This Document Contains Chapters 1 to 2 Chapter 1: First Principles What’s New in the Fifth Edition? • New Economics in Action discussing Boston’s Big Dig Chapter Objectives This chapter will introduce 12 basic principles of economics. • A set of principles for understanding the economics of how individuals make choices: (1) People must make choices because resources are scarce. (2) The opportunity cost of an item is its true cost. (3) “How much” decisions require making trade-offs at the margin. (4) People usually respond to incentives to make themselves better off. • A set of principles for understanding how economies work through the interaction of individual choices: (5) There are gains from trade. (6) Because people respond to incentives, markets move toward equilibrium. (7) Resources should be used as efficiently as possible to achieve society’s goals. (8) Because people usually exploit gains from trade, markets usually lead to efficiency. (9) When markets don’t achieve efficiency, government intervention can improve society’s welfare. • A set of principles for understanding economy-wide interactions: (10) One person’s spending is another person’s income. (11) Overall spending sometimes gets out of line with the economy’s productive capacity. (12) Government policies can change spending. Teaching Tips Individual Choice: The Core of Economics Creating Student Interest • Try opening up the class with questions. For example, ask students if they have made any economic decisions today? Write down their answers on the chalk/whiteboard. You may get answers that include purchasing decisions, such as buying a tank of gas on the way to class. You may want to ask if all economic decisions involve money. Be sure to discuss all of their ideas. • Ask students to identify the resources that they think are scarce, both in their lives and in the world as a whole. Make a list of these items as they call them out and then discuss the items on the list. The obvious items will be time and money. You might use this opportunity to point out that it is not necessarily money that is scarce, but rather income. Other items on the list could include various natural resources, such as fossil fuels, land, food, and water. You might discuss the idea that water and land are only scarce in some places or only at some times. Food is not necessarily scarce, but many people do not have the means or ability to purchase an adequate amount of food. Regarding the decision to come to class, ask students what the benefits of coming to class are, particularly on the first day? Then ask them what the costs of coming to class are? Some of them may think of monetary costs, such as tuition, books, or the parking permit they had to buy. Others may realize that there are other things they could be doing with their time. Use this example to discuss the difference between explicit and implicit cost, and the concept of opportunity cost. Presenting the Material • Emphasize that economics is the study of choices. The choices studied by economists include choices made by individuals, choices made in markets, and economy-wide choices. While money and supply and demand are part of what economists study (these two topics are often what students who haven’t studied economics associate with the discipline), economics deals more broadly with decision-making (choices). For most people, their earliest economics lesson takes place the first time they are in a store and their parents tell them no when they ask for something. That’s when they first learn that you can’t have everything you want (resources are scarce). It can be a difficult lesson (as you can tell if you have ever witnessed a toddler’s reaction in this situation!). • Define the four principles of individual choice and note that these principles will appear repeatedly in upcoming chapters. Students will have no trouble understanding scarcity. To introduce the concept of incentives use your syllabus as an example and have students think about why you might assign homework or offer multiple exams. Why not just offer one final exam at the end of the semester? Students struggle with opportunity cost and marginal analysis. • Help students understand opportunity cost using an example. A basic opportunity cost example might go like this: On Friday night you can babysit and earn $40 or you can go to the movies with your friend, which will cost you $20. What is the opportunity cost of going to the movies? Make sure they understand that the opportunity cost of $60 is the same amount they would end up with if they chose not to go to the movie. • To introduce marginal analysis, use an example similar to the Thinking at the Margin activity from the Activities section. • Finally, be certain that students understand that economics is an approach to decision making and not a list of items to be memorized. Interaction: How Economies Work Creating Student Interest • Ask students to consider a business run by one person; for example, a law firm. Ask the students what the lawyer will have to do in addition to trying cases to keep her law firm running. Examples of these activities could include billing clients, paying the firm’s bills, or keeping the office clean. Ask the students how the lawyer could bring more revenue into her business, leading them to identify hiring other people to take care of billing and cleaning. Use the discussion to highlight the concept of specialization. The discussion can be expanded to also address why countries trade with one another. • Present the famous quote from The Wealth of Nations (1776) by Adam Smith: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.” • Then, ask students to write down what they believe to be the meaning of the Adam Smith statement. You might want to collect what they write and use their more correct interpretations of the meaning to discuss the ideas of specialization and mutual gains from trade. You can also do this without collecting the writings. Discuss how markets can coordinate the activities of millions of individuals for their common benefit. Presenting the Material • The five principles of market interaction will be explored more thoroughly in future chapters, but they can be introduced briefly at this point. The motivation for trade is that trade is mutually beneficial. Use yourself as an example: You teach economics; one of your students can fix computers. You each specialize and then trade: you teach economics to your student and the student fixes your computer. As a result, more economics is taught and more computers are fixed. The trade would not take place if both sides did not benefit. • Ask students what a t-shirt vendor might do if his t-shirts are not selling because the price is too high. Students might respond by saying that he should put the t-shirts on sale. Point out that this is a movement toward equilibrium. • The idea that resources “should” be used efficiently follows from the economic fact of scarcity. Because wants are unlimited and resources are scarce, it makes sense to use those resources efficiently. Efficiency is defined as making the most of the gains from trade given the limited resources society has. If everyone is made better off from a choice and no one is made worse off, then the trade is deemed efficient. • An allocation of resources is efficient if one person is made better off without the possibility of making someone else worst off at the same time. Production is efficient if it is not possible to produce more of one good without reducing the quantity of other goods produced. Use a simple example: One day, a teacher arrives early to class and as students enter the room she gives them a donut from a box of assorted donuts. She does not ask them their preferences. Is this allocation of donuts likely to be efficient? No, because there are likely to be pairs of students who are willing to trade because they like what the other person has better. • Since market activity is based on the voluntary actions of buyers and sellers, markets are usually efficient. Rational people have an incentive to engage in activities that make them better off. Introduce the idea of market failure by way of example. Discuss a monopoly situation or an environmental problem that might be improved by government action. For example, would we want Sprint and Verizon to merge into one company? Do we want companies to be allowed to dump toxic waste into a river? Economy-Wide Interactions Creating Student Interest • Ask students how they think the U.S. economy is doing now in comparison with past years. Next, ask them to explain why they answered the way they did. For example, if they gave the economy a C, why did they assign this grade? If you are teaching macroeconomics you may choose to elaborate on this topic, or you may defer discussion until you reach the macro chapters. If you are teaching microeconomics you may prefer to skip the economy-wide principles altogether. Presenting the Material • Look up data on recent economic activity (see the Web Resources below for tips on where to find this information) and present basic information about current GDP, inflation, and unemployment in comparison with the average long-run values. This will give students a sense of whether the economy is performing above or below average, or right on target. Use the example of a factory that typically produces 100 boxes of output a week. Might they decide in a given week to produce more or less than 100 boxes, and is it even possible to produce more than 100 boxes? This will help students think about spending and production relative to productive capacity. To introduce government policy, ask students to identify reasons why we have government. This is sure to lead to a lively discussion. Common Student Pitfalls • Understanding what the economics discipline is about. Students often think that economics is about money and that an economics course will teach them how to make money. Point out that economics is about choices, and while some choices involve money and monetary values, many choices (like whether to attend class or sleep in) do not. • Accepting that resources are scarce and/or that wants are unlimited. Some students have trouble with the ideas that resources are scarce and that wants are unlimited. Use time as an example. Time is always limited and while a person may not want more goods, they would certainly like to have more time (for instance, to spend with friends and family or devote to a favorite cause). • Thinking at the margin. Marginal analysis can be difficult for students to understand. Give concrete examples of making decisions at the margin. For example, present the case of a group of students ordering pizza. Introduce the idea (though not by name) of diminishing returns by asking them what happens to the enjoyment they receive from each successive slice of pizza. Then explain that one large pizza is $15 and the pizza parlor is running a buy one, get the second one half-price special. Three or more pizzas are $10 each. Use this information to determine the marginal cost of the first and second pizzas and explain how they could use a table to organize the information and determine how many pizzas to buy. • The meaning of efficiency. Efficiency is an important and recurring concept in economics. It is important that students have a solid understanding of efficiency, both because it is a central economic concept and because it is used in slightly different ways in different economic models they will encounter. Efficiency, in general, is the idea of “no waste.” Efficiency is achieved when opportunities to make anyone better off have been fully exploited. No one can be made better off without the cost of making someone worse off. • Equilibrium in economics. The concept of equilibrium is similar to efficiency in that students will see it used in different ways in different models. Equilibrium is not a strictly economic concept. Have students remember different equilibriums they have come across in other disciplines—or simply ask them what it means to lose your equilibrium. Equilibrium means balance, opposing forces are equal, or there is no tendency for change. Chapter Outline Opening Example: This example discusses the idea that all economists use a set of common principles that apply to many different issues. I. Individual Choice: The Core of Economics A. Principle #1: Choices are necessary because resources are scarce. 1. Resources include land, labor, capital, and human capital. 2. Limited resources means society must make choices. B. Principle #2: The true cost of something is its opportunity cost. 1. Opportunity cost is not only monetary cost. C. Principle #3: “How much” is a decision at the margin. 1. Most decisions of interest to economists involve decisions at the margin. An example is: Should I spend one more hour studying economics or one more hour studying chemistry? D. Principle #4: People usually respond to incentives, exploiting opportunities to make themselves better off. 1. People will exploit opportunities until the opportunities are fully exhausted. 2. People respond to incentives. For example, if the salaries of MBAs rise, more students will go to business school. 3. Economists are skeptical of attempts to change people’s behavior that do not change their incentives. II. Interaction: How Economies Work A. An economy is a system for coordinating the productive activities of many people. B. Principle #5: There are gains from trade. 1. In The Wealth of Nations (1776), Adam Smith wrote about the benefits of specialization. C. Principle #6: Markets move toward equilibrium. 1. The fact that markets move to equilibrium is why we can depend on markets to work in a predictable way. D. Principle #7: Resources should be used efficiently to achieve society’s goals. 1. When an economy is efficient, it is producing the maximum gains from trade possible, given the resources available. 2. There are trade-offs between using resources efficiently and attaining equity in the distribution of goods. E. Principle #8: Markets usually lead to efficiency. 1. The incentives built into a market economy ensure that resources are usually put to good use, that all opportunities to make everyone better off have been exploited. 2. The economy as a whole benefits if each individual specializes in a task and trades with others. F. Principle #9: When markets don’t achieve efficiency, government intervention can improve society’s welfare. 1. Markets fail to achieve efficiency for three principal reasons. a. Individual actions have side effects (externalities) that are not properly taken into account. b. One party attempts to capture a greater share of resources for itself. c. Some goods by their very nature are unsuited for efficient management by markets. III. Economy-Wide Interactions A. The economy as a whole has ups and downs. 1. Economies experience recessions when business becomes depressed. 2. To understand recessions, we need to understand economy-wide interactions. B. Principle #10: One person’s spending is another person’s income. C. Principle #11: Overall spending sometimes gets out of line with the economy’s productive capacity. D. Principle #12: Government policies can change spending. 1. The government can change its own spending. 2. The government can vary how much it collects from the public in taxes. 3. The government can control the quantity of money in circulation. Case Studies in the Text Economics in Action Boy or Girl? It Depends on the Cost—This EIA discusses China’s one child per couple policy that was enacted in 1978 in order to address the already large population in the country. An unintended consequence of the policy was the disappearance of girls, as parents had a preference for male children over female children. Ask students the following questions: 1. Why did Chinese families think that having a girl was more costly (less beneficial) than having a boy? (Boys provide labor on the family farm, and sons traditionally care for their parents in their old age.) 2. In recent years, the gender imbalance has been returning to its natural ratio. Why is this? (As the country has become more urban, boys are not needed to work on the farm.) The Fundamental Laws of Traffic Congestion—This EIA explains how the Big Dig in Boston, a huge project that involved putting 3.5 miles of highway underground, adding a new tunnel to Logan airport, and building a new bridge over the Charles River, affected individuals’ commuting decisions (and the interdependence of commuters’ decisions). Ask students the following questions: 1. Was this project successful? (Yes and no. It was successful in reducing congestion in Central Boston, however, traffic got much worse on roads leading into Boston.) 2. How did the traffic situation reach a new equilibrium? (The reduced traffic in Central Boston induced more people to travel into Boston, thus creating congestion in other places. Equilibrium returned when overall driving time returned to its original level.) Adventures in Babysitting—This EIA explains the creation of a babysitting co-op, where parents exchange babysitting tickets for babysitting services. Babysitting tickets are earned by babysitting someone else’s children. The EIA explains that the babysitting co-op experiences a recession when parents became reluctant to spend their tickets. Ask students the following questions: 1. How does a babysitting co-op benefit parents? (Parents are able to make themselves better off by gaining access to babysitting services by providing babysitting services.) 2. What situation in the babysitting co-op was analogous to a recession and why did it occur? (Too few babysitting tickets were available because parents kept babysitting tickets in reserve—they hesitated to spend them.) For Inquiring Minds Using Incentives to Break the Cycle of Poverty—This FIM describes the Brazilian antipoverty program Bolsa Familia, a conditional cash transfer program that gives families a stipend based on achieving various benchmarks. Business Case How Priceline.com Revolutionized the Travel Industry—This business case explains how Priceline.com found their niche in the travel industry by providing sellers, who have a last-minute excess supply of hotel rooms and airline seats, an opportunity to sell at a discounted price to buyers, who are willing to wait and buy at the last minute to get a good deal. Web Resources The Bureau of Labor Statistics website has data on prices and unemployment: www.bls.gov. The Bureau of Economic Analysis website has data on spending, income, and production: www.bea.gov. The Federal Reserve Bank of St. Louis website has an abundance of data on everything from prices to interest rates to spending. From the main page, click on research and data: www.stlouisfed.org. Handout 1-1 Date_________ Name______________________________ Class________ Professor________________ The Opportunity Cost of Attending College Calculate the annual opportunity cost of attending college based on the following expenses: Expense Annual cost ($) Tuition 8,000 Books and school supplies 1,000 Housing 5,000 Food 3,000 Entertainment 2,000 Transportation-related expenses 3,000 What else should be counted as part of the opportunity cost? Thinking at the Margin Hours of advertising Total customers 0 300 1 350 2 380 3 400 4 410 5 415 How many hours should a firm advertise based on the information given: a firm finds that its total customers per week increases as it advertises more hours? Based on this schedule, each extra customer spends an average of $0 at the store, and an extra hour of advertising costs the firm $200/unit. Handout 1-2 Date_________ Name______________________________ Class________ Professor________________ Making Choices Which of the 12 principles is illustrated in each statement? 1. People in Europe drive smaller cars than in the United States because the price of gasoline is higher. 2. You decide to take only three instead of four classes this semester due to your busy work schedule. ________________________________________________________________________________ 3. If you take the babysitting job on Friday night, then you will be unable to go to the party with your friends. ________________________________________________________________________________ 4. Jack and Jane are roommates. Jack makes breakfast for both of them each day, and Jane makes dinner for both of them each day. _________________________________________________________________ 5. In most cases, the open checkout lanes at the grocery store all have the same number of customers waiting to pay for their items. __________________________________________________ 6. The U.S. government’s regulation of air pollution has improved the quality of the air over the years. ____________________________________________________________________________________________________ 7. The government lowers the income tax rate and, as a result, consumers increase their spending on goods and services. ___________________________________________________________________________________________ Difficult Choices Divide into groups and discuss the following scenarios. 1. A society that has 500 children is threatened by a disease that strikes only children. A pharmaceutical company (owned by stockholders) has manufactured a pill that reduces the chances of getting the disease from 90% to only 10%. The company is only able to produce 500 pills at the present time. If parents can get more than one pill it reduces the chance of their child dying. How do you allocate the pills? How do we as a society preserve incentives for the pharmaceutical firm to take risks and come up with more and/or a better medicine? 2. Many issues in medicine illustrate scarcity and economic choices. For example, a liver transplant costs $200,000. Should everyone who has liver disease get the transplant regardless of his or her ability to pay? If everyone cannot get one, should a very old patient or a young patient get the transplant? As a second example, we now have the technology to save premature babies who are below 1,000 grams in weight—despite a high probability that these children will be handicapped. Should we use society’s scarce medical resources to save them? 3. One of the most immediate economic choices for many college students is how many hours per week to work for pay and how many hours to spend studying and attending classes. Pair students and ask them what factors influence their choices. How do the ideas of opportunity cost and making decisions at the margin influence their choices? Chapter 2: Economic Models: Trade-offs and Trade What’s New in the Fifth Edition? • Worksheets for use in the classroom. Chapter Objectives • Explain why models play a crucial role in economics. • Present two simple but important models: the production possibilities frontier and comparative advantage. • Present the circular-flow diagram. • Explain the difference between positive and normative economics. • Explain why economists do not always agree. Teaching Tips Models in Economics Creating Student Interest • Ask students why economists (and economics students) use simplified models. (Because the real world is too complex to consider everything at once. You want to use a more complicated model only if the benefits of added understanding exceed the costs of added difficulty and complexity.) • Construct a paper airplane during class. When you are finished, ask the students what you have made. Give your airplane a test flight. Have the class identify the ways the paper airplane is like a real airplane (e.g., it has wings; it flew). If they have trouble, remind them that they knew what it was, so there must have been some things in common! Have the class identify the ways it is not like a real airplane (size, weight, other details, it did not fly). The paper airplane can help an aerodynamics student learn the basic principles of flight (without the complexity of a 747) just as economic models can help students learn about the basic principles of economics. As understanding increases, so can the complexity of the models used. • An alternative to the paper airplane example is a simple smiley face drawn on the board or an emoticon used in text messages—:) or . Use these representations to have the same discussion with students. How is the image like a real smiling face and how is it different? Why is it so useful in text messaging? (It is simplified and we all know what it means.) How might the level of complexity be increased for the smiley face model? (Add ears, hair.) Presenting the Material • In this chapter students will be introduced to two economic models—the production possibilities frontier and the circular-flow diagram–both of which make simplifying assumptions. For now, discuss another type of model they are all familiar with—the map. Maps are simplifications of reality that have more or less detail, depending on what the user wants to know. Do you use the same type of map to drive from New York to California as you do to drive from point to point in a particular city? No, because for city driving you need to know about all of the roads, whereas for cross-country driving you are mainly interested in interstate highways. Trade-offs: The Production Possibility Frontier Creating Student Interest • Introduce the production possibilities model by evoking the image of a person (or people) stranded on an island—this could be Robinson Crusoe, Gilligan, Tom Hanks in Cast Away, contestants on Survivor. Have your students select the image that they can relate to the most. Present that as an example of the simplest economy you can imagine. Explain to students that you are going to build a model of the economy on the island. Have students list the limited resources available on the island (e.g., trees, sand, water, fish, labor, entrepreneurship). Then have the class consider the immediate needs that must be met using these resources (food, shelter). Explain that the model will represent production in the island economy. Presenting the Material • Use students “producing” grades as a simple example of a production possibility frontier. Put “Economics” on the vertical axis of a graph and “Accounting” on the horizontal axis. Students’ time and energy are fixed for the moment, and putting more time into one subject involves a lower grade in the other subject. (Assuming that the student is equally efficient in “producing” both subjects, the production possibilities graph is a straight line.) Points on the frontier show the possible combinations of grades that the student can achieve. Comparative Advantage and Gains from Trade Creating Student Interest • Ask students if they agree with the idea that if it is cheaper to buy a product from another country than it is to make it yourself, you should buy it from the other country. • Provoke a discussion by asking students if the U.S. economy would be better off without importing so many clothing items from China. Get them to start thinking about the idea that every action has a benefit and a cost. Who benefits from being able to import clothing from China? (Consumers, because the clothing is cheaper.) Who loses as a result of importing more clothing from China? (Domestic producers, because factories close and jobs are lost.) Presenting the Material • Take some time to review the example in the text to illustrate comparative advantage and gains from trade. Next, you can work the example below. Explain to students that in this chapter we are ignoring dollars and will simply trade one good directly for another in order to keep things simple. • Give a simple example of two economies that can produce the following two goods, in the same time period, with a fixed amount of resources. Assume a straight line production possibility frontier. Lozano has an absolute advantage in producing both goods because he can produce more of each individual good than Bilma. Carefully review the concept of opportunity cost and show students how to calculate it. Opportunity cost is what you give up relative to what you gain—for Lozano it is 40 pizzas relative to 20 colas, or 2 pizzas per cola. Since Bilma has a higher opportunity cost (4 pizzas per cola) it will produce the pizza. Show students this also can be done in reverse by finding the opportunity cost of producing pizza. To illustrate the gains from trade, assume that Lozano initially produces and consumes 12 pizzas and 14 colas. Bilma initially produces 16 pizzas and 4 colas. With constant opportunity cost the two will completely specialize. A beneficial rate of exchange can be found between the two countries’ opportunity costs, such as 3 pizzas for 1 cola. Assume they decide to trade 15 pizzas for 5 colas. This leaves Lozano with 15 pizzas (0 produced plus 15 that come from Bilma) and 15 colas (20 produced minus the 5 that go to Bilma). Bilma ends up with 17 pizzas (32 produced minus the 15 that go to Lozano) and 5 colas (0 produced plus the 5 that come from Lozano). They are both better off because they are able to consume more of both goods than they could without specialization and exchange. Transactions: The Circular-Flow Diagram Creating Student Interest • Use the example of a dollar in your pocket. Explain where the dollar came from. (It came from your bank account, and was put there initially by a direct deposit from your university.) Consider where the dollar will go. (You will buy lunch and leave it as a tip, so it will become income for a waitress and then she will have money to spend.) Ask students to think about the last dollar they spent. Where did it come from and where did it go? Presenting the Material • Build the circular-flow diagram by identifying the two major components of the circular-flow diagram first: households and firms. Use your ample artistic skills to draw a house at the top of the board and a factory on the bottom. Tell the class these represent households and firms. Create the circular-flow diagram by asking students the following series of questions. (It will help some students to see the step-by-step construction of the diagram in addition to the completed diagram in the text.) What do households get from the firms? (Goods and services.) Where do they go to get the goods and services? (Stores, markets, etc.) Draw the market for goods and services to the left of the drawing. Draw an arrow above the pictures from the firm to the market and from the market to households and label both “goods and services.” What do the firms get in exchange for the goods and services? (Payment/money.) Draw a line above the pictures back from the households to the market and from the market to the firm and label it “$.” What do the households provide to the firms? (Worker/labor—add that they provide the other resources also.) Where do firms go to get these workers? (Labor market) Draw the market for labor to the right of the drawing. Draw a line below the pictures from the household to the market and from the market to the firm and label both “resources.” What do the households get from the firm in return for their labor/resources? (Payments— wages, rent, interest, profit.) Draw a line below the pictures back from the firm to the market and from the market to the households and label both “wages, rent, interest, profit.” You may want to link changes in the size of the flows to the business cycle discussed in Chapter 1. During expansions, the flow increases; during recessions, it decreases. Positive versus Normative Economics Creating Student Interest • Find an estimate of the average annual tuition at your institution. Write the estimate on the board and tell students you want them to know two things about this number (write them on the board): First, it is the average annual tuition at your institution. Second, this amount is too low. Tell them to write down the two statements. This should cause one or more students to express disagreement with at least one of the statements. If not, ask them if they agree with them or not (and why). Use the statements to lead into your presentation of positive versus normative in economics. • Ask students to make a clearly biased statement concerning the economy. Then ask them to make a perfectly objective statement. Presenting the Material • After explaining the difference between positive and normative, quiz the class by asking them to determine if each of the following statements is positive or normative. If a student identifies the statement as positive, ask how the statement could be tested. Remind them that a positive statement need not be correct, it only needs to be testable. Also remind them that even if everyone agrees with a normative statement, it is still normative. The price of gas is too high. (Normative: What is “too high”?) The Federal Reserve lowered interest rates yesterday. (Positive: You can test this by going to the Federal Reserve’s website or by looking at interest rates.) The national debt should be reduced. (Normative: How can you know/test what “should” be done?) Foreign imports are bad for the economy. (Normative: How do you define “bad”?) Inflation is expected to rise. (Positive: You can survey people and see/test whether they expect inflation to rise.) Common Student Pitfalls • Misunderstanding comparative advantage. Students confuse absolute advantage with comparative advantage. Explain that absolute advantage means you can produce more than someone else can. Comparative advantage means that you can produce something at a lower opportunity cost than someone else. Use the example of two students working on a joint project. One student may be better at every task required to complete the project (have an absolute advantage in all tasks). However, it wouldn’t be efficient to have the one student do everything for the project while the other does nothing. There must be a task that the other student is relatively good at (has a comparative advantage). The pair should identify that task and have the students specialize accordingly. Most students understand the basic idea behind comparative advantage, but many students struggle with the calculation of opportunity cost. They may need to see and work a few examples before the concept sinks in. Start with the example from the text, and then move on to other examples. • The use of the term positive. Students may not understand the different use of the word positive. Make sure they understand that it is not being used in the same way they are familiar with (the opposite of negative). There are many places where economists use generally familiar words to mean something specific to their discipline. Prepare them to get used to learning the new meanings in these cases. In this context, “positive economics” explains the way the world works. It is factual and can therefore be tested. Chapter Outline Opening Example: The Wright Brothers invented a wind tunnel to test models of airplanes. Boeing ran 15,000 hours of wind tunnel tests when it was developing its latest jet, the Dreamliner. Testing models is cheaper and safer than building full-scale versions. Economists use models in the same way. I. Models in Economics: Some Important Examples A. Models allow economists to see the effects of only one change at a time. B. Economic models make use of mathematical tools, especially graphs. II. Trade-offs: The Production Possibility Frontier A. The graph of the production possibilities frontier shows the possible combinations of two goods that can be produced given the scarce resources of the society. B. A point inside the frontier is a feasible combination of two goods that can be produced, but does not use all resources fully; a point outside the frontier is not feasible given the current amount of resources. See text Figure 2-1, shown next. C. The production possibility model illustrates the concepts of: 1. Efficiency: Any point on the frontier represents an efficient use of resources, and any combination of goods inside the frontier represents a point of inefficiency. a. If an economy produces on its production possibilities frontier, it is efficient in production. b. An economy is efficient in allocation if it allocates resources so that consumers are as well off as possible. 2. Opportunity costs: The negative slope of the frontier means that an increase in the production of one good must require a sacrifice of some quantity of the other good. 3. The law of increasing costs: If the frontier is bowed out, the opportunity costs increase as more of one good is produced because resources are not easily transferable from the production of one good to another. 4. Economic growth: Over time as a society gains more resources, the production possibility frontier shifts outward. See text Figure 2-3, shown on the next page. a. Economic growth comes from two basic sources: an increase in factors of production, and technology. III. Comparative Advantage and Gains from Trade A. Comparative advantage, not absolute advantage, is the basis for the gains from trade. B. The concepts of absolute advantage and comparative advantage apply to individuals, firms, and countries. C. The gains from trade are illustrated in text Figure 2-5 (shown next), with a straight-line production possibility frontier for each of two countries: D. Individuals or countries will engage in trade only if the price of the good each is obtaining from trade is less than its own opportunity cost of producing the good. E. This example highlights two important lessons: 1. Both countries are able to produce more and consume more in total. 2. Each country has a comparative advantage in the production of something. F. Although economists have a very positive view of international trade, politicians and the public sometimes have a negative view of international trade. IV. Transactions: The Circular-Flow Diagram A. The circular-flow diagram is a simplified picture of an economy, as demonstrated in text Figure 2-6, shown here. B. The circular-flow diagram can help us understand how the economy manages to provide jobs for a growing population. 1. The number of jobs isn’t fixed, because it depends on how much households spend; the amount households spend depends on how many people are working. V. Positive versus Normative Economics A. Models are especially helpful in answering “what if” questions such as, “How will revenues change with a tax cut?” The answer is a predictive one, not prescriptive; it does not tell you if the policy is good or bad. B. Economists do engage in normative economics. Economic analysis can be used to show that some policies are clearly better than others, especially if one solution is more efficient than another. For example, most economists would favor subsidies to renters over rent-control laws as a more efficient solution to help low-income families obtain housing. VI. When and Why Economists Disagree A. Because economists used different models and make differing simplifying assumptions, they can arrive at different conclusions. B. Many disagreements are eventually resolved by the accumulation of evidence. C. Economic analysis is a method, not a set of conclusions. Case Studies in the Text Economics in Action Rich Nation, Poor Nation—Much of our clothing is produced in other countries that are poorer than the United States. The case study explains that this is because the countries have a comparative advantage in producing clothing. Ask students the following questions: 1. Why are some countries poor? (Their workers are not as productive as workers in richer economies.) 2. Why do consumers in the United States import so much cheap clothing from poor countries? (Despite their poverty, poor countries have a comparative advantage in producing clothing relative to the United States.) Economists: What Are They Good For?—This EIA discusses the various roles that economists play in the business world and in the federal government. Ask students the following questions: 1. Why do companies in the private sector hire economists? (To forecast and predict what will happen to prices.) 2. Why does the government employ large numbers of economists? (To analyze the economic effects of government decisions.) For Inquiring Minds The Model That Ate the Economy—This FIM discusses a model used by financial traders on Wall Street, beginning in 2000, to estimate the likelihood of losing money on mortgage-backed securities (MBS). As subsequent economic events proved, the model seriously underestimated the risk of buying MBS. When Economists Agree—This FIM notes that although economists often disagree, there are some statements that they generally agree on. One statement of agreement: Trade restrictions reduce economic welfare. Global Comparison Pajama Republics—Poor countries have low productivity in clothing manufacturing, but even lower productivity in other industries, thus they have a comparative advantage in clothing manufacturing. Business Case Efficiency, Opportunity Cost, and the Logic of Lean Production—This business case explains the idea behind lean production, with reference to the experiences of Boeing and Toyota. Web Resources The U.S. Census Bureau and the U.S. International Trade Commission have information about exports and imports. https://www.census.gov/and https://usitc.gov/ The National Association of Business Economists has the results of member surveys that indicate what economists currently agree and disagree on, as well as information on careers in economics. http://www.nabe.com/ Appendix Creating Student Interest • Have students discuss the relationship between calories consumed and weight. What is the independent variable? What is the dependent variable? Presenting the Material • Give an example of data and how a graph is set up, then explain how to interpret the graph. Year Health expenditures as a percent of GDP 1950 4.5% 1960 5.3% 1970 7.1% 1980 8.9% 1990 12.2% 2000 13.4% (Source: The Economics of Health and Health Care, S. Folland, A. Goodman, and M. Stano. Prentice Hall, 2001.) Ask students the following questions: 1. With “Health expenditures as a percent of GDP” on the vertical axis of a graph and “Years” on the horizontal axis of the graph, plot the data on the graph. 2. Is the line positively or negatively sloped? (It is positively sloped; as the years have increased, the percent share of GDP has increased.) 3. Is it a linear function? (No, the line is not a straight line.) 4. What does the graph not tell us? (It does not indicate what is causing the increase in health expenditures as a percent of GDP.) Common Student Pitfalls • Students forget the basic setup of a graph: that each point on the graph refers to a specific quantity on the vertical axis and horizontal axis. Use a demand curve to illustrate: point A on the demand curve means that at a price of $1.00, consumers will buy 200 of the good, for example. You may want to point out which axis on the graph is referred to as the vertical axis and which is the horizontal axis. Handout 2-1 Date_________ Name____________________________ Class________ Professor________________ Production Possibilities Consider a country that can produce wheat or airplanes. Here are the points on the production possibility frontier: Maximum annual output options Wheat Airplanes A 1,000 0 B 800 150 C 600 250 D 400 325 E 200 375 F 0 400 What is the opportunity cost of expanding production from 150 airplanes to 250 airplanes? Why is the production possibility graph negatively sloped? Why is it bowed out from the origin? Handout 2-2 Date_________ Name____________________________ Class________ Professor________________ Production Possibilities Purpose: Create a production possibilities frontier for widgets and whatsits that can be produced with a given allocation of capital and labor. Capital: Two desks Paper (cut into half-sheets) Two staplers Labor: Four or six volunteers Product: Widget—a piece of paper folded twice into a square and stapled Whatsit—a piece of paper folded three times Instructions: Step 1: Count the number of widgets that can be produced in 30 seconds using all the resources. Plot this point on the production possibilities graph on the following page. Step 2: Count the number of whatsits that can be produced in 30 seconds using all the resources. Plot this point of the production possibilities graph on the following page. Step 3: Divide the resources in half. Use half to produce widgets and half to produce whatsits. Count the number of widgets and whatsits that can be produced in 30 seconds. Plot this point of the production possibilities graph on the following page. Step 4: Connect the points to show the production possibilities frontier on the following page. Handout 2-3 Date_________ Name____________________________ Class________ Professor________________ Comparative Advantage Activity 1: Working with a partner, each student should do each of the following tasks for 30 seconds: marking the same sized X on a sheet of paper and turning pages in a book. At the end of the time, record the number of Xs drawn and the number of pages turned. Answer the following questions: Given the data for both goods for both partners, what is the opportunity cost of producing each good? Who has comparative advantage in the production of Xs? Who has comparative advantage in the turning of pages? Activity 2: What comparative advantages does the United States have? Do a brief internet search to determine what products the United States exports the most. List them. How do these products compare with the comparative advantages listed above? Activity 3: Consider the pros and cons of the following two statements: “The United States should limit imported textiles from China.” Pros Cons “The United States should prohibit the import of products from abroad that are made with child labor.” Pros Cons Handout 2-4 Date_________ Name____________________________ Class________ Professor________________ Circular-Flow Diagram Activity 1: Draw the circular flow below. Add banks, government, and exports and imports to the circular flow. Activity 2: Consider what will happen in the circular flow from Activity 1 above if consumers decide to spend more money and save less. Beside each entity in the diagram, describe briefly how this change will affect the group. Handout 2-5 Date_________ Name____________________________ Class________ Professor________________ Positive or Normative? Read the following sentences. Write whether the statement is positive or normative. Then, rewrite the statement to make it normative if the original is positive or positive if the original was normative. 1. “More than 60% of women are in the labor market.” 2. “Rent control laws should be implemented because they help to achieve equity or fairness in housing.” (Normative) 3. “Society should take measures to end gun violence.” (Normative) 4. “People who smoke pass on increased medical costs to the whole society.” (Positive) 5. “Single mothers are more than twice as likely as married mothers to be in poverty.” (Positive) Instructor Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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