Discouraged Workers and the Economy

Assignment 2: Discouraged Workers and the Economy

A “discouraged worker” is an individual without a job who has a desire to work; however, the worker has not actively searched for a job within the last six months, because the worker believes that there are no jobs available. Such a worker is not included in the official unemployment count.

Consider a scenario where discouraged workers are now included in the official unemployment rate during a recessionary period in the economy. Which of the three types of unemployment—frictional, structural, or cyclical—do you believe that these unemployed workers would most closely qualify for? How about during a period of economic expansion? Explain your answers and include examples.

Next, discuss and explain how including discouraged workers in the official unemployment rate would affect both the federal deficit and the national debt. Include examples to support your conclusions.

By Friday, January 11, 2013
, post your initial discussion response in the M1: Assignment 2 Discussion Area. By
 Wednesday, January 16, 2013
, read all of the other students’ postings, and post comments in the
 Discussion Area 
on at least two other responses.

Assignment 3: Supply, Demand, & Government in the Markets

A doctoral student has just completed a study for her dissertation and found the following demand and supply schedules for hand held computers to be as follows:










Quantity Demanded

Quantity Supplied




















  1. Using Microsoft Excel, draw a graph illustrating the supply and demand in this market.
  2. What is the equilibrium Price and Quantity in the market?
  3. Now suppose the government imposes a special tax on these computers. Describe what would happen in this market in terms of the supply and demand curve.
  4.  Disregard the new tax in part three.  Now assume that the government imposes a price ceiling of $100 in this market, as a result of protests of price gauging by the sellers.  What would happen to the price and quantity in this market?
  5. Disregard the events of part four.  Assume that the manufacturers of this product lobby the government’s lawmakers, in terms of this product being an essential for college students but they are considering halting production due to the lack of profits.  The lawmakers agree and now set a price floor at $150.  What would happen in this market?
  6. If consumers’ expectations were such that they were concerned about the economy and jobs, what would you think would happen in this market?

Present your analysis in Excel format. Enter non-numerical responses in the same worksheet using textboxes.

By Tuesday, January 15, 2013 
deliver your assignment to the
 M1: Assignment 3 Dropbox.


1: <<<<<<<<<<<b>b>b>b>b>b>b>b>b>b>b>Economics and Economic Reasoning

In my vacations, I visited the poorest quarters of several cities and walked through one street after another, looking at the faces of the poorest people. Next I resolved to make as thorough a study as I could of Political Economy.

Alfred Marshall

What Economics Is

Economics is the study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society. One of the key words in the definition of the term “economics” is coordination. Coordination can mean many things. In the study of economics, coordination refers to how the three central problems facing any economy are solved. These central problems are

1. What, and how much, to produce.

2. How to produce it.

3. For whom to produce it.

Three central coordination problems any economy must solve are what to produce, how to produce it, and for whom to produce it.

How hard is it to make the three decisions? Imagine for a moment the problem of living in a family: the fights, arguments, and questions that come up. “Do I have to do the dishes?” “Why can’t I have piano lessons?” “Bobby got a new sweater. How come I didn’t?” “Mom likes you best.” Now multiply the size of the family by millions. The same fights, the same arguments, the same questions—only for society the questions are millions of times more complicated. In answering these questions, economies find that inevitably individuals want more than is available, given how much they’re willing to work. That means that in our economy there is a problem of scarcity—the goods available are too few to satisfy individuals’ desires.

The coordination questions faced by society are complicated.

Scarcity has two elements: our wants and our means of fulfilling those wants. These can be interrelated since wants are changeable and partially determined by society. The way we fulfill wants can affect those wants. For example, if you work on Wall Street, you will probably want upscale and trendy clothes. Up here in Vermont, I am quite happy wearing Levi’s and flannel.

The quantity of goods, services, and usable resources depends on technology and human action.

The degree of scarcity is constantly changing. The quantity of goods, services, and usable resources depends on technology and human action, which underlie production. Individuals’ imagination, innovativeness, and willingness to do what needs to be done can greatly increase available goods and resources. Who knows what technologies are in our future—nannites or micromachines that change atoms into whatever we want could conceivably eliminate scarcity of goods we currently consume. But they would not eliminate scarcity entirely since new wants are constantly developing.

So, how does an economy deal with scarcity? The answer is coercion. In all known economies, coordination has involved some type of coercion—limiting people’s wants and increasing the amount of work individuals are willing to do to fulfill those wants. The reality is that many people would rather play than help solve society’s problems. So the basic economic problem involves inspiring people to do things that other people want them to do, and not to do things that other people don’t want them to do. Thus, an alternative definition of economics is that it is the study of how to get people to do things they’re not wild about doing (such as studying) and not to do things they are wild about doing (such as eating all the lobster they like), so that the things some people want to do are consistent with the things other people want to do.

A Guide to Economic Reasoning

People trained in economics think in a certain way. They analyze everything critically; they compare the costs and the benefits of every issue and make decisions based on those costs and benefits. For example, say you’re trying to decide whether a policy to eliminate terrorist attacks on airlines is a good idea. Economists are trained to put their emotions aside and ask: What are the costs of the policy, and what are the benefits? Thus, they are open to the argument that security measures, such as conducting body searches of every passenger or scanning all baggage with bomb-detecting machinery, might not be the appropriate policy because the costs might exceed the benefits. To think like an economist involves addressing almost all issues using a cost/benefit approach. Economic reasoning also involves abstracting from the “unimportant” elements of a question and focusing on the “important” ones by creating a simple model that captures the essence of the issue or problem. How do you know whether the model has captured the important elements? By collecting empirical evidence and “testing” the model—matching the predictions of the model with the empirical evidence—to see if it fits. Economic reasoning—how to think like an economist, making decisions on the basis of costs and benefits—is the most important lesson you’ll learn from this book.

Economic reasoning is making decisions on the basis of costs and benefits.

The book Freakonomics gives examples of the economist’s approach. It describes a number of studies by University of Chicago economist Steve Levitt that unlock seemingly mysterious observations with basic economic reasoning. For example, Levitt asks the question: Why do drug dealers on the street tend to live with their mothers? The answer he arrives at is that it is because they can’t afford to live on their own; most earn less than $5 an hour. Why, then, are they dealing drugs and not working a legal job that, even for a minimum-wage job, pays over $6.00 an hour? The answer to that is determined through cost/benefit analysis. While their current income is low, their potential income as a drug dealer is much higher since, given their background and current U.S. institutions, they are more likely to move up to a high position in the local drug business (and Freakonomics describes how it is a business) and earn a six-figure income than they are to move up from working as a Taco Bell technician to an executive earning a six-figure income in corporate America. Levitt’s model is a very simple one—people do what is in their best interest financially—and it assumes that people rely on a cost/benefit analysis to make decisions. Finally, he supports his argument through careful empirical work, collecting and organizing the data to see if they fit the model. His work is a good example of “thinking like an economist” in action.

Economic reasoning, once learned, is infectious. If you’re susceptible, being exposed to it will change your life. It will influence your analysis of everything, including issues normally considered outside the scope of economics. For example, you will likely use economic reasoning to decide the possibility of getting a date for Saturday night, and who will pay for dinner. You will likely use it to decide whether to read this book, whether to attend class, whom to marry, and what kind of work to go into after you graduate. This is not to say that economic reasoning will provide all the answers. As you will see throughout this book, real-world questions are inevitably complicated, and economic reasoning simply provides a framework within which to approach a question. In the economic way of thinking, every choice has costs and benefits, and decisions are made by comparing them.

Marginal Costs and Marginal Benefits

The relevant costs and relevant benefits to economic reasoning are the expected incremental, or additional, costs incurred and the expected incremental benefits that result from a decision. Economists use the term marginal when referring to additional or incremental. Marginal costs and marginal benefits are key concepts.


Web Note 1.1: Costs and Benefits

Marginal Cost and Marginal Benefit

A marginal cost is the additional cost to you over and above the costs you have already incurred. That means not counting sunk costs—costs that have already been incurred and cannot be recovered—in the relevant costs when making a decision. Consider, for example, attending class. You’ve already paid your tuition; it is a sunk cost. So the marginal (or additional) cost of going to class does not include tuition.

Similarly with marginal benefit. A marginal benefit is the additional benefit above what you’ve already derived. The marginal benefit of reading this chapter is the additional knowledge you get from reading it. If you already knew everything in this chapter before you picked up the book, the marginal benefit of reading it now is zero. The marginal benefit is not zero if by reading the chapter you learn that you are prepared for class; before, you might only have suspected you were prepared.


Economic Knowledge in One Sentence: TANSTAAFL

Once upon a time, Tanstaafl was made king of all the lands. His first act was to call his economic advisers and tell them to write up all the economic knowledge the society possessed. After years of work, they presented their monumental effort:


volumes, each about


pages long. But in the interim, King Tanstaafl had become a very busy man, what with running a kingdom of all the lands and all. Looking at the lengthy volumes, he told his advisers to summarize their findings in one volume.

Despondently, the economists returned to their desks, wondering how they could summarize what they’d been so careful to spell out. After many more years of rewriting, they were finally satisfied with their one-volume effort, and tried to make an appointment to see the king. Unfortunately, affairs of state had become even more pressing than before, and the king couldn’t take the time to see them. Instead he sent word to them that he couldn’t be bothered with a whole volume, and ordered them, under threat of death (for he had become a tyrant), to reduce the work to one sentence.

The economists returned to their desks, shivering in their sandals and pondering their impossible task. Thinking about their fate if they were not successful, they decided to send out for one last meal. Unfortunately, when they were collecting money to pay for the meal, they discovered they were broke. The disgusted delivery man took the last meal back to the restaurant, and the economists started down the path to the beheading station. On the way, the delivery man’s parting words echoed in their ears. They looked at each other and suddenly they realized the truth. “We’re saved!” they screamed. “That’s it! That’s economic knowledge in one sentence!” They wrote the sentence down and presented it to the king, who thereafter fully understood all economic problems. (He also gave them a good meal.) The sentence?

There Ain’t No Such Thing As A Free Lunch—TANSTAAFL

Comparing marginal (additional) costs with marginal (additional) benefits will often tell you how you should adjust your activities to be as well off as possible. Just follow the economic decision rule:

If the marginal benefits of doing something exceed the marginal costs, do it.

If the marginal costs of doing something exceed the marginal benefits, don’t do it.

If the marginal benefits of doing something exceed the marginal costs, do it. If the marginal costs of doing something exceed the marginal benefits, don’t do it.

As an example, let’s consider a discussion I might have with a student who tells me that she is too busy to attend my classes. I respond, “Think about the tuition you’ve spent for this class—it works out to about $40 a lecture.” She answers that the book she reads for class is a book that I wrote, and that I wrote it so clearly she fully understands everything. She goes on:

I’ve already paid the tuition and whether I go to class or not, I can’t get any of the tuition back, so the tuition is a sunk cost and doesn’t enter into my decision. The marginal cost to me is what I could be doing with the hour instead of spending it in class. I value my time at $75 an hour [people who understand everything value their time highly], and even though I’ve heard that your lectures are super, I estimate that the marginal benefit of your class is only $


. The marginal cost, $75, exceeds the marginal benefit, $50, so I don’t attend class.

I congratulate her on her diplomacy and her economic reasoning, but tell her that I give a quiz every week, that students who miss a quiz fail the quiz, that those who fail all the quizzes fail the course, and that those who fail the course do not graduate. In short, she is underestimating the marginal benefits of attending my classes. Correctly estimated, the marginal benefits of attending my class exceed the marginal costs. So she should attend my class.


Say you bought a share of Sun Microsystems for $


and a share of Cisco for $10. The price of each is currently $15. Assuming taxes are not an issue, which would you sell if you need $15?

Economics and Passion

Recognizing that everything has a cost is reasonable, but it’s a reasonableness that many people don’t like. It takes some of the passion out of life. It leads you to consider possibilities like these:

• Saving some people’s lives with liver transplants might not be worth the additional cost. The money might be better spent on nutritional programs that would save 20 lives for every 2 lives you might save with transplants.

• Maybe we shouldn’t try to eliminate all pollution, because the additional cost of doing so may be too high. To eliminate all pollution might be to forgo too much of some other worthwhile activity.

• Providing a guaranteed job for every person who wants one might not be a worthwhile policy goal if it means that doing so will reduce the ability of an economy to adapt to new technologies.

• It might make sense for the automobile industry to save $12 per car by not installing a safety device, even though without the safety device some people will be killed.

Economic reasoning is based on the premise that everything has a cost.

You get the idea. This kind of reasonableness is often criticized for being cold-hearted. But, not surprisingly, economists disagree; they argue that their reasoning leads to a better society for the majority of people.

Economists’ reasonableness isn’t universally appreciated. Businesses love the result; others aren’t so sure, as I discovered some years back when my then-girlfriend told me she was leaving me. “Why?” I asked. “Because,” she responded, “you’re so, so… reasonable.” It took me many years after she left to learn what she already knew: There are many types of reasonableness, and not everyone thinks an economist’s reasonableness is a virtue. I’ll discuss such issues later; for now, let me simply warn you that, for better or worse, studying economics will lead you to view questions in a cost/benefit framework.


Can you think of a reason why a cost/benefit approach to a problem might be inappropriate? Can you give an example?

Opportunity Cost

Putting economists’ cost/benefit rules into practice isn’t easy. To do so, you have to be able to choose and measure the costs and benefits correctly. Economists have devised the concept of opportunity cost to help you do that. Opportunity cost is the benefit that you might have gained from choosing the next-best alternative. To obtain the benefit of something, you must give up (forgo) something else—namely, the next-best alternative. The opportunity cost is the value of that next-best alternative; that is a cost because in choosing one thing, you are precluding an alternative choice. The TANSTAAFL story in the box embodies the opportunity cost concept because it tells us that there is a cost to everything; that cost is the next-best forgone alternative.

Opportunity cost is the basis of cost/benefit economic reasoning; it is the benefit that you might have gained from choosing the next-best alternative.

Opportunity Cost

Let’s consider some examples. The opportunity cost of going out once with Natalie (or Nathaniel), the most beautiful woman (attractive man) in the world, is the benefit you’d get from going out with your solid steady, Margo (Mike). The opportunity cost of cleaning up the environment might be a reduction in the money available to assist low-income individuals. The opportunity cost of having a child might be two boats, three cars, and a two-week vacation each year for five years, which are what you could have had if you hadn’t had the child. (Kids really are this expensive.)

Examples are endless, but let’s consider two that are particularly relevant to you: what courses to take and how much to study. Let’s say you’re a full-time student and at the beginning of the term you had to choose five courses. Taking one precludes taking some other, and the opportunity cost of taking an economics course may well be not taking a course on theater. Similarly with studying: You have a limited amount of time to spend studying economics, studying some other subject, sleeping, or partying. The more time you spend on one activity, the less time you have for another. That’s opportunity cost.

Notice how neatly the opportunity cost concept takes into account costs and benefits of all other options, and converts these alternative benefits into costs of the decision you’re now making.

The relevance of opportunity cost isn’t limited to your individual decisions. Opportunity costs are also relevant to government’s decisions, which affect everyone in society. A common example is what is called the guns-versus-butter debate. The resources that a society has are limited; therefore, its decision to use those resources to have more guns (more weapons) means that it will have less butter (fewer consumer goods). Thus, when society decides to spend $50 billion more on an improved health care system, the opportunity cost of that decision is $50 billion not spent on helping the homeless, paying off some of the national debt, or providing for national defense.

Opportunity costs have always made choice difficult, as we see in the early-19th-century engraving, “One or the Other.”

The opportunity cost concept has endless implications. It can even be turned upon itself. For instance, it takes time to think about alternatives; that means that there’s a cost to being reasonable, so it’s only reasonable to be somewhat unreasonable. If you followed that argument, you’ve caught the economic bug. If you didn’t, don’t worry. Just remember the opportunity cost concept for now; I’ll infect you with economic thinking in the rest of the book.


John, your study partner, has just said that the opportunity cost of studying this chapter is about 1/34 the price you paid for this book, since the chapter is about 1/34 of the book. Is he right? Why or why not?

Economic and Market Forces

The opportunity cost concept applies to all aspects of life and is fundamental to understanding how society reacts to scarcity. When goods are scarce, those goods must be rationed. That is, a mechanism must be chosen to determine who gets what.


Ali, your study partner, states that rationing health care is immoral—that health care should be freely available to all individuals in society. How would you respond?

Let’s consider some specific real-world rationing mechanisms. Dormitory rooms are often rationed by lottery, and permission to register in popular classes is often rationed by a first-come, first-registered rule. Food in the United States, however, is generally rationed by price. If price did not ration food, there wouldn’t be enough food to go around. All scarce goods must be rationed in some fashion. These rationing mechanisms are examples of economic forces, the necessary reactions to scarcity.

When an economic force operates through the market, it becomes a market force.

One of the important choices that a society must make is whether to allow these economic forces to operate freely and openly or to try to rein them in. A market force is an economic force that is given relatively free rein by society to work through the market. Market forces ration by changing prices. When there’s a shortage, the price goes up. When there’s a surplus, the price goes down. Much of this book will be devoted to analyzing how the market works like an invisible hand, guiding economic forces to coordinate individual actions and allocate scarce resources. The invisible hand is the price mechanism, the rise and fall of prices that guides our actions in a market.

Economic reality is controlled by three forces:

Economic forces (the invisible hand).

Social and cultural forces.

Political and legal forces.

Societies can’t choose whether or not to allow economic forces to operate—economic forces are always operating. However, societies can choose whether to allow market forces to predominate. Social, cultural, and political forces play a major role in deciding whether to let market forces operate. Economic reality is determined by a contest among these various forces.


Economics in Perspective

All too often, students study economics out of context. They’re presented with sterile analysis and boring facts to memorize, and are never shown how economics fits into the larger scheme of things. That’s bad; it makes economics seem boring—but economics is not boring. Every so often throughout this book, sometimes in the appendixes and sometimes in these boxes, I’ll step back and put the analysis in perspective, giving you an idea from whence the analysis sprang and its historical context. In educational jargon, this is called enrichment.

I begin here with economics itself.

First, its history: In the 1500s there were few universities. Those that existed taught religion, Latin, Greek, philosophy, history, and mathematics. No economics. Then came the Enlightenment (about 1700), in which reasoning replaced God as the explanation of why things were the way they were. Pre-Enlightenment thinkers would answer the question “Why am I poor?” with “Because God wills it.” Enlightenment scholars looked for a different explanation. “Because of the nature of land ownership” is one answer they found.

Such reasoned explanations required more knowledge of the way things were, and the amount of information expanded so rapidly that it had to be divided or categorized for an individual to have hope of knowing a subject. Soon philosophy was subdivided into science and philosophy. In the 1700s, the sciences were split into natural sciences and social sciences. The amount of knowledge kept increasing, and in the late 1800s and early 1900s social science itself split into subdivisions: economics, political science, history, geography, sociology, anthropology, and psychology. Many of the insights about how the economic system worked were codified in Adam Smith’s The Wealth of Nations, written in 1776. Notice that this is before economics as a subdiscipline developed, and Adam Smith could also be classified as an anthropologist, a sociologist, a political scientist, and a social philosopher.

Throughout the 18th and 19th centuries, economists such as Adam Smith, Thomas Malthus, John Stuart Mill, David Ricardo, and Karl Marx were more than economists; they were social philosophers who covered all aspects of social science. These writers were subsequently called classical economists. Alfred Marshall continued in that classical tradition, and his book, Principles of Economics, published in the late 1800s, was written with the other social sciences much in evidence. But Marshall also changed the questions economists ask; he focused on those questions that could be asked in a graphical supply/demand framework.

This book falls solidly in the Marshallian tradition. It sees economics as a way of thinking—as an engine of analysis used to understand real-world phenomena.

Marshallian economics is primarily about policy, not theory. It sees institutions as well as political and social dimensions of reality as important, and it shows you how economics ties in to those dimensions.

Let’s consider an example in which social forces prevent an economic force from becoming a market force: the problem of getting a date for Saturday night. If a school (or a society) has significantly more people of one gender than the other (let’s say more men than women), some men may well find themselves without a date—that is, men will be in excess supply—and will have to find something else to do, say study or go to a movie by themselves. An “excess supply” person could solve the problem by paying someone to go out with him or her, but that would probably change the nature of the date in unacceptable ways. It would be revolting to the person who offered payment and to the person who was offered payment. That unacceptability is an example of the complex social and cultural norms that guide and limit our activities. People don’t try to buy dates because social forces prevent them from doing so.

Social, cultural, and political forces can play a significant role in the economy.

Now let’s consider another example in which political and legal influences stop economic forces from becoming market forces. Say you decide that you can make some money delivering mail in your neighborhood. You try to establish a small business, but suddenly you are confronted with the law. The U.S. Postal Service has a legal exclusive right to deliver regular mail, so you’ll be prohibited from delivering regular mail in competition with the post office. Economic forces—the desire to make money—led you to want to enter the business, but in this case political forces squash the invisible hand.


Your study partner, Joan, states that market forces are always operative. Is she right? Why or why not?

Often political and social forces work together against the invisible hand. For example, in the United States there aren’t enough babies to satisfy all the couples who desire them. Babies born to particular sets of parents are rationed—by luck. Consider a group of parents, all of whom want babies. Those who can, have a baby; those who can’t have one, but want one, try to adopt. Adoption agencies ration the available babies. Who gets a baby depends on whom people know at the adoption agency and on the desires of the birth mother, who can often specify the socioeconomic background (and many other characteristics) of the family in which she wants her baby to grow up. That’s the economic force in action; it gives more power to the supplier of something that’s in short supply.

If our society allowed individuals to buy and sell babies, that economic force would be translated into a market force. The invisible hand would see to it that the quantity of babies supplied would equal the quantity of babies demanded at some price. The market, not the adoption agencies, would do the rationing.2

Most people, including me, find the idea of selling babies repugnant. But why? It’s the strength of social forces reinforced by political forces.

What is and isn’t allowable differs from one society to another. For example, in Cuba and North Korea, many private businesses are against the law, so not many people start their own businesses. In the United States, until the 1970s, it was against the law to hold gold except in jewelry and for certain limited uses such as dental supplies, so most people refrained from holding gold. Ultimately a country’s laws and social norms determine whether the invisible hand will be allowed to work.

Economic forces are always operative; society may allow market forces to operate.

Social and political forces are active in all parts of your life. You don’t practice medicine without a license; you don’t sell body parts or certain addictive drugs. These actions are against the law. But many people do sell alcohol; that’s not against the law if you have a permit. You don’t charge your friends interest to borrow money (you’d lose friends); you don’t charge your children for their food (parents are supposed to feed their children); many sports and media stars don’t sell their autographs (some do, but many consider the practice tacky); you don’t lower the wage you’ll accept in order to take a job away from someone else (you’re no scab). The list is long. You cannot understand economics without understanding the limitations that political and social forces place on economic actions.


Web Note 1.2: Society and Markets

In summary, what happens in a society can be seen as the reaction to, and interaction of, these three forces: economic forces, political and legal forces, and social and historical forces. Economics has a role to play in sociology, history, and politics, just as sociology, history, and politics have roles to play in economics.

What happens in society can be seen as a reaction to, and interaction of, economic forces, political forces, social forces, and historical forces.

Economic Terminology

Economic terminology needs little discussion. It simply needs learning. As terms come up, you’ll begin to recognize them. Soon you’ll begin to understand them, and finally you’ll begin to feel comfortable using them. In this book, I’m trying to describe how economics works in the real world, so I introduce you to many of the terms that occur in business and in discussions of the economy. Whenever possible I’ll integrate the introduction of new terms into the discussion so that learning them will seem painless. In fact I’ve already introduced you to a number of economic terms: opportunity cost, the invisible hand, market forces, economic forces, just to name a few. By the end of the book, I’ll have introduced you to hundreds more.

Economic Insights

Economists have thought about the economy for a long time, so it’s not surprising that they’ve developed some insights into the way it works.

These insights are often based on generalizations, called theories, about the workings of an abstract economy. Theories tie together economists’ terminology and knowledge about economic institutions. Theories are inevitably too abstract to apply in specific cases, and thus a theory is often embodied in an economic model—a framework that places the generalized insights of the theory in a more specific contextual setting—or in an economic principle—a commonly held economic insight stated as a law or general assumption. To see the importance of principles, think back to when you learned to add. You didn’t memorize the sum of 147 and 138; instead, you learned a principle of addition. The principle says that when adding 147 and 138, you first add 7 + 8, which you memorized was 15. You write down the 5 and carry the 1, which you add to 4 + 3 to get 8. Then add 1 + 1 = 2. So the answer is 285. When you know just one principle, you know how to add millions of combinations of numbers.

Theories, models, and principles are empirically tested (as best one can) to ensure that they correspond to reality. Because economics is an observational, not a laboratory, science, economists cannot test their models with controlled experiments. Instead, economists must carefully observe the economy and try to figure out what is affecting what. To do so they look for natural experiments, where something has changed in one place but has not changed somewhere else and compare the results in the two cases. An example of a natural experiment was when New Jersey raised its minimum wage and neighboring state Pennsylvania did not. But even in cases where there is a natural experiment, it is impossible to hold “other things constant,” as is done in laboratory experiments, and thus the empirical results in economics are often subject to dispute.

Theories, models, and principles must be combined with a knowledge of real-world economic institutions to arrive at specific policy recommendations.

While economic models and principles are less general than theories, they are still usually too general to apply in specific cases. Theories, models, and principles must be combined with a knowledge of real-world economic institutions to arrive at specific policy recommendations.

The Invisible Hand Theory

Knowing a theory gives you insight into a wide variety of economic phenomena even though you don’t know the particulars of each phenomenon. For example, much of economic theory deals with the pricing mechanism and how the market operates to coordinate individuals’ decisions. Economists have come to the following insights:

When the quantity supplied is greater than the quantity demanded, price has a tendency to fall.

When the quantity demanded is greater than the quantity supplied, price has a tendency to rise.


There has been a superb growing season and the quantity of tomatoes supplied exceeds the quantity demanded. What is likely to happen to the price of tomatoes?

Using these generalized insights, economists have developed a theory of markets that leads to the further insight that, under certain conditions, markets are efficient. That is, the market will coordinate individuals’ decisions, allocating scarce resources to their best possible use.


means achieving a goal as cheaply as possible. Economists call this insight the invisible hand theory—a market economy, through the price mechanism, will tend to allocate resources efficiently.

Theories, and the models used to represent them, are enormously efficient methods of conveying information, but they’re also necessarily abstract. They rely on simplifying assumptions, and if you don’t know the assumptions, you don’t know the theory. The result of forgetting assumptions could be similar to what happens if you forget that you’re supposed to add numbers in columns. Forgetting that, yet remembering all the steps, can lead to a wildly incorrect answer. For example,

Knowing the assumptions of theories and models allows you to progress beyond gut reaction and better understand the strengths and weaknesses of various economic theories and models. Let’s consider a central economic assumption: the assumption that individuals behave rationally—that what they choose reflects what makes them happiest, given the constraints. If that assumption doesn’t hold, the invisible hand theory doesn’t hold.

Presenting the invisible hand theory in its full beauty is an important part of any economics course. Presenting the assumptions on which it is based and the limitations of the invisible hand is likewise an important part of the course. I’ll do both throughout the book.


Winston Churchill and Lady Astor

There are many stories about Nancy Astor, the first woman elected to Britain’s Parliament. A vivacious, fearless American woman, she married into the English aristocracy and, during the 1930s and 1940s, became a bright light on the English social and political scenes, which were already quite bright.

One story told about Lady Astor is that she and Winston Churchill, the unorthodox genius who had a long and distinguished political career and who was Britain’s prime minister during World War II, were sitting in a pub having a theoretical discussion about morality. Churchill suggested that as a thought experiment Lady Astor ponder the following question: If a man were to promise her a huge amount of money—say a million pounds—for the privilege, would she sleep with him? Lady Astor did ponder the question for a while and finally answered, yes, she would, if the money were guaranteed. Churchill then asked her if she would sleep with him for five pounds. Her response was sharp: “Of course not. What do you think I am—a prostitute?” Churchill responded, “We have already established that fact; we are now simply negotiating about price.”

One moral that economists might draw from this story is that economic incentives, if high enough, can have a powerful influence on behavior. But an equally important moral of the story is that noneconomic incentives also can be very strong. Why do most people feel it’s wrong to sell sex for money, even if they might be willing to do so if the price were high enough? Keeping this second moral in mind will significantly increase your economic understanding of real-world events.

Economic Theory and Stories

Economic theory, and the models in which that theory is presented, often developed as a shorthand way of telling a story. These stories are important; they make the theory come alive and convey the insights that give economic theory its power. In this book I present plenty of theories and models, but they’re accompanied by stories that provide the context that makes them relevant.

Theory is a shorthand way of telling a story.

At times, because there are many new terms, discussing theories takes up much of the presentation time and becomes a bit oppressive. That’s the nature of the beast. As Albert Einstein said, “Theories should be as simple as possible, but not more so.” When a theory becomes oppressive, pause and think about the underlying story that the theory is meant to convey. That story should make sense and be concrete. If you can’t translate the theory into a story, you don’t understand the theory.

Microeconomics and Macroeconomics

Economic theory is divided into two parts: microeconomic theory and macroeconomic theory. Microeconomic theory considers economic reasoning from the viewpoint of individuals and firms and builds up to an analysis of the whole economy. Microeconomics is the study of individual choice, and how that choice is influenced by economic forces. Microeconomics studies such things as the pricing policies of firms, households’ decisions on what to buy, and how markets allocate resources among alternative ends. Our discussion of opportunity cost was based on microeconomic theory. The invisible hand theory comes from microeconomics.

Microeconomics is the study of how individual choice is influenced by economic forces.

As we build up from microeconomic analysis to an analysis of the entire economy, everything gets rather complicated. Many economists try to uncomplicate matters by taking a different approach—a macroeconomic approach—first looking at the aggregate, or whole, and then breaking it down into components.

Macroeconomics is the study of the economy as a whole. It considers the problems of inflation, unemployment, business cycles, and growth.

Macroeconomics focuses on aggregate relationships such as how household consumption is related to income and how government policies can affect growth.

Macroeconomics is the study of the economy as a whole. It considers the problems of inflation, unemployment, business cycles, and growth.

Consider an analogy to the human body. A micro approach analyzes a person by looking first at each individual cell and then builds up. A macro approach starts with the person and then goes on to his or her components—arms, legs, fingernails, feelings, and so on. Put simply, microeconomics analyzes from the parts to the whole; macroeconomics analyzes from the whole to the parts.


Classify the following topics as macroeconomic or microeconomic:

The impact of a tax increase on aggregate output.

The relationship between two competing firms’ pricing behavior.

A farmer’s decision to plant soy or wheat.

The effect of trade on economic growth.

Microeconomics and macroeconomics are very much interrelated. What happens in the economy as a whole is based on individual decisions, but individual decisions are made within an economy and can be understood only within that context. For example, whether a firm decides to expand production capacity will depend on what the owners expect will happen to the demand for their products. Those expectations are determined by macroeconomic conditions. Because microeconomics focuses on the individual and macroeconomics focuses on the whole economy, traditionally microeconomics and macroeconomics are taught separately, even though they are interrelated.

Economic Institutions

To know whether you can apply economic theory to reality, you must know about economic institutions—laws, common practices, and organizations in a society that affect the economy. Corporations, governments, and cultural norms are all examples of economic institutions. Many economic institutions have social, political, and religious dimensions. For example, your job often influences your social standing. In addition, many social institutions, such as the family, have economic functions. I include any institution that significantly affects economic decisions as an economic institution because you must understand that institution if you are to understand how the economy functions.

To apply economic theory to reality, you’ve got to have a sense of economic institutions.

Economic institutions differ significantly among countries. For example, in Germany banks are allowed to own companies; in the United States they cannot. This helps explain why investment decisions are made differently in Germany as compared to the United States. Alternatively, in the Netherlands workers are highly unionized, while in the United States they are not. Unions in the Netherlands therefore have the power to agree to keep wages lower in exchange for more jobs. This means that government policies to control inflation might differ in these two countries.


Economists and Market Solutions

Economic reasoning is playing an increasing role in government policy. Consider the regulation of pollution. Pollution became a policy concern in the 1960s as books such as Rachel Carson’s Silent Spring were published. In 1970, in response to concerns about the environment, the Clean Air Act was passed. It capped the amount of pollutants (such as sulfur dioxide, carbon monoxide, nitrogen dioxides, lead, and hydrocarbons) that firms could emit. This was a “command-and-control” approach to regulation, which brought about a reduction in pollution, but also brought about lots of complaints by firms that either found the limits costly to meet or couldn’t afford to meet them and were forced to close.

Enter economists. They proposed an alternative approach, called cap-and-trade, that achieved the same overall reduction in pollution but at a lower overall cost. In the plan they proposed, government still set a pollution cap that firms had to meet, but it gave individual firms some flexibility. Firms that reduced emissions by less than the required limit could buy pollution permits from other firms that reduced their emissions by more than their limit. The price of the permits would be determined in an “emissions permit market.” Thus, firms that had a low cost of reducing pollution would have a strong incentive to reduce pollution by more than their limit in order to sell these permits, or rights to pollute, to firms that had a high cost of reducing pollution and therefore reduced their pollution by less than what was required. The net reduction was the same, but the reduction was achieved at a lower cost.

In 1990 Congress adopted economists’ proposal and the Clean Air Act was amended to include tradable emissions permits. An active market in emissions permits developed and it is estimated that the tradable permit program has lowered the cost of reducing sulfur dioxide emissions by $1 billion a year. Economists used this same argument to promote an incentive-based solution to world pollution in an agreement among some countries to reduce world pollution known as the Kyoto Protocol. You can read more about the current state of tradable emissions at epa.gov/airmarkets.

Economic institutions sometimes seem to operate in ways quite different than economic theory predicts. For example, economic theory says that prices are determined by supply and demand. However, businesses say that they set prices by rules of thumb—often by what are called cost-plus-markup rules. That is, a firm determines what its costs are, multiplies by 1.4 or 1.5, and the result is the price it sets. Economic theory says that supply and demand determine who’s hired; experience suggests that hiring is often done on the basis of whom you know, not by market forces.

These apparent contradictions have two complementary explanations. First, economic theory abstracts from many issues. These issues may account for the differences. Second, there’s no contradiction; economic principles often affect decisions from behind the scenes. For instance, supply and demand pressures determine what the price markup over cost will be. In all cases, however, to apply economic theory to reality—to gain the full value of economic insights—you’ve got to have a sense of economic institutions.

Economic Policy Options

Economic policies are actions (or inaction) taken by government to influence economic actions. The final goal of the course is to present the economic policy options facing our society today. For example, should the government restrict mergers between firms? Should it run a budget deficit? Should it do something about the international trade deficit? Should it decrease taxes?

I saved this discussion for last because there’s no sense talking about policy options unless you know some economic terminology, some economic theory, and something about economic institutions. Once you know something about them, you’re in a position to consider the policy options available for dealing with the economic problems our society faces.

To carry out economic policy effectively, one must understand how institutions might change as a result of the economic policy.

Policies operate within institutions, but policies also can influence the institutions within which they operate. Let’s consider an example: welfare policy and the institution of the two-parent family. In the 1960s, the United States developed a variety of policy initiatives designed to eliminate poverty. These initiatives provided income to single parents with children, and assumed that family structure would be unchanged by these policies. But family structure changed substantially, and, very likely, these policies played a role in increasing the number of single-parent families. The result was the programs failed to eliminate poverty. Now this is not to say that we should not have programs to eliminate poverty, nor that two-parent families are always preferable to one-parent families; it is only to say that we must build into our policies their effect on institutions.

Some policies are designed to change institutions directly. While these policies are much more difficult to implement than policies that don’t, they also offer the largest potential for gain. Let’s consider an example. In the 1990s, a number of Eastern European countries replaced central planning with market economies and private ownership. The result: Output in those countries fell enormously as the old institutions fell apart. While most Eastern European economies have rebounded from their initial losses, some countries of the former Soviet Union have yet to do so. The hardships these countries continue to experience show the enormous difficulty of implementing policies involving major institutional changes.


True or false? Economists should focus their policy analysis on institutional changes because such policies offer the largest gains.

Objective Policy Analysis

Good economic policy analysis is objective; that is, it keeps the analyst’s value judgments separate from the analysis. Objective analysis does not say, “This is the way things should be,” reflecting a goal established by the analyst. That would be subjective analysis because it would reflect the analyst’s view of how things should be. Instead, objective analysis says, “This is the way the economy works, and if society (or the individual or firm for whom you’re doing the analysis) wants to achieve a particular goal, this is how it might go about doing so.” Objective analysis keeps, or at least tries to keep, subjective views—value judgments—separate.


John, your study partner, is a free market advocate. He argues that the invisible hand theory tells us that the government should not interfere with the economy. Do you agree? Why or why not?

Positive economics is the study of what is, and how the economy works.

To make clear the distinction between objective and subjective analysis, economists have divided economics into three categories: positive economics, normative economics, and the art of economics. Positive economics is the study of what is, and how the economy works. It asks such questions as: How does the market for hog bellies work? How do price restrictions affect market forces? These questions fall under the heading of economic theory.

Normative economics is the study of what the goals of the economy should be.

Normative economics asks such questions as: What should the distribution of income be? What should tax policy be designed to achieve? In discussing such questions, economists must carefully delineate whose goals they are discussing. One cannot simply assume that one’s own goals for society are society’s goals.

Normative economics is the study of what the goals of the economy should be.

The art of economics, also called political economy, is the application of the knowledge learned in positive economics to the achievement of the goals one has determined in normative economics. It looks at such questions as: To achieve a certain distribution of income, how would you go about it, given the way the economy works?3 Most policy discussions fall under the art of economics.

The art of economics is the application of the knowledge learned in positive economics to the achievement of the goals determined in normative economics.


Economics and Global Warming

A good example of the central role that economics plays in policy debates is the debate about global warming. Almost all scientists are now convinced that global warming is occurring and that human activity such as the burning of fossil fuel is the cause. The policy question is what to do about it. To answer that question, most governments have turned to economists. The first part of the question that economists have considered is whether it is worth doing anything, and in a well-publicized report commissioned by the British government, economist Nicholas Stern argued that, based upon his cost/benefit analysis, yes it is worth doing something. The reason: because the costs of not doing anything would likely reduce output by 20 percent in the future, and that those costs (appropriately weighted for when they occur) are less than the benefits of policies that can be implemented.

The second part of the question is: what policies to implement? The policies he recommended were policies that changed incentives—specifically, policies that raised the costs of emitting greenhouse gases and decreased the cost of other forms of production. Those recommended policies reflected the economist’s opportunity cost framework in action: if you want to change the result, change the incentives that individuals face.

There is considerable debate about Stern’s analysis—both with the way he conducted the cost/benefit analysis and with his policy recommendations. Such debates are inevitable when the data are incomplete and numerous judgments need to be made. I suspect that these debates will continue over the coming years with economists on various sides of the debate. Economists are generally not united in their views about complicated policy issues since they differ in their normative views and in their assessment of the problem and of what politically can be achieved; that’s because policy is part of the art of economics, not part of positive economics. But the framework of the policy debate about global warming is the economic framework. Thus, even though political forces will ultimately choose what policy is followed, you must understand the economic framework to take part in the debate.

In each of these three branches of economics, economists separate their own value judgments from their objective analysis as much as possible. The qualifier “as much as possible” is important, since some value judgments inevitably sneak in. We are products of our environment, and the questions we ask, the framework we use, and the way we interpret the evidence all involve value judgments and reflect our backgrounds.


Tell whether the following five statements belong in positive economics, normative economics, or the art of economics.

1. We should support the market because it is efficient.

2. Given certain conditions, the market achieves efficient results.

3. Based on past experience and our understanding of markets, if one wants a reasonably efficient result, markets should probably be relied on.

4. The distribution of income should be left to markets.

5. Markets allocate income according to contributions of factors of production.

Maintaining objectivity is easiest in positive economics, where you are working with abstract models to understand how the economy works. Maintaining objectivity is harder in normative economics. You must always be objective about whose normative values you are using. It’s easy to assume that all of society shares your values, but that assumption is often wrong.

It’s hardest to maintain objectivity in the art of economics because it can suffer from the problems of both positive and normative economics. Because noneconomic forces affect policy, to practice the art of economics we must make judgments about how these noneconomic forces work. These judgments are likely to reflect our own value judgments. So we must be exceedingly careful to be as objective as possible in practicing the art of economics.

Policy and Social and Political Forces

When you think about the policy options facing society, you’ll quickly discover that the choice of policy options depends on much more than economic theory. Politicians, not economists, determine economic policy. To understand what policies are chosen, you must take into account historical precedent plus social, cultural, and political forces. In an economics course, I don’t have time to analyze these forces in as much depth as I’d like. That’s one reason there are separate history, political science, sociology, and anthropology courses.


Web Note 1.3: The Art of Economics

While it is true that these other forces play significant roles in policy decisions, specialization is necessary. In economics, we focus the analysis on the invisible hand, and much of economic theory is devoted to considering how the economy would operate if the invisible hand were the only force operating. But as soon as we apply theory to reality and policy, we must take into account political and social forces as well.

An example will make my point more concrete. Most economists agree that holding down or eliminating tariffs (taxes on imports) and quotas (numerical limitations on imports) makes good economic sense. They strongly advise governments to follow a policy of free trade. Do governments follow free trade policies? Almost invariably they do not. Politics leads society in a different direction. If you’re advising a policy maker, you need to point out that these other forces must be taken into account, and how other forces should (if they should) and can (if they can) be integrated with your recommendations.


There are tons more that could be said by way of introducing you to economics, but an introduction must remain an introduction. As it is, this chapter should have

1. Introduced you to economic reasoning.

2. Surveyed what we’re going to cover in this book.

3. Given you an idea of my writing style and approach.

We’ll be spending long hours together over the coming term, and before entering into such a commitment it’s best to know your partner. While I won’t know you, by the end of this book you’ll know me. Maybe you won’t love me as my mother does, but you’ll know me.

This introduction was my opening line. I hope it also conveyed the importance and relevance that belong to economics. If it did, it has served its intended purpose. Economics is tough, but tough can be fun.


• The three coordination problems any economy must solve are what to produce, how to produce it, and for whom to produce it. In solving these problems, societies have found that there is a problem of scarcity.

• Economic reasoning structures all questions in a cost/ benefit framework: If the marginal benefits of doing something exceed the marginal costs, do it. If the marginal costs exceed the marginal benefits, don’t do it.

• Sunk costs are not relevant in the economic decision rule.

• The opportunity cost of undertaking an activity is the benefit you might have gained from choosing the next-best alternative.

• “There ain’t no such thing as a free lunch” (TANSTAAFL) embodies the opportunity cost concept.

• Economic forces, the forces of scarcity, are always working. Market forces, which ration by changing prices, are not always allowed to work.

• Economic reality is controlled and directed by three types of forces: economic forces, political forces, and social forces.

• Under certain conditions, the market, through its price mechanism, will allocate scarce resources efficiently.

• Economics can be divided into microeconomics and macroeconomics. Microeconomics is the study of individual choice and how that choice is influenced by economic forces. Macroeconomics is the study of the economy as a whole. It considers problems such as inflation, unemployment, business cycles, and growth.

• Economics can be subdivided into positive economics, normative economics, and the art of economics. Positive economics is the study of what is, normative economics is the study of what should be, and the art of economics relates positive to normative economics.

2: The Production Possibility Model, Trade, and Globalization

Economics is a science of thinking in terms of models, joined to the art of choosing models which are relevant to the contemporary world.

—J. M. Keynes

Every economy must solve three main coordination problems:

1. What, and how much, to produce.
2. How to produce it.
3. For whom to produce it.

In Chapter 1, I suggested that you can boil down all economic knowledge into the single phrase “There ain’t no such thing as a free lunch.” There’s obviously more to economics than that, but it’s not a bad summary of the core of economic reasoning—it’s relevant for an individual, for nonprofit organizations, for governments, and for nations. Oh, it’s true that once in a while you can snitch a sandwich, but what economics tells you is that if you’re offered something that approaches free-lunch status, you should also be on the lookout for some hidden cost.

A key element in getting people to recognize that lunches aren’t free is the concept of opportunity cost—every decision has a cost in forgone opportunities—which I introduced you to in Chapter 1. Economists have a model, the production possibility model, that conveys the concept of opportunity costs both numerically and graphically. This model is important for understanding not only opportunity cost but also why people specialize in what they do and trade for the goods they need. Through specialization and trade, individuals, firms, and countries can achieve greater levels of production than they could otherwise achieve.

The Production Possibilities Model

The production possibilities model can be presented both in a table and in a graph. (Appendix A has a discussion of graphs in economics.) I’ll start with the table and then move from that to the graph. Opportunity cost can be seen numerically with a production possibility table—a table that lists a choice’s opportunity costs by summarizing what alternative outputs you can achieve with your inputs. An output is simply a result of an activity, and an input is what you put into a production process to achieve an output. For example, your grade in a course is an output and your study time is an input.


In the graph below, what is the opportunity cost of producing an extra unit of good X in terms of good Y?

A Production Possibility Curve for an Individual

Let’s consider the study-time/grades example. Say you have exactly 20 hours a week to devote to two courses: economics and history. (So maybe I’m a bit optimistic.) Grades are given numerically and you know that the following relationships exist: If you study 20 hours in economics, you’ll get a grade of 100; 18 hours, 94; and so forth.1

Let’s say that the best you can do in history is a 98 with 20 hours of study a week; 19 hours of study guarantees a 96, and so on. The production possibility table in Figure 2-1(a) shows the highest combination of grades you can get with various allocations of the 20 hours available for studying the two subjects. One possibility is getting 70 in economics and 78 in history.

Notice that the opportunity cost of studying one subject rather than the other is embodied in the production possibility table. The information in the table comes from experience: We are assuming that you’ve discovered that if you transfer an hour of study from economics to history, you’ll lose 3 points on your grade in economics and gain 2 points in history. Thus, the opportunity cost of a 2-point rise in your history grade is a 3-point decrease in your economics grade.

The information in the production possibility table also can be presented graphically in a diagram called a production possibility curve. A production possibility curve (PPC) is a curve measuring the maximum combination of outputs that can be obtained from a given number of inputs. It is a graphical presentation of the opportunity cost concept.

The production possibility curve is a curve measuring the maximum combination of outputs that can be obtained from a given number of inputs.

A production possibility curve is created from a production possibility table by mapping the table in a two-dimensional graph. I’ve taken the information from the table in Figure 2-1(a) and mapped it into Figure 2-1(b). The history grade is mapped, or plotted, on the horizontal axis; the economics grade is on the vertical axis.

As you can see from the bottom row of Figure 2-1(a), if you study economics for all 20 hours and study history for 0 hours, you’ll get grades of 100 in economics and 58 in history. Point A in Figure 2-1(b) represents that choice. If you study history for all 20 hours and study economics for 0 hours, you’ll get a 98 in history and a 40 in economics. Point E represents that choice. Points B, C, and D represent three possible choices between these two extremes.

The slope of the production possibility curve tells you the opportunity cost of good X in terms of good Y. You have to give up 2Y to get 1X when you’re around point A.

Notice that the production possibility curve slopes downward from left to right. That means that there is an inverse relationship (a trade-off) between grades in economics and grades in history. The better the grade in economics, the worse the grade in history, and vice versa. That downward slope represents the opportunity cost concept: you get more of one benefit only if you get less of another benefit.

The production possibility curve not only represents the opportunity cost concept but also measures the opportunity cost. For example, in Figure 2-1(b), say you want to raise your grade in history from a 94 to a 98 (move from point D to point E). The opportunity cost of that 4-point increase would be a 6-point decrease in your economics grade, from 46 to 40.

FIGURE 2-1 (A AND B): A Production Possibility Table and Curve for Grades in Economics and History

The production possibility table (a) shows the highest combination of grades you can get with only 20 hours available for studying economics and history. The information in the production possibility table in (a) can be plotted on a graph, as is done in (b). The grade received in economics is on the vertical axis, and the grade received in history is on the horizontal axis.

To summarize, the production possibility curve demonstrates that

1. There is a limit to what you can achieve, given the existing institutions, resources, and technology.

2. Every choice you make has an opportunity cost. You can get more of something only by giving up something else.

Production Possibilities Curve

Increasing Marginal Opportunity Cost

In the study-time/grade example, the opportunity cost of trade remained constant; you could always trade two points on your history grade for three points on your economics grade. This assumption of an unchanging opportunity cost made the production possibility curve a straight line. Although this made the example easier, is it realistic? Probably not, especially if we are using the PPC to describe the choices that a society makes. For many of the choices society must make, opportunity costs tend to increase as we choose more and more of an item. Such a phenomenon is so common, in fact, that it has acquired a name: the principle of increasing marginal opportunity cost. That principle states:

In order to get more of something, one must give up ever-increasing quantities of something else

The principle of increasing marginal opportunity cost tells us that opportunity costs increase the more you concentrate on the activity.

In other words, initially the opportunity costs of an activity are low, but they increase the more we concentrate on that activity.

A production possibility curve that exhibits increasing marginal opportunity costs is bowed outward, as in Figure 2-2(b).

Why are production possibility curves typically bowed outward? Because some resources are better suited for the production of certain kinds of goods than other kinds of goods. To understand what that means, let’s talk about the graph in Figure 2-2(b), which is derived from the table in Figure 2-2(a). This curve represents society’s choice between defense spending (guns) and spending on domestic needs (butter).

Suppose society is producing only butter (point A). Giving up a little butter (1 pound) initially gains us a lot of guns (4), moving us to point B. The next 2 pounds of butter we give up gain us slightly fewer guns (point C). If we continue to trade butter for guns, we find that at point D we gain very few guns from giving up a pound of butter. The opportunity cost of choosing guns over butter increases as we increase the production of guns.

Comparative Advantage

The reason the opportunity cost of guns increases as we produce more guns is that some resources are relatively better suited to producing guns, while others are relatively better suited to producing butter. Put in economists’ terminology, some resources have a comparative advantage over other resources—the ability to be better suited to the production of one good than to the production of another good. In this example, some resources have a comparative advantage over other resources in the production of butter, while other resources have a comparative advantage in the production of guns.

FIGURE 2-2 (A AND B): A Production Possibility Table and Curve

The table in (a) contains information on the trade-off between the production of guns and butter. This information has been plotted on the graph in (b). Notice in (b) that as we move along the production possibility curve from A to F, trading butter for guns, we get fewer and fewer guns for each pound of butter given up. That is, the opportunity cost of choosing guns over butter increases as we increase the production of guns. This concept is called the principle of increasing marginal opportunity cost. The phenomenon occurs because some resources are better suited for the production of butter than for the production of guns, and we use the better ones first.


Production Possibility Curves


If no resource had a comparative advantage in the production of any good, what would the shape of the production possibility curve be? Why?

Comparative Advantage

When making small amounts of guns and large amounts of butter, we first use the resources whose comparative advantage is in the production of guns to produce guns. All other resources are devoted to producing butter. Because the resources used in producing guns aren’t good at producing butter, we’re not giving up much butter to get those guns. As we produce more and more of a good, we must use resources whose comparative advantage is in the production of the other good—in this case, more suitable for producing butter than for producing guns. As we remove resources from the production of butter to get the same additional amount of guns, we must give up increasing amounts of butter. An alternative way of saying this is that the opportunity cost of producing guns becomes greater as the production of guns increases. As we continue to increase the production of guns, the opportunity cost of more guns becomes very high because we’re using resources to produce guns that have a strong comparative advantage for producing butter.

Let’s consider two more examples. Say the United States suddenly decides it needs more wheat. To get additional wheat, we must devote additional land to growing it. This land is less fertile than the land we’re already using, so our additional output of wheat per acre of land devoted to wheat will be less. Alternatively, consider the use of relief pitchers in a baseball game. If only one relief pitcher is needed, the manager sends in the best; if he must send in a second one, then a third, and even a fourth, the likelihood of winning the game decreases.


We would like, if possible, to get as much output as possible from a given amount of inputs or resources. That’s productive efficiency—achieving as much output as possible from a given amount of inputs or resources. We would like to be efficient. The production possibility curve helps us see what is meant by productive efficiency. Consider point A in Figure 2-3(a), which is inside the production possibility curve. If we are producing at point A, we are using all our resources to produce 6 guns and 4 pounds of butter. Point A represents inefficiency—getting less output from inputs that, if devoted to some other activity, would produce more output. That’s because with the same inputs we could be getting either 8 guns and 4 pounds of butter (point B) or 6 pounds of butter and 6 guns (point C). As long as we prefer more to less, both points B and C represent efficiency—achieving a goal using as few inputs as possible. We always want to move our production out to a point on the production possibility curve.


Choices in Context

The production possibility curve presents choices without regard to time and therefore makes opportunity costs clear-cut; there are two choices, one with a higher cost and one with a lower cost. The reality is that most choices are dependent on other choices; they are made sequentially. With sequential choices, you cannot simply reverse your decision. Once you have started on a path, to take another path you have to return to the beginning. Thus, following one path often lowers the costs of options along that path, but it raises the costs of options along another path.

Such sequential decisions can best be seen within the framework of a decision tree—a visual description of sequential choices. A decision tree is shown in the accompanying figure.

Once you make the initial decision to go on path A, the costs of path B options become higher; they include the costs of retracing your path and starting over. The decision trees of life have thousands of branches; each decision you make rules out other paths, or at least increases their costs significantly. (Remember that day you decided to blow off your homework? That decision may have changed your future life.)

Another way of putting this same point is that all decisions are made in context: What makes sense in one context may not make sense in another. For example, say you’re answering the question “Would society be better off if students were taught literature or if they were taught agriculture?” The answer depends on the institutional context. In a developing country whose goal is large increases in material output, teaching agriculture may make sense. In a developed country, where growth in material output is less important, teaching literature may make sense.

Recognizing the contextual nature of decisions is important when interpreting the production possibility curve. Because decisions are contextual, what the production possibility curve for a particular decision looks like depends on the existing institutions, and the analysis can be applied only in institutional and historical context. The production possibility curve is not a purely technical phenomenon. The curve is an engine of analysis to make contextual choices, not a definitive tool to decide what one should do in all cases.


Identify the point(s) of inefficiency and efficiency. What point(s) are unattainable?

Why not move out farther, to point D? If we could, we would, but by definition the production possibility curve represents the most output we can get from a certain combination of inputs. So point D is unattainable, given our resources and technology.

When technology improves, when more resources are discovered, or when the economic institutions get better at fulfilling our wants, we can get more output with the same inputs. What this means is that when technology or an economic institution improves, the entire production possibility curve shifts outward from AB to CD in Figure 2-3(b). How the production possibility curve shifts outward depends on how the technology improves. For example, say we become more efficient at producing butter, but not more efficient at producing guns. Then the production possibility curve shifts outward to AC in Figure 2-3(c).

FIGURE 2-3 (A, B, AND C): Efficiency, Inefficiency, and Technological Change

The production possibility curve helps us see what is meant by efficiency. At point A, in (a), all inputs are used to make 4 pounds of butter and 6 guns. This is inefficient since there is a way to obtain more of one without giving up any of the other, that is, to obtain 6 pounds of butter and 6 guns (point C) or 8 guns and 4 pounds of butter (point B). All points inside the production possibility curve are inefficient. With existing inputs and technology, we cannot go beyond the production possibility curve. For example, point D is unattainable.

A technological change that improves production techniques will shift the production possibility curve outward, as shown in both (b) and (c). How the curve shifts outward depends on how technology improves. For example, if we become more efficient in the production of both guns and butter, the curve will shift out as in (b). If we become more efficient in producing butter, but not in producing guns, then the curve will shift as in (c).

Distribution and Productive Efficiency

In discussing the production possibility curve for a society, I avoided questions of distribution: Who gets what? But such questions cannot be ignored in real-world situations. Specifically, if the method of production is tied to a particular income distribution and choosing one method will help some people but hurt others, we can’t say that one method of production is efficient and the other inefficient, even if one method produces more total output than the other. As I stated above, the term efficiency involves achieving a goal as cheaply as possible. The term has meaning only in regard to a specified goal. Say, for example, that we have a society of ascetics who believe that consumption above some minimum is immoral. For such a society, producing more for less (productive efficiency) would not be efficient since consumption is not its goal. Or say that we have a society that cares that what is produced is fairly distributed. An increase in output that goes to only one person and not to anyone else would not necessarily be efficient.


Your firm is establishing a trucking business in Saudi Arabia. The managers have noticed that women are generally paid much less than men in Saudi Arabia, and they suggest that hiring women would be more efficient than hiring men. What should you respond?

In our society, however, most people prefer more to less, and many policies have relatively small distributional consequences. On the basis of the assumption that more is better than less, economists use their own kind of shorthand for such policies and talk about efficiency as identical to productive efficiency—increasing total output. But it’s important to remember the assumption under which that shorthand is used: that the distributional effects that accompany the policy are acceptable, and that we, as a society, prefer more output.

FIGURE 2-4 (A, B, C, AND D): Examples of Shifts in Production Possibility Curves

Each of these curves reflects a different type of shift. (The axes are left unlabeled on purpose. Manufactured and agricultural goods may be placed on either axis.) Your assignment is to match these shifts with the situations given in the text.

Examples of Shifts in the PPC

To see whether you understand the production possibility curve, let us now consider some situations that can be shown with it. Below, I list four situations. To test your understanding of the curve, match each situation to one of the curves in Figure 2-4.

1. A meteor hits the world and destroys half the earth’s natural resources.

2. Nanotechnology is perfected that lowers the cost of manufactured goods.

3. A new technology is discovered that doubles the speed at which all goods can be produced.

4. Global warming increases the cost of producing agricultural goods.

The correct answers are: 1-d; 2-a; 3-b; 4-c.

If you got them all right, you are well on your way to understanding the production possibility curve.


When a natural disaster hits the midwestern United States, where most of the U.S. butter is produced, what happens to the U.S. production possibility curve for guns and butter?

Trade and Comparative Advantage

Now that we have gone through the basics of the production possibility curve, let’s dig a little deeper. From the above discussion, you know that production possibility curves are generally bowed outward and that the reason for this is comparative advantage. To remind you of the argument, consider Figure 2-5, which is the guns and butter production possibility example I presented earlier.

At point A, all resources are being used to produce butter. As more guns are produced, we take resources away from producing butter that had a comparative advantage in producing guns, so we gain a lot of guns for little butter (the opportunity cost of additional guns is low). As we continue down the curve, the comparative advantage of the resources we use changes, and as we approach B, we use almost all resources to produce guns, so we are using resources that aren’t very good at producing guns. Thus, around point B we gain few guns for a lot of butter (the opportunity cost of additional guns is high).

A society wants to be on the frontier of its production possibility curve. This requires that individuals produce those goods for which they have a comparative advantage. The question for society, then, is how to direct individuals toward those activities. For a firm, the answer is easy. A manager can allocate the firm’s resources to their best use. For example, he or she can assign an employee with good people skills to the human resources department and another with good research skills to research and development. But our economy has millions of individuals, and no manager directing everyone what to do. How do we know that these individuals will be directed to do those things for which they have a comparative advantage? It was this question that was central to the British moral philosopher Adam Smith when he wrote his most famous book, The Wealth of Nations (1776). In it he argued that it was humankind’s proclivity to trade that leads to individuals using their comparative advantage. He writes:

This division of labour, from which so many advantages are derived, is not originally the effect of any human wisdom, which foresees and intends that general opulence to which it gives occasion. It is the necessary, though very slow and gradual consequence of a certain propensity in human nature which has in view no such extensive utility; the propensity to truck, barter, and exchange one thing for another… [This propensity] is common to all men, and to be found in no other race of animals, which seem to know neither this nor any other species of contracts… Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. Nobody ever saw one animal by its gestures and natural cries signify to another, this is mine, that yours; I am willing to give this for that.

FIGURE 2-5: Comparative Advantage and the Production Possibility Curve

As we move down along the production possibility curve from point A to point B, the opportunity cost of producing guns is increasing since we are using resources less suited for gun production.

As long as people trade, Smith argues, the market will guide people, like an invisible hand, to gravitate toward those activities for which they have a comparative advantage. By specializing in the production of goods in which they have a comparative advantage, they will produce the most goods they can. They can then trade with other people who specialize in the production of other goods. For Smith, what was especially neat about this process was that it could take place without enormous amounts of government intervention. Smith writes:

Adam Smith argued that it is humankind’s proclivity to trade that leads to individuals using their comparative advantage.

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. Whoever offers to another a bargain of any kind proposes to do this. Give me that which I want, and you shall have that 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. 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.

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.

FIGURE 2-6: Growth in the Past Two Millennia

For 1,700 years the world economy grew very slowly. Then, since the end of the 18th century with the introduction of markets and the spread of democracy, the world economy has grown at increasing rates.

Source: Angus Maddison, Monitoring the World Economy, OECD, 1995; Angus Maddison, “Poor until 1820,” The Wall Street Journal, January 11, 1999; and author extrapolations.

Markets, Specialization, and Growth

We can see the effect of trade on our well-being empirically by considering the growth of economies. As you can see from Figure 2-6, for 1,700 years the world economy grew very slowly. Then, at the end of the 18th century, the world economy started to grow, and it has grown at a high rate since then.

What changed? The introduction of markets that facilitate trade and the spread of democracy. There’s something about markets that leads to economic growth. Markets allow specialization and encourage trade. The bowing out of the production possibilities from trade is part of the story, but a minor part. As individuals compete and specialize, they learn by doing, becoming even better at what they do. Markets also foster competition, which pushes individuals to find better ways of doing things. They devise new technologies that further the growth process.

The new millennium is offering new ways for individuals to specialize and compete. More and more businesses are trading on the Internet. For example, colleges such as the University of Phoenix are providing online competition for traditional colleges. Similarly, online bookstores and drugstores are proliferating. As Internet technology becomes built into our economy, we can expect more specialization, more division of labor, and the economic growth that follows.

Markets can be very simple or very complicated.

The Benefits of Trade

The reasons why markets can direct people to use their comparative advantages follows from a very simple argument: When people freely enter into a trade, both parties can be expected to benefit from the trade; otherwise, why would they have traded in the first place? So when the butcher sells you meat, he’s better off with the money you give him, and you’re better off with the meat he gives you.


Web Note 2.1: Wine and Cloth

When there is competition in trading, such that individuals are able to pick the best trades available to them, each individual drives the best bargain he or she can. The end result is that both individuals in the trade benefit as much as they possibly can, given what others are willing to trade. This argument for the benefits from trade underlies the general policy of laissez-faire—an economic policy of leaving coordination of individuals’ actions to the market. (Laissez-faire, a French term, means “Let events take their course; leave things alone.”)

Laissez-faire is an economic policy of leaving coordination of individuals’ actions to the market.

Let’s consider a numerical example of the gains that accrue to two countries when they trade, and show how that trade increases the production possibilities, creating the bowed shape of the production possibility curve. I use an international trade example so that you can see that the argument holds for international trade as well as domestic trade.

FIGURE 2-7 (A AND B): The Gains from Trade

Trade makes those involved in the trade better off. If each country specializes and takes advantage of its comparative advantage, the combined production possibility curve becomes bowed outward. In (a), the gains from trade are represented by the movements of the countries from points A and B to point C. In (b), you can see how the combined PPC reflects the “lowest cost rules” principle.

Let’s say that the two countries are Pakistan and Belgium, and that Pakistan has a comparative advantage in producing textiles, while Belgium has a comparative advantage in producing chocolate. Specifically, Pakistan can produce 4,000 yards of textiles a day, or 1 ton of chocolate a day, or any proportional combination in between. (Pakistan’s opportunity cost of 1 ton of chocolate is 4,000 yards of textiles.) Pakistan’s production possibility curve is shown by the orange line in Figure 2-7(a). In a given day, Belgium can produce either 1,000 yards of textiles, 4 tons of chocolate, or any proportion in between. (Belgium’s opportunity cost of 1 ton of chocolate is 250 yards of textiles.) Its production possibility curve is shown by the green line in Figure 2-7(a).


What argument underlies the general laissez-faire policy argument?

In the absence of trade, the most each country can consume is some combination along its production possibility curve. Say Pakistan has chosen to produce and consume 2,000 yards of textiles and 0.5 ton of chocolate (point A), while Belgium has chosen to produce and consume 500 yards of textiles and 2 tons of chocolate (point B).

Let’s now consider what would happen if each specialized, doing what it does best, and then traded with the other for the goods it wants. This separates the production and consumption decisions. Because Pakistan has the lower opportunity cost, it makes sense for Pakistan to specialize in textiles, producing 4,000 yards. Similarly, it makes sense for Belgium to specialize in chocolate, producing 4 tons. By specializing, the countries together produce 4 tons of chocolate and 4,000 yards of textiles. If the countries divide production so that each country gets 2,000 yards of fabric and 2 tons of chocolate, both countries will be consuming at point C, even as they are producing at points D and E, respectively. Point C is beyond both countries’ production possibility curves. This tells us an important principle about trade:

Specialization and trade create gains that make all better off.

Trade lets countries consume beyond their production possibility curve.

It is primarily these gains that lead to economists’ support of free trade and their opposition to barriers to trade.

Trade lets countries consume beyond their production possibility curve.

Comparative Advantage and the Combined PPC

Constructing a production possibility curve that shows the combination of goods these two countries can produce is a useful exercise. I do so in Figure 2-7(b) by first asking how much of each good can be produced if both countries produce the same good. If both countries produce only textiles, 5,000 yards of textiles are made (point F). Alternatively, if they produce only chocolate, 5 tons of chocolate are produced (point G). A third possibility is that Pakistan specializes in the good in which it has a comparative advantage—textiles—and produces 4,000 yards, while Belgium specializes in the good in which it has a comparative advantage—chocolate—producing 4 tons. This combination is shown by point H. Since other combinations of goods are possible, connecting points F, H, and G gives us the combined production possibility curve.


Steve can bake either 4 loaves of bread or 8 dozen cookies a day. Sarah can bake either 4 loaves of bread or 4 dozen cookies a day. Show, using production possibility curves, that Steve and Sarah would be better off specializing in their baking activities and then trading, rather than baking only for themselves.

Notice that this combined production possibility curve has the same slope as Belgium’s from F to H, and the same slope as Pakistan’s from H to G. That is because, when trade is allowed, the slope of the combined production possibility curve is determined by the country with the lowest opportunity cost. It is by producing where costs are lowest that countries can achieve gains from trade. This principle—lowest cost rules—gives us a sense of what happens when we expand the production possibility curve analysis to include many countries rather than just two: The production possibility curve becomes smoother as each country’s comparative advantage governs a smaller portion of the shape. Eventually, as the number of countries that trade gets large, it becomes the smooth bowed curve we drew above for guns and butter.


True or false? Two countries can achieve the greatest gains from trade by each producing the goods for which the opportunity costs are greatest and then trading those goods.

U.S. Textile Production and Trade

When each country follows its comparative advantage, production becomes more efficient and the consumption possibilities for both countries increase. Because of these benefits, most economists support free markets and free trade. The market system gives individual firms an incentive to search for comparative advantages and to produce with lowest-cost methods at lowest-cost locations. This pressures other producers to lower their costs or get out of the business.

The pressure to find comparative advantages is never ending.

The pressure to find comparative advantages is never ending, in part because comparative advantage can change. Two hundred years ago, the United States had a comparative advantage in producing textiles. It was rich in natural resources and labor, and it had a low-cost source of power (water). As the cost of U.S. labor went up, and as trade opportunities widened, that comparative advantage disappeared. As it did, the United States moved out of the textile industry. Countries with cheaper labor, such as Bangladesh, today have the comparative advantage in textiles. As firms have relocated textile production to Bangladesh, total costs have fallen. The gains from trade show up as higher pay for Bangladeshi workers and lower-priced cloth for U.S. consumers. Of course, trade is a two-way street. In return for Bangladesh’s textiles, the United States sends computer software and airplanes, products that would be highly expensive, indeed almost impossible, for Bangladesh to produce on its own. So Bangladeshi consumers, on average, are also made better off by the trade.


Web Note 2.2: Wage Comparison

Outsourcing, Trade, and Comparative Advantage

There is much more to be said about both trade and the gains from trade, and later chapters will explore trade in much more detail. But let me briefly discuss the relationship of the theory of comparative advantage to two terms that you often read about in the newspaper—outsourcing and globalization. In this book, we will use the newspaper definition of outsourcing—the relocation of production once done in the United States to foreign countries.

Let’s begin with outsourcing.

Outsourcing is the relocation of production once done in the United States to foreign countries.


At one time, the term outsourcing was used in a broader context and referred to subcontracting a portion of a firm’s production to another firm either within or outside the United States. However, recently, it has been used in this more narrow sense, and that is how I will use the term here. One service being outsourced today is customer support. More and more, customer support calls are routed to call centers in India, rather than in the United States. By outsourcing call services, the United States imports the service “assistance.” Before recent developments in telecommunications, support call services could not be imported.

To put outsourcing in its proper perspective, you should think of it in relation to insourcing—the relocation of production done abroad to the United States. Outsourcing only becomes an important policy issue to the degree that it significantly exceeds insourcing. While the actual numbers on both are difficult to collect and interpret, there is a general sense that in recent years not only has outsourcing been increasing, insourcing has been decreasing, and hence insourcing is being overwhelmed by outsourcing.

Outsourcing scares many people in the United States because, with wages so much lower in many developing countries than in the United States, they wonder whether all jobs will move offshore: Will the United States be left producing anything? Economists’ answer is: Of course it will. Comparative advantage, by definition, means that if one country has a comparative advantage in producing one set of goods, the other country has to have a comparative advantage in the other set of goods. The real questions are: In what goods will the United States have comparative advantages? and: How will those comparative advantages come about?


Is it likely that all U.S. jobs will one day be outsourced? Why or why not?

One reason people have a hard time thinking of goods in which the United States has a comparative advantage is that they are thinking in terms of labor costs. They ask: Since wages are lower in China, isn’t it cheaper to produce all goods in China? The answer is no; production requires many more inputs than just “labor.”


, institutional structure, specialized types of knowledge, and entrepreneurial know-how are also needed to produce goods, and the United States has significant advantages in these other factors. It is these advantages that result in higher U.S. wages compared to other countries.


The term globalization is broader than outsourcing. Globalization is the increasing integration of economies, cultures, and institutions across the world. In a globalized economy, firms think of production and sales at a global level. They produce where costs are lowest, and sell across the world at the highest price they can get. A globalized world is a world in which economies of the world are highly integrated. Globalization has two effects on firms. The first is positive; because the world economy is so much larger than the domestic economy, the rewards for winning globally are much larger than the rewards for winning domestically. The second effect is negative; it is much harder to win, or even to stay in business, competing in a global market. A company may be the low-cost producer in a particular country yet may face foreign competitors that can undersell it.

The global economy increases the number of competitors for the firm.

Consider the automobile industry. Three companies are headquartered in the United States, but more than 20 automobile companies operate worldwide. U.S. automakers face stiff competition from foreign automakers; unless they meet that competition, they will not survive.


Made in China?

Barbie and her companion Ken are as America n as apple pie, and considering their origins gives us some insight into the modern U.S. economy and its interconnection with other countries. Barbie and Ken are not produced in the United States; they never were. When Barbie first came out in 1959, she was produced in Japan. Today, it is unclear where Barbie and Ken are produced. If you look at the box they come in, it says “Made in China,” but looking deeper we find that Barbie and Ken are actually made in five different countries, each focusing on an aspect of production that reflects its comparative advantage. Japan produces the nylon hair. China provides much of what is normally considered manufacturing—factory spaces, labor, and energy for assembly—but it imports many of the components. The oil for the plastic comes from Saudi Arabia, which is refined into plastic pellets in Taiwan. The United States even provides some of the raw materials that go into the manufacturing process—it provides the cardboard, packing, paint pigments, and the mold.

The diversification of parts that go into the manufacturing of Barbie and Ken is typical of many goods today. As the world economy has become more integrated, the process of supplying components of manufacturing has become more and more spread out, as firms have divided up the manufacturing process in search of the least-cost location for each component.

But the global diversity in manufacturing and supply of components is only half the story of modern production. The other half is the shrinking of the relative importance of that manufacturing, and it is this other half that explains how the United States maintains its position in the world when so much of the manufacturing takes place elsewhere. It does so by maintaining its control over the distribution and marketing of the goods. In fact, of the $15 retail cost of a Barbie or Ken, $12 can be accounted for by activities not associated with manufacturing—design, transportation, merchandising, and advertising. And, luckily for the United States, many of these activities are still done in the United States, allowing the country to maintain its high living standard even as manufacturing spreads around the globe.

The global economy increases the number of competitors for the firm.

These two effects are, of course, related. When you compete in a larger market, you have to be better to survive, but if you do survive the rewards are greater.

Globalization increases competition by allowing greater specialization and division of labor, which, as Adam Smith first observed in The Wealth of Nations, increases growth and improves the standard of living for everyone. Thus, in many ways globalization is simply another name for increased specialization. Globalization allows (indeed, forces) companies to move operations to countries with a comparative advantage. As they do so, they lower costs of production. Globalization leads to companies specializing in smaller portions of the production process because the potential market is not just one country but the world. Such specialization can lead to increased productivity as firms learn from doing.


Insourcing into the United States

In a global economy, a company will locate its operations to wherever it makes most sense to produce. Generally this means that it will locate where the costs are lowest, or where the company can get some unique benefit. When you think of costs, you should think of all costs, not just labor costs. The same with benefits. Doing so, you can see why companies insource production into the United States—as well as outsource production out of the United States.

Consider Novartis, a global pharmaceutical company, which recently moved its global research headquarters from Switzerland to Cambridge, Massachusetts. It chose the United States because Cambridge had a strong concentration of academic biomedical research facilities, making it a great place for collaborations. In this case, the United States’ primary cost advantage was that it had some unique benefits that couldn’t be duplicated elsewhere.

Another example of insourcing is Toyota’s moving of portions of their car production from Japan to the United States. It did so to reduce transportation costs and reduce the political pressure by the U.S. Congress to institute tariffs on cars produced by foreign-owned companies. Relocating also reduced overall costs relative to Japan since Japanese workers are more expensive than the U.S. workers Toyota hires, although not relative to China, where it also has production facilities.

Even Indian and Chinese firms are establishing branches here in the United States, which is a type of insourcing. For example, Lenovo, the Chinese computer maker, acquired IBM’s personal computer division and established sales offices in the United States. Other non-U.S.-based global companies are establishing research and marketing divisions in the United States to take advantage of the creative workforce, and to establish a presence in the United States.


How does globalization reduce the costs of production?

U.S. Comparative Advantage Today and Tomorrow

The United States has excelled particularly in goods that require creativity and innovation. The United States has remained the leader of the world economy and has kept a comparative advantage in many goods even with its high relative wages, in part because of continual innovation. For example, the Internet started in the United States, which is why the United States is the location of so many information technology firms. The United States also has led the way in biotechnology innovation. Similarly, the creative industries, such as film, art, and advertising, have flourished in the United States. These industries are dynamic, high-profit, high-wage industries. (One of the reasons insourcing occurs is that the United States has such a great comparative advantage in these other aspects of production.) As long as U.S. production maintains a comparative advantage in innovation, the United States will be able to specialize in goods that allow firms to pay higher wages.

The real concern about outsourcing involves what happens in the evolution and development of industries. The natural progression is that, as an industry matures, its technology and specialized knowledge spread, which allows more and more of that industry’s production to be outsourced. This means that slowly over time the United States can be expected to lose its comparative advantage in currently “new” industries, such as information technology, just as has happened with other industries in the past.


The Developing Country’s Perspective on Outsourcing

This book is written from a U.S. point o f view. From that perspective, the relevant question is: Can the United States maintain its high wages relative to the low wages in China, India, and other developing countries? I suspect that most U.S. readers hope that it can. From a developing country’s perspective, I suspect that the hope is that it cannot; their hope is that their wage rates catch up with U.S. wage rates. Judged from a developing country’s perspective, the question is: Is it fair that U.S. workers don’t work as hard as we do but earn much more?

The market does not directly take fairness into account. The market is interested only in who can produce a good or service at the lowest cost. This means that in a competitive economy, the United States can maintain its high wages only to the degree that it can produce sufficient goods and services cheaper than low-wage countries can at the market exchange rate. It must keep the trade balance roughly equal.

Developing countries recognize that, in the past, the United States has had a comparative advantage in creativity and innovation, and they are doing everything they can to compete on these levels as well as on basic production levels. They are actively trying to develop such skills in their population and to compete with the United States not only in manufacturing and low-tech jobs but also in research, development, finance, organizational activities, artistic activities, and high-tech jobs. Right now companies in China and India are working to challenge U.S. dominance in all high-tech and creativity fields. (For example, they too are working on nanotechnology.) To do this, they are trying to entice top scientists and engineers to stay in their country, or to return home if they have been studying or working in the United States. Since more than 50 percent of all PhD’s given in science, engineering, and economics go to non-U.S. citizens (in economics, it is more than 70 percent), many observers believe that the United States cannot assume its past dominance in the innovative and high-tech fields will continue forever. The competitive front that will determine whether the United States can maintain much higher wages than developing countries is not the competition in current industries, but competition in industries of the future.

Nanotechnology—dynamic industry of the future?

However, as long as the United States remains as creative and innovative as it has in the past, the outsourcing of maturing industries can be replaced with industries that don’t even exist today, just as information technology replaced many areas of manufacturing in the 1990s. One industry that some economists believe the United States is on the edge of developing is nanotechnology (machining at a subatomic level). The point is that with sufficient creativity and innovation, the U.S. economic future can be quite bright.

Exchange Rates and Comparative Advantage

There is, however, reason to be concerned. If innovation and creativity don’t develop new industries in which the United States has a comparative advantage fast enough, as the current dynamic industries mature and move to low-wage areas, at current exchange rates (the value of a currency relative to the value of foreign currencies), the United States will not maintain comparative advantages in sufficient industries to warrant the relative wage differentials that exist today. In that case, U.S. demand for foreign goods and services will be higher than foreign demand for U.S. goods and services. To bring them into equilibrium, the U.S. wage premium will have to decline to regain our comparative advantages. Since nominal wages (the wages that you see in your paycheck) in the United States are unlikely to fall, this will most likely occur through a decline in the U.S. exchange rate, large increases in foreign wages, or both. Either of these will make foreign products imported into the United States more expensive and U.S. products cheaper for foreigners, and eventually will balance the comparative advantages.

Law of One Price

Many Americans do not like the “exchange rate answer,” but in terms of policy, it is probably the best the United States can hope for. If the United States tries to prevent outsourcing with trade restrictions, U.S.-based companies will find that they can no longer compete internationally, and the United States will be in worse shape than if it had allowed outsourcing. The reality is that competition, combined with transferable technology and similar institutions, drives wages and prices of similar factors and goods toward equality. This reality often goes by the name of the law of one price—the wages of workers in one country will not differ significantly from the wages of (equal) workers in another institutionally similar country. As we will discuss in a later chapter, the debate is about what an “equal” worker is and what an equivalent institutional structure is.

The law of one price states that wages of workers in one country will not differ significantly from the wages of (equal) workers in another institutionally similar country.

Because of a variety of historical circumstances, the United States has been able to avoid the law of one price in wages since World War I. One factor has been the desire of foreigners to increase their holding of U.S. financial assets by trillions of dollars, which has let the United States consume more goods than it produces. Another is that the United States’ institutional structure, technology, entrepreneurial labor force, and nonlabor inputs have given the United States sufficiently strong comparative advantages to offset the higher U.S. wage rates. The passage of time and modern technological changes have been eroding the United States’ comparative advantages based on institutional structure and technology. To the degree that this continues to happen, to maintain a balance in the comparative advantages of various countries, the wages of workers in other countries such as India and China will have to move closer to the wages of U.S. workers.

Globalization and the Timing of Benefits of Trade

One final comment about outsourcing, globalization, and the U.S. economy is in order. None of the above discussion contradicts the proposition that trade makes both countries better off. Thus, the discussion does not support the position taken by some opponents to trade and globalization that outsourcing is hurting the United States and that the United States can be made better off by limiting outsourcing. Instead the discussion is about the timing of the benefits of trade. Many of the benefits of trade already have been consumed by the United States during the years that the United States has been running trade deficits (importing more than it is exporting).

The reality is that the United States has been living better than it could have otherwise precisely because of trade and outsourcing.

It also has been living much better than it otherwise could because it is paying for some of its imports with IOUs promising payment in the future instead of with exports. But there is no free lunch, and when these IOUs are presented for payment, the United States will have to pay for some of the benefits that it already has consumed.

The reality is that the United States has been living better than it could have otherwise precisely because of trade and outsourcing.

While the production possibility curve model does not give unambiguous answers as to what government’s role should be in regulating trade, it does serve a very important purpose. It is a geometric tool that summarizes a number of ideas in economics: opportunity cost, comparative advantage, efficiency, and how trade leads to efficiency. These ideas are all essential to economists’ conversations. They provide the framework within which those conversations take place. Thinking of the production possibility curve (and picturing the economy as being on it) directs you to think of the trade-offs involved in every decision.

The production possibility curve represents the tough choices society must make.

Look at questions such as: Should we save the spotted owl or should we allow logging in the western forests? Should we expand the government health care system or should we strengthen our national defense system? Should we emphasize policies that allow more consumption now or should we emphasize policies that allow more consumption in the future? Such choices involve difficult trade-offs that can be pictured by the production possibility curve.

Not everyone recognizes these trade-offs. For example, politicians often talk as if the production possibility curve were nonexistent. They promise voters the world, telling them, “If you elect me, you can have more of everything.” When they say that, they obscure the hard choices and increase their probability of getting elected.

Economists do the opposite. They promise little except that life is tough, and they continually point out that seemingly free lunches often involve significant hidden costs. Alas, political candidates who exhibit such reasonableness seldom get elected. Economists’ reasonableness has earned economics the nickname the dismal science.

Economists continually point out that seemingly free lunches often involve significant hidden costs.


• The production possibility curve measures the maximum combination of outputs that can be obtained from a given number of inputs. It embodies the opportunity cost concept.

• In general, in order to get more and more of something, we must give up ever-increasing quantities of something else. This is the principle of increasing marginal opportunity cost.

• Trade allows people to use their comparative advantage and shift out society’s production possibility curve.

• The rise of markets coincided with significant increases in output. Specialization, trade, and competition have all contributed to the increase.

• Points inside the production possibility curve are inefficient, points along the production possibility curve are efficient, and points outside are unattainable.

• By specializing in producing those goods for which one has a comparative advantage (lowest opportunity cost), one can produce the greatest amount of goods with which to trade. Doing so, countries can increase consumption. The effects of specialization and trade also can be shown by a shift of the production possibility curve out.

• The typical outward bow of the production possibility curve is the result of comparative advantage and trade.

• Because many goods are cheaper to produce in countries such as China and India, production that formerly took place in the United States is being outsourced to foreign countries.

• If the United States can maintain its strong comparative advantage in goods using new technologies and innovation, the jobs lost by outsourcing can be replaced with other high-paying jobs. If it does not, then some adjustments in relative wage rates or exchange rates must occur.

• Outsourcing is a product of the law of one price, which reflects business’s tendency to shift production to countries where it is cheapest to produce.

• Globalization is the increasing integration of economies, cultures, and institutions across the world.

Key Terms

comparative advantage (27)

efficiency (28)

globalization (35)

inefficiency (28)

input (24)

laissez-faire (32)

law of one price (39)

output (24)

outsourcing (35)

principle of increasing marginal opportunity cost (26)

production possibility curve (24)

production possibility table (23)

productive efficiency (27)

Questions for Thought and Review

1. Design a grade production possibility table and curve that embody the principle of increasing marginal opportunity cost. LO2

2. What would the production possibility curve look like if there were decreasing marginal opportunity costs? Explain. What is an example of decreasing marginal opportunity costs? (Difficult) LO2

3. Show how a production possibility curve would shift if a society became more productive in its output of widgets but less productive in its output of wadgets. LO1

4. Show how a production possibility curve would shift if a society became more productive in the output of both widgets and wadgets. LO1

5. How does the theory of comparative advantage relate to production possibility curves? LO3

6. When all people use economic reasoning, inefficiency is impossible, because if the benefit of reducing that inefficiency were greater than the cost, the inefficiency would be eliminated. Thus, if people use economic reasoning, it’s impossible to be on the interior of a production possibility curve. Is this statement true or false? Why? (Difficult) LO1

7. If neither of two countries has a comparative advantage in either of two goods, what are the gains from trade? LO4

8. If income distribution is tied to a particular production technique, how might that change one’s view of alternative production techniques? (Difficult) LO1

9. Does the fact that the production possibilities model tells us that trade is good mean that in the real world free trade is necessarily the best policy? Explain. LO4

10. What effect has globalization had on the ability of firms to specialize? How has this affected the competitive process? LO5

11. If workers in China and India become as productive as U.S. workers, what adjustments will allow the United States to regain its competitiveness? LO5

12. How can exchange rates change to reduce wage differences between countries? LO5

13. How is outsourcing related to the law of one price? LO5

Problems and Exercises

14. A country has the following production possibility table:

a. Draw the country’s production possibility curve.

b. What’s happening to marginal opportunity costs as output of food increases?

c. Say the country gets better at the production of food. What will happen to the production possibility curve?

d. Say the country gets equally better at producing both food and clothing. What will happen to the production possibility curve? LO1, LO2

15. Research shows that after-school jobs are highly correlated with decreases in grade point averages. Those who work 1 to 10 hours get a 3.0 GPA and those who work 21 hours or more have a 2.7 GPA. Higher GPAs are, however, highly correlated with higher lifetime earnings. Assume that a person earns $8,000 per year for working part-time in college, and that the return to a 0.1 increase in GPA gives one a 10 percent increase in one’s lifetime earnings with a present value of $80,000.

a. What would be the argument for working rather than studying harder?

b. Is the assumption that there is a trade-off between working and grades reasonable? LO1

16. Suppose the United States and Japan have the following production possibility tables:

a. Draw each country’s production possibility curve.

b. In what good does the United States have a comparative advantage?

c. Is there a possible trade that benefits both countries?

d. Draw their combined production possibility curve. LO4

17. Assume the United States can produce Toyotas at the cost of $18,000 per car and Chevrolets at $16,000 per car. In Japan, Toyotas can be produced at 1,000,000 yen and Chevrolets at 500,000 yen.

a. In terms of Chevrolets, what is the opportunity cost of producing Toyotas in each country?

b. Who has the comparative advantage in producing Chevrolets?

c. Assume Americans purchase 500,000 Chevrolets and 300,000 Toyotas each year and that the Japanese purchase far fewer of each. Using productive efficiency as the guide, which country should produce Chevrolets and which should produce Toyotas? LO4

18. Lawns produce no crops but occupy more land (25 million acres) in the United States than any single crop, such as corn. This means that the United States is operating inefficiently and hence is at a point inside the production possibility curve. Right? If not, what does it mean? LO1

19. Groucho Marx is reported to have said, “The secret of success is honesty and fair dealing. If you can fake those, you’ve got it made.” What would likely happen to society’s production possibility curve if everyone could fake honesty? Why? (Hint: Remember that society’s production possibility curve reflects more than just technical relationships.) (Difficult) LO1

20. In 2006 the hourly cost to employers per German industrial worker was $33. The hourly cost to employers per U.S. industrial worker was $23.65, while the average cost per Taiwanese industrial worker was $6.38.

a. Give three reasons why firms produce in Germany rather than in a lower-wage country.

b. Germany has just entered into an agreement with other EU countries that allows people in any EU country, including Greece and Italy, which have lower wage rates, to travel and work in any EU country, including high-wage countries. Would you expect a significant movement of workers from Greece and Italy to Germany right away? Why or why not?

c. Workers in Thailand are paid significantly less than workers in Taiwan. If you were a company CEO, what other information would you want before you decided where to establish a new production facility? LO5

Questions from Alternative Perspectives

1. Why might government be less capable than the market to do good? (Austrian)

2. The text makes it look as if maximizing output is the goal of society.

a. Is maximizing output the goal of society?

b. If the country is a Christian country, should it be?

c. If not, what should it be? (Religious)

3. It has been said that “capitalism robs us of our sexuality and sells it back to us.”

a. Does sex sell?

b. Is sex used to sell goods from Land Rovers to tissue paper?

c. Who, if anyone, is exploited in the use of sex to sell commodities?

d. Are both men and women exploited in the same ways? (Feminist)

4. Thorstein Veblen, one economist to whom this book is dedicated, wrote that vested interests are those seeking “something for nothing.” In this chapter, you learned how technological bias shapes the economy’s production possibilities over time so that a country becomes increasingly good at producing a subset of goods.

a. In what ways have vested interests used their influence to bias the U.S. economy toward the production of military goods at the expense of consumer goods?

b. What are the short-term and long-term consequences of that bias for human welfare, in the United States and abroad? (Institutionalist)

5. Writing in 1776, Adam Smith was concerned not only with the profound effects of the division of labor on productivity (as your textbook notes) but also its stultifying effect on the human capacity. In The Wealth of Nations, Smith warned that performing a few simple operations over and over again could render any worker, no matter his or her native intelligence, “stupid and ignorant.”

a. Does the division of labor in today’s economy continue to have both these effects?

b. What are the policy implications? (Radical)

Web Questions

1. Select a foreign country and, using the CIA World Fact-book (www.cia.gov/cia/publications/factbook), answer the following questions:

a. What goods does the country produce? Purchase from another country?

b. In what goods does it have a comparative advantage? Explain your answer.

c. Name one of its trading partners. Why do you think that country is a trading partner?

2. Go to the International Monetary Fund’s (IMF) Web site (www.imf.org) and search for the article “Globalization: Threat or Opportunity?” Based on this article:

a. Does the IMF support or oppose globalization?

b. Does globalization increase or decrease the amount of inequality in the world?

c. What strategies does it suggest for the poorest countries to benefit from globalization?

d. Does globalization automatically lead to periodic crises?

Answers to Margin Questions

1. You must give up 2 units of good Y to produce 4 units of good X, so the opportunity cost of X is 1/2 Y. (24)

2. If no resource had a comparative advantage, the production possibility curve would be a straight line connecting the points of maximum production of each product as in the graph below.

At all points along this curve, the opportunity cost of producing guns and butter is equal. (27)

3. Points A and C are along the production possibility curve, so they are points of efficiency. Point B is inside the production possibility curve, so it is a point of inefficiency. Point D is to the right of the production possibility curve, so it is unattainable. (28)

4. I remind them of the importance of cultural forces. In Saudi Arabia, women are not allowed to drive. (29)

5. The production possibility curve shifts in along the butter axis as in the graph below. (30)

6. The argument that underlies the general laissez-faire policy argument is that when there is competition in trade, individuals are able to pick the best trades available to them and the end result is that both parties to the trade benefit as much as they possibly can. (33)

7. Steve’s and Sarah’s production possibility curves are shown in the figure below. If they specialize, they can, combined, produce 4 loaves of bread and 8 dozen cookies, which they can split up. Say that Steve gets 2 loaves of bread and 5 dozen cookies (point A). This puts him beyond his original production possibility curve, and thus is an improvement for him. That leaves 2 loaves of bread and 3 dozen cookies for Sarah (point B), which is beyond her original production possibility curve, which is an improvement for her. Both are better off than they would have been. (34)

8. False. By producing the good for which it has a comparative advantage (lowest opportunity cost), a country will have the greatest amount of goods with which to trade and will reap the greatest gains from trade. (34)

9. No. By definition, if one country has a comparative advantage in producing one set of goods, the other country has a comparative advantage in the production in the other set. Jobs will be needed to support this production. Additionally, many jobs cannot be outsourced effectively because they require physical proximity to the point of sale. (35)

10. Globalization allows more trade and specialization. That specialization lowers costs of production since it allows the lowest cost producer to produce each good. (37)

APPENDIX A: Graphish: The Language of Graphs

A picture is worth 1,000 words. Economists, being efficient, like to present ideas in graphs, pictures of points in a coordinate system in which points denote relationships between numbers. But a graph is worth 1,000 words only if the person looking at the graph knows the graphical language: Graphish, we’ll call it. (It’s a bit like English.) Graphish is usually written on graph paper. If the person doesn’t know Graphish, the picture isn’t worth any words and Graphish can be babble.

I have enormous sympathy for students who don’t understand Graphish. A number of my students get thrown for a loop by graphs. They understand the idea, but Graphish confuses them. This appendix is for them, and for those of you like them. It’s a primer in Graphish.

Two Ways to Use Graphs

In this book I use graphs in two ways:

1. To present an economic model or theory visually, showing how two variables interrelate.

2. To present real-world data visually. To do this, I use primarily bar charts, line charts, and pie charts.

Actually, these two ways of using graphs are related. They are both ways of presenting visually the relationship between two things.

Graphs are built around a number line, or axis, like the one in Figure A2-1(a). The numbers are generally placed in order, equal distances from one another. That number line allows us to represent a number at an appropriate point on the line. For example, point A represents the number 4.

FIGURE A2-1 (A, B, AND C): Horizontal and Vertical Number Lines and a Coordinate System

The number line in Figure A2-1(a) is drawn horizontally, but it doesn’t have to be; it also can be drawn vertically, as in Figure A2-1(b).

How we divide our axes, or number lines, into intervals is up to us. In Figure A2-1(a), I called each interval 1; in Figure A2-1(b), I called each interval 10. Point A appears after 4 intervals of 1 (starting at 0 and reading from left to right), so it represents 4. In Figure A2-1(b), where each interval represents 10, to represent 5, I place point B halfway in the interval between 0 and 10.

So far, so good. Graphish developed when a vertical and a horizontal number line were combined, as in Figure A2-1(c). When the horizontal and vertical number lines are put together, they’re called axes. (Each line is an axis. Axes is the plural of axis.) I now have a coordinate system—a two-dimensional space in which one point represents two numbers. For example, point A in Figure A2-1(c) represents the numbers (4, 5)−4 on the horizontal number line and 5 on the vertical number line. Point B represents the numbers (1, 20). (By convention, the horizontal numbers are written first.)

Being able to represent two numbers with one point is neat because it allows the relationships between two numbers to be presented visually instead of having to be expressed verbally, which is often cumbersome. For example, say the cost of producing 6 units of something is $4 per unit and the cost of producing 10 units is $3 per unit. By putting both these points on a graph, we can visually see that producing 10 costs less per unit than does producing 6.

FIGURE A2-2 (A, B, C, AND D): A Table and Graphs Showing the Relationships between Price and Quantity

Another way to use graphs to present real-world data visually is to use the horizontal line to represent time. Say that we let each horizontal interval equal a year, and each vertical interval equal $100 in income. By graphing your income each year, you can obtain a visual representation of how your income has changed over time.

Using Graphs in Economic Modeling

I use graphs throughout the book as I present economic models, or simplifications of reality. A few terms are often used in describing these graphs, and we’ll now go over them. Consider Figure A2-2(a), which lists the number of pens bought per day (column 2) at various prices (column 1).

We can present the table’s information in a graph by combining the pairs of numbers in the two columns of the table and representing, or plotting, them on two axes. I do that in Figure A2-2(b).

By convention, when graphing a relationship between price and quantity, economists place price on the vertical axis and quantity on the horizontal axis.

I can now connect the points, producing a line like the one in Figure A2-2(c). With this line, I interpolate the numbers between the points (which makes for a nice visual presentation). That is, I make the interpolation Aassumption—the assumption that the relationship between variables is the same between points as it is at the points. The interpolation assumption allows us to think of a line as a collection of points and therefore to connect the points into a line.


Inverse and Direct Relationships

Even though the line in Figure A2-2(c) is straight, economists call any such line drawn on a graph a curve. Because it’s straight, the curve in A2-2(c) is called a linear curve—a curve that is drawn as a straight line. Notice that this curve starts high on the left-hand side and goes down to the right. Economists say that any curve that looks like that is downward-sloping. They also say that a downward-sloping curve represents an inverse relationship—a relationship between two variables in which when one goes up, the other goes down. In this example, the line demonstrates an inverse relationship between price and quantity—that is, when the price of pens goes up, the quantity bought goes down.

Figure A2-2(d) presents a nonlinear curve—a curve that is drawn as a curved line. This curve, which really is curved, starts low on the left-hand side and goes up to the right. Economists say any curve that goes up to the right is upward-sloping. An upward-sloping curve represents a direct relationship—a relationship in which when one variable goes up, the other goes up too. The direct relationship I’m talking about here is the one between the two variables (what’s measured on the horizontal and vertical lines). Downward-sloping and upward-sloping are terms you need to memorize if you want to read, write, and speak Graphish, keeping graphically in your mind the image of the relationships they represent.


One can, of course, be far more explicit about how much the curve is sloping upward or downward by defining it in terms of slope—the change in the value on the vertical axis divided by the change in the value on the horizontal axis. Sometimes the slope is presented as “rise over run”:

Slopes of Linear Curves

In Figure A2-3, I present five linear curves and measure their slope. Let’s go through an example to show how we can measure slope. To do so, we must pick two points. Let’s use points A (6, 8) and B (7, 4) on curve a. Looking at these points, we see that as we move from 6 to 7 on the horizontal axis, we move from 8 to 4 on the vertical axis. So when the number on the vertical axis falls by 4, the number on the horizontal axis increases by 1. That means the slope is −4 divided by 1, or −4.

Notice that the inverse relationships represented by the two downward-sloping curves, a and b, have negative slopes, and that the direct relationships represented by the two upward-sloping curves, c and d, have positive slopes. Notice also that the flatter the curve, the smaller the numerical value of the slope; and the more vertical, or steeper, the curve, the larger the numerical value of the slope. There are two extreme cases:

1. When the curve is horizontal (flat), the slope is zero.

2. When the curve is vertical (straight up and down), the slope is infinite (larger than large).

Knowing the term slope and how it’s measured lets us describe verbally the pictures we see visually. For example, if I say a curve has a slope of zero, you should picture in your mind a flat line; if I say “a curve with a slope of minus one,” you should picture a falling line that makes a 45° angle with the horizontal and vertical axes. (It’s the hypotenuse of an isosceles right triangle with the axes as the other two sides.)

Slopes of Nonlinear Curves

The preceding examples were of linear (straight) curves. With nonlinear curves—the ones that really do curve—the slope of the curve is constantly changing. As a result, we must talk about the slope of the curve at a particular point, rather than the slope of the whole curve. How can a point have a slope? Well, it can’t really, but it can almost, and if that’s good enough for mathematicians, it’s good enough for us.

FIGURE A2-3: Slopes of Curves

The slope of a curve is determined by rise over run. The slope of curve a is shown in the graph. The rest are shown below:

Defining the slope of a nonlinear curve is a bit more difficult. The slope at a given point on a nonlinear curve is determined by the slope of a linear (or straight) line that’s tangent to that curve. (A line that’s tangent to a curve is a line that just touches the curve, and touches it only at one point in the immediate vicinity of the given point.) In Figure A2-3, the line LL is tangent to the curve ee at point E. The slope of that line, and hence the slope of the curve at the one point where the line touches the curve, is +1.

Maximum and Minimum Points

Two points on a nonlinear curve deserve special mention. These points are the ones for which the slope of the curve is zero. I demonstrate those in Figure A2-4(a) and (b). At point A we’re at the top of the curve, so it’s at a maximum point; at point B we’re at the bottom of the curve, so it’s at a minimum point. These maximum and minimum points are often referred to by economists, and it’s important to realize that the value of the slope of the curve at each of these points is zero.

There are, of course, many other types of curves, and much more can be said about the curves I’ve talked about. I won’t do so because, for purposes of this course, we won’t need to get into those refinements. I’ve presented as much Graphish as you need to know for this book.

FIGURE A2-4 (A AND B): A Maximum and a Minimum Point

FIGURE A2-5 (A, B, AND C): A Shifting Curve versus a Movement along a Curve

Equations and Graphs

Sometimes economists depict the relationships shown in graphs using equations. Since I present material algebraically in the appendixes to a few chapters, let me briefly discuss how to translate a linear curve into an equation. Linear curves are relatively easy to translate because all linear curves follow a particular mathematical form: y = mx + b, where y is the variable on the vertical axis, x is the variable on the horizontal axis, m is the slope of the line, and b is the vertical-axis intercept. To write the equation of a curve, look at that curve, plug in the values for the slope and vertical-axis intercept, and you’ve got the equation.

For example, consider the blue curve in Figure A2-5(a). The slope (rise over run) is −2 and the number where the curve intercepts the vertical axis is 8, so the equation that depicts this curve is y = −2x + 8. It’s best to choose variables that correspond to what you’re measuring on each axis, so if price is on the vertical axis and quantity is on the horizontal axis, the equation would be p = −2 q + 8. This equation is true for any point along this line. Take point A (1, 6), for example. Substituting 1 for x and 6 for y into the equation, you see that 6 = −2(1) +8, or 6 = 6. At point B, the equation is still true: 4 = −2(2) + 8. A move from point A to point B is called a movement along a curve. A movement along a curve does not change the relationship of the variables; rather, it shows how a change in one variable affects the other.

Sometimes the relationship between variables will change. The curve will either shift, change slope, or both shift and change slope. These changes are reflected in changes to the m and b variables in the equation. Suppose the vertical-axis intercept rises from 8 to 12, while the slope remains the same. The equation becomes y = −2x + 12; for every value of y, x has increased by 4. Plotting the new equation, we can see that the curve has shifted to the right, as shown by the orange line in Figure A2-5(a). If instead the slope changes from −2 to −1, while the vertical-axis intercept remains at 8, the equation becomes y = -x + 8. Figure A2-5(b) shows this change graphically. The original blue line stays anchored at 8 and rotates out along the horizontal axis to the new orange line.

Here’s an example for you to try. The lines in Figure A2-5(c) show two relationships between consumption and income. Write the equation for the blue line.

The answer is C = 1/3 Y + $1,000. Remember, to write the equation you need to know two things: the vertical-axis intercept ($1,000) and the slope (1/3). If the intercept changes to $4,000, the curve will shift up to the orange line as shown.

Presenting Real-World Data in Graphs

The previous discussion treated the Graphish terms that economists use in presenting models that focus on hypothetical relationships. Economists also use graphs in presenting actual economic data. Say, for example, that you want to show how exports have changed over time. Then you would place years on the horizontal axis (by convention) and exports on the vertical axis, as in Figure A2-6(a) and (b). Having done so, you have a couple of choices: you can draw a line graph—a graph where the data are connected by a continuous line; or you can make a bar graph—a graph where the area under each point is filled in to look like a bar. Figure A2-6(a) shows a line graph and Figure A2-6(b) shows a bar graph.

FIGURE A2-6 (A, B, AND C): Presenting Information Visually

Another type of graph is a pie chart—a circle divided into “pie pieces,” where the undivided pie represents the total amount and the pie pieces reflect the percentage of the whole pie that the various components make up. This type of graph is useful in visually presenting how a total amount is divided. Figure A2-6(c) shows a pie chart, which happens to represent the division of grades on a test I gave. Notice that 5 percent of the students got As.

There are other types of graphs, but they’re all variations on line and bar graphs and pie charts. Once you understand these three basic types of graphs, you shouldn’t have any trouble understanding the other types.

Interpreting Graphs about the Real World

Understanding Graphish is important because, if you don’t, you can easily misinterpret the meaning of graphs. For example, consider the two graphs in Figure A2-7(a) and (b). Which graph demonstrates the larger rise in income? If you said (a), you’re wrong. The intervals in the vertical axes differ, and if you look carefully you’ll see that the curves in both graphs represent the same combination of points. So when considering graphs, always make sure you understand the markings on the axes. Only then can you interpret the graph.

FIGURE 2-7 (A AND B): The Importance of Scales

Quantitative Literacy: Avoiding Stupid Math Mistakes

The data of economics are often presented in graphs and tables. Numerical data are compared by the use of percentages, visual comparisons, and simple relationships based on quantitative differences. Economists who have studied the learning process of their students have found that some very bright students have some trouble with these presentations. Students sometimes mix up percentage changes with level changes, draw incorrect implications from visual comparisons, and calculate quantitative differences incorrectly. This is not necessarily a math problem—at least in the sense that most economists think of math. The mistakes are in relatively simple stuff—the kind of stuff learned in fifth, sixth, and seventh grades. Specifically, as reported in “Student Quantitative Literacy: Is the Glass Half-full or Half-empty?” (Robert Burns, Kim Marie McGoldrick, Jerry L. Petr, and Peter Schuhmann, 2002 University of North Carolina at Wilmington Working Paper), when the professors gave a test to students at a variety of schools, they found that a majority of students missed the following questions.

1. What is 25 percent of 400?


none of the above

2. Consider Figure A2-8 where U.S oil consumption and U.S. oil imports are plotted for 1990-2000. Fill in the blanks to construct a true statement: U.S. domestic oil consumption has been steady while imports have been ___; therefore U.S. domestic oil production has been ___.

a. rising; rising

b. falling; falling

c. rising; falling

d. falling; rising

3. Refer to the following table to select the true statement.

a. GDP in Poland was larger in 1992 than in 1991.

b. GDP in Poland was larger in 1994 than in 1993.

c. GDP in Poland was larger in 1991 than in 1992.

d. GDP in Poland was larger in 1993 than in 1994.

e. Both b and c are true.


If U.S. production of corn was 60 million bushels in 2002 and 100 million bushels in 2003, what was the percentage change in corn production from 2002 to 2003?

a. 40

b. 60

c. 66.67

d. 100

e. 200

The reason students got these questions wrong is unknown. Many of them had had higher-level math courses, including calculus, so it is not that they weren’t trained in math. I suspect that many students missed the questions because of carelessness: the students didn’t think about the question carefully before they wrote down the answer.

Throughout this book we will be discussing issues assuming a quantitative literacy sufficient to answer these questions. Moreover, questions using similar reasoning will be on exams. So it is useful for you to see whether or not you fall in the majority. So please answer the four questions given above now if you haven’t done so already.

Now that you’ve answered them, I give you the correct answers upside-down in the footnote at the bottom of the page.1

If you got all four questions right, great! You can stop reading this appendix now. If you missed one or more, read the explanations of the correct answers carefully.

1. The correct answer is c. To calculate a percentage, you multiply the percentage times the number. Thus, 25 percent of 400 is 100.

2. The correct answer is c. To answer it you had to recognize that U.S. consumption of oil comes from U.S. imports and U.S. production. Thus, the distance between the two lines represents U.S. production, which is clearly getting smaller from 1990 to 2000.

3. The correct answer is e. The numbers given to you are percentage changes, and the question is about levels. If the percentage change is positive, as it is in 1993 and 1994, the level is increasing. Thus, 1994 is greater (by 3.5 percent) than 1993, even though the percentage change is smaller than in 1993. If the percentage change is negative, as it is in 1992, the level is falling. Because income fell in 1992, the level of income in 1991 is greater than the level of income in 1992.

4. The correct answer is c. To calculate percentage change, you first need to calculate the change, which in this case is 100 − 60, or 40. So corn production started at a base of 60 and rose by 40. To calculate the percentage change that this represents, you divide the amount of the rise, 40, by the base, 60. Doing so gives us 40/60 = 2/3 =.6667, which is 66.67 percent.

Now that I’ve given you the answers, I suspect that most of you will recognize that they are the right answers. If, after reading the explanations, you still don’t follow the reasoning, you should look into getting some extra help in the course either from your teacher, from your TA, or from some program the college has. If, after reading the explanations, you follow them and believe that if you had really thought about them you would have gotten them right, then the next time you see a chart or a table of numbers being compared really think about them. Be a bit slower in drawing inferences since they are the building blocks of economic discussions. If you want to do well on exams, it probably makes sense to practice some similar questions to make sure that you have concepts down.

A Review

Let’s now review what we’ve covered.

• A graph is a picture of points on a coordinate system in which the points denote relationships between numbers.

• A downward-sloping line represents an inverse relationship or a negative slope.

• An upward-sloping line represents a direct relationship or a positive slope.

• Slope is measured by rise over run, or a change of y (the number measured on the vertical axis) over a change in x (the number measured on the horizontal axis).

• The slope of a point on a nonlinear curve is measured by the rise over the run of a line tangent to that point.

• At the maximum and minimum points of a nonlinear curve, the value of the slope is zero.

• A linear curve has the form y = mx + b.

• A shift in a linear curve is reflected by a change in the b variable in the equation y = mx + b.

• A change in the slope of a linear curve is reflected by a change in the m variable in the equation y = mx + b.

• In reading graphs, one must be careful to understand what’s being measured on the vertical and horizontal axes.

Key Terms

bar graph (49)

graph (44)

inverse relationship (46)


linear curve (46)

coordinate system (44)

interpolation line graph (49)

pie chart (49)

direct relationship (46)

assumption (45)

linear curve (46)

slope (46)

Questions for Thought and Review

1. Create a coordinate space on graph paper and label the following points:

a. (0,5)

b. (−5, −5)

c. (2, −3)

d. (−1, 1)

2. Graph the following costs per unit, and answer the questions that follow.

a. Is the relationship between cost per unit and output linear or nonlinear? Why?

b. In what range in output is the relationship inverse? In what range in output is the relationship direct?

c. In what range in output is the slope negative? In what range in output is the slope positive?

d. What is the slope between 1 and 2 units?

3. Within a coordinate space, draw a line with

a. Zero slope.

b. Infinite slope.

c. Positive slope.

d. Negative slope.

4. Calculate the slope of lines a to e in the following coordinate system.

5. Given the following nonlinear curve, answer the following questions:

a. At what point(s) is the slope negative?

b. At what point(s) is the slope positive?

c. At what point(s) is the slope zero?

d. What point is the maximum? What point is the minimum?

6. Draw the graphs that correspond to the following equations:

a. y = 3x − 8

b. y = 12 − x

c. y = 4x + 2

7. Using the equation y = 3 x + 1,000, demonstrate the following:

a. The slope of the curve changes to 5.

b. The curve shifts up by 500.

8. State what type of graph or chart you might use to show the following real-world data:

a. Interest rates from 1929 to 2005.

b. Median income levels of various ethnic groups in the United States.

c. Total federal expenditures by selected categories.

d. Total costs of producing between 100 and 800 shoes.

1 Throughout the book I’ll be presenting numerical examples to help you understand the concepts. The numbers I choose are often arbitrary. After all, you have to choose something. As an exercise, you might choose different numbers than I did, numbers that apply to your own life, and work out the argument using those numbers.


(Colander 23)

Colander, David C. Macroeconomics, 7th Edition. McGraw-Hill Learning Solutions, 102007. .





Teach a parrot the terms supply and demand and you’ve got an economist.

—Thomas Carlyle


1. State the law of demand and draw a demand curve from a demand table

2. Explain the importance of substitution to the laws of supply and demand

3. Distinguish shifts in demand from movements along a demand curve

4. State the law of supply and draw a supply curve from a supply table

5. Distinguish shifts in supply from movements along a supply curve

6. Explain how the law of demand and the law of supply interact to bring about equilibrium

7. Show the effect of a shift in demand and supply on equilibrium price and quantity

8. State the limitations of demand and supply analysis

Supply and demand. Supply and demand. Roll the phrase around in your mouth; savor it like a good wine. Supply and demand are the most-used words in economics. And for good reason. They provide a good off-the-cuff answer for any economic question. Try it.

Why are bacon and oranges so expensive this winter? Supply and demand.

Why are interest rates falling? Supply and demand.

Why can’t I find decent wool socks anymore? Supply and demand.

The importance of the interplay of supply and demand makes it only natural that, early in any economics course, you must learn about supply and demand. Let’s start with demand.


People want lots of things; they “demand” much less than they want because demand means a willingness and ability to pay. Unless you are willing and able to pay for it, you may want it, but you don’t demand it. For example, I want to own a Ferrari. But, I must admit, I’m not willing to do what’s necessary to own one. If I really wanted one, I’d mortgage everything I own, increase my income by doubling the number of hours I work, not buy anything else, and get that car. But I don’t do any of those things, so at the going price, $650,000, I do not demand a Ferrari. Sure, I’d buy one if it cost $30,000, but from my actions it’s clear that, at $650,000, I don’t demand it. This points to an important aspect of demand: The quantity you demand at a low price differs from the quantity you demand at a high price. Specifically, the quantity you demand varies inversely—in the opposite direction—with price.

Prices are the tool by which the market coordinates individuals’ desires and limits how much people demand. When goods become scarce, the market reduces the quantity people demand; as their prices go up, people buy fewer goods.

As goods become abundant, their prices go down, and people buy more of them. The invisible hand—the price mechanism—sees to it that what people demand (do what’s necessary to get) matches what’s available.

The Law of Demand

The law of demand states that the quantity of a good demanded is inversely related to the good’s price.

The ideas expressed above are the foundation of the law of demand:

Quantity demanded rises as price falls, other things constant.

Or alternatively:

Quantity demanded falls as price rises, other things constant.

This law is fundamental to the invisible hand’s ability to coordinate individuals’ desires: as prices change, people change how much they’re willing to buy.

What accounts for the law of demand? If the price of something goes up, people will tend to buy less of it and buy something else instead. They will substitute other goods for goods whose relative price has gone up. If the price of MP3 files from the Internet rises, but the price of CDs stays the same, you’re more likely to buy that new Snoop Dog recording on CD than to download it from the Internet.


Web Note 4.1: Markets without Money

To see that the law of demand makes intuitive sense, just think of something you’d really like but can’t afford. If the price is cut in half, you—and other consumers—become more likely to buy it. Quantity demanded goes up as price goes down.

When price goes up, quantity demanded goes down. When price goes down, quantity demanded goes up.

Just to be sure you’ve got it, let’s consider a real-world example: demand for vanity—specifically, vanity license plates. When the North Carolina state legislature increased the vanity plates’ price from $30 to $40, the quantity demanded fell from 60,334 to 31,122. Assuming other things remained constant, that is the law of demand in action.

The Demand Curve

A demand curve is the graphic representation of the relationship between price and quantity demanded. Figure 4-1 shows a demand curve.

As you can see, the demand curve slopes downward. That’s because of the law of demand: as the price goes up, the quantity demanded goes down, other things constant. In other words, price and quantity demanded are inversely related.


Why does the demand curve slope downward?

FIGURE 4-1: A Sample Demand Curve

The law of demand states that the quantity demanded of a good is inversely related to the price of that good, other things constant. As the price of a good goes up, the quantity demanded goes down, so the demand curve is downward-sloping.

Notice that in stating the law of demand, I put in the qualification “other things constant.” That’s three extra words, and unless they were important I wouldn’t have included them. But what does “other things constant” mean? Say that over two years, both the price of cars and the number of cars purchased rise. That seems to violate the law of demand, since the number of cars purchased should have fallen in response to the rise in price. Looking at the data more closely, however, we see that individuals’ income has increased. Other things didn’t remain the same.

“Other things constant” places a limitation on the application of the law of demand.

The increase in price works as the law of demand states—it decreases the number of cars bought. But the rise in income increases the demand for cars at every price. That increase in demand outweighs the decrease in quantity demanded that results from a rise in price, so ultimately more cars are sold. If you want to study the effect of price alone—which is what the law of demand refers to—you must make adjustments to hold income constant. Because other things besides price affect demand, the qualifying phrase “other things constant” is an important part of the law of demand.

The other things that are held constant include individuals’ tastes, prices of other goods, and even the weather. Those other factors must remain constant if you’re to make a valid study of the effect of an increase in the price of a good on the quantity demanded. In practice, it’s impossible to keep all other things constant, so you have to be careful when you say that when price goes up, quantity demanded goes down. It’s likely to go down, but it’s always possible that something besides price has changed.

Shifts in Demand versus Movements along a Demand Curve

Shifts in Demand versus Movements along a Demand Curve

To distinguish between the effects of price and the effects of other factors on how much of a good is demanded, economists have developed the following precise terminology—terminology that inevitably shows up on exams. The first distinction is between demand and quantity demanded.

• Demand refers to a schedule of quantities of a good that will be bought per unit of time at various prices, other things constant.

• Quantity demanded refers to a specific amount that will be demanded per unit of time at a specific price, other things constant.

In graphical terms, the term demand refers to the entire demand curve. Demand tells us how much will be bought at various prices. Quantity demanded tells us how much will be bought at a specific price; it refers to a point on a demand curve, such as point A in Figure 4-1. This terminology allows us to distinguish between changes in quantity demanded and shifts in demand. A change in price changes the quantity demanded. It refers to a movement along a demand curve—the graphical representation of the effect of a change in price on the quantity demanded. A change in anything other than price that affects demand changes the entire demand curve. A shift factor of demand causes a shift in demand, the graphical representation of the effect of anything other than price on demand.


The uncertainty caused by the terrorist attacks of September 11, 2001, made consumers reluctant to spend on luxury items. This reduced ____. Should the missing words be demand for luxury goods or quantity of luxury goods demanded?

Shift Factors of Demand

Important shift factors of demand include

1. Society’s income.

2. The prices of other goods.







5. Taxes on and subsidies to consumers.


From our example above of the “other things constant” qualification, we saw that a rise in income increases the demand for goods. For most goods this is true. As individuals’ income rises, they can afford more of the goods they want, such as steaks, computers, or clothing. These are normal goods. For other goods, called inferior goods, an increase in income reduces demand. An example is urban mass transit. A person whose income has risen tends to stop riding the bus to work because she can afford to buy a car and rent a parking space.


Web Note 4.2: Income and Demand

Price of Other Goods

Because people make their buying decisions based on the price of related goods, demand will be affected by the prices of other goods. Suppose the price of jeans rises from $25 to $35, but the price of khakis remains at $25. Next time you need pants, you’re apt to try khakis instead of jeans. They are substitutes. When the price of a substitute rises, demand for the good whose price has remained the same will rise. Or consider another example. Suppose the price of movie tickets falls. What will happen to the demand for popcorn? You’re likely to increase the number of times you go to the movies, so you’ll also likely increase the amount of popcorn you purchase. The lower cost of a movie ticket increases the demand for popcorn because popcorn and movies are complements. When the price of a good declines, the demand for its complement rises.


An old saying goes: “There’s no accounting for taste.” Of course, many advertisers believe otherwise. Changes in taste can affect the demand for a good without a change in price. As you become older, you may find that your taste for rock concerts has changed to a taste for an evening sitting at home watching TV.

Explain the effect of each of the following on the demand for new computers:

1. The price of computers falls by 30 percent.

2. Total income in the economy rises.


Expectations will also affect demand. Expectations can cover a lot. If you expect your income to rise in the future, you’re bound to start spending some of it today. If you expect the price of computers to fall soon, you may put off buying one until later.

Taxes and Subsidies

Taxes levied on consumers increase the cost of goods to consumers and therefore reduce demand for those goods. Subsidies to consumers have the opposite effect. When states host tax-free weeks during August’s back-to-school shopping season, consumers load up on products to avoid sales taxes. Demand for retail goods rises during the tax holiday.

These aren’t the only shift factors. In fact anything—except the price of the good itself—that affects demand (and many things do) is a shift factor. While economists agree these shift factors are important, they believe that no shift factor influences how much of a good people buy as consistently as its price. That’s why economists make the law of demand central to their analysis.

Change in price causes a movement along a demand curve; a change in a shift in demand

To make sure you understand the difference between a movement along a demand curve and a shift in demand, let’s consider an example. Singapore has one of the world’s highest number of cars per mile of road. This means that congestion is considerable. Singapore adopted two policies to reduce road use: It increased the fee charged to use roads and it provided an expanded public transportation system. Both policies reduced congestion. Figure 4-2(a) shows that increasing the toll charged to use roads from $1 to $2 per 50 miles of road reduces quantity demanded from 200 to 100 cars per mile every hour (a movement along the demand curve). Figure 4-2(b) shows that providing alternative methods of transportation such as buses and subways shifts the demand curve for roads in to the left so that at every price, demand drops by 25 cars per mile every hour.

FIGURE 4-2 (A AND B): Shift in Demand versus a Change in Quantity Demanded

A rise in a good’s price results in a reduction in quantity demanded and is shown by a movement up along a demand curve from point A to point B in (a). A change in any other factor besides price that affects demand leads to a shift in the entire demand curve, as shown in (b).

A Review

Let’s test your understanding: What happens to your demand curve for CDs in the following examples: First, let’s say you buy an MP3 player. Next, let’s say that the price of CDs falls; and finally, say that you won $1 million in a lottery. What happens to the demand for CDs in each case? If you answered: It shifts in to the left; it remains unchanged; and it shifts out to the right—you’ve got it.

The Demand Table

As I emphasized in Chapter 2, introductory economics depends heavily on graphs and graphical analysis—translating ideas into graphs and back into words. So let’s graph the demand curve.

Figure 4-3(a), a demand table, describes Alice’s demand for renting DVDs. For example, at a price of $2, Alice will rent (buy the use of) 6 DVDs per week, and at a price of 50 cents she will rent 9.

Four points about the relationship between the number of DVDs Alice rents and the price of renting them are worth mentioning. First, the relationship follows the law of demand: As the rental price rises, quantity demanded decreases. Second, quantity demanded has a specific time dimension to it. In this example, demand refers to the number of DVD rentals per week. Without the time dimension, the table wouldn’t provide us with any useful information. Nine DVD rentals per year is quite different from 9 DVD rentals per week. Third, the analysis assumes that Alice’s DVD rentals are interchangeable—the 9th DVD rental doesn’t significantly differ from the 1st, 3rd, or any other DVD rental. The fourth point is already familiar to you: The analysis assumes that everything else is held constant.


From a Demand Table to a Demand Curve

The demand table in (a) is translated into a demand curve in (b). Each combination of price and quantity in the table corresponds to a point on the curve. For example, point A on the graph represents row A in the table: Alice demands 9 DVD rentals at a price of 50 cents. A demand curve is constructed by plotting all points from the demand table and connecting the points with a line.

From a Demand Table to a Demand Curve

Figure 4-3(b) translates the demand table in Figure 4-3(a) into a demand curve. Point A (quantity = 9, price = $.50) is graphed first at the (9, $.50) coordinates. Next we plot points B, C, D, and E in the same manner and connect the resulting dots with a solid line. The result is the demand curve, which graphically conveys the same information that’s in the demand table. Notice that the demand curve is downward sloping, indicating that the law of demand holds.

The demand curve represents the maximum price that an individual will pay.

The demand curve represents the maximum price that an individual will pay for various quantities of a good; the individual will happily pay less. For example, say Netflix offers Alice 6 DVD rentals at a price of $1 each (point F of Figure 4-3(b)). Will she accept? Sure; she’ll pay any price within the shaded area to the left of the demand curve. But if Netflix offers her 6 rentals at $3.50 each (point G), she won’t accept. At a price of $3.50 apiece, she’s willing to rent only 3 DVDs.


Derive a market demand curve from the following two individual demand curves:

Individual and Market Demand Curves

Normally, economists talk about market demand curves rather than individual demand curves. A market demand curve is the horizontal sum of all individual demand curves. Firms don’t care whether individual A or individual B buys their goods; they only care that someone buys their goods.

It’s a good graphical exercise to add individual demand curves together to create a market demand curve. I do that in Figure 4-4. In it I assume that the market consists of three buyers, Alice, Bruce, and Carmen, whose demand tables are given in Figure 4-4(a). Alice and Bruce have demand tables similar to the demand tables discussed previously. At a price of $3 each, Alice rents 4 DVDs; at a price of $2, she rents 6. Carmen is an all-or-nothing individual. She rents 1 DVD as long as the price is equal to or less than $1; otherwise she rents nothing. If you plot Carmen’s demand curve, it’s a vertical line. However, the law of demand still holds: As price increases, quantity demanded decreases.

FIGURE 4-4 (A AND B): From Individual Demands to a Market Demand Curve

The table (a) shows the demand schedules for Alice, Bruce, and Carmen. Together they make up the market for DVD rentals. Their total quantity demanded (market demand) for DVD rentals at each price is given in column 5. As you can see in (b), Alice’s, Bruce’s, and Carmen’s demand curves can be added together to get the total market demand curve. For example, at a price of $2, Carmen demands 0, Bruce demands 3, and Alice demands 6, for a market demand of 9 (point D).


Six Things to Remember about a Demand Curve

• A demand curve follows the law of demand: When price rises, quantity demanded falls, and vice versa.

• The horizontal axis—quantity—has a time dimension.

• The quality of each unit is the same.

• The vertical axis—price—assumes all other prices remain the same.

• The curve assumes everything else is held constant.

• Effects of price changes are shown by movements along the demand curve. Effects of anything else on demand (shift factors) are shown by shifts of the entire demand curve.

The quantity demanded by each consumer is listed in columns 2, 3, and 4 of Figure 4-4(a). Column 5 shows total market demand; each entry is the horizontal sum of the entries in columns 2, 3, and 4. For example, at a price of $3 apiece (row F), Alice demands 4 DVD rentals, Bruce demands 1, and Carmen demands 0, for a total market demand of 5 DVD rentals.

Figure 4-4(b) shows three demand curves: one each for Alice, Bruce, and Carmen. The market, or total, demand curve is the horizontal sum of the individual demand curves. To see that this is the case, notice that if we take the quantity demanded at $1 by Alice (8), Bruce (5), and Carmen (1), they sum to 14, which is point B (14, $1) on the market demand curve. We can do that for each price. Alternatively, we can simply add the individual quantities demanded, given in the demand tables, prior to graphing (which we do in column 5 of Figure 4-4(a)), and graph that total in relation to price. Not surprisingly, we get the same total market demand curve.

Individual and Market Demand Curves

In practice, of course, firms don’t measure individual demand curves, so they don’t sum them up in this fashion. Instead, they statistically estimate market demand. Still, summing up individual demand curves is a useful exercise because it shows you how the market demand curve is the sum (the horizontal sum, graphically speaking) of the individual demand curves, and it gives you a good sense of where market demand curves come from. It also shows you that, even if individuals don’t respond to small changes in price, the market demand curve can still be smooth and downward sloping. That’s because, for the market, the law of demand is based on two phenomena:

1. At lower prices, existing demanders buy more.

2. At lower prices, new demanders (some all-or-nothing demanders like Carmen) enter the market.

For the market, the law of demand is based on two phenomena:

1. At lower prices, existing demanders buy more.

2. At lower prices, new demanders enter the market.


In one sense, supply is the mirror image of demand. Individuals control the factors of production—inputs, or resources, necessary to produce goods. Individuals’ supply of these factors to the market mirrors other individuals’ demand for those factors. For example, say you decide you want to rest rather than weed your garden. You hire someone to do the weeding; you demand labor. Someone else decides she would prefer more income instead of more rest; she supplies labor to you. You trade money for labor; she trades labor for money. Her supply is the mirror image of your demand.

For a large number of goods and services, however, the supply process is more complicated than demand. For many goods there’s an intermediate step: individuals supply factors of production to firms.

Let’s consider a simple example. Say you’re a taco technician. You supply your labor to the factor market. The taco company demands your labor (hires you). The taco company combines your labor with other inputs such as meat, cheese, beans, and tables, and produces tacos (production), which it supplies to customers in the goods market. For produced goods, supply depends not only on individuals’ decisions to supply factors of production but also on firms’ ability to transform those factors of production into usable goods.

The supply process of produced goods is generally complicated. Often there are many layers of firms—production firms, wholesale firms, distribution firms, and retailing firms—each of which passes on in-process goods to the next layer of firms. Real-world production and supply of produced goods is a multistage process.

Supply of produced goods involves a much more complicated process than demand and is divided into analysis of factors of production and the transformation of those factors into goods.

The supply of nonproduced goods is more direct. Individuals supply their labor in the form of services directly to the goods market. For example, an independent contractor may repair your washing machine. That contractor supplies his labor directly to you.

Thus, the analysis of the supply of produced goods has two parts: an analysis of the supply of factors of production to households and to firms and an analysis of the process by which firms transform those factors of production into usable goods and services.

The Law of Supply

There’s a law of supply that corresponds to the law of demand. The law of supply states:

Quantity supplied rises as price rises, other things constant.

Or alternatively:

Quantity supplied falls as price falls, other things constant.

Price determines quantity supplied just as it determines quantity demanded. Like the law of demand, the law of supply is fundamental to the invisible hand’s (the market’s) ability to coordinate individuals’ actions.

The law of supply is based on a firm’s ability to switch from producing one good to another, that is, to substitute. When the price of a good a person or firm supplies rises, individuals and firms can rearrange their activities in order to supply more of that good to the market. They want to supply more because the opportunity cost of not supplying the good rises as its price rises. For example, if the price of corn rises and the price of soy beans has not changed, farmers will grow less soy beans and more corn, other things constant.

The law of supply is based on substitution and the expectation of profits.

With firms, there’s a second explanation of the law of supply. Assuming firms’ costs are constant, a higher price means higher profits (the difference between a firm’s revenues and its costs). The expectation of those higher profits leads it to increase output as price rises, which is what the law of supply states.

FIGURE 4-5: A Sample Supply Curve

The supply curve demonstrates graphically the law of supply, which states that the quantity supplied of a good is directly related to that good’s price, other things constant. As the price of a good goes up, the quantity supplied also goes up, so the supply curve is upward sloping.

The Supply Curve

A supply curve is the graphical representation of the relationship between price and quantity supplied. A supply curve is shown in Figure 4-5.

Notice how the supply curve slopes upward to the right. That upward slope captures the law of supply. It tells us that the quantity supplied varies directly—in the same direction—with the price.

As with the law of demand, the law of supply assumes other things are held constant. If the price of soy beans rises and quantity supplied falls, you’ll look for something else that changed—for example, a drought might have caused a drop in supply. Your explanation would go as follows: Had there been no drought, the quantity supplied would have increased in response to the rise in price, but because there was a drought, the supply decreased, which caused prices to rise.

As with the law of demand, the law of supply represents economists’ off-the-cuff response to the question “What happens to quantity supplied if price rises?” If the law seems to be violated, economists search for some other variable that has changed. As was the case with demand, these other variables that might change are called shift factors.

Shifts in Supply versus Movements along a Supply Curve

Shifts in Supply versus Movements along a Supply Curve

The same distinctions in terms made for demand apply to supply.

Supply refers to a schedule of quantities a seller is willing to sell per unit of time at various prices, other things constant.

Quantity supplied refers to a specific amount that will be supplied at a specific price.


In the early 2000s the price of gasoline rose, causing the demand for hybrid cars to rise. As a result, the price of hybrid cars rose. This made ___ rise. Should the missing words be the supply or the quantity supplied?

In graphical terms, supply refers to the entire supply curve because a supply curve tells us how much will be offered for sale at various prices. “Quantity supplied” refers to a point on a supply curve, such as point A in Figure 4-5.

The second distinction that is important to make is between the effects of a change in price and the effects of shift factors on how much is supplied. Changes in price cause changes in quantity supplied; such changes are represented by a movement along a supply curve—the graphical representation of the effect of a change in price on the quantity supplied. If the amount supplied is affected by anything other than price, that is, by a shift factor of supply, there will be a shift in supply—the graphical representation of the effect of a change in a factor other than price on supply.

Shift Factors of Supply

Other factors besides price that affect how much will be supplied include the price of inputs used in production, technology, expectations, and taxes and subsidies. Let’s see how.

Price of Inputs

Firms produce to earn a profit. Since their profit is tied to costs, it’s no surprise that costs will affect how much a firm is willing to supply. If costs rise, profits will decline, and a firm has less incentive to supply. Supply falls when the price of inputs rises. If costs rise substantially, a firm might even shut down.


Advances in technology change the production process, reducing the number of inputs needed to produce a good, and thereby reducing its cost of production. A reduction in the cost of production increases profits and leads suppliers to increase production. Advances in technology increase supply.


Explain the effect of each of the following on the supply of romance novels:

1. The price of paper rises by 20 percent.

2. Government increases the sales tax on producers of all books by 5 percentage points.


Supplier expectations are an important factor in the production decision. If a supplier expects the price of her good to rise at some time in the future, she may store some of today’s output in order to sell it later and reap higher profits, decreasing supply now and increasing it later.

Taxes and Subsidies

Taxes on suppliers increase the cost of production by requiring a firm to pay the government a portion of the income from products or services sold. Because taxes increase the cost of production, profit declines and suppliers will reduce supply. The opposite is true for subsidies. Subsidies to suppliers are payments by the government to produce goods; they reduce the cost of production. Subsidies increase supply. Taxes on suppliers reduce supply.

These aren’t the only shift factors. As was the case with demand, a shift factor of supply is anything other than its price that affects supply.

A Shift in Supply versus a Movement along a Supply Curve

The same “movement along” and “shift of” distinction that we developed for demand exists for supply. To make that distinction clear, let’s consider an example: the supply of oil. In September 2005, Hurricane Katrina hit the Gulf Coast region of the United States and disrupted oil supply lines and production in the United States. U.S. production of oil declined from 4.6 to 4.1 million barrels each day at a $50 price. This disruption reduced the amount of oil U.S. producers were offering for sale at every price, thereby shifting the supply of U.S. oil to the left from S0 to S1, and the quantity of oil supplied at the $50 price fell from point A to point B in Figure 4-6. But the price did not stay at $50. It rose to $80. In response to the higher price, other areas in the United States increased their quantity supplied (from point B to point C in Figure 4-6). That increase due to the higher price is called a movement along the supply curve. So if a change in quantity supplied occurs because of a higher price, it is called a movement along the supply curve; if a change in supply occurs because of one of the shift factors (i.e., for any reason other than a change in price), it is called a shift in supply.

FIGURE 4-6: Shifts in Supply versus Movement along a Supply Curve

A shift in supply results when the shift is due to any cause other than a change in price. It is a shift in the entire supply curve (see the arrow from A to B). A movement along a supply curve is due to a change in price only (see the arrow from B to C). To differentiate the two, movements caused by changes in price are called changes in the quantity supplied, not changes in supply.

A Review

To be sure you understand shifts in supply, explain what is likely to happen to your supply curve for labor in the following cases: (1) You suddenly decide that you absolutely need a new car. (2) You win a million dollars in the lottery. And finally, (3) the wage you earn doubles. If you came up with the answers: shift out to the right, shift in to the left, and no change—you’ve got it down. If not, it’s time for a review.

Do we see such shifts in the supply curve often? Yes. A good example is computers. For the past 30 years, technological changes have continually shifted the supply curve for computers out to the right.

The Supply Table

Remember Figure 4-4(a)’s demand table for DVD rentals? In Figure 4-7(a), we follow the same reasoning to construct a supply table for three hypothetical DVD suppliers. Each supplier follows the law of supply: When price rises, each supplies more, or at least as much as each did at a lower price.

From a Supply Table to a Supply Curve

Figure 4-7(b) takes the information in Figure 4-7(a) ‘s supply table and translates it into a graph of each supplier’s supply curve. For instance, point C A on Ann’s supply curve corresponds to the information in columns 1 and 2, row C. Point C A is at a price of $1 per DVD and a quantity of 2 DVDs per week. Notice that Ann’s supply curve is upward sloping, meaning that price is positively related to quantity. Charlie’s and Barry’s supply curves are similarly derived.

The supply curve represents the set of minimum prices an individual seller will accept for various quantities of a good. The market’s invisible hand stops suppliers from charging more than the market price. If suppliers could escape the market’s invisible hand and charge a higher price, they would gladly do so. Unfortunately for them, and fortunately for consumers, a higher price encourages other suppliers to begin selling DVDs. Competing suppliers’ entry into the market sets a limit on the price any supplier can charge.

FIGURE 4-7 (A AND B): From Individual Supplies to a Market Supply

As with market demand, market supply is determined by adding all quantities supplied at a given price. Three suppliers—Ann, Barry, and Charlie—make up the market of DVD suppliers. The total market supply is the sum of their individual supplies at each price, shown in column 5 of (a).

Each of the individual supply curves and the market supply curve have been plotted in (b). Notice how the market supply curve is the horizontal sum of the individual supply curves.

Individual and Market Supply Curves

The market supply curve is derived from individual supply curves in precisely the same way that the market demand curve was. To emphasize the symmetry, I’ve made the three suppliers quite similar to the three demanders. Ann (column 2) will supply 2 at $1; if price goes up to $2, she increases her supply to 4. Barry (column 3) begins supplying at $1, and at $3 supplies 5, the most he’ll supply regardless of how high price rises. Charlie (column 4) has only two units to supply. At a price of $3.50 he’ll supply that quantity, but higher prices won’t get him to supply any more.

Individual and Market Supply Curves

The market supply curve is the horizontal sum of all individual supply curves. In Figure 4-7(a) (column 5), we add together Ann’s, Barry’s, and Charlie’s supplies to arrive at the market supply curve, which is graphed in Figure 4-7(b). Notice that each point corresponds to the information in columns 1 and 5 for each row. For example, point H corresponds to a price of $3.50 and a quantity of 14.

The market supply curve’s upward slope is determined by two different sources: as price rises, existing suppliers supply more and new suppliers enter the market. Sometimes existing suppliers may not be willing to increase their quantity supplied in response to an increase in prices, but a rise in price often brings brand-new suppliers into the market. For example, a rise in teachers’ salaries will have little effect on the number of hours current teachers teach, but it will increase the number of people choosing to be teachers.

The law of supply is based on two phenomena:

1. At higher prices, existing suppliers supply more.

2. At higher prices, new suppliers enter the market.

The Interaction of Supply and Demand

Thomas Carlyle, the English historian who dubbed economics “the dismal science,” also wrote this chapter’s introductory tidbit. “Teach a parrot the terms supply and demand and you’ve got an economist.” In earlier chapters, I tried to convince you that economics is not dismal. In the rest of this chapter, I hope to convince you that, while supply and demand are important to economics, parrots don’t make good economists. If students think that when they’ve learned the terms supply and demand they’ve learned economics, they’re mistaken. Those terms are just labels for the ideas behind supply and demand, and it’s the ideas that are important. What matters about supply and demand isn’t the labels but how the concepts interact. For instance, what happens if a freeze kills the blossoms on the orange trees? If price doesn’t change, the quantity of oranges supplied isn’t expected to equal the quantity demanded. But in the real world, prices do change, often before the frost hits, as expectations of the frost lead people to adjust. It’s in understanding the interaction of supply and demand that economics becomes interesting and relevant.


When you have a market in which neither suppliers nor consumers collude and in which prices are free to move up and down, the forces of supply and demand interact to arrive at an equilibrium. The concept of equilibrium comes from physics—classical mechanics. Equilibrium s a concept in which opposing dynamic forces cancel each other out. For example, a hot-air balloon is in equilibrium when the upward force exerted by the hot air in the balloon equals the downward pressure exerted on the balloon by gravity. In supply/demand analysis, equilibrium means that the upward pressure on price is exactly offset by the downward pressure on price. Equilibrium quantity is the amount bought and sold at the equilibrium price. Equilibrium price s the price toward which the invisible hand drives the market. At the equilibrium price, quantity demanded equals quantity supplied.


Six Things to Remember about a Supply Curve

• A supply curve follows the law of supply. When price rises, quantity supplied increases, and vice versa.

• The horizontal axis—quantity—has a time dimension.
• The quality of each unit is the same.

• The vertical axis—price—assumes all other prices remain constant.

• The curve assumes everything else is constant.

• Effects of price changes are shown by movements along the supply curve.

• Effects of nonprice determinants of supply are shown by shifts of the entire supply curve.

What happens if the market is not in equilibrium—if quantity supplied doesn’t equal quantity demanded? You get either excess supply or excess demand, and a tendency for prices to change.

Excess Supply

If there is excess supply (a surplus), quantity supplied is greater than quantity demanded, and some suppliers won’t be able to sell all their goods. Each supplier will think: “Gee, if I offer to sell it for a bit less, I’ll be the lucky one who sells my goods; someone else will be stuck with goods they can’t sell.” But because all suppliers with excess goods will be thinking the same thing, the price in the market will fall. As that happens, consumers will increase their quantity demanded. So the movement toward equilibrium caused by excess supply is on both the supply and demand sides.

Bargain hunters can get a deal when there is excess supply.

Excess Demand

The reverse is also true. Say that instead of excess supply, there’s excess demand (a shortage)—quantity demanded is greater than quantity supplied. There are more consumers who want the good than there are suppliers selling the good. Let’s consider what’s likely to go through demanders’ minds. They’ll likely call long-lost friends who just happen to be sellers of that good and tell them it’s good to talk to them and, by the way, don’t they want to sell that…? Suppliers will be rather pleased that so many of their old friends have remembered them, but they’ll also likely see the connection between excess demand and their friends’ thoughtfulness. To stop their phones from ringing all the time, they’ll likely raise their price. The reverse is true for excess supply. It’s amazing how friendly suppliers become to potential consumers when there’s excess supply.

Price Adjusts

This tendency for prices to rise when the quantity demanded exceeds the quantity supplied and for prices to fall when the quantity supplied exceeds the quantity demanded is a central element to understanding supply and demand. So remember:

When quantity demanded is greater than quantity supplied, prices tend to rise.

When quantity supplied is greater than quantity demanded, prices tend to fall.

Prices tend to rise when there is excess demand and fall when there is excess supply.

Two other things to note about supply and demand are (1) the greater the difference between quantity supplied and quantity demanded, the more pressure there is for prices to rise or fall, and (2) when quantity demanded equals quantity supplied, the market is in equilibrium.

Price Adjustment and Equilibrium

People’s tendencies to change prices exist as long as quantity supplied and quantity demanded differ. But the change in price brings the laws of supply and demand into play. As price falls, quantity supplied decreases as some suppliers leave the business (the law of supply). And as some people who originally weren’t really interested in buying the good think, “Well, at this low price, maybe I do want to buy,” quantity demanded increases (the law of demand). Similarly, when price rises, quantity supplied will increase (the law of supply) and quantity demanded will decrease (the law of demand).

Whenever quantity supplied and quantity demanded are unequal, price tends to change. If, however, quantity supplied and quantity demanded are equal, price will stay the same because no one will have an incentive to change.

The Graphical Interaction of Supply and Demand

Figure 4-8 shows supply and demand curves for DVD rentals and demonstrates the force of the invisible hand. Let’s consider what will happen to the price of DVDs in three cases:

1. When the price is $3.50 each.

2. When the price is $1.50 each.

3. When the price is $2.50 each.

1. When price is $3.50, quantity supplied is 7 and quantity demanded is only 3. Excess supply is 4. Individual consumers can get all they want, but most suppliers can’t sell all they wish; they’ll be stuck with DVDs that they’d like to rent. Suppliers will tend to offer their goods at a lower price and demanders, who see plenty of suppliers out there, will bargain harder for an even lower price. Both these forces will push the price as indicated by the down arrows in Figure 4-8.

Now let’s start from the other side.

2. Say price is $1.50. The situation is now reversed. Quantity supplied is 3 and quantity demanded is 7. Excess demand is 4. Now it’s consumers who can’t get what they want and suppliers who are in the strong bargaining position. The pressures will be on price to rise in the direction of the up arrows in Figure 4-8.

3. At $2.50, price is at its equilibrium: quantity supplied equals quantity demanded. Suppliers offer to sell 5 and consumers want to buy 5, so there’s no pressure on price to rise or fall. Price will tend to remain where it is (point E in Figure 4-8). Notice that the equilibrium price is where the supply and demand curves intersect.

What Equilibrium Isn’t

It is important to remember two points about equilibrium. First, equilibrium isn’t a state of the world. It’s a characteristic of the model—the framework you use to look at the world. The same situation could be seen as an equilibrium in one framework and as a disequilibrium in another. Say you’re describing a car that’s speeding along at 100 miles an hour. That car is changing position relative to objects on the ground. Its movement could be, and generally is, described as if it were in disequilibrium. However, if you consider this car relative to another car going 100 miles an hour, the cars could be modeled as being in equilibrium because their positions relative to each other aren’t changing.

FIGURE 4-8: The Interaction of Supply and Demand

Combining Ann’s supply from Figure 4-7 and Alice’s demand from Figure 4-4, let’s see the force of the invisible hand. When there is excess demand, there is upward pressure on price. When there is excess supply, there is downward pressure on price. Understanding these pressures is essential to understanding how to apply economics to reality.

Second, equilibrium isn’t inherently good or bad. It’s simply a state in which dynamic pressures offset each other. Some equilibria are awful. Say two countries are engaged in a nuclear war against each other and both sides are blown away. An equilibrium will have been reached, but there’s nothing good about it.

Equilibrium is not inherently good or bad.

Political and Social Forces and Equilibrium

Understanding that equilibrium is a characteristic of the model, not of the real world, is important in applying economic models to reality. For example, in the preceding description, I said equilibrium occurs where quantity supplied equals quantity demanded. In a model where economic forces were the only forces operating, that’s true. In the real world, however, other forces—political and social forces—are operating. These will likely push price away from that supply/demand equilibrium. Were we to consider a model that included all these forces—political, social, and economic—equilibrium would be likely to exist where quantity supplied isn’t equal to quantity demanded. For example:

• Farmers use political pressure to obtain prices that are higher than supply/demand equilibrium prices.

• Social pressures often offset economic pressures and prevent unemployed individuals from accepting work at lower wages than currently employed workers receive.

• Existing firms conspire to limit new competition by lobbying Congress to pass restrictive regulations and by devising pricing strategies to scare off new entrants.

• Renters often organize to pressure local government to set caps on the rental price of apartments.

FIGURE 4-9 (A AND B): Shifts In Supply and Demand

If demand increases from D0 to D1, as shown in (a), the quantity of DVD rentals that was demanded at a price of $2.25, 8, increases to 10, but the quantity supplied remains at 8. This excess demand tends to cause prices to rise. Eventually, a new equilibrium is reached at the price of $2.50, where the quantity supplied and the quantity demanded are 9 (point B).

If supply of DVD rentals decreases, then the entire supply curve shifts inward to the left, as shown in (b), from S0 to S1. At the price of $2.25, the quantity supplied has now decreased to 6 DVDs, but the quantity demanded has remained at 8 DVDs. The excess demand tends to force the price upward. Eventually, an equilibrium is reached at the price of $2.50 and quantity 7 (point C).

If social and political forces were included in the analysis, they’d provide a counter-pressure to the dynamic forces of supply and demand. The result would be an equilibrium with continual excess supply or excess demand if the market were considered only in reference to economic forces. Economic forces pushing toward a supply/demand equilibrium would be thwarted by social and political forces pushing in the other direction.

Shifts in Supply and Demand

Supply and demand are most useful when trying to figure out what will happen to equilibrium price and quantity if either supply or demand shifts. Figure 4-9(a) deals with an increase in demand. Figure 4-9(b) deals with a decrease in supply.


Demonstrate graphically the effect of a heavy frost in Florida on the equilibrium quantity and price of oranges.

Let’s consider again the supply and demand for DVD rentals. In Figure 4-9(a), the supply is S0 and initial demand is D0. They meet at an equilibrium price of $2.25 per DVD and an equilibrium quantity of 8 DVDs per week (point A). Now say that the demand for DVD rentals increases from D0 to D1. At a price of $2.25, the quantity of DVD rentals supplied will be 8 and the quantity demanded will be 10; excess demand of 2 exists.

The excess demand pushes prices upward in the direction of the small arrows, decreasing the quantity demanded and increasing the quantity supplied. As it does so, movement takes place along both the supply curve and the demand curve.

The upward push on price decreases the gap between the quantity supplied and the quantity demanded. As the gap decreases, the upward pressure decreases, but as long as that gap exists at all, price will be pushed upward until the new equilibrium price ($2.50) and new quantity (9) are reached (point B). At point B, quantity supplied equals quantity demanded. So the market is in equilibrium. Notice that the adjustment is twofold: The higher price brings about equilibrium by both increasing the quantity supplied (from 8 to 9) and decreasing the quantity demanded (from 10 to 9).


The Supply and Demand for Children

In Chapter 1, I distinguished between an economic force and a market force. Economic forces are operative in all aspects of our lives; market forces are economic forces that are allowed to be expressed through a market. My examples in this chapter are of market forces—of goods sold in a market—but supply and demand also can be used to analyze situations in which economic, but not market, forces operate. An economist who is adept at this is Gary Becker of the University of Chicago. He has applied supply and demand analysis to a wide range of issues, even the supply and demand for children.

Becker doesn’t argue that children should be bought and sold. But he does argue that economic considerations play a large role in people’s decisions on how many children to have. In farming communities, children can be productive early in life; by age six or seven, they can work on a farm. In an advanced industrial community, children provide pleasure but generally don’t contribute productively to family income. Even getting them to help around the house can be difficult.

Becker argues that since the price of having children is lower for a farming society than for an industrial society, farming societies will have more children per family. Quantity of children demanded will be larger. And that’s what we find. Developing countries that rely primarily on farming often have three, four, or more children per family. Industrial societies average fewer than two children per family.

Figure 4-9(b) begins with the same situation that we started with in Figure 4-9(a); the initial equilibrium quantity and price are 8 DVDs per week and $2.25 per DVD (point A). In this example, however, instead of demand increasing, let’s assume supply decreases—say because some suppliers change what they like to do and decide they will no longer supply DVDs. That means that the entire supply curve shifts inward to the left (from S0 to S1). At the initial equilibrium price of $2.25, the quantity demanded is greater than the quantity supplied. Two more DVDs are demanded than are supplied. (Excess demand = 2.)

This excess demand exerts upward pressure on price. Price is pushed in the direction of the small arrows. As the price rises, the upward pressure on price is reduced but will still exist until the new equilibrium price, $2.50, and new quantity, 7, are reached. At $2.50, the quantity supplied equals the quantity demanded. The adjustment has involved a movement along the demand curve and the new supply curve. As price rises, quantity supplied is adjusted upward and quantity demanded is adjusted downward until quantity supplied equals quantity demanded where the new supply curve intersects the demand curve at point C, an equilibrium of 7 and $2.50.

Here is an exercise for you to try. Demonstrate graphically how the price of computers could have fallen dramatically in the past 10 years, even as demand increased. (Hint: Supply has increased even more, so even at lower prices, far more computers have been supplied than were being supplied 10 years ago.)


Demonstrate graphically the likely effect of an increase in the price of gas on the equilibrium quantity and price of hybrid cars.

The Limitations of Supply/Demand Analysis

Supply and demand are tools, and, like most tools, they help us enormously when used appropriately. Used inappropriately, however, they can be misleading. Throughout the book I’ll introduce you to the limitations of the tools, but let me discuss an important one here.

In supply/demand analysis, other things are assumed constant. If other things change, then one cannot directly apply supply/demand analysis. Sometimes supply and demand are interconnected, making it impossible to hold other things constant. Let’s take an example. Say we are considering the effect of a fall in the wage rate on unemployment. In supply/demand analysis, you would look at the effect that fall would have on workers’ decisions to supply labor, and on business’s decision to hire workers. But there are also other effects. For instance, the fall in the wage lowers people’s income and thereby reduces demand. That reduction may feed back to firms and reduce the demand for their goods, which might reduce the firms’ demand for workers. If these effects do occur, and are important enough to affect the result, they have to be added for the analysis to be complete. A complete analysis always includes the relevant feedback effects.


When determining the effect of a shift factor on price and quantity, in which of the following markets could you likely assume that other things will remain constant?

1. Market for eggs.

2. Labor market.

3. World oil market.

4. Market for luxury boats.

There is no single answer to the question of which ripples must be included, and much debate among economists involves which ripple effects to include. But there are some general rules. Supply/demand analysis, used without adjustment, is most appropriate for questions where the goods are a small percentage of the entire economy. That is when the other-things-constant assumption will most likely hold. As soon as one starts analyzing goods that are a large percentage of the entire economy, the other-things-constant assumption is likely not to hold true. The reason is found in the fallacy of composition—the false assumption that what is true for a part will also be true for the whole.

The fallacy of composition is the false assumption that what is true for a part will also be true for the whole.

Consider a lone supplier who lowers the price of his or her good. People will substitute that good for other goods, and the quantity of the good demanded will increase. But what if all suppliers lower their prices? Since all prices have gone down, why should consumers switch? The substitution story can’t be used in the aggregate. There are many such examples.


Why is the fallacy of composition relevant for macroeconomic issues?

An understanding of the fallacy of composition is of central relevance to macroeconomics. In the aggregate, whenever firms produce (whenever they supply), they create income (demand for their goods). So in macro, when supply changes, demand changes. This interdependence is one of the primary reasons we have a separate macroeconomics. In macroeconomics, the other-things-constant assumption central to microeconomic supply/demand analysis cannot hold.

It is to account for these interdependencies that we separate macro analysis from micro analysis. In macro we use curves whose underlying foundations are much more complicated than the supply and demand curves we use in micro.

It is to account for interdependency between aggregate supply decisions and aggregate demand decisions that we have a separate micro analysis and a separate macro analysis.

One final comment: The fact that supply and demand may be interdependent does not mean that you can’t use supply/demand analysis; it simply means that you must modify its results with the interdependency that, if you’ve done the analysis correctly, you’ve kept in the back of your head. Using supply and demand analysis is generally a step in any good economic analysis, but you must remember that it may be only a step.


Throughout the book, I’ll be presenting examples of supply and demand. So I’ll end this chapter here because its intended purposes have been served. What were those intended purposes? First, I exposed you to enough economic terminology and economic thinking to allow you to proceed to my more complicated examples. Second, I have set your mind to work putting the events around you into a supply/demand framework. Doing that will give you new insights into the events that shape all our lives. Once you incorporate the supply/demand framework into your way of looking at the world, you will have made an important step toward thinking like an economist.


• The law of demand states that quantity demanded rises as price falls, other things constant.

• The law of supply states that quantity supplied rises as price rises, other things constant.

• Factors that affect supply and demand other than price are called shift factors. Shift factors of demand include income, prices of other goods, tastes, expectations, and taxes on and subsidies to consumers. Shift factors of supply include the price of inputs, technology, expectations, and taxes on and subsidies to producers.

• A change in quantity demanded (supplied) is a movement along the demand (supply) curve. A change in demand (supply) is a shift of the entire demand (supply) curve.

• The laws of supply and demand hold true because individuals can substitute.

• A market demand (supply) curve is the horizontal sum of all individual demand (supply) curves.

• When quantity supplied equals quantity demanded, prices have no tendency to change. This is equilibrium.

• When quantity demanded is greater than quantity supplied, prices tend to rise. When quantity supplied is greater than quantity demanded, prices tend to fall.

• When the demand curve shifts to the right (left), equilibrium price rises (declines) and equilibrium quantity rises (falls).

• When the supply curve shifts to the right (left), equilibrium price declines (rises) and equilibrium quantity rises (falls).

• In the real world, you must add political and social forces to the supply/demand model. When you do, equilibrium is likely not going to be where quantity demanded equals quantity supplied.

• In macro, small side effects that can be assumed away in micro are multiplied enormously and can significantly change the results. To ignore them is to fall into the fallacy of composition.

Key Terms

demand (83)

demand curve (82)

equilibrium (93)

equilibrium price (93)

equilibrium quantity (93)

excess demand (93)

excess supply (93)

fallacy of composition (98)

law of demand (82)

law of supply (88)

market demand curve (86)

market supply curve (92)

movement along a demand curve (83)

movement along a supply curve (90)

quantity demanded (83)

quantity supplied (89)

shift in demand (83)

shift in supply (90)

supply (89)

supply curve (89)

Questions for Thought and Review

1. State the law of demand. Why is price inversely related to quantity demanded? LO1, LO2

2. State the law of supply. Why is price directly related to quantity supplied? LO4

3. List four shift factors of demand and explain how each affects demand. LO3

4. Distinguish the effect of a shift factor of demand on the demand curve from the effect of a change in price on the demand curve. LO3

5. Mary has just stated that normally, as price rises, supply will increase. Her teacher grimaces. Why? LO4

6. List four shift factors of supply and explain how each affects supply. LO5

7. Derive the market supply curve from the following two individual supply curves. LO4

8. It has just been reported that eating red meat is bad for your health. Using supply and demand curves, demonstrate the report’s likely effect on the equilibrium price and quantity of steak sold in the market. LO7

9. Why does the price of airline tickets rise during the summer months? Demonstrate your answer graphically. LO7

10. Why does sales volume rise during weeks when states suspend taxes on sales by retailers? Demonstrate your answer graphically. LO7

11. What is the expected impact of increased security measures imposed by the federal government on airlines on fares and volume of travel? Demonstrate your answer graphically. (Difficult) LO7

12. Explain what a sudden popularity of “Economics Professor” brand casual wear would likely do to prices of that brand. LO7

13. In a flood, usable water supplies ironically tend to decline because the pumps and water lines are damaged. What will a flood likely do to prices of bottled water? LO7

14. The price of gas shot up significantly in 2005 to over $2.50 a gallon. What effect did this likely have on the demand for diesel cars that get better mileage than the typical car? LO7

15. In June 2004, OPEC announced it would increase oil production by 11 percent. What was the effect on the price of oil? Demonstrate your answer graphically. LO7

16. Oftentimes, to be considered for a job, you have to know someone in the firm. What does this observation tell you about the wage paid for that job? (Difficult) LO6

17. In most developing countries, there are long lines of taxis at airports, and these taxis often wait two or three hours. What does this tell you about the price in that market? Demonstrate with supply and demand analysis. LO7

18. Define the fallacy of composition. How does it affect the supply/demand model? LO8

19. Why is a supply/demand analysis that includes only economic forces likely to be incomplete? LO8

20. In which of the following three markets are there likely to be the greatest feedback effects: market for housing, market for wheat, market for manufactured goods? LO8

Problems and Exercises

21. You’re given the following individual demand tables for comic books.

a. Determine the market demand table.

b. Graph the individual and market demand curves.

c. If the current market price is $4, what’s total market demand? What happens to total market demand if price rises to $8?

d. Say that an advertising campaign increases demand by 50 percent. Illustrate graphically what will happen to the individual and market demand curves. LO1

22. You’re given the following demand and supply tables:

a. Draw the market demand and market supply curves.

b. What is excess supply/demand at price $37? Price $67?

c. Label equilibrium price and quantity. LO1, LO2, LO6

23. Draw hypothetical supply and demand curves for tea. Show how the equilibrium price and quantity will be affected by each of the following occurrences:

a. Bad weather wreaks havoc with the tea crop.

b. A medical report implying tea is bad for your health is published.

c. A technological innovation lowers the cost of producing tea.

d. Consumers’ income falls. (Assume tea is a normal good.) LO7

24. You’re a commodity trader and you’ve just heard a report that the winter wheat harvest will be 2.09 billion bushels, a 44 percent jump, rather than an expected 35 percent jump to 1.96 billion bushels. (Difficult)

a. What would you expect would happen to wheat prices?

b. Demonstrate graphically the effect you suggested in a. LO7

25. In the United States, say gasoline costs consumers about $2.50 per gallon. In Italy, say it costs consumers about $6 per gallon. What effect does this price differential likely have on:

a. The size of cars in the United States and in Italy?

b. The use of public transportation in the United States and in Italy?

c. The fuel efficiency of cars in the United States and in Italy? What would be the effect of raising the price of gasoline in the United States to $4 per gallon? LO7

26. In 2004, Argentina imposed a 20 percent tax on natural gas exports.

a. Demonstrate the likely effect of that tax on gas exports using supply and demand curves.

b. What did it likely do to the price of natural gas in Argentina?

c. What did it likely do to the price of natural gas out side of Argentina? LO7

27. In the early 2000s, the demand for housing increased substantially as low interest rates increased the number of people who could afford homes.

a. What was the likely effect of this on housing prices? Demonstrate graphically.

b. In 2005, mortgage rates began increasing. What was the likely effect of this increase on housing prices? Demonstrate graphically.

c. In a period of increasing demand for housing, would you expect housing prices to rise more in Miami suburbs, which had room for expansion and fairly loose laws about subdivisions, or in a city such as San Francisco, which had limited land and tight subdivision restrictions? LO7

28. In 1994, the U.S. postal service put a picture of rodeo rider Ben Pickett, not the rodeo star, Bill Pickett, whom it meant to honor, on a stamp. It printed 150,000 sheets. Recognizing its error, it recalled the stamp, but it found that 183 sheets had already been sold. (Difficult)

a. What would the recall likely do to the price of the 183 sheets that were sold?

b. When the government recognized that it could not recall all the stamps, it decided to issue the remaining ones. What would that decision likely do?

c. What would the holders of the misprinted sheet likely do when they heard of the government’s decision? LO7

29. What would be the effect of a 75 percent tax on lawsuit punitive awards that was proposed by California Governor Arnold Schwarzenegger in 2004 on: (Difficult)

a. The number of punitive awards. Demonstrate your answer using supply and demand curves.

b. The number of pre-trial settlements. L O 7

30. State whether supply/demand analysis used with out significant modification is suitable to assess the following:

a. The impact of an increase in the demand for pencils on the price of pencils.

b. The impact of an increase in the supply of labor on the quantity of labor demanded.

c. The impact of an increase in aggregate savings on aggregate expenditures.

d. The impact of a new method of producing CDs on the price of CDs. LO8

Questions from Alternative Perspectives

1. In a centrally planned economy, how might central planners estimate supply or demand? (Austrian)

2. In the late 19th century, Washington Gladden said, “He who battles for the Christianization of society, will find their strongest foe in the field of economics. Economics is indeed the dismal science because of the selfishness of its maxims and the inhumanity of its conclusions.”

a. Evaluate this statement.

b. Is there a conflict between the ideology of capitalism and the precepts of Christianity?

c. Would a society that emphasized a capitalist mode of production benefit by a moral framework that emphasized selflessness rather than selfishness? (Religious)

3. Economics is often referred to as the study of choice.

a. In U.S. history, have men and women been equally free to choose the amount of education they receive even within the same family?

b. What other areas can you see where men and women have not been equally free to choose?

c. If you agree that men and women have not had equal rights to choose, what implications does that have about the objectivity of economic analysis? (Feminist)

4. Knowledge is derived from a tautology when something is true because you assume it is true. In this chapter, you have learned the conditions under which supply and demand explain outcomes. Yet, as your text author cautions, these conditions may not hold. How can you be sure if they ever hold? (Institutionalist)

5. Do you think consumers make purchasing decisions based on general rules of thumb instead of price?

a. Why would consumers do this?

b. What implication might this have for the conclusions drawn about markets? (Post-Keynesian)

6. Some economists believe that imposing international labor standards would cost jobs. In support of this argument, one economist said, “Either you believe labor demand curves are downward sloping, or you don’t.” Of course, not to believe that demand curves are negatively sloped would be tantamount to declaring yourself an economic illiterate. What else about the nature of labor demand curves might help a policy maker design policies that could counteract the negative effects of labor standards employment? (Radical)

Web Questions

1. Go to the U.S. Census Bureau’s home page (www.census.gov) and navigate to the population pyramids for 2000, for 2025, and for 2050. What is projected to happen to the age distribution in the United States? Other things constant, what do you expect will happen in the next 50 years to the relative demand and supply for each of the following, being careful to distinguish between shifts of and a movement along a curve:

a. Nursing homes.

b. Prescription medication.

c. Baby high chairs.

d. College education.

2. Go to the Energy Information Administration’s home page (www.eia.doe.gov) and look up its most recent “Short-Term Energy Outlook” and answer the following questions:

a. List the factors that are expected to affect demand and supply for energy in the near term. How will each affect demand? Supply?

b. What is the EIA’s forecast for world oil prices? Show graphically how the factors listed in your answer to a are consistent with the EIA’s forecast. Label all shifts in demand and supply.

c. Describe and explain EIA’s forecast for the price of gasoline, heating oil, and natural gas. Be sure to mention the factors that are affecting the forecast.

3. Go to the Tax Administration home page (www.taxadmin.org) and look up sales tax rates for the 50 U.S. states.

a. Which states have no sales tax? Which state has the highest sales tax?

b. Show graphically the effect of sales tax on supply, demand, equilibrium quantity, and equilibrium price.

c. Name two neighboring states that have significantly different sales tax rates. How does that affect the supply or demand for goods in those states?

Answers to Margin Questions

1. The demand curve slopes downward because price and quantity demanded are inversely related. As the price of a good rises, people switch to purchasing other goods whose prices have not risen by as much. (82)

2. Demand for luxury goods. The other possibility, quantity of luxury goods demanded, is used to refer to movements along (not shifts of) the demand curve. (83)

3. (1) The decline in price will increase the quantity of computers demanded (movement down along the demand curve); (2) With more income, demand for computers will rise (shift of the demand curve out to the right). (84)

4. When adding two demand curves, you sum them horizontally, as in the accompanying diagram. (86)

5. The quantity supplied rose because there was a movement along the supply curve. The supply curve itself remained unchanged. (89)

6. (1) The supply of romance novels declines since paper is an input to production (supply shifts in to the left); (2) the supply of romance novels declines since the tax increases the cost to the producer (supply shifts in to the left). (90)

7. A heavy frost in Florida will decrease the supply of oranges, increasing the price and decreasing the quantity demanded, as in the accompanying graph. (96)

8. An increase in the price of gas will likely increase the demand for hybrid cars, increasing their price and increasing the quantity supplied, as in the accompanying graph. (97)

9. Other things are most likely to remain constant in the egg and luxury boat markets because each is a small percentage of the whole economy. Factors that affect the world oil market and the labor market will have ripple effects that must be taken into account in any analysis. (98)

10. The fallacy of composition is relevant for macroeconomic issues because it reminds us that, in the aggregate, small effects that are immaterial for micro issues can add up and be material. (98)

(Colander 81)

Colander, David C. Macroeconomics, 7th Edition. McGraw-Hill Learning Solutions, 102007. .

5: Using Supply and Demand

It is by invisible hands that we are bent and tortured worst.



1. Explain real-world events using supply and demand.

2. Discuss how exchange rates are determined using supply and demand.

3. Demonstrate the effect of a price ceiling and a price floor on a market.

4. Explain the effect of excise taxes and tariffs on equilibrium price and quantity.

5. Explain the effect of a third-party-payer system on equilibrium price and quantity.

Supply and demand give you a lens through which to view the economy. That lens brings into focus issues that would otherwise seem like a muddle. In this chapter, we use the supply/demand lens to consider real-world events.

Real-World Supply and Demand Applications

Let’s begin by giving you an opportunity to apply supply/demand analysis to real-world events. Below are three events. After reading each, try your hand at explaining what happened, using supply and demand curves. To help you in the process Figure 5-1 provides some diagrams. Before reading my explanation, try to match the shifts to the examples. In each, be careful to explain which curve, or curves, shifted and how those shifts affected equilibrium price and quantity.

1. In the spring of 2006,

Cyclone Larry

tore through key growing regions of Australia with 180-miles-per-hour winds wiping out 80 percent of Australia’s banana crop. Banana prices rose overnight from $1.00 to $2.00 a pound, where they were expected to remain for some time. Market: Bananas in Australia.

2. Now that it can cost as much as $100 to fill a tank of gas, Americans are switching from SUVs to more fuel-efficient cars. The number of people shopping for used SUVs fell over 30 percent in 2006 and the price of used SUVs fell an average of 10 percent. Market: Used SUVs in the United States.

3. Due to the entry of new coffee-growers (such as Vietnam) in the market, improved growing techniques, and favorable growing weather, the price of raw coffee beans fell from about $2.00 a pound in 1997 to less than $0.50 a pound in 2002. Some growers have proposed a marketing campaign to boost demand to match the increase in supply. While it’s unlikely to be successful, for this analysis, let’s assume it is. Market: Raw coffee beans.

Now that you’ve matched them, let’s see if your analysis matches mine.

FIGURE 5-1: (A, B, AND C)

Cyclone Larry

Weather is a shift factor of supply. The cyclone shifted the supply curve for bananas from Australia to the left, as shown in Figure 5-1(b). At the original price, $1 a pound (shown by P0), quantity demanded exceeded quantity supplied and the invisible hand of the market pressured the price to rise until quantity demanded equaled quantity supplied at $2 a pound (shown by P1).


True or false? If supply rises, price will rise.

Sales of SUVs

Gas is a significant cost of driving a car. To reduce their automotive gas bills, Americans reduced their demand for gas-guzzling SUVs, both new and used. Figure 5-1(a) shows that the demand curve for SUVs in the used-car market shifted from D0 to D1. At the original price P0, sellers were unable to sell the SUVs they wanted to sell and began to lower their price. Buyers of used SUVs were able to purchase them at a 10 percent lower price, shown by P1.

Coffee Beans

Increased rainfall in Brazil, as well as more efficient farm machinery, has increased the coffee bean yield per acre. The entry of Vietnam into the coffee market has added more coffee beans on the market. This increase in supply is represented by a shift of the supply curve out to the right, as Figure 5-1(c) shows. Equilibrium price declined from $2.00 to $0.50 per pound in just two years and equilibrium quantity rose (where D0 and S1 intersect). Let’s now consider the Coffee Growers’ Federation recommendation to market coffee so that increases in demand would match increases in consumption. If successful, this would shift the demand curve out to the right sufficiently to raise the price of coffee back to $2.00 a pound and to raise equilibrium quantity even further. So in this case both supply and demand shift out.


Web Note 5.1: Fair Trade Coffee

Now that we’ve been through some straightforward examples, let’s get more adventurous and apply supply/demand analysis to a case where you really have to be careful about what price you are talking about—the demand and supply for euros, the common currency in Europe.

The Price of a Foreign Currency

The market for foreign currencies is called the foreign exchange (forex) market. It is this market that determines the exchange rates—the price of one country’s currency in terms of another’s currency—that newspapers report daily in tables such as the table on the next page that shows the cost of various currencies in terms of dollars and dollars in terms of other currencies. From it you can see that on March 6, 2007, one riyal cost about 27 cents and one rand cost 14 cents. (If you are wondering which countries have riyals and rands for currencies, look at the table.)


Supply and Demand in Action

Sorting out the effects of the shifts of supply or demand or both can be confusing. Here are some helpful hints to keep things straight:

• Draw the initial demand and supply curves and label them. The equilibrium price and quantity is where these curves intersect. Label them.

• If only price has changed, no curves will shift and a shortage or surplus will result.

• If a nonprice factor affects demand, determine the direction demand has shifted and add the new demand curve. Do the same for supply.

• Equilibrium price and quantity is where the new demand and supply curves intersect. Label them.

• Compare the initial equilibrium price and quantity to the new equilibrium price and quantity.

See if you can describe what happened in the three graphs below.

People demand currencies of other countries to buy those countries’ goods and assets.

Unless you collect currencies, the reason you want the currency of another country is that you want to buy something that country produces or an existing asset of that country. Say you want to buy a Hyundai car that costs 12.793 million South Korean won. Looking at the table, you see that 1 won costs $0.0010553. This means that 12.793 million won will cost you $13,500.45. So before you can buy the Hyundai, somebody must go to a forex market with $13,500.45 and exchange those dollars for 12.793 million won. Only then can the car be bought in the United States. Most final buyers don’t do this; the importer does it for them. But whenever a foreign good is bought, someone must trade currencies.

The determination of exchange rates is the same as the determination of price. A currency is just another good.

To see what determines exchange rates, let’s consider the price of the euro—the currency used by 13 of the members of the European Union. In 2001, one euro sold for $0.85. It rose to $1.30 in the early 2000s. What caused this rise? Supply and demand. Once you recognize that a currency is just another good, what may appear to be a hard subject (the determination of exchange rates) becomes an easy subject (what determines a good’s price). All you have to do is to replace the good I used in Chapter 4 (DVDs) with euros, and apply the same reasoning process we’ve used so far to determine the equilibrium price of the euro.

The determination of exchange rates is the same as the determination of price. A currency is just another good.


You are going to Chile and plan to exchange $100. According to the foreign exchange rate table in the text, how many Chilean pesos will you receive?

Foreign Exchange

Figure 5-2 shows supply and demand curves for the euro. As with any good, the supply of euros represents those people who are selling euros and the demand for the euro represents those people who are buying euros. Sellers of euros are Europeans who want to buy U.S. goods and assets. Buyers of euros are U.S. citizens who want to buy European goods and assets. (For simplicity, we assume that the only countries that exist are the United States and European countries that use the euro as their currency.)

The rise in the value of the euro in the early 2000s occurred for a number of reasons. The one we will focus on here is the recession and falling interest rates in the United States. We begin with demand D0 and supply S0 for euros, resulting in an equilibrium price of $0.85 in 2001. Because the U.S. economy entered a recession, and because U.S. interest rates fell, Europeans bought fewer U.S. financial assets such as stocks and bonds. That meant they supplied fewer euros because they needed to buy fewer U.S. dollars. The supply of euros fell from S0 to S1. At the same time, Americans also decided to buy more European stocks and bonds because European interest rates were relatively higher. In addition, the Chinese and Japanese governments increased their demand for European assets. Because they needed to pay for these European assets with euros, the demand for euros rose from D0 to D1. Combined, the two shifts led to a rise in the price of the euro as shown in Figure 5-2, increasing the price to $1.30 in 2005, where it remained into 2007.

There is more to the determination of exchange rates than this, but as is often the case, supply/demand analysis gives you a good first entry into what is otherwise a potentially confusing issue.

FIGURE 5-2: The Market for Euros

The price of the euro increased as American investors increased their demand for euros to buy European goods and invest in the European stock market, while Europeans bought fewer U.S. goods and fewer American stocks, decreasing Americans’ supply of euros. The combined effect was a rise in the dollar price of euros.

A Review

Now that we’ve been through some examples, let’s review. Remember: Anything that affects demand and supply other than price of the good will shift the curves. Changes in the price of the good result in movements along the curves. Another thing to recognize is that when both curves are shifting, you can get a change in price but little change in quantity, or a change in quantity but little change in price.

Anything other than price that affects demand or supply will shift the curves.

To test your understanding Table 5-1 gives you six generic results from the interaction of supply and demand. Your job is to decide what shifts produced those results. This exercise is a variation of the one with which I began the chapter. It goes over the same issues, but this time without the graphs. On the left-hand side of Table 5-1, I list combinations of movements of observed prices and quantities, labeling them 1-6. On the right I give six shifts in supply and demand, labeling them a – f.


Say a hormone has been discovered that increases cows’ milk production by 20 percent. Demonstrate graphically what effect this discovery would have on the price and quantity of milk sold in a market.

TABLE 5-1:

If you don’t confuse your “shifts of” with your “movements along,” supply and demand provide good off-the-cuff answers for any economic questions.

You are to match the shifts with the price and quantity movements that best fit each described shift, using each shift and movement only once. My recommendation to you is to draw the graphs that are described in a – f, decide what happens to price and quantity, and then find the match in 1-6.

Now that you’ve worked them, let me give you the answers I came up with. They are: 1-e; 2-a; 3-b; 4-f; 5-d; 6-c.; How did I come up with the answers? I did what I suggested you do—took each of the scenarios on the right and predicted what happens to price and quantity. For case a, supply shifts in to the left and there is a movement up along the demand curve. Since the demand curve is downward-sloping, the price rises and quantity declines. This matches number 2 on the left. For case b, demand shifts out to the right. Along the original supply curve, price and quantity would rise. But supply shifts in to the left, leading to even higher prices but lower quantity. What happens to quantity is unclear, so the match must be number 3. For case c, demand shifts in to the left. There is movement down along the supply curve with lower price and lower quantity. This matches number 6. For case d, demand shifts out and supply shifts out. As demand shifts out, we move along the supply curve to the right and price and quantity rise. But supply shifts out too, and we move out along the new demand curve. Price declines, erasing the previous rise, and the quantity rises even more. This matches number 5.


If both demand and supply shift in to the left, what happens to price and quantity?

TABLE 5-2: Diagram of Effects of Shifts of Demand and Supply on Price and Quantity

I’ll leave it up to you to confirm my answers to e and f. Notice that when supply and demand both shift, the change in either price or quantity is uncertain—it depends on the relative size of the shifts. As a summary, I present a diagrammatic of the combinations in Table 5-2.


If price and quantity both fell, what would you say was the most likely cause?

Government Intervention in the Market

People don’t always like the market-determined price. If the invisible hand were the only factor that determined prices, people would have to accept it. But it isn’t; social and political forces also determine price. For example, when prices fall, sellers look to government for ways to hold prices up; when prices rise, buyers look to government for ways to hold prices down. Let’s now consider the effect of such actions. Let’s start with an example of the price being held down.

Price Ceilings

When government wants to hold prices down, it imposes a price ceiling—a government-imposed limit on how high a price can be charged. That limit is generally below the equilibrium price. (A price ceiling that is above the equilibrium price will not have any effect at all.) From Chapter 4, you already know the effect of a price that is below the equilibrium price—quantity demanded will exceed quantity supplied and there will be excess demand. Let’s now look at an example of rent control—a price ceiling on rents, set by government—and see how that excess demand shows up in the real world.

FIGURE 5-3: Rent Control in Paris

A price ceiling imposed on housing rent in Paris during World War II created a shortage of housing when World War II ended and veterans returned home. The shortage would have been eliminated if rents had been allowed to rise to $17 per month.


Web Note 5.2: Rent Control

Rent controls exist today in a number of American cities as well as other cities throughout the world. Many of the laws governing rent were first instituted during the two world wars in the first half of the 20th century. Consider Paris, for example. In World War II, the Paris government froze rent to ease the financial burden of those families whose wage earners were sent to fight in the war. When the soldiers returned at the end of the war, the rent control was continued; removing it would have resulted in an increase in rents from $2.50 to $17 a month, and that was felt to be an unfair burden for veterans.

Price Ceilings

Figure 5-3 shows this situation. The below-market rent set by government created an enormous shortage of apartments. Initially this shortage didn’t bother those renting apartments, since they got low-cost apartments. But it created severe hardships for those who didn’t have apartments. Many families moved in with friends or extended families. Others couldn’t find housing at all and lived on the streets. Eventually the rent controls started to cause problems even for those who did have apartments. The reason why is that owners of buildings cut back on maintenance. More than 80 percent of Parisians had no private bathrooms and 20 percent had no running water. Since rental properties weren’t profitable, no new buildings were being constructed and existing buildings weren’t kept in repair. It was even harder for those who didn’t have apartments.


What is the effect of the price ceiling, Pc, shown in the graph below on price and quantity?

Since the market price was not allowed to ration apartments, alternative methods of rationing developed. People paid landlords bribes to get an apartment, or watched the obituaries and then simply moved in their furniture before anyone else did. Eventually the situation got so bad that rent controls were lifted.

The system of rent controls is not only of historical interest. Below I list some phenomena that existed in New York City recently.

1. A couple paid $350 a month for a two-bedroom Park Avenue apartment with a solarium and two terraces, while another individual paid $1,200 a month for a studio apartment shared with two roommates.

2. The vacancy rate for apartments in New York City was 3.5 percent. Anything under 5 percent is considered a housing emergency.

3. The actress Mia Farrow paid $2,900 a month (a fraction of the market-clearing rent) for 10 rooms on Central Park West. It was an apartment her mother first leased 60 years ago.

4. Would-be tenants made payments, called key money, to current tenants or landlords to get apartments.

Your assignment is to explain how these phenomena might have come about, and to demonstrate, with supply and demand, the situation that likely caused them. (Hint: New York City had rent control.)

Now that you have done your assignment (you have, haven’t you?), let me give you my answers so that you can check them with your answers.

With price ceilings, existing goods are no longer rationed entirely by price. Other methods of rationing existing goods arise called nonprice rationing.

The situation is identical with that presented above in Figure 5-3. Take the first item. The couple lived in a rent-controlled apartment while the individual with roommates did not. If rent control were eliminated, rent on the Park Avenue apartment would rise and rent on the studio would most likely decline. Item 2: The housing emergency was a result of rent control. Below-market rent resulted in excess demand and little vacancy. Item 3: That Mia Farrow rents a rent-controlled apartment was the result of nonprice rationing. Instead of being rationed by price, other methods of rationing arose. These other methods of rationing scarce resources are called nonprice rationing. In New York City, strict rules determined the handing down of rent-controlled apartments from family member to family member. Item 4: New residents searched for a long time to find apartments to rent, and many discovered that illegal payments to landlords were the only way to obtain a rent-controlled apartment. Key money is a black market payment for a rent-controlled apartment. Because of the limited supply of apartments, individuals were willing to pay far more than the controlled price. Landlords used other methods of rationing the limited supply of apartments—instituting first-come, first-served policies, and, in practice, selecting tenants based on gender, race, or other personal characteristics, even though such discriminatory selection was illegal.

If rent controls had only the bad effects described above, no community would institute them. They are, however, implemented with good intentions—to cope with sudden increases in demand for housing that would otherwise cause rents to explode and force many poor people out of their apartments. The negative effects occur over time as buildings begin to deteriorate and the number of people looking to rent and unable to find apartments increases. As this happens, people focus less on the original renters and more on new renters excluded from the market and on the inefficiencies of price ceilings. Since politicians tend to focus on the short run, we can expect rent control to continue to be used when demand for housing suddenly increases.

Price Floors


What is the effect of the price floor, Pf, shown in the graph below, on price and quantity?

Sometimes political forces favor suppliers, sometimes consumers. So let us now go briefly through a case when the government is trying to favor suppliers by attempting to prevent the price from falling below a certain level. Price floors—government-imposed limits on how low a price can be charged—do just this. The price floor is generally above the existing price. (A price floor below equilibrium price would have no effect.) When there is an effective price floor, quantity supplied exceeds quantity demanded and the result is excess supply.

An example of a price floor is the minimum wage. Both individual states and the federal government impose minimum wage laws—laws specifying the lowest wage a firm can legally pay an employee. The U.S. federal government first instituted a minimum wage of 25 cents per hour in 1938 as part of the Fair Labor Standards Act. It has been raised many times since, and in the early 2000s the federal government voted to raise it to over $7.00 an hour. (With inflation, that’s a much smaller increase than it looks.)

FIGURE 5-4: A Minimum Wage

A minimum wage, Wmin, above equilibrium wage, We, helps those who are able to find work, shown by Q2, but hurts those who would have been employed at the equilibrium wage but can no longer find employment, shown by Qe – Q2. A minimum wage also hurts producers who have higher costs of production and consumers who may face higher product prices.

In 2007 about 1.7 million hourly wage earners received the minimum wage, or about 2.2 percent of hourly paid workers, most of whom are unskilled. The market-determined equilibrium wage for skilled workers is generally above the minimum wage.


Web Note 5.3: Minimum Wage

Price Floors

The effect of a minimum wage on the unskilled labor market is shown in Figure 5-4. The government-set minimum wage is above equilibrium, as shown by Wmin. At the market-determined equilibrium wage We, the quantity of labor supplied and demanded equals Qe. At the higher minimum wage, the quantity of labor supplied rises to Q1 and the quantity of labor demanded declines to Q2. There is an excess supply of workers (a shortage of jobs) represented by the difference Q1 – Q2. This represents people who are looking for work but cannot find it.

The minimum wage helps some people and hurts others.

Who wins and who loses from a minimum wage? The minimum wage improves the wages of the Q2 workers who are able to find work. Without the minimum wage, they would have earned We per hour. The minimum wage hurts those, however, who cannot find work at the minimum wage but who are willing to work, and would have been hired, at the market-determined wage. These workers are represented by the distance Qe – Q2 in Figure 5-4. The minimum wage also hurts firms that now must pay their workers more, increasing the cost of production, and consumers to the extent that firms are able to pass that increase in production cost on in the form of higher product prices.

All economists agree that the above analysis is logical and correct. But they disagree about whether governments should have minimum wage laws. One reason is that the empirical effects of minimum wage laws are relatively small; in fact, some studies have found them to be negligible. (There is, however, much debate about these estimates, since “other things” never remain constant.) A second reason is that some real-world labor markets are not sufficiently competitive to fit the supply/demand model. A third reason is that the minimum wage affects the economy in ways that some economists see as desirable and others see as undesirable. I point this out to remind you that the supply/demand framework is a tool to be used to analyze issues. It does not provide final answers about policy. (In microeconomics, economists explore the policy issues of interferences in markets much more carefully.)

Because the federal minimum wage is low, and not binding for most workers, a movement called the living-wage movement has begun. The living-wage movement focuses on local governments, calling on them to establish a minimum wage at a living wage—a wage necessary to support a family at or above the federally determined poverty line. By 2007, over 70 local governments had passed living-wage laws, with minimum wages ranging between $6.25 an hour in Milwaukee and $12.00 in Santa Cruz. The analysis of these living-wage laws is the same as that for minimum wages.

Excise Taxes

Let’s now consider an example of a tax on goods. An excise tax is a tax that is levied on a specific good. The luxury tax on expensive cars that the United States imposed in 1991 is an example. A tariff is an excise tax on an imported good. What effect will excise taxes and tariffs have on the price and quantity in a market?

To lend some sense of reality, let’s take the example from the early 1990s, when the United States taxed the suppliers of expensive boats. Say the price of a boat before the luxury tax was $60,000, and 600 boats were sold at that price. Now the government taxes suppliers $10,000 for every luxury boat sold. What will the new price of the boat be, and how many will be sold?

A tax on suppliers shifts the supply curve up by the amount of the tax.

If you were about to answer “$70,000,” be careful. Ask yourself whether I would have given you that question if the answer were that easy. By looking at supply and demand curves in Figure 5-5, you can see why $70,000 is the wrong answer.

To sell 600 boats, suppliers must be fully compensated for the tax. So the tax of $10,000 on the supplier shifts the supply curve up from S0 to S1. However, at $70,000, consumers are not willing to purchase 600 boats. They are willing to purchase only 420 boats. Quantity supplied exceeds quantity demanded at $70,000. Suppliers lower their prices until quantity supplied equals quantity demanded at $65,000, the new equilibrium price.

The new equilibrium price is $65,000, not $70,000. The reason is that at the higher price, the quantity of boats people demand is less. Some people choose not to buy boats and others find substitute vehicles or purchase their boats outside the United States. This is a movement up along a demand curve to the left. Excise taxes reduce the quantity of goods demanded. That’s why boat manufacturers were up in arms after the tax was imposed and why the revenue generated from the tax was less than expected. Instead of collecting $10,000 × 600 ($6 million), revenue collected was only $10,000 × 510 ($5.1 million). (The tax was repealed in 1993.)


Your study partner, Umar, has just stated that a tax on demanders of $2 per unit will raise the equilibrium price from $4 to $6. How do you respond?

Excise Taxes

A tariff has the same effect on the equilibrium price and quantity as an excise tax. The difference is that only foreign producers sending goods into the United States pay the tax. An example is the 30 percent tariff imposed on steel imported into the United States in 2002. The government instituted the tariffs because U.S. steelmakers were having difficulty competing with lower-cost foreign steel. The tariff increased the price of imported steel, making U.S. steel more competitive to domestic buyers. As expected, the price of imported steel rose by over 15 percent, to about $230 a ton, and the quantity imported declined. Tariffs don’t hurt just the foreign producer. Tariffs increase the cost of imported products to domestic consumers. In the case of steel, manufacturing companies such as automakers faced higher production costs. The increase in the cost of steel lowered production in those industries and increased the cost of a variety of goods to U.S. consumers.

FIGURE 5-5: The Effect of an Excise Tax

An excise tax on suppliers shifts the entire supply curve up by the amount of the tax. Since at a price equal to the original price plus the tax there is excess supply, the price of the good rises by less than the tax.

Quantity Restrictions

Another way in which governments often interfere with, or regulate, markets is with licenses, which limit entry into a market. For example, to be a doctor you need a license; to be a vet you need a license; and in some places to be an electrician, a financial planner, or a cosmetologist, or to fish, you need a license. There are many reasons for licenses, and we will not consider them here. Instead, we will simply consider what effect licenses have on the price and quantity of the activity being licensed. Specifically, we’ll look at a case where the government issues a specific number of licenses and holds that number constant. The example we’ll take is licenses to drive a taxi. In New York City, these are called taxi medallions because the license is an aluminum plate attached to the hood of a taxi. Taxi medallions were established in 1937 as a way to increase the wages of licensed taxi drivers. Wages of taxi drivers had fallen from $26 a week in 1929 to $15 a week in 1933. As wages fell, the number of taxi drivers fell from 19,000 to about 12,000. The remaining 12,000 taxi drivers successfully lobbied New York City to grant drivers with current licenses who met certain requirements permanent rights to drive taxis—medallions. (It wasn’t until the early 2000s that the number of medallions was increased slightly.) The restriction had the desired effect. As the economy grew, demand for taxis grew (the demand for taxis shifted out) and because the supply of taxis remained at about 12,000, the wages of the taxi drivers owning medallions increased, as is shown in Figure 5-6(a).


What is the effect of the quantity restrictions, QR, shown in the graph below, on equilibrium price and quantity?

Issuing taxi medallions had a secondary effect. Because New York City also granted medallion owners the right to sell their medallions, a market in medallions developed. Those fortunate enough to have been granted a medallion by the city found that they had a valuable asset. A person wanting to drive a taxi, and earn those high wages, had to buy a medallion from an existing driver. This meant that while new taxi drivers would earn a higher wage once they had bought a license, their wage after taking into account the cost of the license would be much lower.

FIGURE 5-6 (A AND B): Quantity Restrictions in the Market for Taxi Licenses

In 1937, New York City limited the number of taxi licenses to 12,000 as a way to increase the wages of taxi drivers. It had the intended effect, as (a) shows. Because taxi medallions were limited in supply, as demand for taxi services rose, so did the demand for medallions. Their price rose significantly, as (b) shows.


Third-Party-Payer Markets

In a third-party-payer system, the person who chooses the product doesn’t pay the entire cost. Here, with a co-payment of $5, consumers demand 18 units. Sellers require $45 per unit for that quantity. Total expenditures, shown by the entire shaded region, are much greater compared to when the consumer pays the entire cost, shown by just the dark shaded region.

As the demand for taxis rose, the medallions became more and more valuable. The effect on the price of medallions is shown in Figure 5-6(b). The quantity restriction, QR, means that any increases in demand lead only to price increases. Although the initial license fee was minimal, increases in demand for taxis quickly led to higher and higher medallion prices.

Quantity restrictions tend to increase price.

The demand for taxi medallions continues to increase each year as the New York City population grows more than the supply is increased. The result is that the price of a taxi medallion continues to rise. Even with the slight increase in the number of medallions, today taxi medallions cost about $400,000, giving anyone who has bought that license a strong reason to oppose an expansion in the number of licenses being issued.1

Third-Party-Payer Markets

As a final example for this chapter, let’s consider third-party-payer markets. In third-party-payer markets, the person who receives the good differs from the person paying for the good. An example is the health care market where many individuals have insurance. They generally pay a co-payment for health care services and an HMO or other insurer pays the remainder. Medicare and Medicaid are both third-party payers. Figure 5-7 shows what happens in the supply/demand model when there is a third-party-payer market and a small co-payment. In the normal case, when the individual demander pays for the good, equilibrium quantity is where quantity demanded equals quantity supplied—in this case at an equilibrium price of $25 and an equilibrium quantity of 10.

Under a third-party-payer system, the person who chooses how much to purchase doesn’t pay the entire cost. Because the co-payment faced by the consumer is much lower, quantity demanded is much greater. In this example with a co-payment of $5, the consumer demands 18. Given an upward-sloping supply curve, the seller requires a higher price, in this case $45 for each unit supplied to provide that quantity. Assuming the co-payment is for each unit, the consumers pay $5 of that price for a total out-of-pocket cost of $90 ($5 times 18). The third-party payer pays the remainder, $40, for a cost of $720 ($40 times 18). Total spending is $810. This compares to total spending of only $250 (25 times 10) if the consumer had to pay the entire price. Notice that with a third-party-payer system, total spending, represented by the large shaded rectangle, is much higher than total spending if the consumer paid, represented by the small darker rectangle.

In third-party-payer markets, equilibrium quantity and total spending are much higher.

The third-party-payer system describes much of the health care system in the United States today. Typically, a person with health insurance makes a fixed co-payment of $5 to $10 for an office visit, regardless of procedures and tests provided. Given this payment system, the insured patient has little incentive to limit the procedures offered by the doctor. The doctor charges the insurance company, and the insurance company pays. The rise in health care costs over the past decades can be attributed in part to the third-party-payer system.

A classic example of how third-party-payer systems can affect choices is a case where a 70-year-old man spent weeks in a hospital recovering from surgery to address abdominal bleeding. The bill, to be paid by Medicare, was nearing $275,000 and the patient wasn’t recovering as quickly as expected. The doctor finally figured out that the patient’s condition wasn’t improving because ill-fitting dentures didn’t allow him to eat properly. The doctor ordered the hospital dentist to fix the dentures, but the patient refused the treatment. Why? The patient explained: “Seventy-five dollars is a lot of money.” The $75 procedure wasn’t covered by Medicare.


If the cost of textbooks were included in tuition, what would likely happen to their prices? Why?

Third-party-payer systems are not limited to health care. (Are your parents or the government paying for part of your college? If you were paying the full amount, would you be demanding as much college as you currently are?) Anytime a third-party-payer system exists, the quantity demanded will be higher than it otherwise would be. Market forces will not hold down costs as much as they would otherwise because the person using the service doesn’t have an incentive to hold down costs. Of course, that doesn’t mean that there are no pressures. The third-party payers—parents, employers, and government—will respond to this by trying to limit both the quantity of the good individuals consume and the amount they pay for it. For example, parents will put pressure on their kids to get through school quickly rather than lingering for five or six years, and government will place limitations on what procedures Medicare and Medicaid patients can use. The goods will be rationed through social and political means. Such effects are not unexpected; they are just another example of supply and demand in action.


I began this chapter by pointing out that supply and demand are the lens through which economists look at reality. It takes practice to use that lens, and this chapter gave you some practice. Focusing the lens on a number of issues highlighted certain aspects of those issues. The analysis was simple but powerful and should, if you followed it, provide you with a good foundation for understanding the economist’s way of thinking about policy issues.


• By minding your Ps and Qs—the shifts of and movements along curves—you can describe almost all events in terms of supply and demand.

• The determination of prices of currencies—foreign exchange rates—can be analyzed with the supply and demand model in the same way as any other good can be.

• A price ceiling is a government-imposed limit on how high a price can be charged. Price ceilings below market price create shortages.

• A price floor is a government-imposed limit on how low a price can be charged. Price floors above market price create surpluses.

• Taxes and tariffs paid by suppliers shift the supply curve up by the amount of the tax or tariff. They raise the equilibrium price (inclusive of tax) and decrease the equilibrium quantity.

• Quantity restrictions increase equilibrium price and reduce equilibrium quantity.

• In a third-party-payer market, the consumer and the one who pays the cost differ. Quantity demanded, price, and total spending are greater when a third party pays than when the consumer pays.

Key Terms

euro (106)

exchange rate (105)

excise tax (113)

minimum wage law (111)

price ceiling (109)

price floor (111)

rent control (110)

tariff (113)

third-party-payer market (115)

Questions for Thought and Review

1. Say that the equilibrium price and quantity both rose. What would you say was the most likely cause? LO1

2. Say that equilibrium price fell and quantity remained constant. What would you say was the most likely cause? LO1

3. The dollar price of the South African rand fell from 29 cents to 22 cents in 1996, the same year the country was rocked by political turmoil. Using supply/demand analysis, explain why the turmoil led to a decline in the price of the rand. LO2

4. Demonstrate graphically the effect of a price ceiling. LO3

5. Demonstrate graphically why rent controls might increase the total payment that new renters pay for an apartment. LO3

6. Demonstrate graphically the effect of a price floor. LO3

7. Graphically show the effects of a minimum wage on the number of unemployed. LO3

8. Demonstrate graphically the effect of a tax of $4 per unit on equilibrium price and quantity. LO4



, like medallions, are quantity restrictions on imported goods. Demonstrate the effect of a quota on the price of imported goods. LO4

10. Supply/demand analysis states that equilibrium occurs where quantity supplied equals quantity demanded, but in U.S. agricultural markets quantity supplied almost always exceeds quantity demanded. How can this be? LO4

11. Nobel Prize-winning economist Bill Vickrey has suggested that automobile insurance should be paid as a tax on gas, rather than as a fixed fee per year per car. How would that change likely affect the number of automobiles that individuals own? (Difficult) LO4

12. In early 2004, following the toppling of President Aris-tide, the price of a 110-pound sack of rice in Haiti doubled from $22.50 to $45 because of disruptions at Haitian ports. (Eighty percent of Haiti’s rice is imported.) Demonstrate graphically the effect of the import disruptions on the equilibrium price and quantity of rice purchased in Haiti. LO2

13. The U.S. imposes substantial taxes on cigarettes but not on loose tobacco. When the tax went into effect, what effect did it likely have for cigarette rolling machines? (Difficult) LO4

14. In what ways is the market for public post-secondary education an example of a third-party-payer market? What’s the impact of this on total educational expenditures? LO5

15. What reasons might governments have to support third-party-payer markets? (Difficult) LO5

Problems and Exercises

16. Since 1981, the U.S. government has supported the price of sugar produced by U.S. sugar producers by limiting import of sugar into the United States. Restricting imports is effective because the United States consumes more sugar than it produces.

a. Using supply/demand analysis, demonstrate how import restrictions increase the price of domestic sugar.

b. What other import policy could the government implement to have the same effect as the import restriction? LO1

c. Under the Uruguay Round of the General Agreement on Tariffs and Trade in 1997, the United States agreed to permit at least 1.25 million tons of sugar to be imported into the United States. How does this affect the U.S. sugar price support program?

17. In some states and localities “scalping” is against the law, although enforcement of these laws is spotty. (Difficult)

a. Using supply/demand analysis and words, demonstrate what a weakly enforced antiscalping law would likely do to the price of tickets.

b. Using supply/demand analysis and words, demonstrate what a strongly enforced antiscalping law would likely do to the price of tickets. LO1

18. Apartments in New York City are often hard to find. One of the major reasons is rent control. (Difficult)

a. Demonstrate graphically how rent controls could make apartments hard to find.

b. Often one can get an apartment if one makes a side payment to the current tenant. Can you explain why?

c. What would be the likely effect of eliminating rent controls?

d. What is the political appeal of rent controls? LO1, LO3

19. Until recently, angora goat wool (mohair) has been designated as a strategic commodity (it used to be utilized in some military clothing). Because of that, in 1992 for every dollar’s worth of mohair sold to manufacturers, ranchers received $3.60. (Difficult)

a. Demonstrate graphically the effect of the elimination of this designation and subsidy.

b. Explain why the program was likely kept in existence for so long.

c. Say that a politician has suggested that the government should pass a law that requires all consumers to pay a price for angora goat wool high enough so that the sellers of that wool would receive $3.60 more than the market price. Demonstrate the effect of the law graphically. Would consumers support it? How about suppliers? LO4

20. The technology is now developing so that road use can be priced by computer. A computer in the surface of the road picks up a signal from your car and automatically charges you for the use of the road.

a. How could this technological change contribute to ending bottlenecks and rush hour congestion?

b. What are some of the problems that might develop with such a system?

c. How would your transportation habits likely change if you had to pay to use roads? LO1

21. In 1938 Congress created a Board of Cosmetology in Washington, D.C., to license beauticians. To obtain a license, people had to attend a cosmetology school. In 1992 this law was used by the board to close down a hair braiding salon specializing in cornrows and braids operated by unlicensed Mr. Uqdah, even though little was then taught in cosmetology schools about braiding and cornrows. (Difficult)

a. What possible reason can you give for why this board exists?

b. What options might you propose to change the system?

c. What will be the political difficulties of implementing those options? LO1

22. In the Oregon health care plan for rationing Medicaid expenditures, therapy to slow the progression of AIDS and treatment for brain cancer were covered, while liver transplants and treatment for infectious mononucleosis were not covered. (Difficult)

a. What criteria do you think were used to determine what was covered and what was not covered?

b. Should an economist oppose the Oregon plan because it involves rationing?

c. How does the rationing that occurs in the market differ from the rationing that occurs in the Oregon plan? LO1

23. Airlines and hotels have many frequent flyer and frequent visitor programs in which individuals who fly the airline or stay at the hotel receive bonuses that are the equivalent to discounts.

a. Give two reasons why these companies have such programs rather than simply offering lower prices.

b. Can you give other examples of such programs?

c. What is a likely reason why firms whose employees receive these benefits do not require their employees to give the benefits to the firm? LO1

24. You’re given the following supply and demand tables:

a. What is equilibrium price and quantity in a market system with no interferences?

b. If this were a third-party-payer market where the consumer pays $2, what is the quantity demanded? What is the price charged by the seller?

c. What is total spending in the two situations described in a and b? LO5

25. Demonstrate the effect on price and quantity of each of the following events:

a. In a recent popularity test, Elmo topped Cookie Monster in popularity (this represents a trend in children’s tastes). Market: cookies.

b. The Atkins Diet that limits carbohydrates was reported to be very effective. Market: bread. LO1

26. In 1996, the television networks were given $70 billion worth of space on public airways for broadcasting high definition television rather than auction it off. (Difficult)

a. Why do airways have value?

b. After the airway had been given to the network, would you expect that the broadcaster would produce high definition television? LO1

27. In 2004, oil facilities in Iraq were attacked and strong economies in the United States and China boosted the demand for oil.

a. Demonstrate graphically how these events led to oil prices in excess of $40 a barrel in June 2004. What was the effect on the equilibrium quantity of oil bought and sold?

b. As a result of political pressure, OPEC agreed to in crease the daily quota by 2 million barrels a day. What was the likely effect on equilibrium oil price and quantity? Demonstrate your answer graphically. LO1

28. About 10,000 tickets for the 2005 Men’s Final Four college basketball games at the St. Louis Edward Jones Dome were to be sold in a lottery system for between $110 and $130 apiece. Typically applications exceed available tickets by 100,000. A year before the game, scalpers were al ready offering to sell tickets for between $200 and $2,000 depending on seat location, even though the practice is illegal. (Difficult)

a. Demonstrate the supply and demand for Final Four tickets. How do you know that there is an excess demand for tickets at $130?

b. Demonstrate the scalped price of between $200 and $2,000.

c. What would be the effect of legalizing scalping on the resale value of Final Four tickets? LO1

29. In the early 2000s, Whole Foods Market Inc. switched to a medical care plan that had a high deductible, which meant that employees were responsible for the first $1,500 of care, whereas after that they received 80 percent coverage. The firm also put about $800 in an account for each employee to use for medical care. If they did not use this money, they could carry it over to the next year.

a. What do you expect happened to medical claim costs?

b. What do you believe happened to hospital admissions?

c. Demonstrate graphically the reasons for your answers in a and b. LO5

30. In Japan, doctors prescribe drugs and supply the drugs to the patient, receiving a 25 percent markup. In the United States, doctors prescribe drugs, but, generally, they do not sell them. (Difficult)

a. Which country prescribes the most drugs? Why?

b. How would a plan to limit the price of old drugs, but not new drugs to allow for innovation, likely affect the drug industry?

c. How might a drug company in the United States encourage a doctor in the United States, where doctors receive nothing for drugs, to prescribe more drugs? LO5

31. Kennesaw University Professor Frank A. Adams III and Auburn University Professors A. H. Barnett and David L. Kaserman recently estimated the effect of legalizing the sale of cadaverous organs, which currently are in short age at zero price. Demonstrating with supply and demand curves, what are the effects of the following two possibilities on the equilibrium price and quantity of transplanted organs if their sale were to be legalized?

a. Many of those currently willing to donate the organs of a deceased relative at zero price are offended that organs can be bought and sold.

b. People are willing to provide significantly more organs as price offered rises only marginally. LO1

Questions from Alternative Perspectives

1. Some economists believe minimum wages create distortions in the labor market. If you are an employer and unable to hire the one willing and able to work for the lowest wage, how else might you choose a worker? Is this fair? Why or why not? (Austrian)

2. The book gives the example of a man who treated Medicare payments as different from his out-of-pocket payments. If you could save Medicare $100,000 by spending $20 of your own, should you? (Religious)

3. On average, women are paid less than men. What are the likely reasons for that? Should the government intervene with a law that requires firms to pay equal wages to those with comparable skills? (Feminist)

4. Biological evolution occurs very slowly; cultural evolution occurs less slowly, but still slowly compared to institutional and market evolution.

a. Give some examples of these observations about the different speeds of adjustment.

b. Explain the relevance of these observations to economic reasoning. (Institutionalist)

5. Most religions argue that individuals should not fully exploit market positions. For example, the text makes it sound as if allowing prices to rise to whatever level clears the market is the best policy to follow. That means that if, for example, someone were stranded in the desert and were willing to pay half his or her future income for life for a drink of water, that it would be appropriate to charge him or her that price. Is it appropriate? Why or why not? (Religious)

6. Rent control today looks far different than the rent freeze New York City enacted after World War II. Most rent controls today simply restrict annual rent increases and guarantee landlords a “fair return” in return for maintaining their properties.

a. How would the economic effects of today’s rent controls differ from the rent control programs depicted in your textbook?

b. Do you consider them an appropriate mechanism to address the disproportionate power that landlords hold over tenants?

c. If not, what policies would you recommend to address that inequity and the lack of affordable housing in U.S. cities? (Radical)

Web Questions

1. Go to the Cato Institute’s home page (www.cato.org) and search for the article “How Rent Control Drives Out Affordable Housing” by William Tucker. After reading the article, answer the following questions:

a. What is a shadow market, and why does one develop when there is rent control?

b. Why is housing a particularly easy good to hoard?

How does this affect newcomers to a city?

c. How do vacancy rates compare among cities with and without rent control? Does this make sense within the supply/demand framework?

2. Go to the Economic Policy Institute’s home page (www.epinet.org) and search for the article “Minimum Wage Issue Guide: Facts at a Glance.” Using that article, answer the following questions:

a. What has happened to the minimum wage adjusted for inflation since the 1970s? Within the standard supply/demand framework, how does this affect unemployment resulting from the minimum wage?

b. Who is affected by the minimum wage?

c. Do the authors believe jobs will be lost if the minimum wage is raised? Why or why not?

Answers to Margin Questions

1. False. When supply rises, supply shifts out to the right. Price falls because demand slopes downward. (105)

2. You will receive 53,763 pesos. One U.S. dollar = 537.63 Chilean pesos. So multiplying 537.63 by 100 gives you 53,763 pesos. (107)

3. A discovery of a hormone that will increase cows’ milk production by 20 percent will increase the supply of milk, pushing the price down and increasing the quantity demanded, as in the accompanying graph. (108)

4. Quantity decreases but it is unclear what happens to price. (108)

5. It is likely demand shifted in and supply remained constant. (109)

6. Since the price ceiling is above the equilibrium price, it will have no effect on the market-determined equilibrium price and quantity. (110)

7. Since the price floor is below the equilibrium price, it will have no effect on the market-determined equilibrium price and quantity. (111)

8. I state that the tax will most likely raise the price by less than $2 since the tax will cause the quantity demanded to decrease. This will decrease quantity supplied, and hence decrease the price the suppliers receive. In the diagram below, Q falls from Q0 to Q1 and the price the supplier receives falls from $4 to $3, making the final price $5, not $6. (113)

9. Given the quantity restriction, equilibrium quantity will be Q R and equilibrium price will be P0, which is higher than the market equilibrium price of Pe. (114)

10. Universities would probably charge the high tuition they do now, but they would likely negotiate with publishers for lower textbook prices, because they are both demanding and paying for the textbook. (116)

APPENDIX A: Algebraic Representation of Supply, Demand, and Equilibrium

In this chapter and Chapter 4, I discussed demand, supply, and the determination of equilibrium price and quantity in words and graphs. These concepts can also be presented in equations. In this appendix I do so, using straight-line supply and demand curves.

The Laws of Supply and Demand in Equations

Since the law of supply states that quantity supplied is positively related to price, the slope of an equation specifying a supply curve is positive. (The quantity intercept term is generally less than zero since suppliers are generally unwilling to supply a good at a price less than zero.) An example of a supply equation is

QS = −5 + 2P

where QS is units supplied and P is the price of each unit in dollars per unit. The law of demand states that as price rises, quantity demanded declines. Price and quantity are negatively related, so a demand curve has a negative slope. An example of a demand equation is

QD = 10 −P

where QD is units demanded and P is the price of each unit in dollars per unit.

Determination of Equilibrium

The equilibrium price and quantity can be determined in three steps using these two equations. To find the equilibrium price and quantity for these particular demand and supply curves, you must find the quantity and price that solve both equations simultaneously.

Step 1: Set the quantity demanded equal to quantity supplied:

Step 2: Solve for the price by rearranging terms. Doing so gives:

3P = 15

P = $5

Thus, equilibrium price is $5.

Step 3: To find equilibrium quantity, you can substitute $5 for P in either the demand or supply equation. Let’s do it for supply: Q5 = −5 + (2×5) = 5 units. I’ll leave it to you to confirm that the quantity you obtain by substituting P = $5 in the demand equation is also 5 units.

The answer could also be found graphically. The supply and demand curves specified by these equations are depicted in Figure A5-1. As you can see, demand and supply intersect; quantity demanded equals quantity supplied at a quantity of 5 units and a price of $5.

FIGURE A-5.1: Supply and Demand Equilibrium

The algebra in this appendix leads to the same results as the geometry in the chapter. Equilibrium occurs where quantity supplied equals quantity demanded.

Movements along a Demand and Supply Curve

The demand and supply curves above represent schedules of quantities demanded and supplied at various prices. Movements along each can be represented by selecting various prices and solving for quantity demanded and supplied. Let’s create a supply and demand table using the above equations—supply: QS = −5 + 2P; demand: QD = 10 − P.

As you move down the rows, you are moving up along the supply schedule, as shown by increasing quantity supplied, and moving down along the demand schedule, as shown by decreasing quantity demanded. Just to confirm your equilibrium quantity and price calculations, notice that at a price of $5, quantity demanded equals quantity supplied.

Shifts of a Demand and Supply Schedule

What would happen if suppliers changed their expectations so that they would be willing to sell more goods at every price? This shift factor of supply would shift the entire supply curve out to the right. Let’s say that at every price, quantity supplied increases by 3. Mathematically the new equation would be QS = −2 + 2P. The quantity intercept increases by 3. What would you expect to happen to equilibrium price and quantity? Let’s solve the equations mathematically first.

Step 1: To determine equilibrium price, set the new quantity supplied equal to quantity demanded:

10 − P = −2 + 2P

Step 2: Solve for the equilibrium price:

12 = 3P

P = $4

Step 3: To determine equilibrium quantity, substitute P in either the demand or supply equation:

QD =10-(1×4) = 6 units

QS = −2 + (2 × 4) = 6 units

Equilibrium price declined to $4 and equilibrium quantity rose to 6, just as you would expect with a rightward shift in a supply curve.

Now let’s suppose that demand shifts out to the right. Here we would expect both equilibrium price and equilibrium quantity to rise. We begin with our original supply and demand curves—supply: QS = −5 + 2P; demand: QD = 10 − P. Let’s say at every price, the quantity demanded rises by 3. The new equation for demand would be QD = 13 − P. You may want to solve this equation for various prices to confirm that at every price, quantity demanded rises by 3. Let’s solve the equations for equilibrium price and quantity.

Step 1: Set the quantities equal to one another:

13 − P = −5 + 2P

Step 2: Solve for equilibrium price:

18 = 3P

P = $6

Step 3: Substitute P in either the demand or supply equation:

QD = 13 − (1 × 6) = 7 units

QS = −5 + (2 × 6) = 7 units

Equilibrium price rose to $6 and equilibrium quantity rose to 7 units, just as you would expect with a rightward shift in a demand curve.

Just to make sure you’ve got it, I will do two more examples. First, suppose the demand and supply equations for wheat per year in the United States can be specified as follows (notice that the slope is negative for the demand curve and positive for the supply curve):

QD = 500 − 2P

QS = −100 + 4P

P is the price in dollars per thousand bushels and Q is the quantity of wheat in thousands of bushels. Remember that the units must always be stated. What are the equilibrium price and quantity?

Step 1: Set the quantities equal to one another:

500 − 2P = −100 + 4P

Step 2: Solve for equilibrium price:

600 = 6P

P = $100

Step 3: Substitute P in either the demand or supply equation:

QD = 500 − (2 × 100) = 300

QS = −100 + (4 × 100) = 300

Equilibrium quantity is 300 thousand bushels.

As my final example, take a look at Alice’s demand curve depicted in Figure 4-4(b) in Chapter 4. Can you write an equation that represents the demand curve in that figure? It is QD = 10 − 2P. At a price of zero, the quantity of DVD rentals Alice demands is 10, and for every increase in price of $1, the quantity she demands falls by 2. Now look at Ann’s supply curve shown in Figure 4-7(b) in Chapter 4. Ann’s supply curve mathematically is QS = 2P. At a zero price, the quantity Ann supplies is zero, and for every $1 increase in price, the quantity she supplies rises by 2. What are the equilibrium price and quantity?

Step 1: Set the quantities equal to one another:

10 − 2P = 2P

Step 2: Solve for equilibrium price:

4P = 10

P = $2.5

Step 3: Substitute P in either the demand or supply equation:

QD = 10 − (2 × 2.5) = 5, or

QS = 2 × 2.5 = 5 DVDs per week

Ann is willing to supply 5 DVDs per week at $2.50 per rental and Alice demands 5 DVDs at $2.50 per DVD rental. Remember that in Figure 4-8 in Chapter 4, I showed you graphically the equilibrium quantity and price of Alice’s demand curve and Ann’s supply curve. I’ll leave it up to you to check that the graphic solution in Figure 4-8 is the same as the mathematical solution we came up with here.

Price Ceilings and Price Floors

Let’s now consider a price ceiling and price floor. We start with the supply and demand curves:

QS = −5 + 2P

QD = 10 + P

This gave us the solution:

P = 5

Q = 5

Now, say that a price ceiling of $4 is imposed. Would you expect a shortage or a surplus? If you said “shortage,” you’re doing well. If not, review the chapter before continuing with this appendix. To find out how much the shortage is, we must find out how much will be supplied and how much will be demanded at the price ceiling. Substituting $4 for price in both equations lets us see that QS = 3 units and QD = 6 units. There will be a shortage of 3 units. Next, let’s consider a price floor of $6. To determine the surplus, we follow the same exercise. Substituting $6 into the two equations gives a quantity supplied of 7 units and a quantity demanded of 4 units, so there is a surplus of 3 units.

Taxes and Subsidies

Next, let’s consider the effect of a tax of $1 placed on the supplier. That tax would decrease the price received by suppliers by $1. In other words:

QS = −5 + 2(P − 1)

Multiplying the terms in parentheses by 2 and collecting terms results in

QS = −7 + 2P

This supply equation has the same slope as in the previous case, but a new intercept term—just what you’d expect. To determine the new equilibrium price and quantity, follow steps 1 to 3 discussed earlier. Setting this new equation equal to demand and solving for price gives

P = 5 ⅔

Substituting this price into the demand and supply equations tells us equilibrium quantity:

QS = QD = 4 ⅓ units

Of that price, the supplier must pay $1 in tax, so the price the supplier receives net of tax is $4⅔.

Next, let’s say that the tax were put on the demander rather than on the supplier. In that case, the tax increases the price for demanders by $1 and the demand equation becomes

QD = 10 − (P + 1), or

QD = 9 − P

Again solving for equilibrium price and quantity requires setting the demand and supply equations equal to one another and solving for price. I leave the steps to you. The result is

P = 42/3

This is the price the supplier receives. The price demanders pay is $52/3. The equilibrium quantity will be 4 1/3 units.

These are the same results we got in the previous cases showing that, given the assumptions, it doesn’t matter who actually pays the tax: The effect on equilibrium price and quantity is identical no matter who pays it.


Finally, let’s consider the effect of a quota of 4 1/3 placed on the market. Since a quota limits the quantity supplied, as long as the quota is less than the market equilibrium quantity, the supply equation becomes

Qs = 4 1/3

where QS is the actual amount supplied. The price that the market will arrive at for this quantity is determined by the demand curve. To find that price, substitute the quantity 4 1/3 into the demand equation (QD = 10 − P):

4 1/3 = 10 − P

and solve for P:

P = 52/3

Since consumers are willing to pay $52/3, this is what suppliers will receive. The price that suppliers would have been willing to accept for a quantity of 4 1/3 is $42/3. This can be found by substituting the amount of the quota in the supply equation:

4 1/3 = −5 + 2P

and solving for P:

2P = 9 1/3

P = 42/3

Notice that this result is very similar to the tax. For demanders it is identical; they pay $52/3 and receive 4 1/3 units. For suppliers, however, the situation is much preferable; instead of receiving a price of $42/3, the amount they received with the tax, they receive 52/3. With a quota, suppliers receive the “implicit tax revenue” that results from the higher price.

Question 1

Using Microsoft Excel, draw a graph illustrating the supply and demand in this market.










Using Microsoft Excel, draw a graph illustrating the supply and demand in this market.
Price/Computer Quantity Demanded Quantity Supplied
200 100 2200

75 1

25 20

150 1500 1900
125 175 1750
2000 1600

250 1450
2500 1

275 1150

Supply 2200


1900 1750 1600 1450


1150 200 175 150 125 100 75 50 25 Demand



1500 1750 2000


0 2500


200 175 150 125 100 75 50 25



Question 2

What is the equilibrium Price and Quantity in the market?
Your response comes here

Supply 2200 2050 1900 1750 1600 1450 1300 1150 200 175 150 125 100 75 50 25 Demand 1000 1250 1500 1750 2000


2500 2750 200 175 150 125 100 75 50 25 Volumes

Question 3

Price/Computer Quantity Demanded Quantity Supplied

200 1000 2200 300
175 1250 2050 275
150 1500 1900 250
125 1750 1750 225
100 2000 1600 200
75 2250 1450 175
50 2500 1300 150
25 2750 1150 125

Your response comes here

Now suppose the government imposes a special tax on these computers. Describe what would happen in this market in terms of the supply and demand curve.
Price supplied + 100 tax

Supply 2200 2050 1900 1750 1600 1450 1300 1150 200 175 150 125 100 75 50 25 Demand 1000 1250 1500 1750 2000 2250 2500 2750 200 175 150 125 100 75 50 25 Supply + 100 tax 2200 2050 1900 1750 1600 1450 1300 1150 300 275 250 225 200 175 150 125 Volumes

Question 4

Price/Computer Quantity Demanded Quantity Supplied

200 1000 2200 100
175 1250 2050 100
150 1500 1900 100
125 1750 1750 100
100 2000 1600 100
75 2250 1450 100
50 2500 1300 100
25 2750 1150 100

Your response comes here

Disregard the new tax in part three. Now assume that the government imposes a price ceiling of $100 in this market, as a result of protests of price gauging by the sellers. What would happen to the price and quantity in this market?
Price ceeling

Supply 2200 2050 1900 1750 1600 1450 1300 1150 200 175 150 125 100 75 50 25 Demand 1000 1250 1500 1750 2000 2250 2500 2750 200 175 150 125 100 75 50 25 Price ceeling 100 1000 1250 1500 1750 2000 2250 2500 2750 100 100 100 100 100 100 100 100 Volumes

Question 5

Price/Computer Quantity Demanded Quantity Supplied Price ceeling

200 1000 2200 150
175 1250 2050 150
150 1500 1900 150
125 1750 1750 150
100 2000 1600 150
75 2250 1450 150

50 2500 1300 150

25 2750 1150 150

Your response comes here

Disregard the events of part four. Assume that the manufacturers of this product lobby the government’s lawmakers, in terms of this product being an essential for college students but they are considering halting production due to the lack of profits. The lawmakers agree and now set a price floor at $150. What would happen in this market?

Supply 2200 2050 1900 1750 1600 1450 1300 1150 200 175 150 125 100 75 50 25 Demand 1000 1250 1500 1750 2000 2250 2500 2750 200 175 150 125 100 75 50 25 Price ceeling 150 1000 1250 1500 1750 2000 2250 2500 2750 150 150 150 150 150 150 150 150 Volumes

Question 6

Price/Computer Quantity Demanded Quantity Supplied

200 1000 2200

175 1250 2050

150 1500 1900

125 1750 1750 1450
100 2000 1600

75 2250 1450

50 2500 1300 2200
25 2750 1150

Your response comes here

If consumers’ expectations were such that they were concerned about the economy and jobs, what would you think would happen in this market?
Lower demand for bad expectations

Supply 2200 2050 1900 1750 1600 1450 1300 1150 200 175 150 125 100 75 50 25 Demand 1000 1250 1500 1750 2000 2250 2500 2750 200 175 150 125 100 75 50 25 Lower demand 700 950 1200 1450 1700 1950 2200 2450 200 175 150 125 100 75 50 25 Volumes

Still stressed with your coursework?
Get quality coursework help from an expert!