Chapter One

1. Chapter One The Central Idea

2. Economics • Economics is the study of how people deal with scarcity • Scarcity: Situation in which the quantity of resources is insufficient to meet all wants (not enough stuff for our wants) • Leads to CHOICES: Must give up one thing in favor for another • Economic interaction is the exchanges of goods and services between people • These interactions can occur in a MARKET – an arrangement where economic exchanges between people take place

3. Consumer Decisions • Opportunity Cost: Value of the next-best alternative that was not chosen • Gains from Trade: Improvements in income, production, or satisfaction owing to the exchange of goods or services • Important: Voluntary trade only happens if BOTH parties gain. • Does not change total amount of goods, just redistributes or reallocates

4. Figure 1.1: Gains from Trade Through a Better Allocation of Goods

5. Consumer Decisions • When acting alone, Emily and Johann can only produce 1 card each (2 total) • If they sell their services to each other, they can produce 10 total cards • They BOTH gain from trade

6. Consumer Decisions • Specialization: People concentrating on what they are good at • Creates a DIVISION OF LABOR: workers concentrate on different tasks • Comparative Advantage: A situation where a person can produce a good for a lower opportunity cost than another person. • When people specialize where they have a comparative advantage, overall production is increased • International Trade: Exchange of goods or services between people in different countries

7. Scarcity and Choice for the Economy as a Whole • Consumption vs. Investment • Opportunity cost of producing 200 movies instead of 100 movies is 2,000 computers • OC of making 300 movies instead of 200 movies is 4,000 computers • OC of making 400 movies instead of 300 is 5,000 computers • OC of making 500 movies instead of 400 is 13,000 computers

8. Production Possibilities • Because OC continues to go up as we make more movies, it is called INCREASING opportunity cost

9. Figure 1.2: The Production Possibilities Curve

10. Production Possibilities Curve • Bows out because of increasing opportunity cost of producing movies – each move causes a more dramatic fall in graph • Points of line: EFFICIENT • Points under or to the left of line: INEFFICIENT • Points over or to the right of line: IMPOSSIBLE

11. Figure 1.3: Shifts in the Production Possibilities Curve

12. Shifts in the PP Curve • Shift out, up, right means increase in production, due to things like more workers or developing technology • Doesn’t need to be a uniform shift • Impossible points are not “forever” impossible

13. Figure 1.4: Shifts in the Production Possibilities Curve Depend on Choices

14. Market Economies and Price Systems • Market Economy: An economy where prices are freely determined and goods and services can be traded freely in markets • Examples: United States, Mexico, Australia • Command Economy (Centrally Planned Economy): An economy where the government determines prices and production • Examples: Soviet Union, China • Market Economies are more productive, so most of the world is trying to convert

15. Key Elements of a Market Economy • Freely Determined Prices • Leads to inefficiencies. Example – feeding bread to cows in the Soviet Union • Property Rights and Incentives • Property rights give people control over their assets • Incentives are devices used to motivate people to take action, usually increasing productivity • Freedom to Trade both home and abroad

16. Key Elements of a Market Economy, continued • A Role For Government • How much involvement should government have? Police? Education? Welfare? • Market Failure: Market is inefficient, potential for government involvement • Government Failure: Government made things worse • Role of Private Organizations • Organizations exist to reduce transaction costs (costs of buying and selling)

17. The Price System • Signals • As demand increases, prices increase therefore “signaling” that there needs to be more workers, more production, etc. • Incentives • If more money is entering an industry, more firms will enter. In contrast, it will hurt competing industries. • Distribution • Workers in “hot” industries earn more, while competing industries’ employees will earn less.

18. Answers to Text Problems 1. The limited budget for guest speakers means that you can either bring in Spike Lee for one lecture or have ten lectures by former economic advisers. As a resource, Spike Lee is scarcer than former economic advisers are, and therefore his price for a lecture is much higher. The scarcity represented by the limited budget means that either Spike Lee or former economic advisers can be invited to speak, and therefore a choice must be made. It is necessary to consider how many people will attend the lecture and what those people will prefer. To determine whether the money is better spent on Spike Lee or former economic advisers, you have to compare the additional satisfaction per dollar spent on Spike Lee versus the former economic advisers.

19. Answers to Text Problems 2. The opportunity cost of attending one more year of school is the income given up by not working over that year. So, in a sense, the cost of any additional year of school for each graduate is the same: lost income. However, the income one can earn increases with the attainment of higher levels of education. Therefore, the opportunity cost (income given up) of one year of school for the medical school graduate will be larger than the opportunity cost of the college graduate. Of the three graduates, the high school graduate has the smallest opportunity cost of an additional year of education.

20. Answers to Text Problems 3. The opportunity cost of any choice is the next-best or second-best alternative given up. Allison's opportunity cost of ranking the consulting job first is not being able to attend a local community college. The third alternative involving world travel has nothing to do with the opportunity cost of consulting. An opportunity cost is the next-best alternative given up.

21. Answers to Text Problems 4. Assuming that people like salt and pepper to season food, both of us are better off if we trade one salt shaker for one pepper shaker. We both gain from a better allocation. There is no production going on in the question. We both lose if trade is prevented, not just the one person in the country that does not allow trade.

22. Answers to Text Problems 5. A. Tina is producing 30 units of salsa and Julia is producing 15 units of salsa. Total production is 45 units of salsa and 4 advertisements. B. Gains from trade are possible because they have different comparative advantages. This is to say, they have different relative efficiencies in the production of salsa and advertisements. C. Total production will be 5 ads and 50 units of salsa per week.

23. Answers to Text Problems • A. B. The opportunity cost of increasing the time spent on math from 80 to 100 percent is 50 points on the English paper, a decrease in the English grade from 50 points to 0 points. The opportunity cost of increasing the time spent on math from 60 to 80 percent is 20 points on the English paper, a decrease in the paper's grade from 70 points to 50 points. C. There are increasing opportunity costs from spending more time studying math. This is because additional time spent on one subject takes away from the time available for the other subject, and time taken away from that subject becomes increasingly valuable when less time is available for that subject. D. Given the figures in the chart, there is no distribution of time between English and math that will create a grade of 92 on both. Therefore, the tradeoff curve needs to shift to the right. This might occur due to learning new study techniques.

24. Answers to Text Problems • A. B. PPF shifts out mainly in the production of cars. This is seen in the dashed line in the figure.

25. Answers to Text Problems 8. Japan had a high rate of saving relative to the United States, emphasizing investment more than Americans. As you can see in Figure 1.3 in Chapter 1, higher investment results in a more rapid growth of the country's production possibilities curve. The consumption and investment decisions of past Japanese generations allow the current generation to enjoy a higher quantity and diversity of goods.

26. Answers to Text Problems 9. First, if Huey is not very efficient (inside his PPF) at either studying or having fun, Tracy may help with both by helping Huey be more efficient at having fun and studying. Huey would move toward his PPF. Second, if Huey is efficient (on his PPF), Tracy may know something new about how to study and how to have fun. Here, Huey's PPF shifts outward. In either case, Huey is not being efficient.Figure 1-3 shows how Huey's economics grade could be increased without affecting his grade in mathematics starting from an inefficient situation.

27. Answers to Text Problems 10. Neither the country that sets prices nor the country that tries to adjust prices daily is a market economy. A market economy has prices determined in a free market through the interaction of self-interested buyers and sellers.

28. Answers to Text Problems 11. Oil is bought and sold on a world market. A higher price tells U.S. producers that their oil is more valuable and encourages them to increase production. The higher price redistributes income away from consumers of oil toward producers of oil.

29. Answers to Text Problems 12. Nearly any good and service can be put into the sentence to produce a true statement. The statement will not work, however, in the case of some public goods (for example, national defense); goods that involve externalities (such as clean air); services in which the transport costs are prohibitive (haircuts); goods and services that are explicitly illegal (illicit drugs); or human beings themselves (that is, slavery is illegal).

30. Chapter Review • The _____________ of a choice is the value of the foregone alternative that was not chosen. • Comparative advantage • Production possibility • Opportunity cost • Gain from trade

31. Chapter Review 2. Specialization in production results in ______________. • gains from trade • division of labor • increasing opportunity costs • comparative advantage

32. Chapter Review 3. The ________________ is the price of money in terms of another. • trade rate • exchange rate • medium of exchange • comparative rate

33. Chapter Review 4. The two major types of economies are _____________ and ____________ economies. A. multilateral, command B. central, planned C. market, government D. market, command

34. Chapter Review 5. In a market economy, prices serve as _______________, provide _____________, and affect the _______________. • signals, incentive, distribution of income • distribution of income, signals, incentive • signals, distribution of income, incentive • incentive, signals, distribution of income

35. Chapter Review 6. Scarcity is a characteristic of a command economy, but not of a market economy. A. True B. False

36. Chapter Review 7. If Canada produces two goods with less resources than the United States, there can be no comparative advantage in those two goods. • True • False

37. Chapter Review 8. The production possibilities curve slopes downward. • True • False

38. Chapter Review 9. A market economy is also called a centrally planned economy. • True • False

39. Chapter Review 10. Freely determined prices and property rights are characteristics of centrally planned economies. • True • False

40. Chapter Review 11. When one person or group of people can produce one good relative to another good with comparatively less time, effort, or resources than another person can produce that good, this is called • comparative advantage. • specialization. • opportunity cost. • division of labor.

41. Chapter Review 12. When more than two people engage in trade, it is called • international trade. • multilateral trade. • gains from trade. • comparative advantage.

42. Chapter Review 13. The production possibilities curve • slopes downward and is bowed out from the origin. • slopes upward and is bowed out from the origin. • slopes downward and is bowed in toward the origin. • slopes upward and is bowed in toward the origin

43. Chapter Review 14. Points outside the production possibilities curve are • efficient. • inefficient. • impossible. • possible.

44. Chapter Review 15. Economic growth causes • an inward shift in the production possibilities curve. • an outward shift in the production possibilities curve. • an upward movement on the production possibilities curve. • a downward movement on the production possibilities curve.

45. Chapter Review 16. The price that one department of an organization must pay to receive goods and services from another department in the same organization is called a(n) • transfer price. • transaction cost. • opportunity cost. • transaction price.

46. Chapter Review 17. Which of the following is NOT one of the important roles of prices in a market economy? • They serve as signals. • They provide incentives. • They form preferences. • They affect the distribution of income.

47. Chapter Review 18. If the economy devotes all of its resources to steel production, it will be producing at point • A • B • H • G

48. Chapter Review 19. Point F in the diagram represents • an efficient production level. • an inefficient production level. • an impossible production level. • a possible production level.

49. Chapter Review 20. If the economy is currently producing at point E, then • it is utilizing its resources efficiently. • it is utilizing its resources inefficiently. • it is on its production possibilities curve. • it is beyond its production possibilities curve.

50. Problems 1. Sharon has only thirty dollars to spend for her weekend entertainment. She can go to a college football game for thirty dollars, or she can go to the movies for ten dollars. Explain the problem of scarcity and choice in this context. What will Sharon consider as she decides whether to go to the football game or the movie?