price of novels. When novels are
cheap, Emma buys them in large quantities. As they become more expensive, she instead borrows

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books from the library or chooses to go to the movies rather than read. Similarly, at any given price,
Emma buys more novels when she has a higher income. That is, when her income increases, she
spends part of the additional income on novels and part on other goods.

We now have three variables—the price of novels, income, and the number of novels purchased—
which are more than we can represent in two dimensions. To put the information from Table A-1 in
graphical form, we need to hold one of the three variables constant and trace out the relationship
between the other two. Because the demand curve represents the relationship between price and
quantity demanded, we hold Emma’s income constant and show how the number of novels she buys
varies with the price of novels.

Suppose that Emma’s income is $30,000 per year. If we place the number of novels Emma
purchases on the x-axis and the price of novels on the y-axis, we can graphically represent the middle
column of Table A-1. When the points that represent these entries from the table—(5 novels, $10), (9
novels, $9), and so on—are connected, they form a line. This line, pictured in Figure A-3, is known as
Emma’s demand curve for novels; it tells us how many novels Emma purchases at any given price.
The demand curve is downward sloping, indicating that a higher price reduces the quantity of novels
demanded. Because the quantity of novels demanded and the price move in opposite directions, we say
that the two variables are negatively related. (Conversely, when two variables move in the same
direction, the curve relating them is upward sloping, and we say that the variables are positively
related.)

TABLE A-1
Novels Purchased by Emma
This table shows the number of novels Emma buys at various incomes and prices. For any given
level of income, the data on price and quantity demanded can be graphed to produce Emma’s
demand curve for novels, as shown in Figures A-3 and A-4.

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FIGURE A-3
Demand Curve
The line D1 shows how Emma’s purchases of novels depend on the price of novels when her income is held
constant. Because the price and the quantity demanded are negatively related, the demand curve slopes
downward.

Now suppose that Emma’s income rises to $40,000 per year. At any given price, Emma will
purchase more novels than she did at her previous level of income. Just as earlier we drew Emma’s
demand curve for novels using the entries from the middle column of Table A-1, we now draw a new
demand curve using the entries from the right column of the table. This new demand curve (curve D2)
is pictured alongside the old one (curve D1 in Figure A-4; the new curve is a similar line drawn farther
to the right. We therefore say that Emma’s demand curve for novels shifts to the right when her income
increases. Likewise, if Emma’s income were to fall to $20,000 per year, she would buy fewer novels at
any given price and her demand curve would shift to the left (to curve D3).

In economics, it is important to distinguish between movements along a curve and shifts of a curve.
As we can see from Figure A-3, if Emma earns $30,000 per year and novels cost $8 apiece, she will
purchase 13 novels per year. If the price of novels falls to $7, Emma will increase her purchases of
novels to 17 per year. The demand curve, however, stays fixed in the same place. Emma still buys the
same number of novels at each price, but as the price falls, she moves along her demand curve from

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left to right. By contrast, if the price of novels remains fixed at $8 but her income rises to $40,000,
Emma increases her purchases of novels from 13 to 16 per year. Because Emma buys more novels at
each price, her demand curve shifts out, as shown in Figure A-4.

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FIGURE A-4
Shifting Demand Curves
The location of Emma’s demand curve for novels depends on how much income she earns. The more she earns,
the more novels she will purchase at any given price, and the farther to the right her demand curve will lie.
Curve D1 represents Emma’s original demand curve when her income is $30,000 per year. If her income rises to
$40,000 per year, her demand curve shifts to D2. If her income falls to $20,000 per year, her demand curve
shifts to D3.

There is a simple way to tell when it is necessary to shift a curve: When a relevant variable that is
not named on either axis changes, the curve shifts. Income is on neither the x-axis nor the y-axis of the
graph, so when Emma’s income changes, her demand curve must shift. The same is true for any
change that affects Emma’s purchasing habits, with the sole exception of a change in the price of
novels. If, for instance, the public library closes and Emma must buy all the books she wants to read,
she will demand more novels at each price, and her demand curve will shift to the right. Or if the price
of movies falls and Emma spends more time at the movies and less time reading, she will demand
fewer novels at each price, and her demand curve will shift to the left. By contrast, when a variable on
an axis of the graph changes, the curve does not shift. We read the change as a movement along the
curve.

Slope

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One question we might want to ask about Emma is how much her purchasing habits respond to price.
Look at the demand curve pictured in Figure A-5. If this curve is very steep, Emma purchases nearly
the same number of novels regardless of whether they are cheap or expensive. If this curve is much
flatter, the number of novels Emma purchases is more sensitive to changes in the price. To answer
questions about how much one variable responds to changes in another variable, we can use the
concept of slope.

The slope of a line is the ratio of the vertical distance covered to the horizontal distance covered as
we move along the line. This definition is usually written out in mathematical symbols as follows:

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FIGURE A-5
Calculating the Slope of a line
To calculate the slope of the demand curve, we can look at the changes in the x- and y-coordinates as we move
from the point (21 novels, $6) to the point (13 novels, $8). The slope of the line is the ratio of the change in the
y-coordinate (−2) to the change in the x- coordinate (+8), which equals −¼.

where the Greek letter Δ (delta) stands for the change in a variable. In other words, the slope of a line
is equal to the “rise” (change in y) divided by the “run” (change in x). The slope will be a small
positive number for a fairly flat upward-sloping line, a large positive number for a steep upward-
sloping line, and a negative number for a downward-sloping line. A horizontal line has a slope of zero
because in this case the y-variable never changes; a vertical line is said to have an infinite slope
because the y-variable can take any value without the x-variable changing at all.

What is the slope of Emma’s demand curve for novels? First of all, because the curve slopes down,
we know the slope will be negative. To calculate a numerical value for the slope, we must choose two
points on the line. With Emma’s income at $30,000, she will purchase 21 novels at a price of $6 or 13
novels at a price of $8. When we apply the slope formula, we are concerned with the change between
these two points; in other words, we are concerned with the difference between them, which lets us
know that we will have to subtract one set of values from the other, as follows:

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Figure A-5 shows graphically how this calculation works. Try computing the slope of Emma’s demand
curve using two different points. You should get exactly the same result, −1/4. One of the properties of
a straight line is that it has the same slope everywhere. This is not true of other types of curves, which
are steeper in some places than in others.

The slope of Emma’s demand curve tells us something about how responsive her purchases are to
changes in the price. A small slope (a number close to zero) means that Emma’s demand curve is
relatively flat; in this case, she adjusts the

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number of novels she buys substantially in response to a price change. A larger slope (a number
farther from zero) means that Emma’s demand curve is relatively steep; in this case, she adjusts the
number of novels she buys only slightly in response to a price change.

Cause and Effect
Economists often use graphs to advance an argument about how the economy works. In other words,
they use graphs to argue about how one set of events causes another set of events. With a graph like
the demand curve, there is no doubt about cause and effect. Because we are varying price and holding
all other variables constant, we know that changes in the price of novels cause changes in the quantity
Emma demands. Remember, however, that our demand curve came from a hypothetical example.
When graphing data from the real world, it is often more difficult to establish how one variable affects
another.

The first problem is that it is difficult to hold everything else constant when studying the
relationship between two variables. If we are not able to hold other variables constant, we might
decide that one variable on our graph is causing changes in the other variable when those changes are
actually being caused by a third omitted variable not pictured on the graph. Even if we have identified
the correct two variables to look at, we might run into a second problem—reverse causality. In other
words, we might decide that A causes B when in fact B causes A. The omitted-variable and reverse-
causality traps require us to proceed with caution when using graphs to draw conclusions about causes
and effects.

Omitted Variables To see how omitting a variable can lead to a deceptive graph, let’s consider an
example. Imagine that the government, spurred by public concern about the large number of deaths
from cancer, commissions an exhaustive study from Big Brother Statistical Services, Inc. Big Brother
examines many of the items found in people’s homes to see which of them are associated with the risk
of cancer. Big Brother reports a strong relationship between two variables: the number of cigarette
lighters that a household owns and the probability that someone in the household will develop cancer.
Figure A-6 shows this relationship.

What should we make of this result? Big Brother advises a quick policy response. It recommends
that the government discourage the ownership of cigarette lighters by taxing their sale. It also
recommends that the government require warning labels: “Big Brother has determined that this lighter
is dangerous to your health.”

FIGURE A-6
Graph with an Omitted Variable
The upward-sloping curve shows that members of households with more cigarette lighters are more likely to
develop cancer. Yet we should not conclude that ownership of lighters causes cancer because the graph does not
take into account the number of cigarettes smoked.

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In judging the validity of Big Brother’s analysis, one question is key: Has Big Brother held constant
every relevant variable except the one under consideration? If the answer is no, the results are suspect.
An easy explanation for Figure A-6 is that people who own more cigarette lighters are more likely to
smoke cigarettes and that cigarettes, not lighters, cause cancer. If Figure A-6 does not hold constant
the amount of smoking, it does not tell us the true effect of owning a cigarette lighter.

This story illustrates an important principle: When you see a graph used to support an argument
about cause and effect, it is important to ask whether the movements of an omitted variable could
explain the results you see.

Reverse Causality Economists can also make mistakes about causality by misreading its direction.
To see how this is possible, suppose the Association of American Anarchists commissions a study of
crime in America and arrives at Figure A-7, which plots the number of violent crimes per thousand
people in major cities against the number of police officers per thousand people. The anarchists note
the curve’s upward slope and argue that because police increase rather than decrease the amount of
urban violence, law enforcement should be abolished.

If we could run a controlled experiment, we would avoid the danger of reverse causality. To run an
experiment, we would randomly assign different numbers of police to different cities and then
examine the correlation between police and crime. Figure A-7, however, is not based on such an
experiment. We simply observe that more dangerous cities have more police officers. The explanation
for

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CHAPTER

3
Interdependence and the Gains from

Trade

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onsider your typical day. You wake up in the morning and pour yourself juice from oranges
grown in Florida and coffee from beans grown in Brazil. Over breakfast, you watch a news

program broadcast from New York on your television made in China. You get dressed in clothes made
of cotton grown in Georgia and sewn in factories in Thailand. You drive to class in a car made of parts
manufactured in more than a dozen countries around the world. Then you open up your economics
textbook written by an author living in Massachusetts, published by a company located in Ohio, and
printed on paper made from trees grown in Oregon.

Every day, you rely on many people, most of whom you have never met, to provide you with the

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goods and services that you enjoy. Such interdependence is possible because people trade with one
another. Those people providing you with goods and services are not acting out of generosity. Nor is
some government agency directing them to satisfy your desires. Instead,

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people provide you and other consumers with the goods and services they produce because they get
something in return.

In subsequent chapters, we examine how an economy coordinates the activities of millions of
people with varying tastes and abilities. As a starting point for this analysis, in this chapter we consider
the reasons for economic interdependence. One of the Ten Principles of Economics highlighted in
Chapter 1 is that trade can make everyone better off. We now examine this principle more closely.
What exactly do people gain when they trade with one another? Why do people choose to become
interdependent?

The answers to these questions are key to understanding the modern global economy. Most
countries today import from abroad many of the goods and services they consume, and they export to
foreign customers many of the goods and services they produce. The analysis in this chapter explains
interdependence not only among individuals but also among nations. As we will see, the gains from
trade are much the same whether you are buying a haircut from your local barber or a T-shirt made by
a worker on the other side of the globe.

3-1 A Parable for the Modern Economy
To understand why people choose to depend on others for goods and services and how this choice
improves their lives, let’s look at a simple economy. Imagine that there are two goods in the world:
meat and potatoes. And there are two people in the world—a cattle rancher named Rose and a potato
farmer named Frank—each of whom would like to eat both meat and potatoes.

The gains from trade are most obvious if Rose can produce only meat and Frank can produce only
potatoes. In one scenario, Frank and Rose could choose to have nothing to do with each other. But
after several months of eating beef roasted, boiled, broiled, and grilled, Rose might decide that self-
sufficiency is not all it’s cracked up to be. Frank, who has been eating potatoes mashed, fried, baked,
and scalloped, would likely agree. It is easy to see that trade would allow them to enjoy greater
variety: Each could then have a steak with a baked potato or a burger with fries.

Although this scene illustrates most simply how everyone can benefit from trade, the gains would be
similar if Frank and Rose were each capable of producing the other good, but only at great cost.
Suppose, for example, that Rose is able to grow potatoes but her land is not very well suited for it.
Similarly, suppose that Frank is able to raise cattle and produce meat but he is not very good at it. In
this case, Frank and Rose can each benefit by specializing in what he or she does best and then trading
with the other person.

The gains from trade are less obvious, however, when one person is better at producing every good.
For example, suppose that Rose is better at raising cattle and better at growing potatoes than Frank. In
this case, should Rose choose to remain self-sufficient? Or is there still reason for her to trade with
Frank? To answer this question, we need to look more closely at the factors that affect such a decision.

3-1a Production Possibilities
Suppose that Frank and Rose each work 8 hours per day and can devote this time to growing potatoes,

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raising cattle, or a combination of the two. The table in Figure 1 shows the amount of time each person
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each good. Frank can produce an ounce of potatoes in 15 minutes and an ounce of meat in 60 minutes.
Rose, who is more productive in both activities, can produce an ounce of potatoes in 10 minutes and
an ounce of meat in 20 minutes. The last two columns in the table show the amounts of meat or
potatoes Frank and Rose can produce if they devote all 8 hours to producing only that good.

FIGURE 1
The Production Possibilities Frontier
Panel (a) shows the production opportunities available to Frank the farmer and Rose the rancher. Panel (b)
shows the combinations of meat and potatoes that Frank can produce. Panel (c) shows the combinations of meat
and potatoes that Rose can produce. Both production possibilities frontiers are derived assuming that Frank and
Rose each work 8 hours per day. If there is no trade, each person’s production possibilities frontier is also his or
her consumption possibilities frontier.

Panel (b) of Figure 1 illustrates the amounts of meat and potatoes that Frank can produce. If Frank
devotes all 8 hours of his time to potatoes, he produces 32 ounces of potatoes (measured on the
horizontal axis) and no meat. If he devotes all his time to meat, he produces 8 ounces of meat
(measured on the vertical axis) and no potatoes. If Frank divides his time equally between the two
activities, spending 4 hours on each, he produces 16 ounces of potatoes and 4 ounces of meat. The
figure shows these three possible outcomes and all others in between.

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This graph is Frank’s production possibilities frontier. As we discussed in Chapter 2, a production
possibilities frontier shows the various mixes of output that an economy can produce. It illustrates one
of the Ten Principles of Economics in Chapter 1: People face trade-offs. Here Frank faces a trade-off
between producing meat and producing potatoes.

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You may recall that the production possibilities frontier in Chapter 2 was drawn bowed out. In that
case, the rate at which society could trade one good for the other depended on the amounts that were
being produced. Here, however, Frank’s technology for producing meat and potatoes (as summarized
in Figure 1) allows him to switch between the two goods at a constant rate. Whenever Frank spends 1
hour less producing meat and 1 hour more producing potatoes, he reduces his output of meat by 1
ounce and raises his output of potatoes by 4 ounces—and this is true regardless of how much he is
already producing. As a result, the production possibilities frontier is a straight line.

Panel (c) of Figure 1 shows the production possibilities frontier for Rose. If Rose devotes all 8 hours
of her time to potatoes, she produces 48 ounces of potatoes and no meat. If she devotes all her time to
meat, she produces 24 ounces of meat and no potatoes. If Rose divides her time equally, spending 4
hours on each activity, she produces 24 ounces of potatoes and 12 ounces of meat. Once again, the
production possibilities frontier shows all the possible outcomes.

If Frank and Rose choose to be self-sufficient rather than trade with each other, then each consumes
exactly what he or she produces. In this case, the production possibilities frontier is also the
consumption possibilities frontier. That is, without trade, Figure 1 shows the possible combinations of
meat and potatoes that Frank and Rose can each produce and then consume.

These production possibilities frontiers are useful in showing the trade-offs that Frank and Rose
face, but they do not tell us what Frank and Rose will actually choose to do. To determine their
choices, we need to know the tastes of Frank and Rose. Let’s suppose they choose the combinations
identified by points A and B in Figure 1. Based on his production opportunities and food preferences,
Frank decides to produce and consume 16 ounces of potatoes and 4 ounces of meat, while Rose
decides to produce and consume 24 ounces of potatoes and 12 ounces of meat.

3-1b Specialization and Trade
After several years of eating combination B, Rose gets an idea and goes to talk to Frank:

ROSE: Frank, my friend, have I got a deal for you! I know how to improve life for both of us. I
think you should stop producing meat altogether and devote all your time to growing
potatoes. According to my calculations, if you work 8 hours a day growing potatoes,
you’ll produce 32 ounces of potatoes. If you give me 15 of those 32 ounces, I’ll give you
5 ounces of meat in return. In the end, you’ll get to eat 17 ounces of potatoes and 5
ounces of meat every day, instead of the 16 ounces of potatoes and 4 ounces of meat you
now get. If you go along with my plan, you’ll have more of both foods. [To illustrate her
point, Rose shows Frank panel (a) of Figure 2.]

FRANK: (sounding skeptical) That seems like a good deal for me. But I don’t understand why you
are offering it. If the deal is so good for me, it can’t be good for you too.

ROSE: Oh, but it is! Suppose I spend 6 hours a day raising cattle and 2 hours growing potatoes.
Then I can produce 18 ounces of meat and 12 ounces of potatoes. After I give you 5
ounces of my meat in exchange for 15 ounces of your potatoes, I’ll end up with 13
ounces of meat and 27 ounces of potatoes, instead of the 12 ounces of meat and 24
ounces of potatoes that I now get. So I will also consume more of both foods than I do
now. [She points out panel (b) of Figure 2.]

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FRANK: I don’t know…. This sounds too good to be true.
ROSE: It’s really not as complicated as it first seems. Here—I’ve summarized my proposal for

you in a simple table. [Rose shows Frank a copy of the table at the bottom of Figure 2.]
FRANK: (after pausing to study the table) These calculations seem correct, but I am puzzled.

How can this deal make us both better off?
ROSE: We can both benefit because trade allows each of us to specialize in doing what we do

best. You will spend more time growing potatoes and less time raising cattle. I will
spend more time raising cattle and less time growing potatoes. As a result of
specialization and trade, each of us can consume more meat and more potatoes without
working any more hours.

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FIGURE 2
How Trade Expands the Set of Consumption Opportunities
The proposed trade between Frank the farmer and Rose the rancher offers each of them a combination of meat
and potatoes that would be impossible in the absence of trade. In panel (a), Frank gets to consume at point A*
rather than point A. In panel (b), Rose gets to consume at point B* rather than point B. Trade allows each to
consume more meat and more potatoes.

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Quick Quiz Draw an example of a production possibilities frontier for Robinson Crusoe, a
shipwrecked sailor who spends his time gathering coconuts and catching fish. Does this frontier limit
Crusoe’s consumption of coconuts and fish if he lives by himself? Does he face the same limits if he
can trade with natives on the island?

3-2 Comparative Advantage: The Driving Force of
Specialization
Rose’s explanation of the gains from trade, though correct, poses a puzzle: If Rose is better at both
raising cattle and growing potatoes, how can Frank ever specialize in doing what he does best? Frank
doesn’t seem to do anything best. To solve this puzzle, we need to look at the principle of comparative
advantage.

As a first step in developing this principle, consider the following question: In our example, who
can produce potatoes at a lower cost—Frank or Rose? There are two possible answers, and in these
two answers lie the solution to our puzzle and the key to understanding the gains from trade.

3-2a Absolute Advantage
One way to answer the question about the cost of producing potatoes is to compare the inputs required
by the two producers. Economists use the term absolute advantage when comparing the productivity
of one person, firm, or nation to that of another. The producer that requires a smaller quantity of inputs
to produce a good is said to have an absolute advantage in producing that good.

absolute advantage the ability to produce a good using fewer inputs than another producer

In our example, time is the only input, so we can determine absolute advantage by looking at how
much time each type of production takes. Rose has an absolute advantage both in producing meat and
in producing potatoes because she requires less time than Frank to produce a unit of either good. Rose
needs to input only 20 minutes to produce an ounce of meat, whereas Frank needs 60 minutes.
Similarly, Rose needs only 10 minutes to produce an ounce of potatoes, whereas Frank needs 15
minutes. Based on this information, we can conclude that Rose has the lower cost of producing
potatoes, if we measure cost in terms of the quantity of inputs.

3-2b Opportunity Cost and Comparative Advantage
There is another way to look at the cost of producing potatoes. Rather than comparing inputs required,
we can compare opportunity costs. Recall from Chapter 1 that the opportunity cost of some item is
what we give up to get that item. In our example, we assumed that Frank and Rose each spend 8 hours
a day working. Time spent producing potatoes, therefore, takes away from time available for
producing meat. When reallocating time between the two goods, Rose and Frank give up units of one
good to produce units of the other, thereby moving along the production possibilities frontier. The
opportunity cost measures the trade-off between the two goods that each producer faces.

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opportunity cost whatever must be given up to obtain some item

Let’s first consider Rose’s opportunity cost. According to the table in panel (a) of Figure 1,
producing 1 ounce of potatoes takes 10 minutes of work. When Rose spends those 10 minutes
producing potatoes, she spends 10 minutes less

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producing meat. Because Rose needs 20 minutes to produce 1 ounce of meat, 10 minutes of work
would yield ½ ounce of meat. Hence, Rose’s opportunity cost of producing 1 ounce of potatoes is ½
ounce of meat.

TABLE 1
The Opportunity Cost of Meat and Potatoes

Opportunity Cost of:
1 oz of Meat 1 oz of Potatoes

Frank the farmer 4 oz potatoes ¼, oz meat
Rose the rancher 2 oz potatoes ½ oz meat

Now consider Frank’s opportunity cost. Producing 1 ounce of potatoes takes him 15 minutes.
Because he needs 60 minutes to produce 1 ounce of meat, 15 minutes of work would yield ¼ ounce of
meat. Hence, Frank’s opportunity cost of 1 ounce of potatoes is ¼ ounce of meat.

Table 1 shows the opportunity costs of meat and potatoes for the two producers. Notice that the
opportunity cost of meat is the inverse of the opportunity cost of potatoes. Because 1 ounce of potatoes
costs Rose ½ ounce of meat, 1 ounce of meat costs Rose 2 ounces of potatoes. Similarly, because 1
ounce of potatoes costs Frank ¼ ounce of meat, 1 ounce of meat costs Frank 4 ounces of potatoes.

Economists use the term comparative advantage when describing the opportunity costs faced by
two producers. The producer who gives up less of other goods to produce Good X has the smaller
opportunity cost of producing Good X and is said to have a comparative advantage in producing it. In
our example, Frank has a lower opportunity cost of producing potatoes than Rose: An ounce of
potatoes costs Frank only ¼ ounce of meat, but it costs Rose ½ ounce of meat. Conversely, Rose has a
lower opportunity cost of producing meat than Frank: An ounce of meat costs Rose 2 ounces of
potatoes, but it costs Frank 4 ounces of potatoes. Thus, Frank has a comparative advantage in growing
potatoes, and Rose has a comparative advantage in producing meat.

comparative advantage the ability to produce a good at a lower opportunity cost than another
producer

Although it is possible for one person to have an absolute advantage in both goods (as Rose does in
our example), it is impossible for one person to have a comparative advantage in both goods. Because
the opportunity cost of one good is the inverse of the opportunity cost of the other, if a person’s
opportunity cost of one good is relatively high, the opportunity cost of the other good must be
relatively low. Comparative advantage reflects the relative opportunity cost. Unless two people have
the same opportunity cost, one person will have a comparative advantage in one good, and the other
person will have a comparative advantage in the other good.

3-2c Comparative Advantage and Trade

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The gains from specialization and trade are based not on absolute advantage but on comparative
advantage. When each person specializes in producing the good for which he or she has a comparative
advantage, total production in the economy rises. This increase in the size of the economic pie can be
used to make everyone better off.

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In our example, Frank spends more time growing potatoes, and Rose spends more time producing
meat. As a result, the total production of potatoes rises from 40 to 44 ounces, and the total production
of meat rises from 16 to 18 ounces. Frank and Rose share the benefits of this increased production.

We can also look at the gains from trade in terms of the price that each party pays the other. Because
Frank and Rose have different opportunity costs, they can both get a bargain. That is, each of them
benefits from trade by obtaining a good at a price that is lower than his or her opportunity cost of that
good.

Consider the proposed deal from Frank’s viewpoint. Frank receives 5 ounces of meat in exchange
for 15 ounces of potatoes. In other words, Frank buys each ounce of meat for a price of 3 ounces of
potatoes. This price of meat is lower than his opportunity cost for an ounce of meat, which is 4 ounces
of potatoes. Thus, Frank benefits from the deal because he gets to buy meat at a good price.

Now consider the deal from Rose’s viewpoint. Rose buys 15 ounces of potatoes for a price of 5
ounces of meat. That is, the price of potatoes is ⅓ ounce of meat. This price of potatoes is lower than
her opportunity cost of an ounce of potatoes, which is ½ ounce of meat. Rose benefits because she gets
to buy potatoes at a good price.

The story of Rose the rancher and Frank the farmer has a simple moral, which should now be clear:
Trade can benefit everyone in society because it allows people to specialize in activities in which they
have a comparative advantage.

3-2d The Price of the Trade
The principle of comparative advantage establishes that there are gains from specialization and trade,
but it raises a couple of related questions: What determines the price at which trade takes place? How
are the gains from trade shared between the trading parties? The precise answer to these questions is
beyond the scope of this chapter, but we can state one general rule: For both parties to gain from
trade, the price at which they trade must lie between the two opportunity costs.

In our example, Frank and Rose agreed to trade at a rate of 3 ounces of potatoes for each ounce of
meat. This price is between Rose’s opportunity cost (2 ounces of potatoes per ounce of meat) and
Frank’s opportunity cost (4 ounces of potatoes per ounce of meat). The price need not be exactly in the
middle for both parties to gain, but it must be somewhere between 2 and

To see why the price has to be in this range, consider what would happen if it were not. If the price
of meat were below 2 ounces of potatoes, both Frank and Rose would want to buy meat, because the
price would be below each of their opportunity costs. Similarly, if the price of meat were above 4
ounces of potatoes, both would want to sell meat, because the price would be above their opportunity
costs. But there are only two members of this economy. They cannot both be buyers of meat, nor can
they both be sellers. Someone has to take the other side of the deal.

A mutually advantageous trade can be struck at a price between 2 and 4. In this price range, Rose
wants to sell meat to buy potatoes, and Frank wants to sell potatoes to buy meat. Each party can buy a
good at a price that is lower than his or her opportunity cost. In the end, each person specializes in the
good for which he or she has a comparative advantage and is, as a result, better off.

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Quick Quiz Robinson Crusoe can gather 10 coconuts or catch 1 fish per hour. His friend Friday
can gather 30 coconuts or catch 2 fish per hour. What is Crusoe’s opportunity cost of catching 1 fish?
What is Friday’s? Who has an absolute advantage in catching fish? Who has a comparative advantage
in catching fish?

FYI The Legacy of Adam Smith and David Ricardo

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conomists have long understood the gains from trade. Here is how the great economist Adam
Smith put the argument:

It is a maxim of every prudent master of a family, never to attempt to make at home what it will
cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys
them of the shoemaker. The shoemaker does not attempt to make his own clothes but employs a
tailor. The farmer attempts to make neither the one nor the other, but employs those different
artificers. All of them find it for their interest to employ their whole industry in a way in which they
have some advantage over their neighbors, and to purchase with a part of its produce, or what is
the same thing, with the price of part of it, whatever else they have occasion for.

This quotation is from Smith’s 1776 book An Inquiry into the Nature and Causes of the Wealth of
Nations, which was a landmark in the analysis of trade and economic interdependence.

David Ricardo

Smith’s book inspired David Ricardo, a millionaire stockbroker, to become an economist. In his
1817 book Principles of Political Economy and Taxation, Ricardo developed the principle of
comparative advantage as we know it today. He considered an example with two goods (wine and
cloth) and two countries (England and Portugal). He showed that both countries can gain by
opening up trade and specializing based on comparative advantage.

Ricardo’s theory is the starting point of modern international economics, but his defense of free
trade was not a mere academic exercise. Ricardo put his beliefs to work as a member of the British
Parliament, where he opposed the Corn Laws, which restricted the import of grain.

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The conclusions of Adam Smith and David Ricardo on the gains from trade have held up well
over time. Although economists often disagree on questions of policy, they are united in their
support of free trade. Moreover, the central argument for free trade has not changed much in the past
two centuries. Even though the field of economics has broadened its scope and refined its theories
since the time of Smith and Ricardo, economists’ opposition to trade restrictions is still based largely
on the principle of comparative advantage.

3-3 Applications of Comparative Advantage
The principle of comparative advantage explains interdependence and the gains from trade. Because
interdependence is so prevalent in the modern world, the principle of comparative advantage has many
applications. Here are two examples, one fanciful and one of great practical importance.

3-3a Should Tom Brady Mow His Own Lawn?
Tom Brady spends a lot of time running around on grass. One of the most talented football players of
all time, he can throw a pass with a speed and accuracy that most casual athletes can only dream of.
Most likely, he is talented at other physical activities as well. For example, let’s imagine that Brady can
mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he
should?

To answer this question, we can use the concepts of opportunity cost and comparative advantage.
Let’s say that Brady can mow his lawn in 2 hours. In that same 2 hours, he could film a television
commercial and earn $20,000. By contrast, Forrest Gump, the boy next door, can mow Brady’s lawn in
4 hours. In that same 4 hours, Gump could work at McDonald’s and earn $40.

“They did a nice job mowing this grass. “

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IN THE NEWS Economics within a Marriage

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An economist argues that you shouldn’t always unload the dishwasher justAn economist argues that you shouldn’t always unload the dishwasher just
because you’re better than your partner at itbecause you’re better than your partner at it.
You’re Dividing the Chores Wrong
By Emily Oster

o one likes doing chores. In happiness surveys, housework is ranked down there with
commuting as activities that people enjoy the least. Maybe that’s why figuring out who does

which chores usually prompts, at best, tense discussion in a household and, at worst, outright
fightin

If everyone is good at something different, assigning chores is easy. If your partner is great at
grocery shopping and you are great at the laundry, you’re set. But this isn’t always—or even usually
—the case. Often one person is better at everything. (And let’s be honest, often that person is the
woman.) Better at the laundry, the grocery shopping, the cleaning, the cooking. But does that mean
she should have to do everything?

Before my daughter was born, I both cooked and did the dishes. It wasn’t a big deal, it didn’t take
too much time, and honestly I was a lot better at both than my husband. His cooking repertoire
extended only to eggs and chili, and when I left him in charge of the dishwasher, I’d often find he
had run it “full” with one pot and eight forks.

After we had a kid, we had more to do and less time to do it in. It seemed like it was time for
some reassignments. But, of course, I was still better at doing both things. Did that mean I should do
them both?

I could have appealed to the principle of fairness: We should each do half. I could have appealed
to feminism—surveys show that women more often than not get the short end of the chore stick. In
time-use data, women do about 44 minutes more housework than men (2 hours and 11 minutes
versus 1 hour and 27 minutes). Men outwork women only in the areas of “lawn” and “exterior
maintenance.” I could have suggested he do more chores to rectify this imbalance, to show our
daughter, in the Free To Be You and Me style, that Mom and Dad are equal and that housework is
fun if we do it together! I could have simply smashed around the pans in the dishwasher while
sighing loudly in the hopes he would notice and offer to do it himself.

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But luckily for me and my husband, I’m an economist, so I have more effective tools than passive
aggression. And some basic economic principles provided the answer. We needed to divide the
chores because it is simply not efficient for the best cook and dishwasher to do all the cooking and
dishwashing. The economic principle at play here is increasing marginal cost. Basically, people get
worse when they are tired. When I teach my students at the University of Chicago this principle, I
explain it in the context of managing their employees. Imagine you have a good employee and a
not-so-good one. Should you make the good employee do literally everything?

Usually, the answer is no. Why not? It’s likely that the not-so-good employee is better at 9 a.m.
after a full night of sleep than the good employee is at 2 a.m. after a 17-hour workday. So you want
to give at least a few tasks to your worse guy. The same principle applies in your household. Yes,
you (or your spouse) might be better at everything. But anyone doing the laundry at 4 a.m. is likely
to put the red towels in with the white T-shirts. Some task splitting is a good idea. How much
depends on how fast people’s skills decay.

To “optimize” your family efficiency (every economist’s ultimate goal—and yours, too), you
want to equalize effectiveness on the final

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task each person is doing. Your partner does the dishes, mows the lawn, and makes the grocery
list. You do the cooking, laundry, shopping, cleaning, and paying the bills. This may seem
imbalanced, but when you look at it, you see that by the time your partner gets to the grocery-list
task, he is wearing thin and starting to nod off. It’s all he can do to figure out how much milk you
need. In fact, he is just about as good at that as you are when you get around to paying the bills,
even though that’s your fifth task.

If you then made your partner also do the cleaning—so it was an even four and four—the house
would be a disaster, since he is already exhausted by his third chore while you are still doing fine.
This system may well end up meaning one person does more, but it is unlikely to result in one
person doing everything.

Once you’ve decided you need to divide up the chores in this way, how should you decide who
does what? One option would be randomly assigning tasks; another would be having each person do
some of everything. One spousal-advice website I read suggested you should divide tasks based on
which ones you like the best. None of these are quite right. (In the last case, how would anyone ever
end up with the job of cleaning the bathroom?)

To decide who does what, we need more economics. Specifically, the principle of comparative
advantage. Economists usually talk about this in the context of trade. Imagine Finland is better than
Sweden at making both reindeer hats and snowshoes. But they are much, much better at the hats and
only a little better at the snowshoes. The overall world production is maximized when Finland
makes hats and Sweden makes snowshoes.

We say that Finland has an absolute advantage in both things but a comparative advantage only
in hats. This principle is part of the reason economists value free trade, but that’s for another column
(and probably another author). But it’s also a guideline for how to trade tasks in your house. You
want to assign each person the tasks on which he or she has a comparative advantage. It doesn’t
matter that you have an absolute advantage in everything. If you are much, much better at the
laundry and only a little better at cleaning the toilet, you should do the laundry and have your
spouse get out the scrub brush. Just explain that it’s efficient!

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In our case, it was easy. Other than using the grill—which I freely admit is the husband domain—
I’m much, much better at cooking. And I was only moderately better at the dishes. So he got the job
of cleaning up after meals, even though his dishwasher loading habits had already come under
scrutiny. The good news is another economic principle I hadn’t even counted on was soon in play:
learning by doing. As people do a task, they improve at it. Eighteen months into this new
arrangement the dishwasher is almost a work of art: neat rows of dishes and everything carefully
screened for “top-rack only” status. I, meanwhile, am forbidden from getting near the dishwasher.
Apparently, there is a risk that I’ll “ruin it.”

Ms. Oster is a professor of economics at the University of Chicago.

Source: Slate, November 21, 2012. The article is found in the link:
http://www.slate.com/articles/double_x/doublex/2012/ll/dividing_the_chores_who_should_cook_and_who_should_clean.2.html

In this example, Brady has an absolute advantage in mowing lawns because he can do the work with
a lower input of time. Yet because Brady’s opportunity cost of mowing the lawn is $20,000 and
Gump’s opportunity cost is only $40, Gump has a comparative advantage in mowing lawns.

The gains from trade in this example are tremendous. Rather than mowing his own lawn, Brady
should make the commercial and hire Gump to mow the lawn. As long as Brady pays Gump more than
$40 and less than $20,000, both of them are better off.

3-3b Should the United States Trade with Other Countries?
Just as individuals can benefit from specialization and trade with one another, as Frank and Rose did,
so can populations of people in different countries. Many of the goods that Americans enjoy are
produced abroad, and many of the goods produced in the United States are sold abroad. Goods
produced abroad and sold domestically are called imports. Goods produced domestically and sold
abroad are called exports.

imports goods produced abroad and sold domestically
exports goods produced domestically and sold abroad

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To see how countries can benefit from trade, suppose there are two countries, the United States and
Japan, and two goods, food and cars. Imagine that the two countries produce cars equally well: An
American worker and a Japanese worker can each produce one car per month. By contrast, because the
United States has more and better land, it is better at producing food: A U.S. worker can produce 2
tons of food per month, whereas a Japanese worker can produce only 1 ton of food per month.

The principle of comparative advantage states that each good should be produced by the country
that has the smaller opportunity cost of producing that good. Because the opportunity cost of a car is 2
tons of food in the United States but only 1 ton of food in Japan, Japan has a comparative advantage in
producing cars. Japan should produce more cars than it wants for its own use and export some of them
to the United States. Similarly, because the opportunity cost of a ton of food is 1 car in Japan but only
½ car in the United States, the United States has a comparative advantage in producing food. The
United States should produce more food than it wants to consume and export some to Japan. Through
specialization and trade, both countries can have more food and more cars.

In reality, of course, the issues involved in trade among nations are more complex than this example
suggests. Most important among these issues is that each country has many citizens with different
interests. International trade can make some individuals worse off, even as it makes the country as a
whole better off. When the United States exports food and imports cars, the impact on an American
farmer is not the same as the impact on an American autoworker. Yet, contrary to the opinions
sometimes voiced by politicians and pundits, international trade is not like war, in which some
countries win and others lose. Trade allows all countries to achieve greater prosperity.

Quick Quiz Suppose that a skilled brain surgeon also happens to be the world’s fastest typist.
Should she do her own typing or hire a secretary? Explain.

3-4 Conclusion
You should now understand more fully the benefits of living in an interdependent economy. When
Americans buy tube socks from China, when residents of Maine drink orange juice from Florida, and
when a homeowner hires the kid next door to mow the lawn, the same economic forces are at work.
The principle of comparative advantage shows that trade can make everyone better off.

Having seen why interdependence is desirable, you might naturally ask how it is possible. How do
free societies coordinate the diverse activities of all the people involved in their economies? What
ensures that goods and services will get from those who should be producing them to those who
should be consuming them? In a world with only two people, such as Rose the rancher and Frank the
farmer, the answer is simple: These two people can bargain and allocate resources between
themselves. In the real world with billions of people, the answer is less obvious. We take up this issue
in Chapter 4, where we see that free societies allocate resources through the market forces of supply
and demand.

Summary

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Each person consumes goods and services produced by many other people both in the United States
and around the world. Interdependence and trade are desirable because they allow everyone to
enjoy a greater quantity and variety of goods and services.
There are two ways to compare the ability of two people to produce a good. The person who can
produce the good with the smaller quantity of inputs is said to have an absolute advantage in
producing the good. The person who has the smaller opportunity cost of producing the good is said
to have a comparative advantage. The gains from trade are based on comparative advantage, not
absolute advantage.
Trade makes everyone better off because it allows people to specialize in those activities in which
they have a comparative advantage.
The principle of comparative advantage applies to countries as well as to people. Economists use
the principle of comparative advantage to advocate free trade among countries.

Key Concepts
absolute advantage, p. 52
opportunity cost, p. 52
comparative advantage, p. 53
imports, p. 57
exports, p. 57

Questions for Review
1. Under what conditions is the production possibilities frontier linear rather than bowed out?
2. Explain how absolute advantage and comparative advantage differ.
3. Give an example in which one person has an absolute advantage in doing something but another

person has a comparative advantage.
4. Is absolute advantage or comparative advantage more important for trade? Explain your reasoning

using the example in your answer to Question

5. If two parties trade based on comparative advantage and both gain, in what range must the price of

the trade lie?
6. Why do economists oppose policies that restrict trade among nations?

Quick Check Multiple Choice
In an hour, David can wash 2 cars or mow 1 lawn, and Ron can wash 3 cars or mow 1 lawn. Who
has the absolute advantage in car washing, and who has the absolute advantage in lawn mowing?

David in washing, Ron in mowing.

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a.
b.

a.
b.
c.

d.
4.

Ron in washing, David in mowing.
David in washing, neither in mowing.
Ron in washing, neither in mowing.

Once again, in an hour, David can wash 2 cars or mow 1 lawn, and Ron can wash 3 cars or mow 1
lawn. Who has the comparative advantage in car washing, and who has the comparative advantage
in lawn mowing?

David in washing, Ron in mowing.
Ron in washing, David in mowing.
David in washing, neither in mowing.
Ron in washing, neither in mowing.

When two individuals produce efficiently and then make a mutually beneficial trade based on
comparative advantage,

they both obtain consumption outside their production possibilities frontier.
they both obtain consumption inside their production possibilities frontier.
one individual consumes inside her production possibilities frontier, while the other consumes
outside hers.
each individual consumes a point on her own production possibilities frontier.

Which goods will a nation typically import?
those goods in which the nation has an absolute advantage

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c.
d.

a.
b.
c.
d.

a.
b.
c.
d.
1.
a.
b.
2.
a.
b.
c.

d.
e.
f.

PRINTED BY: marquez007@email.phoenix.edu. Printing is for personal, private use only. No part of
this book may be reproduced or transmitted without publisher’s prior permission. Violators will be
prosecuted.

those goods in which the nation has a comparative advantage
those goods in which other nations have an absolute advantage
those goods in which other nations have a comparative advantage

Suppose that in the United States, producing an aircraft takes 10,000 hours of labor and producing
a shirt takes 2 hours of labor. In China, producing an aircraft takes 40,000 hours of labor and
producing a shirt takes 4 hours of labor. What will these nations trade?

China will export aircraft, and the United States will export shirts.
China will export shirts, and the United States will export aircraft.
Both nations will export shirts.
There are no gains from trade in this situation.

Mark can cook dinner in 30 minutes and wash the laundry in 20 minutes. His roommate takes half
as long to do each task. How should the roommates allocate the work?

Mark should do more of the cooking based on his comparative advantage.
Mark should do more of the washing based on his comparative advantage.
Mark should do more of the washing based on his absolute advantage.
There are no gains from trade in this situation.

Problems and Applications
Maria can read 20 pages of economics in an hour. She can also read 50 pages of sociology in an
hour. She spends 5 hours per day studying.

Draw Maria’s production possibilities frontier for reading economics and sociology.
What is Maria’s opportunity cost of reading 100 pages of sociology?

American and Japanese workers can each produce 4 cars a year. An American worker can produce
10 tons of grain a year, whereas a Japanese worker can produce 5 tons of grain a year. To keep
things simple, assume that each country has 100 million workers.

For this situation, construct a table analogous to the table in Figure 1.
Graph the production possibilities frontiers for the American and Japanese economies.
For the United States, what is the opportunity cost of a car? Of grain? For Japan, what is the
opportunity cost of a car? Of grain? Put this information in a table analogous to Table 1.
Which country has an absolute advantage in producing cars? In producing grain?
Which country has a comparative advantage in producing cars? In producing grain?
Without trade, half of each country’s workers produce cars and half produce grain. What

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g.
3.
a.
b.
c.
4.
a.
b.
c.

quantities of cars and grain does each country produce?
Starting from a position without trade, give an example in which trade makes each country
better off.

Pat and Kris are roommates. They spend most of their time studying (of course), but they leave
some time for their favorite activities: making pizza and brewing root beer. Pat takes 4 hours to
brew a gallon of root beer and 2 hours to make a pizza. Kris takes 6 hours to brew a gallon of root
beer and 4 hours to make a pizza.

What is each roommate’s opportunity cost of making a pizza? Who has the absolute advantage
in making pizza? Who has the comparative advantage in making pizza?
If Pat and Kris trade foods with each other, who will trade away pizza in exchange for root
beer?
The price of pizza can be expressed in terms of gallons of root beer. What is the highest price
at which pizza can be traded that would make both roommates better off? What is the lowest
price? Explain.

Suppose that there are 10 million workers in Canada and that each of these workers can produce
either 2 cars or 30 bushels of wheat in a year.

What is the opportunity cost of producing a car in Canada? What is the opportunity cost of
producing a bushel of wheat in Canada? Explain the relationship between the opportunity costs
of the two goods.
Draw Canada’s production possibilities frontier. If Canada chooses to consume 10 million cars,
how much wheat can it consume without trade? Label this point on the production possibilities
frontier.
Now suppose that the United States offers to buy 10 million cars from Canada in exchange for
20 bushels of wheat per car. If Canada continues to consume 10 million cars, how much wheat
does this deal allow Canada to consume? Label this point on your diagram. Should Canada
accept the deal?

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5.
a.
b.
c.
6.
a.
b.
c.
d.

a.
b.

a.
b.
c.
d.
PRINTED BY: marquez007@email.phoenix.edu. Printing is for personal, private use only. No part of this
book may be reproduced or transmitted without publisher’s prior permission. Violators will be prosecuted.

England and Scotland both produce scones and sweaters. Suppose that an English worker can
produce 50 scones per hour or 1 sweater per hour. Suppose that a Scottish worker can produce 40
scones per hour or 2 sweaters per hour.

Which country has the absolute advantage in the production of each good? Which country has
the comparative advantage?
If England and Scotland decide to trade, which commodity will Scotland trade to England?
Explain.
If a Scottish worker could produce only 1 sweater per hour, would Scotland still gain from
trade? Would England still gain from trade? Explain.

The following table describes the production possibilities of two cities in the country of Baseballia:

Pairs of Red Socks per Worker per
Hour

Pairs of White Socks per Worker per
Hour

Boston 3 3
Chicago 2 1

Without trade, what is the price of white socks (in terms of red socks) in Boston? What is the
price in Chicago?
Which city has an absolute advantage in the production of each color sock? Which city has a
comparative advantage in the production of each color sock?
If the cities trade with each other, which color sock will each export?
What is the range of prices at which trade can occur?

A German worker takes 400 hours to produce a car and 2 hours to produce a case of wine. A
French worker takes 600 hours to produce a car and X hours to produce a case of wine.

For what values of X will gains from trade be possible? Explain.
For what values of X will Germany export cars and import wine? Explain.

Suppose that in a year an American worker can produce 100 shirts or 20 computers and a Chinese
worker can produce 100 shirts or 10 computers.

For each country, graph the production possibilities frontier. Suppose that without trade the
workers in each country spend half their time producing each good. Identify this point in your
graphs.
If these countries were open to trade, which country would export shirts? Give a specific
numerical example and show it on your graphs. Which country would benefit from trade?
Explain.
Explain at what price of computers (in terms of shirts) the two countries might trade.
Suppose that China catches up with American productivity so that a Chinese worker can
produce 100 shirts or 20 computers. What pattern of trade would you predict now? How does

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9.
a.

b.
c.
d.
e.

this advance in Chinese productivity affect the economic well-being of the citizens of the two
countries?

Are the following statements true or false? Explain in each case.
“Two countries can achieve gains from trade even if one of the countries has an absolute
advantage in the production of all goods.”
“Certain very talented people have a comparative advantage in everything they do.”
“If a certain trade is good for one person, it can’t be good for the other one.”
“If a certain trade is good for one person, it is always good for the other one.”
“If trade is good for a country, it must be good for everyone in the country.”

Go to CengageBrain.com to purchase access to the proven, critical Study Guide to accompany this
text, which features additional notes and context, practice tests, and much more.

http://cengagebrain.com/

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PRINTED BY: marquez007@email.phoenix.edu. Printing is for personal, private use only. No part of this book
may be reproduced or transmitted without publisher’s prior permission. Violators will be prosecuted.

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