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Instructor’s Manual

Survey of ECON

First Edition

Robert L. Sexton

Prepared by

Bob Sandman and David Ferrell

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iii

CONTENTS

PART ONE INTRODUCTION TO ECONOMICS

Chapter 1 The Role and Method of Economics..................................................................1 Chapter 2 The Economic Way of Thinking ......................................................................21 Chapter 3 Supply and Demand .........................................................................................35 Chapter 4 Using Supply and Demand...............................................................................49 Chapter 5 Market Failure and Public Choice....................................................................64

PART TWO MICROECONOMICS

Chapter 6 Production and Costs........................................................................................76 Chapter 7 Firms in Competitive Markets..........................................................................89 Chapter 8 Monopoly .......................................................................................................103 Chapter 9 Monopolistic Competition and Oligopoly......................................................117 Chapter 10 Labor Markets, Income Distribution, and Poverty.........................................132

PART THREE MACROECONOMICS

Chapter 11 Introduction to Macroeconomics: Unemployment, Inflation, and Economic Fluctuations ..................................................................................151

Chapter 12 Economic Growth...........................................................................................172 Chapter 13 Aggregate Demand and Aggregate Supply ....................................................192 Chapter 14 Fiscal Policy ...................................................................................................211 Chapter 15 The Federal Reserve and Monetary Policy ....................................................231 Chapter 16 Monetary Institutions .....................................................................................249 Chapter 17 Issues in Macroeconomic Theory and Policy ................................................266 Chapter 18 International Economics.................................................................................283

ESSAYS

The Midnight Economist......................................................................................................308

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Chapter 1 – The Role and Method of Economics Use the Section Summaries to preview the chapter's content. Section Summaries The following section summaries appear on the Student Review Cards. S1 – Economics: A Brief Introduction Economics is the study of the choices we make among our many wants and desires given our limited resources. Scarcity forces us to choose, and choices are costly because we must give up other opportunities that we value—this is the economic problem. Our scarce resources can be grouped into four categories: labor, land, capital, and entrepreneurship. Entrepreneurship is the process of combining labor, land, and capital to produce goods and services. Goods are tangible items that we value or desire, and services are intangible acts for which people are willing to pay. Everyone faces scarcity, and it cannot be eliminated. S2 – Economic Behavior Economists assume that individuals act as if they are motivated by self-interest and respond in predictable ways to changing circumstances. Self-interest to an economist is not a narrow monetary self-interest. A person acting in self-interest might pursue personal gain, but that does not necessarily exclude helping others. Rational behavior merely means that people do the best they can, based on their values and information, under current and anticipated future circumstances. Because most people seek opportunities that make them better off, we can predict what will happen when incentives are changed. S3 – Markets A market is the process of buyers and sellers exchanging goods and services. In most countries, resources are allocated through a market economy. Efficiency is achieved when the economy gets the most out of its scarce resources. Voluntary exchange and the price system guide people’s choices and help determine what goods are produced and how they’re produced. Market failure occurs when the economy fails to allocate resources efficiently on its own. We use a circular flow model to illustrate the flow of goods and services. Households and firms interact with each other in product markets (where households buy and firms sell) and factor markets (where households sell and firms buy). S4 – Economic Theory A theory is an established explanation that accounts for known facts or phenomena. Specifically, economic theories are statements or propositions about patterns of human behavior that occur expectedly under certain circumstances. Theories use abstraction to weed out relevant from irrelevant information. A theory begins with a hypothesis, which is tested through empirical analysis. If the data collected supports the hypothesis, it can be tentatively accepted as an economic theory.


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Conventionally, we distinguish two main branches of economics: microeconomics, which deals with smaller units in the economy, and macroeconomics, which deals with the aggregate or total economy.

S5 – Pitfalls to Avoid in Scientific Thinking The two major pitfalls to avoid are confusing correlation with causation and the fallacy of composition. The fact that two events usually occur together (correlation) does not necessarily mean that the one caused the other to occur (causation). The fallacy of composition tells us that if a thing is true for an individual, it is not necessarily true on a group level. S6 – Positive and Normative Economics Positive analysis deals with factual statements trying to explain the world. Normative analysis deals with value judgments trying to improve the world. An important distinction is that positive statements can be tested but normative statements cannot. S7 – Why Study Economics? Perhaps the best reason for studying economics is that so many of the things of concern in the world around us are at least partly economic in character. The study of economics provides a systematic, disciplined way of thinking. APPENDIX: Working with Graphs Sometimes the use of visual aids, such as graphs, greatly enhances our understanding of a theory. This textbook will use graphs throughout to enhance the understanding of important economic relationships. This appendix provides a guide on how to read and create your own graphs. Use the Teaching Tips to plan what key concepts you wish to emphasize. Teaching Tips You can also find selected teaching tips located on your Chapter 1 Instructor Prep Card. • It is crucial to clearly discuss the basic paradigm that underlies all that we do in

economics. Show what we mean by scarcity; how scarcity implies the necessity of making choices; how choices imply the bearing of opportunity costs; and how, when combined with the assumption of self-interest, that results in the Rule of Rational Choice: whatever the choice or action, do “it” if and only if E(MB) > E(MC). This, in turn, when continued as long as that inequality holds, becomes the basic intuition leading to what economists define as equilibrium (there is no incentive to change your behavior, absent a change in incentives). When this is clear, it can become the focus for student retention (e.g., how is this technique or diagram an application of the rule of rational choice), and there is almost no end to the examples and illustrations that can be made to show students the applicability of the economic way of thinking.


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• A useful way to integrate student understanding of how value is created and the crucial role of entrepreneurship in the process is to show students that all forms of creating value involve one or more of the following: Resources are being moved from less to more valuable forms (what we typically thing of as production does not create matter; it simply rearranges it); from less to more valuable locations (the value created in transportation); from less to more valuable time periods (the value created in speculation); or from lower valuing to higher valuing uses and/or users (the value created in exchange). In each case, there is a large aspect of entrepreneurship in trying to discover higher valued forms, locations, and times and higher valuing users than others have discovered. Further, this reinforces the fact that the incentives facing entrepreneurs are crucial to the value creating process.

• A good way to illustrate entrepreneurship to students is to discuss in class how each of them is an entrepreneur when it comes to discovering the best way to “produce” higher grades in the course. Different people learn better in different ways, handle pressure differently, have different attitudes toward the risk of getting a lower grade if they do less well than expected, different time constraints, etc. Further, not all courses are the same, and what works well in one course (e.g., memorization of terms) may not work well in another (e.g., one requiring application). Should you always go to class? Is it more effective to read before class, after class, or not at all? Should you use a study guide? Should you study in groups? All these questions are entrepreneurial in nature.

• A good way to get students thinking about scarcity is to ask them what is scarce when one decides to go on a diet. We usually think of food as being scarce, yet in this case, it is healthier food (with fewer calories rather than more) and self-restraint in eating that are scarce.

• You can show students that the prototypical “Ugly American,” who complains that “they don’t do it like back home” when they travel, is someone who fails to recognize that there isn’t a single right way (the way you are used to) to do something, but rather that the best way to do things changes in different circumstances due to different relative scarcities. For example, you don’t see nearly as many large cars where gasoline is far more expensive, streets are narrower, and parking is much more difficult.

• A useful illustration of self-interest is to ask what kind of nails a steelmaker would likely make if it were rewarded on the basis of the weight of nails produced (railroad spikes, because it is less costly to produce a given weight of nails that way) and contrast that result to what it would likely make if it were rewarded on the basis of the number of nails made (pins, because it is less costly to produce a given number of pins than of larger nails). Those results can then be compared to what would happen if the steelmaker were rewarded by being allowed to keep any profits. (It would make those products it thought people valued at more than the cost of production, which depends on what people value in their current circumstances.)

• Students sometimes struggle with economics’ self-interest assumption because they often consider themselves to be acting altruistically. Point out to students that the belief that they are more altruistic than they really are is consistent with self-interest (we want to think well of ourselves), and then ask them whether they think self-interest or altruism is a more reliable way to get others to coordinate behavior in a society.


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• The connection between economics and other social sciences can be illustrated by behavior modification in psychology. Behavior modification can be shown to be an application of the rule of rational choice, where you raise the marginal benefit or lower the marginal cost of behavior you want to encourage (like a market subsidy) and lower the marginal benefit or raise the marginal cost of behavior you want to discourage (like a market tax).

• It is worth emphasizing that economic principles allow economists to know better what not to do than what to do. We can identify choices that would do poorly in achieving intended goals, but we don’t know what course of action will be the best possible in a complex world of uncertainty.

• You can illustrate the role of incentives by discussing with your class whether you should reward marginal exam improvement by giving higher grades to the students who improve the most from their first exam results to the final. There are conflicting incentives facing students here. There are great incentives to improve (you don’t stop studying because you think you will get a C no matter what you do on the final), but such a grading system would also give students incentives to do terribly on the first test, so that they could improve more.

• A good analogy to the importance of the price mechanism as a form of communication is travel to a foreign country where one does not speak the language of the country. Ask if any of the students have ever traveled in a country where they did not speak the language. Ask one of those who have how well they found out what they wanted to know and how well they did at achieving their objectives as a result. For most, the honest answer is “not so well.” For those who insist they did just fine, ask them how often it was because foreigners knew English, and how often it was because prices were clearly indicated in those countries.

• Because most students have heard that market systems built on private property rights are based on the selfishness of people, it is often interesting to ask students whether market systems are based on people’s selfishness or on protecting people from others’ selfishness. They will tend to answer “selfishness.” Then you can show that property rights, while they do allow you to do “selfish” things with your own property, also prevent others from selfishly using or abusing your property without your consent or without paying sufficient compensation to acquire your consent. Given that each of us is vastly outnumbered by “others,” property rights’ protections against others’ selfishness may well be its most important function.

• The circular flow model is primarily designed to remind students that in the economy as a whole, “everything depends on everything else.” As a result, if you wish, you could use a more developed circular flow model to trace the many effects of a given change in one market on others, as well as identify some of the changes in other markets that would have an impact on any particular market.

• As an example of the approach used in economic theorizing and modeling, ask students whether an airplane model needs to have wings and seats. Typically some will say both and others will say only wings are necessary. Then ask what difference it makes whether the model is intended to train stewardesses in their jobs or to investigate its aerodynamics. They will quickly see that the right sort of model will reflect its intended use; abstracting from those aspects that are unimportant to the question at hand to better focus on the important considerations you want to investigate.


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• A useful illustration of how models come to be accepted in science is the replacement of the Ptolemaic geocentric model of the solar system (everything revolves around the earth) with the Copernican heliocentric model of the solar system (everything revolves around the sun). With the development of improving telescopes, more of the solar system could be seen. But as a result, it eventually became impossible to construct a geocentric model that was consistent with empirical observations, while those observations were consistent with a heliocentric model.

• The text’s emphasis on empirical testing of theories can be reinforced by getting students to see that a major part of economic research is the search to design tests that will discriminate among different hypotheses proposed to explain something. When something is consistent with multiple hypotheses, we don’t have much of an idea of what is going on, so that a test that distinguishes among hypotheses in that circumstance can be very valuable.

• I find rain dancing to be a good illustration of confusing correlation with causation. If a group of people decides that a deity that brings them rain needs its anger appeased by rain dancing at the beginning of the normal rainy season and they dance long enough, it will rain. It will not rain because they danced, but because the rainy season started. But once a belief in the necessity of rain dancing has begun, it can be very hard to change, because every time they dance (if they dance long enough), it rains.

• Weather can also be used to illustrate problems of establishing causation. Since heaters come on in the winter and air conditioners in the summer, one could conclude that heaters cause the house to be colder and air conditioners cause it to be hotter.

• Similarly, chill drafts can be blamed for catching a cold in the winter (because looking back, it’s easy to remember being exposed to some recent draft in the winter) even though the more scientific reason is that you are inside more, closely exposed to more of other people’s “bugs,” in the winter than in the summer.

• In addition to the illustrations of the fallacy of composition from the text, you could add leaving early to beat the traffic (similar to arriving early to beat the crowd) and cutting your price to take sales from rivals (which doesn’t work if all rivals lower their prices).

• The text emphasizes economics as a disciplined way of thinking, not as the source of clear-cut answers for every circumstance. It is worth emphasizing why the economic way of thinking points toward “it depends” as the first part of the answer to general questions (because the expected marginal benefits and expected marginal costs of choices depend on so many factors).


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If you wish to use the PowerPoint slides, use the Chapter Outline to plan your lecture. Chapter Outline PowerPoint Slides 3–4

S1 – Economics: A Brief Introduction

PowerPoint Slide 5 Economics: A Brief Introduction PowerPoint Slide 6 Scarcity and Unlimited Human Wants PowerPoint Slides 7–11 Scarcity and Limited Resources

A. Economics—A Word with Many Different Meanings

Economics is the study of the allocation of our limited resources to satisfy unlimited wants. Resources are inputs used to produce goods and services. Our wants exceed what our resources can produce. We call this fact scarcity. Scarcity forces us to decide how best to use our limited resources. The economic problem: Scarcity forces us to choose, and choices are costly because we must give up other opportunities that we value. The economic problem is evident in every aspect of our lives.

B. Scarcity and Unlimited Human Wants

Economics is concerned primarily with scarcity, how well we satisfy our unlimited wants in a world of limited resources. People are not able to fulfill all of their wants, both material and nonmaterial. As long as human wants exceed available resources, scarcity will exist.

C. Scarcity and Limited Resources

The scarce resources that are used in the production of goods and services can be grouped into four categories: labor, land, capital, and entrepreneurship. Labor is the total of both physical and mental effort expended by people in the production of goods and services. Land includes the natural resources used in the production of goods and services. Capital is the equipment and structures used to produce other goods. It also includes human capital, the productive knowledge and skills people receive from education and on-the-job training. Entrepreneurship is the process of combining labor, land, and capital to produce goods and services. Entrepreneurs make the tough and risky decisions about what and how to produce. Entrepreneurs are always looking for new ways to improve production techniques or to create new products, lured by the chance to make a profit. We are all entrepreneurs when we try new products or when we find better ways to manage our households or our study time.


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PowerPoint Slides 12–13 Goods and Services PowerPoint Slides 14–16 Does Everyone Face Scarcity? PowerPoint Slide 17 Will Scarcity Ever Be Eradicated? PowerPoint Slide 18

D. What Are Goods and Services?

Goods are those items that we value or desire. They can be tangible goods that are physical or intangible goods (such as friendship) that are not. Services are the intangible acts for which people are willing to pay. All goods and services, whether they are tangible or intangible, are produced from scarce resources and can be subjected to economic analysis. Scarce goods created from scarce resources are called economic goods. If there are not enough economic goods for all of us, we will have to compete for those scarce goods. That is, scarcity ultimately leads to competition for the available goods and services. We all want more tangible and intangible goods and services. In economics, we assume that more goods and services lead to greater satisfaction. In contrast to goods, bads are those items that we do not desire or want. The elimination or reduction of a bad is a good.

E. Does Everyone Face Scarcity?

We all face scarcity because we cannot have all of the goods and services that we desire. However, because we all have different wants and desires, scarcity affects everyone differently. Even the richest person must live with scarcity and must, at some point, choose one want or desire over another. As we get more affluent, we learn of new luxuries to provide us with satisfaction. Wealth creates a new set of wants to be satisfied. No evidence indicates that people would not find a valuable use for additional income, no matter how rich they become. Even the wealthy individual who decides to donate all of her money to charity faces the constraints of scarcity. If she had greater resources, she could do still more for others.

F. Will Scarcity Ever Be Eradicated?

Scarcity never has and never will be eradicated. The same creativity that permits new methods to produce goods and services in greater quantities also reveals new wants. New wants quickly replace old ones. Moreover, although people seem to be happier when they can buy more goods and services, it is likely that over a period of time a rising quantity of goods and services will not increase human happiness. It is very possible that our wants grow as fast, if not faster, than our ability to meet those wants, so we still feel scarcity as much or more than we did before.

Section Check 1

PowerPoint Slides 19–20

S2 – Economic Behavior

PowerPoint Slide 21 Self-Interest

A. Self-Interest


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PowerPoint Slides 22–23 Rational Behavior PowerPoint Slides 24–26 Incentives PowerPoint Slide 27 Incentives: Examples PowerPoint Slide 28

Economists assume that individuals act as if they are motivated by self-interest and respond in predictable ways to changing circumstances. Self-interest can include benevolence; it is not solely narrow monetary self-interest.

B. What Is Rational Behavior?

Economists believe that people, for the most part, engage in rational behavior. To an economist, rational behavior merely means that people do the best they can, based on their values and information, under current and anticipated future circumstances. It is even rational when people make choices they later regret, because they have limited information. Rational behavior applies to the actions people take to pursue their own goals—whatever those goals may be—and they need not be materialistic or widely shared. Rational behavior does not mean that people do not make mistakes, but it does mean that people learn from past mistakes and that their decisions in the future reflect that information.

C. People Respond to Changes in Incentives

In acting rationally, people are responding to incentives. That is, they react to changes in expected marginal benefits and expected marginal costs. In fact, much of human behavior can be explained and predicted as a response to incentives. Human behavior is shaped and influenced in predictable ways by changes in economic incentives, and economists use this information to predict what will happen when the benefits and costs of any choice are changed.

Section Check 2


S3 – Markets

PowerPoint Slide 31 Markets PowerPoint Slide 32 Markets: Allocating Scarce Resources

A market is the process of buyers and sellers exchanging goods and services. A. How Does the Market Work to Allocate Scarce Resources?

The market economy provides a way for millions of producers and consumers to allocate scarce resources. For the most part, markets are efficient. To an economist, efficiency is achieved when the economy gets the most out of its scarce resources. Competitive markets are powerful—buyers’ collective “voice” can make existing products better and/or less expensive, they can improve production processes, and they can create new products. Market prices serve as the language of the market system.

Markets may not always lead to your desired tastes and preferences. Markets do not come with a moral compass; they simply provide what buyers are willing and able to pay for and what sellers are willing and able to produce.


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PowerPoint Slides 33–34 Market Prices PowerPoint Slide 35 The Pencil: Example PowerPoint Slide 36 Countries that Do Not Rely on a Market System PowerPoint Slides 37–39 Market Failure PowerPoint Slides 40–41 Markets and Income Distribution PowerPoint Slides 42–43 The Circular Flow Model

B. Market Prices Provide Important Information

Market prices communicate important information to both consumers and suppliers. Prices communicate information about the relative availability of products to consumers, and they provide suppliers with critical information about the relative value that consumers place on those products.

The basis of a market economy is voluntary exchange and the price system that guides people’s choices and produces solutions to the questions of what goods to produce and how to produce and distribute them (example: a pencil).

C. Countries that Do Not Rely on a Market System

Countries that do not rely on the market system have no clear communication between buyers and sellers. The former Soviet Union, where quality was virtually nonexistent, experienced many shortages of quality goods and surpluses of low-quality goods.

D. Market Failure

The market mechanism is a simple but effective and efficient general means of allocating resources among alternative uses. But market failure can lead the economy to fail to allocate resources efficiently (examples: pollution and scientific research). When the economy produces too little or too much of something, the government can improve society’s well-being by intervening.

Sometimes a painful trade-off exists between how much an economy can produce efficiently and how that output is distributed—the degree of equality. An efficient market rewards those that produce goods and services that others are willing and able to buy. But this does not guarantee a “fair” or equal distribution of income.

E. The Circular Flow Model

A continuous flow of goods and services is bought and sold between the producers of goods and services, which we call firms, and households, the buyers of goods and services. A continuous flow of income also flows from firms to households as they buy their inputs to produce the goods and services they sell. These exchanges take place in product markets and factor markets.

F. Product Markets

Product markets are the markets for consumer goods and services. Households buy the goods and services that firms produce and sell. The payments for the purchases flow to the firms at the same time that goods and services flow to households.

G. Factor Markets

Factor or input markets are the markets where households sell their factors of production—capital, land, labor and entrepreneurship—to firms. Households receive money payments from firms as compensation.


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PowerPoint Slide 44 Exhibit 1.1 PowerPoint Slide 45 The Circular Flow Model: Example PowerPoint Slide 46

H. The Simple Circular Flow Model

Ex.1.1 – The Circular Flow Diagram

The simple circular flow model of income and output illustrates the continuous flow of goods and payments between firms and households, with the product market on the top half and the factor or input markets on the bottom half.

Section Check 3


S4 – Economic Theory

PowerPoint Slide 49 Economic Theories PowerPoint Slide 50 Abstraction PowerPoint Slide 51 Developing a Testable Proposition PowerPoint Slide 52 Empirical Analysis

A. Economic Theories

A theory is an established explanation that accounts for known facts or phenomena. Economic theories are statements or propositions about patterns of human behavior that are expected to take place under certain circumstances. Economic theories help us to sort out and understand the complexities of economic behavior. We expect a good theory to explain and predict well. A good economic theory, then, should help us to better understand and predict human economic behavior, using simplifying assumptions. Only testing these models reveals if those simplifying assumptions are justified.

B. Abstraction Is Important

Economic theories must abstract from many of the particular details of situations to better focus on the behavior to be explained (like a road map). An economic theory provides a broad view, not a detailed examination, of human economic behavior.

C. Developing a Testable Proposition

The beginning of any theory is a hypothesis, a testable proposition that makes some type of prediction about behavior in response to certain changes in conditions. In economic theory, a hypothesis is a testable prediction about how people will behave or react to a change in economic circumstances. (For example, if CD prices increase, we hypothesize that fewer CDs would be sold.) Once a hypothesis is stated, it is tested by comparing what it predicts will happen to what actually happens. Empirical analysis, the use of data to test hypotheses, is applied to determine whether or not a hypothesis fits well with the facts. Determining whether an economic hypothesis is acceptable is more difficult than is the case in the natural or physical sciences. The laboratory of economists is usually the real world. Unlike chemists, economists cannot easily control all the variables that might influence human behavior. If an economic hypothesis is supported by the data, it can then be tentatively accepted as an economic theory.


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PowerPoint Slide 53 The Ceteris Paribus Assumption PowerPoint Slide 54 Predicting on a Group Level PowerPoint Slides 55–56 Two Branches of Economics PowerPoint Slide 57

D. Science and Stories The facts of a complex world do not organize themselves. Understanding requires that a conceptual order be imposed on those facts to counteract the confusion that would otherwise result (e.g., to interpret a particular market behavior, economists must separate out other contributing factors). Without a story—a theory of causation—we cannot sort out and understand the complex reality that surrounds us.

E. The Ceteris Paribus Assumption

Virtually all theories in economics are expressed using a ceteris paribus (“let everything else be equal” or “holding everything else constant”) assumption. When economists try to assess the effect of one variable on another, they must keep their relationship isolated from other events that might also influence the situation that the theory tries to explain or predict. (For example, the theory that if I study harder, I will perform better on a test must hold other things constant.)

F. Why Do Economists Predict on a Group Level?

Observation and prediction are more difficult in the social sciences than in physical sciences. Human behavior is more variable and often less readily predictable than experiments in a laboratory. However, by looking at the actions of a large group of people, economists can still make many reliable predictions about human behavior. Economists’ predictions usually refer to the collective behavior of large groups rather than to that of specific individuals to discern general patterns of actions.

G. The Two Branches of Economics: Microeconomics and Macroeconomics

Conventionally, we distinguish between two main branches of economics—microeconomics and macroeconomics. Microeconomics deals with the smaller units within the economy, attempting to understand the decision-making behavior of firms and households and their interaction in markets for particular goods or services. Macroeconomics deals with the aggregate or total economy; it looks at economic problems as they influence the whole of society, including the topics of inflation, unemployment, business cycles, and economic growth.

Section Check 4


S5 – Pitfalls to Avoid in Scientific Thinking

PowerPoint Slide 60 Confusing Correlation and Causation

A. Confusing Correlation and Causation

Without a theory of causation, no scientist could sort out and understand the enormous complexity of the real world. But one must always be careful not to confuse correlation with causation. The fact that two sets of phenomena are correlated does not necessarily mean that one caused the other to occur.


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PowerPoint Slide 61 The Fallacy of Composition PowerPoint Slide 62

Variables may be correlated, without there being any causation between them. For instance, there may be another variable that is responsible for causing both events. (For example, warm weather may cause both higher crime and higher ice cream sales, but one of these does not cause the other.) We must always be careful not to confuse correlation with causation and to be clear on the direction of causation.

B. The Fallacy of Composition

Economic thinking requires us to be aware of the problems associated with aggregation, particularly the fallacy of composition. Even if something is true for an individual, it is not necessarily true in the aggregate. (For example, standing up at a football game to see better only works if others do not do the same thing.)

Section Check 5


S6 – Positive and Normative Economics

PowerPoint Slides 65–66 Positive and Normative Statements PowerPoint Slide 67 Disagreement Is Common in Most Disciplines

A. Positive Statement

In the role of scientist, an economist tries to objectively observe patterns of behavior without reference to the appropriateness or inappropriateness of that behavior. This objective, value-free approach, utilizing the scientific method, is called positive analysis. Positive statements deal with the impact of variable A on variable B. A positive statement does not have to be a true statement, but it does have to be a testable statement. A good economist/scientist strives to be as fair and objective as possible in evaluating evidence and in stating conclusions based on the evidence.

B. Normative Statement

Opinions expressed about the desirability of various actions are called normative statements. Normative statements involve judgments about what should be or what ought to happen. It is important to distinguish between positive and normative analysis because many controversies in economics revolve around policy considerations that contain both. Positive statements are attempts to describe what happens and why it happens, while normative statements are attempts to prescribe what should be done. However, our positive views of how the world works will impact our normative views of what should be done.

C. Disagreement Is Common in Most Disciplines

Disagreement is common in most disciplines. The majority of disagreements in economics stem from normative issues, as differences in values or policy beliefs result in conflict. (For example, tradeoffs exist between individual freedom and some views of fairness in evaluating government policies.)


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PowerPoint Slide 68 Economists Do Agree PowerPoint Slide 69

Most economists agree on a wide range of issues, including rent control, import tariffs, export restrictions, the use of wage and price controls to curb inflation, and the minimum wage.

Section Check 6

PowerPoint Slide 70

S7 – Why Study Economics?

PowerPoint Slide 71 Why Study Economics? PowerPoint Slide 72 Economics Is All Around Us

Among the best reasons to study economics is that so many of the things of concern in the world around us are at least partly economic in character. A student of economics becomes aware that, at a basic level, much of economic life involves choosing among alternative possible courses of action—making choices between our conflicting wants and desires in a world of scarcity. Economics provides some clues as to how to intelligently evaluate those options and determine the most appropriate choices in given situations. Economics helps develop a disciplined method of thinking about problems. It may not always give you clear-cut answers, but it gives you the economic way of thinking, which provides valuable problem-solving tools.

A. Economics Is All Around Us

Economists weigh added costs against added benefits. Economists cannot answer most questions in a general way because the answers depend on the circumstances. Economists can, however, pose the right kind of questions and provide criteria for evaluating the appropriateness of choices. Having some knowledge of the workings of market forces can help make more informed and appropriate decisions, including financial decisions. Economics won’t necessarily make you richer, but it may keep you from making some decisions that would make you poorer.

PowerPoint Slide 73 Appendix: Working with Graphs

PowerPoint Slide 74 Working with Graphs PowerPoint Slide 75 Exhibit 1.2 PowerPoint Slide 76 Types of Graphs PowerPoint Slides 77–80 Exhibit 1.3 PowerPoint Slide 81 Relationships between Two Variables

A. Graphs Are an Important Economic Tool

Graphs are important tools that allow economists to better understand the workings of the economy. Graphs are used throughout this text to enhance the understanding of important economic relationships. The most useful economics graph connects the Y-axis with the X-axis. Ex.1.2 – Plotting a Graph Four common types of graphs are pie charts, bar graphs, time-series graphs, and scatter diagrams. Ex.1.3 – Pie Chart, Bar Graph, Time-Series Graph, and Scatter Diagram

B. Using Graphs to Show the Relationship between Two Variables

A variable is something that is measured by a number. Relationships between two variables can be expressed in a simple two-dimensional graph.


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PowerPoint Slide 82 Exhibit 1.4 PowerPoint Slide 83 Exhibit 1.5 PowerPoint Slide 84 Relationships among Three Variables PowerPoint Slides 85–86 Exhibit 1.6 PowerPoint Slide 87 Shifts versus Movements PowerPoint Slide 88 Exhibit 1.7 PowerPoint Slides 89–90 Slope PowerPoint Slides 91–92 Exhibit 1.8

A positive relationship means that two variables move in the same direction. That is, an increase in one variable (practice time) is accompanied by an increase in another variable (overall score) or a decrease in one variable is accompanied by a decrease in another variable. Ex.1.4 – A Positive Relationship When two variables move in different directions, there is a negative relationship between the two variables. When one variable rises, the other variable falls.

C. The Graph of a Demand Curve

A downward-sloping line, the demand curve, shows the different combinations of price and quantity purchased. The higher you go up on the vertical (price) axis, the smaller the quantity purchased on the horizontal axis, and the lower you go down along the vertical (price) axis, the greater the quantity purchased. Ex.1.5 – A Negative Relationship

D. Using Graphs to Show the Relationship among Three Variables

Although only two variables are shown on the axes, graphs can be used to show the relationship between three variables. For example, a rise in income may increase the quantity of CDs (or DVDs) purchased at each possible price, which shifts the whole demand curve for CDs (or DVDs) outward to a new position. Ex.1.6 – Shifting a Curve It is important to remember the difference between a movement up and down along a curve and a shift in the whole curve. A change in one of the variables on the graph, like price or quantity purchased, will cause a movement along the curve. A change in one of the variables not shown, like income in our example, will cause the whole curve to shift. Ex.1.7 – Shifts versus Movements

E. Slope

The slope, or steepness, of curves can be either positive (upward-sloping) or negative (downward-sloping). A curve that is downward-sloping represents an inverse, or negative, relationship between the two variables; a curve that is upward-sloping represents a direct, or positive relationship between the two variables. Ex.1.8 – Downward- and Upward-Sloping Linear Curve


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PowerPoint Slide 93 Slope: Linear Curves PowerPoint Slide 94 Exhibit 1.9 PowerPoint Slide 95 Slope: Nonlinear Curves PowerPoint Slide 96 Exhibit 1.10

The slope of a linear curve between two points measures the relative rates of change of two variables. The slope of a linear curve can be defined as the ratio of the change in the Y value to the change in the X value, or the ratio of the rise to the run. Ex.1.9 – Slopes of Positive and Negative Curves Along a nonlinear curve, the slope varies from point to point. However, we can find the slope of such a curve at any point by finding the slope of the tangent to that curve at that point. Ex.1.10 – Slopes of a Nonlinear Curve

Remember that failure to understand graphs is one reason that many students have problems with economics.

Key Terms aggregate fallacy of composition normative statement bads goods positive statement capital human capital product markets causation hypothesis rational behavior ceteris paribus intangible goods resources correlation labor scarcity economic goods land services economics macroeconomics simple circular flow modelefficiency market tangible goods empirical analysis market failure the economic problem entrepreneurship microeconomics theory factor (or input) markets

Appendix Key Terms bar graph scatter diagram variable negative relationship slope X-axis pie chart time-series graph Y-axis positive relationship Key Formulas The Student Review Card Deck has a card devoted to the key economic formulas covered in this text. There are no key formulas in Chapter 1. You can use the following videos to supplement the discussion of topics discussed in this chapter. You can find them at www.cengagebrain.com. At the home page, search for the ISBN of your title (from the back cover of your book) using the search box at the top of the page. This will take you to the product page where the videos can be found.


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Videos ABC News Videos

1. The Unintended Consequences of Safety Precautions – Wearing a helmet when you ride a bicycle is the safe thing to do, right? As the video shows, the answer to this question isn't as straightforward as we may believe.

Ask the Instructor Videos 1. Why do economists talk about money? Do they really believe that people are

motivated only by money? – Economists talk a lot about money and wealth because data on these variables is readily available. Because of this, economists focus on income and wealth maximization when attempting to measure peoples' progress toward their assumed objective of maximizing well-being. But economists recognize that many things other than monetary incentives motivate people.

Graphing Workshops 1. Working with Graphs – This tutorial is about the basics of graphing. The

graphs we will be using involve two quantities, or variables. One of them is measured along the horizontal axis, also called the x-axis. This axis begins at the origin, which is marked zero.

You can use the Self-Review as a check of student learning. If students cannot answer questions for a section, plan to reteach that content. Chapter 1 – Self-Review: Questions and Answers You can find the following quiz on page 21 at the end of Chapter 1. Students can find answers to this quiz online at www.cengagebrain.com. S1–Economics: A Brief Introduction 1. What is the definition of economics?

Economics is the study of the choices we make among our many wants and desires given our limited resources.

2. Which of the following goods are scarce? a. garbage—not scarce (note that garbage is not a good, but a reduction in garbage

would be a good) b. salt water in the ocean—not scarce c. clothes—scarce d. clean air in a big city—scarce e. dirty air in a big city—not scarce f. a public library—scarce

S2–Economic Behavior 3. What does rational self-interest involve?

Economists consider individuals to be acting in their rational self-interest if they are striving to do their best to achieve their goals with their limited income, time, and


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knowledge, and given their expectations of the likely future consequences (both benefits and costs) of their behavior.

4. What is rational behavior? Rational behavior is when people do the best they can based on their values and information, under current and anticipated future consequences. Rational individuals weigh the benefits and costs of their actions and they only pursue actions if they perceive their benefits to be greater than the costs.

S3–Markets 5. What do market prices communicate to others in society?

The prices charged by suppliers communicate the relative availability of products to consumers; the prices consumers are willing to pay communicate the relative value consumers place on products to producers. That is, market prices provide a way for both consumers and suppliers to communicate about the relative value of resources.

6. Why does the circular flow of money move in the opposite direction from the flow of goods and services? The circular flow of money moves in the opposite direction from the flow of goods and services because the money flows are the payments made in exchange for the goods and services.

S4–Economic Theory 7. Why do economic predictions refer to the behavior of groups of people rather

than individuals? Economists’ predictions usually refer to the collective behavior of large groups rather than individuals because looking at the behaviors of a large group of individuals allows economists to discern general patterns of actions and therefore make more reliable generalizations.

8. Are the following topics ones that would be covered in microeconomics or macroeconomics? a. the effects of an increase in the supply of lumber on the home-building

industry—microeconomics b. changes in the national unemployment rate—macroeconomics c. changes in the inflation rate—macroeconomics d. changes in the country’s economic growth rate—macroeconomics e. the price of concert tickets—microeconomics

S5–Pitfalls to Avoid in Scientific Thinking 9. What types of misinterpretation result from confusing correlation and

causation? Confusing correlation between variables with causation can lead to misinterpretation in which a person “sees” causation between two variables or events where none exists or in which a third variable or event is responsible for causing both of them.

10. Do any of the following statements involve fallacies? If so, which ones? a. Because sitting in the back of the classroom is correlated with getting lower

grades in the class, students should always sit closer to the front of the classroom.—This involves confusing correlation with causation.


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b. Historically, the stock market rises in years the NFC team wins the Super Bowl and falls when the AFC wins the Super Bowl; I am rooting for the NFC team to win for the sake of my investment portfolio.—This involves confusing correlation with causation.

c. Gasoline prices were higher last year than in 1970, yet people purchased more gas, which contradicts the law of demand.—This is a violation of the ceteris paribus conditions.

S6–Positive and Normative Economics 11. Why is the positive/normative distinction important?

It is important to distinguish between positive and normative statements because many controversies in economics revolve around policy considerations that contain both. Deciding whether a policy is good requires both positive analysis (what will happen) and normative analysis (is what happens good or bad).

S7–Why Study Economics? 12. Why is economics worth studying?

Perhaps the best reason to study economics is that so many of the things that concern us are at least partly economic in character. Economics helps us to intelligently evaluate our options and determine the most appropriate choices in many given situations. It helps develop a disciplined method of thinking about problems.

You can use the following questions and exercises to work with students as part of your in-class discussion. You might also use them as an in-class quiz or give them to students as an independent homework assignment. Class Exercises

1. Write your own definition of economics. What are the main elements of the definition? Answer: The definition must recognize the central parts of the economist’s point of view: resources are scarce; scarcity forces us to make choices; and the cost of any choice is the highest valued of the lost opportunities.

2. Identify whether each of the following transactions takes place in the factor

market or the product market. a. Billy buys a sofa from Home Time Furniture for his new home. b. Home Time Furniture pays its manager her weekly salary. c. The manager buys dinner at Billy’s Café. d. After he pays all of his employees their wages and pays his other bills, the

owner of Billy’s Café takes his profit.


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Answers: a. Product market b. Factor market c. Product market d. Factor market Furniture is a good purchased in the product market from firms. Labor is a resource that households sell to firms in the factor market. Restaurant food is a good purchased by consumers in the product market. Finally, Billy’s entrepreneurial resource is paid a profit, which is the amount left over after all his other costs have been paid. This takes place in the factor market.

3. The Environmental Protection Agency asks you to help it understand the causes

of urban pollution. Air pollution problems are worse the higher the Air Quality Index. You develop the following two hypotheses. Hypothesis I: Air pollution will be a greater problem the higher the average temperature in the urban area. Hypothesis II: Air pollution will be a greater problem, the greater the population of the urban area.

Test each hypothesis with the facts given below. Which hypothesis fits the facts better? Have you developed a theory?

Metropolitan Statistical Area

Days with Polluted Air*

Average Maximum Temperature

Population (thousands)

Cincinnati, OH 30 64.0 1,979 El Paso, TX 13 77.1 680 Milwaukee, WI 12 55.9 1,690 Atlanta, GA 24 72.0 4,112 Philadelphia, PA 33 63.2 5,101 Albany, NY 8 57.6 876 San Diego, CA 20 70.8 2,814 Los Angeles, CA 80 70.6 9,519

*Air Quality Index greater than 100 (2002) Source: U.S. Dept. of Commerce, Bureau of Census, 2002 Statistical Abstract of the United States, Tables Nos. 30, and 363; U.S. EPA, Air Trends Report, 2002, EPA.Gov/airtrends/Factbook. Answer: The data support the second hypothesis better than the first. The number of days with polluted air generally increases with the population. The five cities with the most days “with polluted air” are large places. The first hypothesis does not seem to be supported by the data. El Paso, Texas, was the hottest place on our list and had relatively few polluted days. The causes of air pollution are complex and many things affect the level of


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pollution in a city. In our limited world of seven cities, the second hypothesis is supported by the facts, and we could make a theoretical statement that air pollution will increase in general as population increases.

4. In the 1940s, Dr. Melvin Page conducted a national campaign to stop people other

than infants from drinking milk. According to Page, milk was a dangerous food and a leading cause of cancer. He pointed to the fact that more people died of cancer in Wisconsin, the nation’s leading milk producer, than any other state as proof of his claim. How would you evaluate Dr. Page’s claim? Answer: This is a case of mistaking correlation for causation. People in Wisconsin tended to live long lives and since cancer is a disease of middle and old age, it was a more frequent cause of death in Wisconsin than in other states. An area low in cancer deaths is likely to be an area of poor health where inhabitants die young.

5. Are the following statements normative or positive, or do they contain both

normative and positive statements? a. A higher income-tax rate would generate increased tax revenues. Those extra

revenues should be used to give more government aid to the poor. b. The study of physics is more valuable than the study of sociology, but both

should be studied by all college students. c. An increase in the price of corn will decrease the amount of corn purchased.

However, it will increase the amount of wheat purchased. d. A decrease in the price of butter will increase the amount of butter purchased,

but that would be bad because it would increase Americans’ cholesterol levels. e. The birth rate is reduced as economies urbanize, but it also leads to a decreased

average age of developing countries’ populations. Answers: a. Both normative and positive statements. b. Normative statements. c. Positive statements. d. Both normative and positive statements. e. Positive statements.

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