This Document Contains Chapters 1 to 3 Chapter 1 The Big Ideas Learning Objectives After completing this chapter students should: > know the Ten Big Ideas in economics. > appreciate that economics is not just about business and stock markets, but it can help them understand many things they encounter in their everyday lives. > see that economics can be fun! Chapter Outline The chapter is organized around 10 “Big Ideas”: Big Idea One: Incentives Matter Big Idea Two: Good Institutions Align Self-Interest with the Social Interest Big Idea Three: Trade-offs Are Everywhere Opportunity Cost Big Idea Four: Thinking on the Margin Big Idea Five: The Power of Trade Big Idea Six: The Importance of Wealth and Economic Growth Big Idea Seven: Institutions Matter Big Idea Eight: Economic Booms and Busts Cannot Be Avoided but Can Be Moderated Big Idea Nine: Inflation Is Caused by Increases in the Supply of Money Big Idea Ten: Central Banking Is a Hard Job The Biggest Idea of All: Economics Is Fun Chapter Narrative This chapter briefly introduces 10 big ideas in economics that the students will learn more thoroughly in later chapters. Each big idea is explained, and then its importance is illustrated by showing how it explains some real-world phenomenon that the students should find interesting. The chapter aims to excite students about economics while giving them a quick introduction to the big ideas. The chapter opens by explaining how the British government rewarded ship captains for transporting convicts to Australia in the eighteenth century. At first, the captains were paid per convict who boarded the ship. The sailors treated the prisoners inhumanely, and their death rates were extraordinarily high. Then, when the government changed the payment system so that it paid captains according to how many prisoners walked off their ship in Australia, rather than how many walked on in England, suddenly the prisoners’ survival rate shot up to 99 percent. This illustration leads into the first big idea: incentives matter. Big Idea One: Incentives Matter Incentives are rewards or penalties that influence behavior. Changing the incentives changed how the captains treated their prisoners. Under the first payment system, there was no monetary reward for delivering the prisoners alive. In fact, if they didn’t feed the prisoners, the captains could sell the prisoners’ rations and earn even more money. Captains’ incentives were to treat prisoners poorly. Once they were paid according to how many healthy passengers they delivered, their incentives and thus their behavior changed for the better. The MRU video Introduction to Economics introduces economics in general and discusses the importance of incentives in particular using the story of British prisoner transports to Australia. This video might provide a nice opening to your first lecture. Monetary rewards are one major incentive in our society. As Adam Smith said, “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.” Teaching Tip: It’s easy to illustrate this idea to students quickly. Glance around the room and see who just recently purchased something, such as a Coke or coffee. Ask about the transaction. Who sold it? What was the seller’s name? Did the seller know the student’s name? Why was that product available there? What was the seller’s incentive? Emphasize the number of things that students need from people who have no incentive to help them other than the monetary reward. Not all incentives are monetary—fame, power, reputation, sex, and love are all important incentives. Emphasize that economics can explain things motivated by these incentives as well. Students should come away realizing that economics is not limited to explaining things that are paid for in money. Big Idea Two: Good Institutions Align Self-Interest with the Social Interest The story of how ships’ captains changed their behavior relates to the second big idea. Incentives are not fixed in stone. Different institutions or rules can engender different incentives and behaviors. An institution is good when it aligns an individual’s self-interest with society’s interest. An institution is bad, and so are the outcomes, when individuals’ incentives run counter to society’s interest. Under the right conditions, markets align self-interest and social interest. It’s good that business people make money by pleasing consumers. Self-interest on their part can be good for society. Teaching Tip: Ask students if they ever worked overtime at a job. Why did they do it? Get them to explain that they wanted to earn the extra money. They were acting out of self-interest. But then emphasize how their self-interest made them provide more services to someone else than they would have otherwise. Be sure to point out that self-interest is neither good nor bad because it is how we progress as a species. What is important is the institutions. The captains’ greed led to bad outcomes (poorly treated passengers) when institutions were bad. But that same greed, or desire for self-interest, led to good outcomes (more passengers making it to Australia) when the institutions changed. Greed’s goodness (or usefulness) depends on the institutions. Markets with mutual voluntary interaction make self-interest useful most of the time. Big Idea Three: Trade-offs Are Everywhere Students are first introduced to opportunity cost (without using that term) by the somewhat shocking conclusion that economists worry that pharmaceutical drugs could be too safe. In 2004, Merck withdrew the arthritis drug Vioxx from the market after a study showed that it could cause heart attacks and strokes. Yet the FDA had approved the drug five years earlier, and millions had used it. Students will be tempted to conclude that the FDA should be more careful studying new drugs so that drugs like Vioxx never reach the market. Making drugs safer necessitates a trade-off: fewer companies will develop drugs because it would be more costly. This is known as drug loss. It will also take longer for good drugs to make it to market, causing people to miss out on the drug’s beneficial effect in the interim. This is known as drug lag. It takes an average of 12 years and $900 million to bring a new drug to market in the United States. The trade-off society faces for safer drugs is fewer drugs and getting them more slowly. Such trade-offs are inevitable in a world of scarcity—that is, when there are not enough resources to satisfy all of our wants. How we use our scarce resources to satisfy as many of our wants as possible is what the authors refer to as the “great economic problem.” Scarcity, trade-offs, and the great economic problem bring us to a key concept in economics: opportunity cost. The opportunity cost of a choice is the value of the opportunities lost because of that choice. Teaching Tip: Students are used to thinking of costs as monetary costs. Take some time to illustrate opportunity costs with examples that they can relate to. For example, what is the opportunity cost of going to a movie one night? How would that opportunity cost change if you had an exam the next day? The textbook provides another nice example: What is the cost of going to college? Tuition, books, lost wages, room and board. Ask students which of these is not an opportunity cost. Ask them if they considered lost wages when they decided to attend. Then explain why college enrollment is affected by the business cycle. Teaching Tip: You can have some fun with examples of opportunity cost by asking students questions that relate to everyday life. Try asking the following: > In a social situation, have you ever walked up to two attractive people, looking for a date? You have to choose who to focus on. The opportunity cost of talking to the person you chose is loss of the opportunity to talk to the other person. (This leads nicely to the joke: an economist was asked how his wife was. He answered, “Compared to whom?”) > Does anyone play basketball? If you’re on a fast break and you pull up for a three-pointer, what is your opportunity cost? > If you weren’t here in my class today, what would you be doing? Keep drilling them with questions until they seem to get it. Big Idea Four: Thinking on the Margin Most choices are made on the margin. Should we do a little more of an activity or a little less? This concept is introduced in the book with a brief discussion of a driver making incremental changes to his speed as he travels down the highway. When he hasn’t seen a police cruiser in a while, he increases his speed a little more. When he finally spots one as he approaches a big city, he decreases his speed a little. Just like many decisions in life, the driver’s decision about his speed is not made once and for all upon starting his car. Rather, when it is beneficial to do so, he speeds up a little, until the benefits of speeding up a little no longer outweigh the costs (the increased likelihood of a ticket). Teaching Tip: Here is a fun illustration of marginal thinking from students’ everyday lives. Ask if they have ever chosen to go out with their friends instead of with their boyfriend or girlfriend and heard the objection, “You care more about them than you do me.” At least one hand will go up. Then explain that they now have an answer: “Not in an absolute sense. You are more important, but given that I already spend so much time with you, seeing them tonight is more important to me only on the margin.” Big Idea Five: The Power of Trade The benefits of trade go much further than the simple benefits of exchange. Through specialization, trade can increase productivity, and higher productivity leads to more output. One way that specialization increases productivity is through the division of knowledge. A producer who specializes in the production of just a few goods can become an expert in the production of those goods, learning things that would not have been learned if every person produced just a small amount of every good for his or her own use. Likewise, specialization allows producers to take advantage of economies of scale, the cost savings that can be achieved when goods are produced in higher quantities. The theory of comparative advantage maintains that specialization and trade can benefit everyone involved. The key is for producers (individuals, firms, or countries) to focus on the goods they can produce for the lowest opportunity cost and then trade with each other. The text uses the example of Martha Stewart, who, although likely a very skilled ironer, hires someone to do her ironing. The reason? The opportunity cost of her ironing is running her company (Martha Stewart Living Omnimedia). If the profits from her company that she foregoes when she spends an hour ironing is greater than the value of ironing, then she should spend time running her company and use those higher profits to pay someone to iron her clothes. Big Idea Six: The Importance of Wealth and Economic Growth Some students will be tempted to discount the importance of wealth and economic growth because they associate it only with material standards of living. Now’s the time to drive home the point that increases in wealth give us more of many of the things we all value. A few quick examples from the text: > In 2007, more than half a billion people around the world contracted malaria, and about 1 million died of it. We think of it as a tropical disease, but people used to get it in the United States frequently until the 1940s. Better drainage, removal of mosquito breeding sites, and insecticides all contributed to wiping malaria out. We needed to grow wealthy enough to pay for these things before malaria could be eradicated. > In the United States, 993 in 1,000 children born survive until at least age five years. In Liberia, one of the world’s poorest countries, the survival rate is only 765 in 1,000. Most things people care about—like life expectancy, nutrition, and literacy—are all easier to get when you are wealthier. It is also helpful to point out the circular relationship between these ideas. As wealth increases, there is more free time to pursue specialization. This specialization leads to more efficient production methods, which increases economic growth or the ability to produce more goods and service. This increases wealth, further leading to more free time and so on. A good example of this is how better and cheaper sources of light allowed more work past sunset, leading to more efficient forms of light generation. Big Idea Seven: Institutions Matter If wealth is so important, this naturally leads us to ask how to get wealth. This was the focus of much of Adam Smith’s seminal book An Inquiry into the Nature and Causes of the Wealth of Nations. Wealthy countries tend to have lots of physical and human capital and use them with the best technology available to produce goods and services more efficiently. But this still raises the question of why some countries have more than others and why they use it more efficiently. It all comes back to Big Idea One: Incentives Matter. Entrepreneurs, investors, and savers need the right incentives to save and invest in physical and human capital, innovation, and efficient organization. The institutions most important in supporting good incentives for these are property rights, political stability, honest government, a dependable legal system, and competitive and open markets. Teaching Tip: Ask the students how many of them came to college because they expect to earn more. How have the institutions in the United States given them the confidence to make that investment in their human capital? North Korea and South Korea provide a striking example of how different institutions affect wealth creation. The two countries have a common culture and geography and were equally poor in 1950. South Korea embraced property rights and markets, while North Korea did not. Today South Korea has more than 10 times the per capita income of North Korea. Teaching Tip: If you have access to the Internet in the classroom, pull up a satellite image of the Korean peninsula at night and show them the difference in light emissions between the two countries as an indicator of development. Big Idea Eight: Economic Booms and Busts Cannot Be Avoided but Can Be Moderated Booms and busts are part of the normal response to changing economic conditions. Not all booms and busts are the same, though. The Great Depression was the worst economic downturn the United States has ever had. Output dropped by 30 percent, unemployment rose above 20 percent, and the stock market lost a third of its value. This was not a normal recession. Most economists believe that if the government had acted differently, the Depression would have been less severe. Monetary and fiscal policies affect the length and severity of economic booms and busts. At one time, economists believed that government policy could be used to end the economy’s boom and bust cycle. But most economists no longer believe that, and we’ve learned that when these policies are used poorly, they make recessions worse and the economy more volatile. An example you can use is ships on the ocean. Waves on the ocean cannot be stopped, they are just part of nature. If you are on a small boat you are constantly being tossed by these waves. If you are on a cruise ship you will likely forget you are on the ocean. The waves are still there; however, the builders of the ship have installed technology to mitigate the impact of the waves on the ship. Monetary and fiscal policy work in much the same way by mitigating the impact of the natural business cycle on the economy. Big Idea Nine: Inflation Is Caused by Increases in the Supply of Money Inflation is an increase in the general level of prices in an economy. Increases in the money supply cause inflation. Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon.” Potential Pitfall: Although inflation comes from increases in the money supply, students are likely to think oil or greedy businessmen cause inflation. It’s worth stressing the monetary causes and how other factors influence relative prices but not the general level of prices. Inflation has negative consequences. Emphasize how inflation makes it hard to figure out the real value of goods and services. Most students in the United States have not experienced the chaos of serious inflation, whereas Zimbabwe recently had an inflation rate of over 531 billion percent. Money in that situation becomes virtually worthless and must be spent as soon as it’s earned, making organized trade harder. In Zimbabwe, people started buying things with prepaid cell phone minutes and gas cards instead of the national currency. You can highlight this idea by having the students assume you hand out envelopes with between one and five dollars in them. Now assume you are holding an auction for something the students want (such as answers to the exam) and ask the students what is the highest price one person can bid. Now assume the envelopes had up to ten dollars in them. Now what is the highest possible bid? Note to the students that the good being auctioned has not changed, only the price because there is more money. Big Idea Ten: Central Banking Is a Hard Job The Federal Reserve controls monetary policy in the United States. But there is a lag—often months—from when the Fed makes a decision to when the effects of that decision are known. When it prints too much money, we get inflation. If it prints too little, we get falling prices. And often as prices and wages fall, the adjustment does not go smoothly. But because of the lag, the Fed is always shooting at an unknown moving target. Most economists believe the Fed does more good than harm, but when the Fed does its difficult job poorly, it can cause great harm. Biggest Idea of All: Economics Is Fun The whole point of the first chapter, and your first lecture of the semester, is to excite students about economics. We need to show the students that: > economics is all around them in their daily lives. > economics is crucial for understanding the world and how to make it a better place. > these principles of economics hold everywhere across the globe and through time. The motto of the book is “See the Invisible Hand. Understand Your World.” Chapter 1 and your lectures should arouse a desire in students to do that. Chapter 2 The Power of Trade and Comparative Advantage Learning Objectives After completing this chapter students should: > understand that trade makes people better off when preferences differ. > know that trade increases productivity through specialization and the division of knowledge. > understand comparative and absolute advantage and how comparative advantage increases productivity. > know that trade improves the welfare of both low-productivity and high-productivity countries. Chapter Outline Trade and Preferences Specialization, Productivity, and the Division of Knowledge Comparative Advantage The Production Possibility Frontier Opportunity Costs and Comparative Advantage Comparative Advantage and Wages Adam Smith on Trade Trade and Globalization Takeaway Chapter Narrative This chapter illustrates how trade promotes cooperation that allows both highly productive countries and less productive countries to gain through trading with each other. The chapter provides examples of trade between individuals and trade between countries. Included is the famous Adam Smith quotation illustrating the link between trade among individuals and trade among countries: “What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom.” It is important to emphasize to students that the same principles explain all trade, whether between countries or individuals. The MRU video The Big Ideas of Trade motivates the importance of trade in economics and explains how trade benefits society. This is a good video to open the discussion of trade. This video is also useful for illustrating the ideas in the next section of the chapter. Trade and Preferences This section tells the story of the founding of eBay. A young computer programmer, Pierre Omidyar, finished the code for what would become eBay in 1995. To test it out, he posted a broken laser pointer to the site and asked for a dollar. It sold for $14.83. He was so surprised that he contacted the buyer to make sure that he understood it was broken. It turns out that the buyer was a collector of broken laser pointers! Trade transformed something that was worthless to Omidyar to something that was valuable to someone else. Value was increased simply by a swap between people with different preferences. Today eBay operates in more than 30 countries and earns billions of dollars in revenue. When people with different preferences trade with each other on eBay, each person becomes better off, and so does eBay by facilitating the transaction. The short lesson of this section: trade increases value by moving goods from people who value them less to people who value them more. Teaching Tip: It is easy to demonstrate to students how trade can increase value among individuals. Describe (or actually perform) an exercise in which each student randomly draws one item from a box containing a mixture of different candy bars. Students do not know the brand of candy they will receive until it is drawn from the box, and they must keep the first item selected. Once each student has drawn an item from the box, ask them to rate on a scale from one to ten how happy they are with what they received from the random draw. Add up the total rating for the class. The total rating provides a measure of total happiness or value for the class. Then announce that everyone has one minute to trade their candy bar with anyone else in the class, and they may trade as many times as they wish during this time. When the trading has ended, ask students again to rate their happiness, and once again add up the ratings for the class. The rating should be higher after the trading. Explain to the class that the level of happiness, or value, increased through trade, even though no new candy was given. The increase in value simply results from moving the candy around so that it winds up with the people who value it most. Specialization, Productivity, and the Division of Knowledge When people trade, it allows them to specialize in producing one thing rather than trying to produce everything they need. Try asking your students how well they would eat and how well-clothed they would be if they had to produce all their own food and clothing. Specialization increases production in two ways. First, by specializing in farming, for example, farmers learn a lot more about farming than other people, so they become better at it. Second, they can afford to buy large-scale farming machines that are more productive because they are going to produce in far greater quantities than individuals would produce for their own use. Most instructors are used to emphasizing specialization and the division of labor. Modern Principles is different in that this section emphasizes the division of knowledge. The human brain is limited, and if knowledge is divided across many brains and then trade occurs, we can collectively benefit from more knowledge than any one mind could hold. If every person in society produced the same thing as the neighbors, the combined knowledge of a society of a million people would barely exceed the knowledge of one brain. In a modern economy, trade allows us to harness far more knowledge through specialization. The book considers a Valentine’s Day rose that may have been grown in Kenya, flown to Amsterdam on a refrigerated airplane, and ultimately trucked to Topeka by drivers drinking Columbian coffee. Each person involved understands only a small part the whole process, but because of trade, their collective knowledge is able to deliver the rose. Teaching Tip: To convey the importance of a group of knowledgeable individuals rather than one individual, you can highlight the positive aspect of wikiss or web communities (message boards). Whether it is Wikipdeia.org or a similar wiki for a television show, video game, or even software, it is the collective work of individuals with specific knowledge in certain aspects of subject coming together in a central location to create an authoritative guide on the subject solely via trade. Wikis and web communities (or message boards) have become the go-to source to troubleshoot problems. You can also see similar ideas in the numerous “How To” video channels on YouTube. Neurosurgeons, heart surgeons, and other medical specialists all have very specialized knowledge and are able to acquire that knowledge only because they can trade with other people. If it weren’t for the cook, housecleaner, and dog walker, these doctors would never be able to acquire their expert skills because they would be too busy performing all of these tasks for themselves. The person who specializes as a dog walker is a vital part of the productive gains from specialization, just as the neurosurgeon is. When trade increases across larger areas and includes more people, it allows society to harness even more knowledge. The opening of the former communist bloc and China brought billions of new minds into the international division of knowledge and makes us all more productive. The MRU video How the Division of Knowledge Saved My Son’s Life provides a real-world example of how the division of knowledge and specialization are intimately related to trade and how we all benefit from the resulting increase in productivity. Comparative Advantage The third reason for trade is to take advantage of people’s differing abilities relative to each other. The book contrasts absolute advantage with comparative advantage using the example of Martha Stewart. An absolute advantage in production exists when a country or person can produce the same good using fewer inputs than another country or person. But comparative advantage exists when a country or person can produce the same good at a lower opportunity cost. Martha Stewart doesn’t do her own ironing. She may be the world’s best ironer. But she can do her ironing only at the expense of time away from running her business. Her blouses might look slightly better if she did them herself, but the gain would be small compared to the losses that would result from having someone else run her business while she irons. She has an absolute advantage in ironing and running a business but a comparative advantage only at running her business. The MRU video Comparative Advantage introduces the idea of comparative advantage in general terms and explains how it makes both parties in a trade better off. The MRU video Another Look at Comparative Advantage provides a more detailed look at comparative advantage. The distinction between comparative advantage and absolute advantage is explained early in the video. The video concludes with a homework problem that students can do for themselves. Production possibilities frontiers are not used in the video. The MRU video Comparative Advantage Video provides the answer to the homework problem presented at the end of the previous video and illustrates how trade based on comparative advantage makes both parties in the trade better off. The Production Possibility Frontier The production possibilities frontier (PPF) shows all of the combinations of goods that a country can produce given its productivity and supply of inputs. The book plots a PPF for the United States and Mexico in Figure 2.1. Figure 2.1: Production and Consumption in Mexico and the United States Without Trade Potential Pitfall: Students will be confused throughout the discussion of trade if they do not understand the basics of the PPF. Take the time to explain the key points of working with these graphs. Explain that producing combinations of goods outside the PPF is impossible with given resources and technology. Points inside the PPF are inefficient because you are leaving resources unused. Points on the PPF are efficient. Then explain how the slope of the PPF relates to the opportunity costs of producing each good. Do not move on until students can take a PPF and calculate the opportunity costs of producing both goods in both countries, as shown in Table 2.1 in the text. It may be worthwhile to provide your own example for students to work for themselves. Emphasize that even though Mexico is less productive than the United States, it still has a comparative advantage in producing shirts, as shown in Table 2.1. The theory of comparative advantage says that to increase its wealth, a country should produce the goods it can make at low cost and buy the goods that it can make only at high cost relative to other countries. The book illustrates this by supposing that the United States and Mexico each devote 12 units of labor to producing shirts and 12 units to producing computers. Find the spots on their respective PPFs. The book then moves 12 units of Mexico’s labor out of computers and into shirt production and two units of U.S. labor out of shirt production and into computer production. This allows Mexico to trade three shirts to the United States for one computer. You can illustrate that they both reach a point outside of their original PPF. You might want to trace some more points outside of the PPF that Mexico and the United States could achieve with specialization and trade. Teaching Tip: Students sometimes have a hard time understanding that the gains from trade come from the fact that one country is always a lower-cost producer of some good. I like to tell a story from Steven Landsburg’s The Armchair Economist. Suppose there are two ways to make cars. One is the way you are familiar with on an assembly line in Detroit. The other is to grow crops in Iowa and then truck them to this fancy new machine parked in an Oakland, California, harbor. You put the crops in the machine and push it out of view offshore and three months later it pulls back up to the docks and spits out cars. Which method should you use to make cars? Obviously, whichever is less expensive. That fancy machine is a boat that trades the crops to Japan for cars. Trade is just like a production technology that can lower costs. Figure 2.2: Production and Consumption in Mexico and the United States with Trade Teaching Tip: Emphasize to students that consumption must equal production when there is no trade. In other words, when you don’t trade, you can consume only what you produce yourself. But with trade, consumption can exceed production. That is, trade allows a country to move beyond its PPF. You can make a big deal out of this—even refer to it as the “magic” of trade—since it allows you to reach points that were previously considered out of reach. It is worthwhile to emphasize, however, that we still are not producing beyond the PPF; we are only consuming at points beyond the PPF. Potential Pitfall: Many students will be concerned that there are no gains from trade for a high-productivity country when it trades with a low-productivity country. Emphasize that unless each country can produce every good at the exact same opportunity costs, there will always be gains from trade. The key is that the difference in opportunity costs allows each country to produce something more cheaply than the other. The same way it makes sense for Martha Stewart to trade with a housekeeper, it makes sense for productive nations to trade with less productive ones. Comparative Advantage and Wages Another common fear is that rich countries can’t compete with poor countries that pay low wages. The book deals with this fear by incorporating wages into the example of trade between the United States and Mexico. Assume a computer sells for $300 and shirts for $100 (consistent with the 3-to-1 trade). The value of Mexican consumption is 1 × $300 plus 6 × $100 for $900 total divided by 24 workers, which equals an average wage of $37.50. In the United States, 12 × $300 plus 9 × $100 equals $4,800 divided by 24 workers for an average wage of $200. Despite the fact that Mexico is a low-wage nation and the United States a high-wage nation, they both still gain from trade. After trade, the book’s example shows that Mexico gets 1 × $300 plus 9 × $100 for $1,200, or an average wage of $50, while the U.S. wage rises to $216.67. The fact that productivity is lower in Mexico is what causes Mexican wages to be lower. Specialization and trade let all workers improve their wage regardless of their initial level of productivity. Adam Smith on Trade The book briefly introduces students to Adam Smith, who reinforces the concept that specialization and trade make sense for countries for the same reason they make sense for individuals. Trade and Globalization The Roman Empire had plenty of trade. The Dark Ages saw a decrease in long-distance trade, and the Renaissance saw it expand again. Global trade was common in the nineteenth century as well. Technology changes what goods are traded globally, but globalization itself is not new. Global trade isn’t fundamentally different from domestic trade. The book introduces Don Boudreaux’s quote, “Globalization is the advance of human cooperation across national boundaries.” Takeaway Trade makes people better off when their preferences differ. Trade also increases productivity through specialization and the division of knowledge. When countries specialize and trade according to comparative advantage, they produce the goods they can produce at low cost and trade for the goods they can produce only at high cost. Everyone and every country has a comparative advantage in something, so all can gain from trade. The logic of trade for individuals is relatively easy for students to accept, but they likely have tons of myths in their head when it comes to international trade. It will probably take some time to dispel these myths and help them understand the logic of trade. I suggest one exercise to get you started. In- and Out-of-Class Activities To have your students internalize how trade between two countries benefits both countries and how many misconceptions surround the topic, you can ask each student to bring in a news article critical of international trade. Ask them to identify why the author of the article thinks international trade in the particular case isn’t beneficial. Ask the students to assess the merit of the objection. Then use each criticism and student response as the basis for a brief class discussion. It may be helpful to provide students with an online resource for finding articles. For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU Video: Trade and Preferences The Big Ideas of Trade Specialization, Productivity, and the Division of Knowledge How the Division of Knowledge Saved My Son’s Life Comparative Advantage Comparative Advantage Comparative Advantage Another Look at Comparative Advantage Comparative Advantage Comparative Advantage Homework Chapter 3 Supply and Demand Learning Objectives After completing this chapter, students should understand: > what a demand curve is and why it’s negatively sloped. > what consumer surplus is and how to measure it. > what shifts demand and why. > what a supply curve is and why it’s positively sloped. > what producer surplus is and how to measure it. > what shifts supply and why. Chapter Outline The Demand Curve for Oil Consumer Surplus What Shifts the Demand Curve? Important Demand Shifters Income Population Price of Substitutes Price of Complements Expectations Tastes The Supply Curve for Oil Producer Surplus What Shifts the Supply Curve? Important Supply Shifters Technological Innovations and Changes in the Price of Inputs Taxes and Subsidies Expectations Entry or Exit of Producers Changes in Opportunity Costs Takeaway Chapter Narrative This chapter introduces students to supply and demand by studying the market for oil. Although other markets are discussed in this chapter and throughout the book, the real-world example of the oil market is revisited in many chapters to give students a better feel for how all of the chapters are interrelated. Teaching Tip: Even if you choose to use your own examples in class to illustrate supply and demand, it may be helpful to use a few examples from the market for oil so that students pick up on the continuity being developed in the text. Potential Pitfall: Chapters 3 and 4 are absolutely crucial for students’ future success in your course. If they do not understand these early chapters, it is likely they will understand little in the remainder of the course. It might be worth giving a quick quiz after the presentation of Chapter 4 to confirm that they are ready to move on. If the students do poorly on this quiz, they might be best served by spending more time on these chapters, even if it means cutting material you originally planned to cover later in the course. If students leave your course with only a firm grasp of supply and demand, they will have gained more than if they have only weak knowledge of this material along with other topics. Supply and demand will be far more relevant in most of their lives than anything you teach them about cost curves or oligopolies. The Demand Curve for Oil The demand curve is a function that shows the quantity demanded at various prices. It can be constructed from information on prices and quantities demanded. The demand curve can be read two ways, horizontally or vertically. It’s useful to teach students to read the curve both ways. > Read horizontally: at a price of X, move to the right until you hit the demand curve and then move down to find the quantity demanded. > Read vertically: at a quantity of Y, move up until you hit the demand curve and then move to the left to find the price that demanders are willing to pay for the Yth unit of the good. This price also gives the marginal benefit for the Yth unit of the good. Teaching Tip: It is important to also highlight the idea of the demand curve giving us the marginal benefit as this too will be used later in the course. I like to highlight this with an “axiom” that “People will never pay more for something than the benefit they receive from it.” It can be a fun discussion to ask students to suggest cases where this axiom fails to hold. In-Class Exercise: Give students a supply and demand schedule by listing three or four prices and their matching quantities in a table. Ask them to construct a demand curve based on that information. Here’s one schedule given for oil in the book (with quantity in millions of barrels per day). Feel free to use it or construct one yourself. Price Quantity Demanded $55 5 20 25 5 50 Once students have constructed a demand curve, they need to understand why it is negatively sloped. The text explains that oil is not equally valuable in all of its uses. It can be used for valuable things like jet fuel (which must be made from petroleum) or for less valuable things like making rubber duckies. When the price is very high, oil is used only where it has the greatest value or produces the highest marginal benefit. As the price of oil drops, people are willing to purchase oil and put it to uses that generate less marginal benefit. More generally, consumers put the first unit of a good they buy to the use they value most highly. They are willing to pay the most for that first unit. When they purchase an additional unit, it goes to a slightly less valuable use. So the price must come down if they are to be enticed to buy more. This gives us the law of demand: the lower the price, the greater the quantity demanded. The law of demand implies that the demand curve will be downward-sloping. The MRU video The Demand Curve introduces the demand curve and explains why price and quantity demanded are inversely related. This video provides a nice introduction to the discussion of demand. Consumer Surplus Consumer surplus is the gain consumers get from making an exchange. It’s the difference between the price they paid and the maximum amount they would have been willing to pay. A demand curve measures the maximum amount consumers would be willing to pay for any given quantity of a good or service. To measure consumer surplus from an exchange, students should measure the vertical distance between the price and the demand curve. Teaching Tip: You can easily personalize consumer surplus. Look for a student with a Coke, coffee, or water. Ask how much they paid for it. Then ask if that was the maximum they would have paid or whether they would have bought it if the store had been charging a little more. They likely will say they would have bought it at a slightly higher price. Then ask for the maximum price they would have paid. Or, because students’ answers to questions like these can sometimes be unreliable, another approach is to raise the price by some increment (say, 25 cents) until the student decides that they would not have made the purchase. Calculate the consumer surplus from the transaction and relate this to how it would be measured on a demand curve. Another way to do this is to ask the student to image they are going to purchase a big-ticket item such as a TV. Assume they have picked out the TV they want at the local store and they save up the money equal to what they are willing to pay for the TV, only to find that the TV is now on sale at a lower price. That difference is part of consumer surplus because they now have more money to spend on other things. Potential Pitfall: Throughout the discussion of consumer surplus it is important to emphasize that price and willingness to pay are two distinctly different concepts. If students confuse or fail to make the distinction between these concepts, they will not understand consumer surplus. To calculate total consumer surplus in a market, students must add up the consumer surplus from all of the individual transactions. That is, the vertical distance between the demand curve and price (for all quantities whose demand curve lies above the price) must be summed. This is done by calculating the total area under the demand curve and above the price. To simplify things, use a linear demand curve so that the area is a triangle and use the simple formula ½ × base × height to calculate the total consumer surplus. The MRU video A Deeper Look at the Demand Curve provides a detailed look at the demand curve, how it can be read both horizontally and vertically, and how consumer surplus is measured. Shifts in demand are also introduced. What Shifts the Demand Curve? Students need to understand that demand curves change and that things can cause the whole curve to move, or shift. An increase in demand causes the curve to shift out, or up and to the right. A decrease in demand causes the curve to shift in, or down and to the left. Teaching Tip: Now would be a good time to distinguish between a change in demand and a change in quantity demanded. It is crucial to explain that the distinct wording is important here. When price changes, there is a movement along a given curve called a change in quantity demanded by consumers. When a change occurs in any factor other than price that affects demand, there is a shift of the entire demand curve called a change in demand. Because demand is a relationship between price and quantity, any time something other than price or quantity changes, the whole curve must move. This is a point many students confuse. The text explains it in more depth in Chapter 4, but it is worth mentioning in your lecture now. Important Demand Shifters Any factor other than price that affects demand is called a demand shifter. The text discusses several common factors that can cause a shift in demand: > Income > Population > Price of substitutes > Price of complements > Expectations > Tastes The important thing for students to understand is that most of these should be intuitive. They should ask themselves, “What would make people willing to buy more at the same price?” or “What would make people willing to pay more for the same quantity?” If they can think about the answers to these questions, they should be able to figure out most questions about demand shifts that may be asked of them. Income In general, as people get richer, they buy more things. So when income increases, demand shifts out. In China and India, two large countries, incomes have risen rapidly. Demand for oil has risen with that rise in incomes. Normal goods are goods for which demand increases when incomes increase. Most goods are normal goods. But not all goods have greater demand when incomes increase: goods for which demand decreases when income rises are inferior goods. College students commonly consume inferior goods. The text gives the example of Ramen noodles. Cheap beer is another example of an inferior good that students consume. Teaching Tip: Ask students what things they plan to stop buying once they graduate and get a full-time job. You’re likely to get lots of examples of inferior goods. Population The impact of population on demand is intuitive: having more people implies more demand. You can also talk about how changes in the composition of a population will affect the demand for particular products. For example, how does an aging population or a baby boom affect the demand for certain goods and services? Price of Substitutes Substitutes are two goods that can serve the same purpose. Both natural gas and oil can heat a home. They are substitutes for each other. When goods are substitutes, a decrease in the price of one of the goods will lead to a decrease in the demand for the other good. Teaching Tip: Ask students about some of the things they consume that have common substitutes. For instance, “If McDonalds’ prices doubled, would you go to Burger King or Wendy’s more often?” Ask them about Coke and Pepsi, Coors Light and Miller Light. The list goes on. Get a few examples from them and draw the relevant shifts for both increases and decreases in price. Price of Complements Complements are goods that are often consumed together—such as fries and ketchup, DVD movies and players, baseball gloves and bats, gaming consoles and games. Goods are complements when a decrease in the price of one good leads to an increase in the demand for the other good. Again, ask your students for some examples of things they tend to consume together, and graph how demand shifts when the price of a complement changes. Teaching Tip: Demand shifts for complements and substitutes are often a subject that students believe they understand while you are demonstrating examples but struggle with when they have to solve problems. After covering complements and substitutes in class, it’s often a good idea to pose a couple of questions to students and ask them to draw the demand shifts in their notes. Give them a few questions and a few minutes to solve them. Then go over the answers. It’s an easy way for students to get immediate feedback on whether they really understood what you were teaching or were just following along. Expectations Expectations of future events can shift demand today. If you teach in an area where hurricanes, floods, or snowstorms frequently occur, the students should understand this with a quick example. What happens to the demand for some essential items (bread, water, batteries, generators) when people know a storm is coming? Show the relevant shifts. You can also use gasoline as an example. How would the students respond to an expected increase in the price of gasoline this weekend? Tastes Changes in taste can increase or decrease demand. When doctors warned that too much fat could lead to heart attacks, the demand for beef decreased; when Dr. Robert Atkins published his diet promising weight loss on a high-protein diet, the demand for beef increased. Students can relate to many pop culture events that have caused demand shifts from changes in taste. What happened to the demand for Celtics merchandise when Kevin Garnett joined the team? Ask the students what entertainment star recently had a scandal. Show how it changed the taste—and demand curve—for the performer’s music downloads, movies, or concerts. Potential Pitfall: It is important to emphasize to students that this list of demand shifters is not comprehensive. These are the most common demand shifters, but students should always have an open mind for considering other possible demand shifters. For example, how would an unusually cold winter affect the demand for heating oil? Although weather is not mentioned in this list, students should be able to determine that the demand for heating oil increases as the weather gets colder. The MRU video The Demand Curve Shifts provides a detailed look at what a shift in demand means along with a discussion of the various factors that cause a shift of the demand curve. The Supply Curve for Oil The supply curve is a function showing the quantity of oil that suppliers would be willing and able to sell as prices go up and down. As with the demand curve, students should become comfortable reading it either horizontally or vertically. > Read horizontally: At a price of X, move to the right until you hit the supply curve. Then move down to find the quantity that suppliers are willing to provide. > Read vertically: At a quantity of Y, move up until you hit the supply curve. Then move to the left to find the price necessary to induce suppliers to provide that quantity. This will also give you the marginal cost of the Yth good, which is the minimum amount the firm must get in order to sell that unit of the good. In-Class Exercise: You can provide a supply schedule and have the students construct the supply curve. Again, the book provides a hypothetical supply schedule for oil (in millions of barrels per day): Price Quantity $55 50 20 30 5 10 It is important for students to understand why supply curves are positively sloped. To explain this concept, the text notes the actual cost of extracting oil around the world. (Saudi Arabia comes in at $2 per barrel, Iran and Iraq only slightly higher, Nigeria around $5, Russia around $7, Alaska around $10, Britain’s North Sea crude at $12, Canada just over $22, the continental United States just over $27.) The text explains that as the price of oil rises, it becomes profitable to extract and sell oil from more and more of these regions, increasing the total quantity supplied. Another way of saying this is that as the price that suppliers can get for oil increases, they are willing to spend more money (face higher marginal costs) to produce the oil. More generally, the relationship between price and the quantity producers are willing to supply is known as the law of supply: the higher the price, the greater the quantity supplied. The law of supply implies that the supply curve will be upward-sloping. The MRU video The Supply Curve introduces the supply curve and explains why price and quantity supplied are positively related. This video provides a nice introduction to the discussion of supply. Producer Surplus Producer surplus is the producer’s gain from exchange. It’s the difference between the price the producer receives and the minimum price it would have taken to encourage it to supply a given quantity of a good. Graphically, it is read as the vertical distance between the supply curve and the market price. Again, to help students fully understand producer surplus, emphasize the distinction between the actual price received by the producer and the minimum price required to encourage production. Potential Pitfall: Typically, at least one student will ask the question of why the firm does not just keep producing a good. For example, if the quantity supplied of a good is four units at a price of $5, why not produce a fifth good? Students understand that firms want to maximize profits (which is usually the motivate for this question, if they sell five, won’t they make more money?), so you can remind them that reading the supply curve vertically shows us how much it costs to make each good. So, the reason the firm will not produce a fifth unit is because the cost of producing that unit is more than the $5 they get if they were to sell it, so they would lose money. Showing this usually helps the students to get this idea. Total producer surplus is calculated as the area above the supply curve and below the market price. Once again, it is easy to demonstrate the calculation of total producer surplus using a linear supply curve along with the formula ½ × base × height for calculating the area of a triangle. The MRU video A Deeper Look at the Supply Curve provides a detailed look at the supply curve, how it can be read both horizontally and vertically, and how producer surplus is measured. Shifts in supply are also introduced. What Shifts the Supply Curve? It is possible for the entire relationship between price and quantity supplied to change. Once again, it is important to distinguish between a change in price that causes a movement along a given supply curve (called a change in quantity supplied) and factors other than price that shift the entire supply curve (called a change in supply). Factors that increase supply will shift the supply curve out, or down and to the right. Factors that decrease supply will shift the supply curve in, or up and to the left. Potential Pitfall: Using “up” and “down” to describe shifts in supply curves can mislead students. The confusion results from the natural tendency to associate increases with upward shifts, when in fact an upward shift of the supply curve represents a decrease in supply. For this reason, it is usually more reliable to think of shifts in supply in terms of right and left. That is, an increase in supply shifts the supply curve to the right, and a decrease in supply shifts the curve to the left. As a general rule, I always encourage students to label shift in both supply and demand as “right” or “left,” which makes it less confusing for students. Important Supply Shifters Any factor other than price that affects supply is called a supply shifter. The text discusses several common factors that can shift supply curves: > Technological innovations and changes in the price of inputs > Taxes and subsidies > Expectations > Entry or exit of producers > Changes in opportunity costs Technological Innovations and Changes in the Price of Inputs Any factor that affects the cost of production will cause a change in supply. Technological innovations and changes in input prices are two such factors. For example, a technological innovation that reduced the cost of drilling oil would make producers more willing to supply oil at any given price. The supply curve would shift out and to the right. This is called an increase in supply of oil. As a reference, this is exactly what occurred with the advent of hydraulic fracturing. A reduction in the price of an input to production will have the same effect. If oil rig workers accepted lower wages, it would be cheaper to produce oil, and the supply curve would shift out and to the right. Conversely, if workers required higher wages, the supply curve would shift in and to the left. Taxes and Subsidies Firms care about the final price that they receive for the goods they supply. Levying a tax on firms’ output is equivalent to increasing the cost of production. It makes firms less willing to supply the good than before, so the supply curve shifts in and to the left. In the case of the tax, it’s helpful to think of the shift as a shift up in supply. If a firm previously was willing to supply 60 million barrels of oil at $40 and a $10 tax per barrel is levied on its output, the firm would now require $50 to supply the same 60 million barrels. The supply curve would shift up by exactly $10 at each and every point along the curve. This upward shift is equivalent to a shift in and to the left, so it is a decrease in supply. Subsidies are just the opposite of a tax. With a subsidy, a firm would receive extra cash for each unit of output. The supply curve shifts down at each and every point by the amount of the subsidy, which is an increase in supply. Note that some instructors may prefer to postpone the discussion of taxes and subsidies until they are discussed in more detail later in the text. Expectations Future expectations affect how much a supplier is willing to provide today. If a firm expects prices to increase, it has an incentive to withhold output today so it will have more to sell at higher prices later. This will shift the current supply in, or to the left. Conversely, if it expects prices to fall, it will increase the amount it is willing to supply today, all else equal, shifting the supply curve out, or to the right. Entry or Exit of Producers Changes in the number of producers in a market will affect the supply of a product. For example, before the North American Free Trade Agreement, there were tighter restrictions on Canadian lumber entering the United States. Since the restrictions were reduced, more lumber from Canada enters the United States. At any given price, the supply will include not only the lumber that was previously supplied by U.S. lumber producers but also the additional lumber from Canadian producers. This is most easily thought of as a shift in the supply curve to the right, read horizontally. Exit of producers has the opposite effect. It might be beneficial to make sure students understand this shift factor as it will come into play later in the semester. Changes in Opportunity Costs Changes in the opportunity cost of producing a good shift the supply curve. This factor can be a little more difficult to understand than some of the others. Remember that the concept of opportunity cost refers to the next-best alternative use of resources. For this reason, this supply shifter can also be considered a change in the prices of other goods that can be produced with the same inputs. For example, consider gasoline and heating oil, two goods produced from petroleum. What happens to the supply of gasoline if an unusually cold winter drives up the cost of heating oil? The increase in the price of heating oil reflects an increase in the opportunity cost of producing gasoline, so the supply of gasoline decreases. Or, stated differently, the higher price of heating oil diverts the use of petroleum away from gasoline production and toward the production of heating oil. The supply of gasoline shifts in and to the left. For another example, the book tells a story of a farmer who can plant soybeans or wheat. The opportunity cost of producing soybeans is not to produce wheat. So what happens if the price of wheat increases? An increase in the price of wheat increases the opportunity cost of producing soybeans. So as the price of wheat increases, at any given price for soybeans, a smaller quantity will be supplied. The supply curve for soybeans shifts in and to the left. Teaching Tip: Students can think about this intuitively in their own lives with things they supply. Their labor is often the main good students have experience supplying. Ask for a volunteer who would be willing to help you move boxes of books this weekend if you paid. Establish the volunteer’s supply schedule by asking how many hours they would be willing to work for different pay rates. After you establish this, you can change the opportunity cost. What would happen to the opportunity cost if you announced plans to give an exam on Monday? Would they work as many hours? What if everyone in the room whom they find attractive asked her out this weekend? The MRU video The Supply Curve Shifts provides a detailed look at what a shift in supply means along with a discussion of the various factors that cause a shift of the supply curve. Takeaway The key points in this chapter: > What demand curves and supply curves show > What consumer surplus and producer surplus are and how to measure them > The key factors that affect supply and demand and how to shift demand and supply curves correctly in response to changes in those factors The importance of this chapter for the remainder of the course is hard to overstate. Supply and demand are unquestionably the most important concepts a student can take away from the course, and a poor understanding of these concepts will hamper a student throughout the remainder of the course. In- and Out-of-Class Activities The best way for students to get comfortable with shifting supply and demand curves is to practice. Once your lecture is over, spend some time asking them to shift supply and demand curves on their own in response to situations you present to them. You might also throw in a few cases where the quantity of supply or demand would change to help emphasis the importance of distinguishing the two. Here are some examples to get you started. What would happen (or did happen): > to the demand for Cleveland Cavaliers tickets when LeBron James was traded to another team? After he was traded back? > to the supply of houses if lumber becomes more expensive? > to the supply of cars if the price of cars were to increase? > to the demand for iPhones if the price of iPhones were to increase? > to the demand for televisions if computers broadcast more video of live events? > to the demand for CD players when iTunes was released? > to the supply of sneakers if companies had to hire expensive U.S. labor instead of foreign labor? > to the supply of automobiles if the government subsidized production? > to the demand for Mavericks merchandise after they won the NBA finals? > to the supply of automobiles if GM went out of business? > to the demand for McDonald’s hamburgers if a Wendy’s opened up next door? > to the supply of new flat-screen televisions if the economy is expected to be in a prolonged recession? > to the supply of tortilla chips if the government provides subsidies for the production of ethanol? (Hint: Corn is the primary input for the production of both tortilla chips and ethanol.) For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU video: The Demand Curve for Oil The Demand Curve Consumer Surplus A Deeper Look at the Demand Curve What Shifts the Demand Curve? The Demand Curve Shifts The Supply Curve for Oil The Supply Curve Producer Surplus A Deeper Look at the Supply Curve What Shifts the Supply Curve? The Supply Curve Shifts Instructor Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766
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