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Instructor’s Resource Manual Mark Rush, University of Florida

Microeconomics 14e

Michael Parkin

Table of Contents

Preface Perspective Flexibility  Part 1 Chapter 1 Chapter 2  Part 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7  Part 3 Chapter 8 Chapter 9  Part 4 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15  Part 5 Chapter 16 Chapter 17  Part 6 Chapter 18 Chapter 19 Chapter 20

MyLab Economics How to Assemble Your Course

v vii ix

Introduction What is Economics? The Economic Problem

1 9

How Markets Work Demand and Supply Elasticity Efficiency and Equity Government Actions in Markets Global Markets in Action

21 35 45 57 69

Households’ Choice Utility and Demand Possibilities, Preferences, and Choices

81 93

Firms and Markets Organizing Production Output and Costs Perfect Competition Monopoly Monopolistic Competition Oligopoly

103 113 125 137 151 159

Market Failure and Government Public Choices, Public Goods, and Healthcare Externalities

169 179

Factor Markets, Inequality, and Uncertainty Markets for Factors of Production Economic Inequality Uncertainty and Information

189 203 213

P e r s p e c t i v e

MYLAB ECONOMICS

It’s About Time What if you could spend less time grading, and more time teaching? And what if, at the same time, you could strengthen the incentives for your students to do their homework and come to class better prepared? With MyLab Economics, what sounds like a free lunch is now an achievable goal! MyLab Economics is a turn-key, online solution for your economics course. Using a new and powerful graphing tool and question bank, students can self-test and generate a study plan, and instructors can assign homework and capture grades. With a tight, everything-in-one-place organization around the new testing tool, questions include true-false, multiple choice, fill-ins, numerical, and complete the graph. Many of the questions are generated algorithmically, a feature that rewards understanding and penalizes rote learning. Practice tests for each section of the textbook enable students to test their ability and identify the areas in which they need further work. Based on a student’s performance on a practice test, a personalized study plan shows where further study is needed. Once students have received their study plan, additional practice exercises, keyed to the textbook, provide extensive practice and link directly to the eText with animated graphs, an electronic tutorial, and other resources. Users of MyLab Economics will revel in the powerful graphing tool integrated into both the practice tests and practice exercises. This tool enables students to manipulate graphs and see how the concepts, numbers, and graphs are connected. Questions that use the graphing tool (like all other questions) can be submitted and graded online. MyLab Economics saves your students time because it identifies what they have not yet mastered and creates a Personalized Study Plan. This study plan consists of a series of additional practice exercises. Using tutorial instruction launched directly from practice exercises, students can follow step-by-step solutions and tutorials that promote self-discovery. With an abundant collection of interactive resources, students will come to class better prepared. MyLab Economics saves instructors time in answering questions, tracking performance, and giving practice tests. Instructors can customize the practice tests or leave students to use the supplied pre-built tests. Additional MyLab Economics tools include:  eText 

Animated figures

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Electronic tutorials

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Glossary

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Glossary Flashcards

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Office Hours

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Daily Economics in the News updates and archives

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Links to the most useful economic data and information sources on the Internet

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Research Navigator—extensive help on the research process and four exclusive databases of credible and reliable source material including the New York Times, the Financial Times, and peer-reviewed journals © 2023 Pearson Education, Inc.

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MYLAB ECONOMICS

Registration for MyLab Economics To learn more, and to register for MyLab Economics, please go to www.myconlab.com and click on the link to request an access code. Your Pearson sales representative will then be in touch to help you get started.

Flexibility

HOW TO ASSEMBLE YOUR COURSE

Introduction Instructors who have already used Michael Parkin’s Microeconomics are aware of its flexibility: There are many ways to teach from this book, depending on your preferences. Because there is no necessarily right or wrong way to teach a principles of microeconomics class, the microeconomic part of the book can be used in a variety of ways. The most obvious one is the order in which the chapters are printed. Other paths are illustrated in Table 1.

Microeconomics Table 1 presents the flexibility in the microeconomic chapters. This is organized according to the three basic foundation chapters followed by a large selection of chapters you can next tackle. After finishing some or all of these chapters, more choices are presented. You can move quickly or slowly to the examining production and firms; quickly or slowly to efficiency and government policy in markets; quickly or slowly to consumer choice. The choice is up to you because you can shape the course you want to teach.

HOW TO ASSEMBLE YOUR COURSE

Table 1

C h a p t e r

WHAT IS ECONOMICS?

The Big Picture Where we are going: After completing Chapter 1, the student will have a good sense for the range of questions that economics addresses and will be on the path towards an economic way of thinking. The students will begin to think of cost as a forgone alternative—an opportunity cost—and also about making choices by balancing marginal costs and marginal benefits. Chapter 2 reinforces the central themes of Chapter 1 by laying out a core economic model, the production possibilities frontier (PPF), and using it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 also provides a deeper explanation, again with a model, of the concepts of marginal cost and marginal benefit, beginning with the concept of efficiency, and concluding with a review of the source of the gains from specialization and exchange.

New in the Fourteenth Edition When discussing the social interest and four major issues, the issue of financial instability has been replaced with a discussion of social interest issues surrounding the COVID pandemic. The emphasis in this discussion is that often self-interested decisions are not in the social interest (for example, whether to socially distance) so that rules governing behavior may need to be established. The last topic, dealing with Economists in the Economy, now includes a section covering the diversity challenge in economics. It points out that fewer women and minorities receive bachelor’s PhD degrees in economics than in STEM majors in general. It also discusses efforts being made to overcome this lack of diversity. The Economics in the News presenting Mark Zuckerberg’s vision to have the Internet available to the whole world has been eliminated to make room for the coverage of diversity in the profession. This important chapter is not one to gloss over as it lays down an important foundation that can be drawn from as you move through more specific applications later. Students relate well to the section on self and social interest which calls out issues of both efficiency and fairness and is great for class discussion.

CHAPTER 1

Lecture Notes

What Is Economics? I.

Definition of Economics  

Economic questions arise because we always want more than we can get, so we face scarcity, the inability to satisfy all our wants. Everyone faces scarcity because no one can satisfy all of his or her wants. Scarcity forces us to make choices over the available alternative. The choices we make depend on incentives, a reward that encourages a choice or a penalty that discourages a choice.

Forbes lists Bill Gates and Warren Buffet among some of the wealthiest Americans. Do these two men face scarcity? According to The Wall Street Journal, both men are ardent bridge players, yet they have never won one of the many national bridge tournaments they have entered as a team. These two men can easily afford the best bridge coaches in the world and but other duties keep them from practicing as much as they would need to in order to win. So even the wealthiest two Americans face scarcity (of time) and must choose how to spend their time. Economics  Economics is the social science that studies the choices that individuals, businesses, governments and entire societies make when they cope with scarcity and the incentives that influence and reconcile those choices.  Economists work to understand when the pursuit of self-interest advances the social interest  Economics is divided into microeconomics and macroeconomics:  Microeconomics is the study of the choices that individuals and businesses make, the way these choices interact in markets, and the influence of governments.  Macroeconomics is the study of the performance of the national economy and the global economy. On the first day do a “pop quiz.” Have your students write on paper the answer to “What is Economics?” Reassure them that this is their opinion since it is the first day. You will find most of the answers focused around money and/or business. Stress that Economics is a social science, a study of human behavior given the scarcity problem. All too often first-time students (especially business students) think that Economics is just about making money. Certainly, the discipline can and does outline reasons why workers work longer hours to increase their wage earnings, or why firms seek profit as their incentive. But Economics also explains why a terminally ill cancer patient might opt for pain medication as opposed to continued chemotherapy/radiation, or why someone no longer in the workforce wants to go to college and attain a Bachelor’s degree, in their sheer pleasure of learning and understanding. Stressing the social part of our science now will help later when relating details to the overall bigger picture (especially when time later in the semester seems scarce, no pun intended!). The definition in the text: “Economics is the social science that studies the choices that individuals, businesses, governments, and societies make as they cope with scarcity and the incentives that influence and reconcile these choices,” is a modern language version of Lionel Robbins famous definition, “Economics is the science which studies human behavior as a relationship between ends and scarce means that have alternative uses.” Other definitions include those of Keynes and Marshall: John Maynard Keynes: “The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps it possessors to draw correct conclusions.” Alfred Marshall: “Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.” A “shorthand” definition that resonates with students is: “Economics is the study of trying to satisfy unlimited wants with limited resources.” Students can—and do—easily abbreviate this definition to “unlimited wants and limited resources,” which captures an essential economic insight.

WHAT IS ECONOMICS?

II. Two Big Economic Questions How do choices wind up determining what, how, and for whom goods and services are produced? What, How and For Whom?  Goods and services are the objects that people value and produce to satisfy human wants. What we produce changes over time—today we produce more streaming music than 5 years ago.  Goods and services are produced using the productive resources called factors of production. These are land (the “gifts of nature”, natural resources), labor (the work time and work effort people devote to production), capital (the tools, instruments, machines, buildings, and other constructions now used to produce goods and services), and entrepreneurship (the human resource that organizes labor, land, and capital).  The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, work experience, and on-the-job training.  Owners of the factors of production earn income by selling the services of their factors. Land earns rent, labor earns wages, capital earns interest, and entrepreneurship earns profit. Do Choices Made in the Pursuit of Self-Interest also promote the social interest?  You make a choice in your self-interest if you think that choice is the best one available for you.  An outcome is in the social interest if it is best for society as a whole.  A major question economists explore is “Could it be possible that when each of us makes choices in our selfinterest, these choices are in the social interest?’ Students (and others!) often take the answers to the what, how, and for whom questions for granted. For instance, most of the time we do not bother to wonder “How does our economy determine how many light bulbs, automobiles, and pizzas to produce?” (what), or “Why does harvesting wheat from a plot of land in India occur with hundreds of laborers toiling with oxen pulling threshing machines, while in the United States, a single farmer streaming music and sitting in an air-conditioned cab of a $500,000 machine harvests the same quantity of wheat from the same sized plot of land?” (how), or “Why is the annual income of an inspiring and effective grade school teacher much less than that of an average major-league baseball player?” (for whom). Explaining the answers to these types of questions and determining whether the answers are in the social interest is a major part of microeconomics. Figure 1.1 in the textbook “What Three Countries Produce” ties in nicely with Chapter 2’s later discussion on the PPF. Figure 1.1 also links the three questions of what, how and for whom nicely to the component parts of those questions: goods and services, factors of production (land, labor, capital, entrepreneurship), and incomes economic agents earn (rent, wages, interest and profit). 

We can examine whether the self-interested choices serve the social interest for a variety topics:  Globalization: Buying an iPod allows workers overseas to earn a wage and provide for family  Information-Age Monopolies: A firm producing popular software leads to format standards  Climate Change: Carbon dioxide emissions led to higher global temperatures and climate change  The Covid pandemic: Covid-19 spreads through social contact, so a person who socially isolates avoids infection and avoids infecting others, but people may not choose the optimal degree of isolation

III. Economic Way of Thinking Scarcity requires choices and choices create tradeoffs. What is the difference between scarcity and poverty? Ask the students why they haven’t yet attained all of their personal goals. One reason will be that they lack sufficient money. Ask them if they could attain all of their goals if they were as rich as Bill Gates. They quickly realize that time is a big constraint—and the great leveler: we all have only 24 hours in a day. They have stumbled on the fact that scarcity, which even Bill Gates faces, is not poverty. © 2023 Pearson Education, Inc.

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A Choice is a Tradeoff  A tradeoff is an exchange—giving up one thing to get another.  Whatever choice you make, you could have chosen something else. Virtually every choice that can be thought of involves a tradeoff. Presenting a few of the following as examples can help your class better appreciate this key point:  Consumption and savings: If someone decides to save more of his or her income, savings can be funneled through the financial system to finance businesses new capital purchases. As a society, we trade off current consumption for economic growth and higher future consumption.  Education and training: A student remaining in school for another two years to complete a degree will need to forgo a significant amount of leisure time. But by doing so, he or she will be better educated and will be more productive. As a society, we trade off current production for greater future production.  Research and development: Factory automation brings greater productivity in the future, but means smaller current production. As a society, we trade off current production for greater future production. Making a Rational Choice  A rational choice is one that compares costs and benefits and achieves the greatest benefit over cost for the person making the choice.  But how do people choose rationally? Why do more people choose to stream movies rather than buy blurays? Why has the U.S. government chosen to build an interstate highway system and not an interstate highspeed railroad system? The answers turn on comparing benefits and costs. Benefit: What you Gain  The benefit of something is the gain or pleasure that it brings and is determined by preferences—by what a person likes and dislikes and the intensity of those feelings.  Some benefits are large and easy to identify, such as the benefit that you get from being in school. Much of that benefit is the additional goods and services that you will be able to enjoy with the boost to your earning power when you graduate.  Some benefits are small, such as the benefit you get from a slice of pizza. That benefit is just the pleasure and nutrition that you get from your pizza. Cost: What You Must Give Up Seeing choices as tradeoffs shows there is an opportunity cost of a choice. The opportunity cost of something is the highest-valued alternative that must be given up to get it. So, for instance, the opportunity cost of being in school is all the good things that you can’t afford and don’t have the spare time to enjoy. What is the Opportunity Cost of Getting a College Degree? When the students calculate their opportunity cost of being in school, be sure they place a value on their leisure time lost to studying on weekends and evenings. Most students are shaken when they realize that when lost leisure time and income is included in their calculations, the opportunity cost of a college degree approaches $200,000 or more. Don’t leave them hanging here though. Mention that a college education does yield a high rate of financial return over. To ensure that people do not die of any serious side effects, the Food and Drug Administration (FDA) requires all drug companies to thoroughly test newly developed medicines before allowing them to be sold in the United States. However, it takes many years to perform these tests and many people suffering from the terminal diseases these new medicines are designed to cure will die before good new medicines are eventually approved for use. Yet, if the FDA were to abandon this testing process, many others would die from the serious side effects of those bad medicines that made it to market. People’s lives will be at risk under either policy alternative. This stark example of a tradeoff reveals the idea that choices have opportunity costs.

WHAT IS ECONOMICS?

How Much? Choosing at the Margin  Making choices at the margin means looking at the trade-offs that arise from making small changes in an activity. People make choices at the margin by comparing the benefit from a small change in an activity (which is the marginal benefit) to the cost of making a small change in an activity (which is the marginal cost).  Changes in marginal benefits and marginal costs alter the incentives that we face when making choices. When incentives change, people’s decisions change.  For example, if homework assignments are weighed more heavily in a class’s final grade, the marginal benefit of completing homework assignments has increased and more students will do the homework. Choices Respond to Incentives  Economists take human nature as given and view people acting in their self-interest.  Self-interest actions are not necessarily selfish actions.

IV. Economics as Social Science and Policy Tool Economist as Social Scientist  Economists distinguish between positive statements and normative statements. A positive statement is about “what is” and is testable. A normative statement is about “what ought to be” and is an opinion and so is inherently not testable. A positive statement is “Raising the tax on a gallon of gasoline will raise the price of gasoline and lead more people to buy smaller cars” while a normative statement is “The tax on a gallon of gasoline should be raised.”  Economists tend to agree on positive statements, though they might disagree on normative statements.  An economic model describes some aspect of the economic world that includes only those features needed for the purpose at hand. Economic models describe the economic world in the same way that a road map explains the road system: Both focus on only what is important and both are abstract depictions of the real world.  Testing an economic model can be difficult, given we observe the outcomes of the simultaneous operation of many factors. So, economists use the following to copy with the problem:  Natural experiment: A situation that arises in the ordinary course of economic life in which the one factor of interest is different and other things are equal or similar.  Statistical Investigation: A statistical investigation might look for the correlation of two variables, to see if there is some tendency for the two variables to move in a predictable and related way (e.g. cigarette smoking and lung cancer).  Economic Experiment: Putting people in a decision-making situation and varying the influence of one factor at a time to see how they respond. Economist as Policy Adviser  Economics is useful. It is a toolkit for advising governments and businesses and for making personal decisions.  For a given goal, economics provides a method of evaluating alternative solutions— comparing marginal benefits and marginal costs and finding the solution that makes the best use of the available resources. The success of a model is judged by its ability to predict. Help your student’s appreciate that no matter how appealing or “realistic looking” a model appears to be, it is useless if it fails to predict. And the converse, no matter how abstract or far removed from reality a model appears to be, if it predicts well, it is valuable. Milton Friedman’s Pool Hall example illustrates the point nicely. Imagine a physicist’s model that predicts where a carefully placed shot of a pool shark would go as he tries to sink the eight ball into the corner pocket. The model would be a complex, trigonometric equation involving a plethora of Greek symbols that no ordinary person would even recognize as representing a pool shot. It certainly wouldn’t depict what we actually see—a pool stick striking a pool cue on a rectangular patch of green felt. It wouldn’t even reflect the thought processes of the pool shark that relies on years of experience and the right “touch.” Yet, constructed correctly, this mathematical model would predict

CHAPTER 1

exactly where the cue ball would strike the eight ball, hit opposite the bank, and fall into the corner pocket. (You can easily invent analogous examples from any sport.)

V. Economists in the Economy Jobs for an Economics Major  Economists work for private firms, governments, and international organizations. Some have a bachelor’s degree, while others have a master’s degree or a PhD.  On their jobs, economists often collect and analyze data on production and use of resources, goods, and services in order to predict future trends or devise ways to use resources more efficiently.  Economists have jobs as market research analysts, financial analysts, and, less often, budget analysts. There were about 1,300,000 of these jobs in the United States in 2020. Will Jobs for Economics Majors Grow?  The Bureau of Labor Statistics (BLS) forecasts that from 20194 to 2029, jobs for PhD economists will grow 14 percent; jobs for budget analysts will grow by only 3 percent; but jobs for financial analysts will grow by 5 percent; and jobs for market research analysts will grow by 18 percent. Earnings of Economics Majors  The Web resource payscale.com reports the earnings of economics majors range between $48,000 to $133,000 with a median of $108,000.  Pay in analyst jobs is lower, with an average of $65,800 for market research analysts and $83,700 for financial research analysts. Skills Needed for Economics Jobs  Five skills are needed for an economics related job:  Critical-Thinking Skills: The ability to clarify and solve problems using logic and relevant evidence.  Analytical Skills: The use of economic ideas and tools to examine data, notice patterns, and reach a logical conclusion.  Math Skills: The ability to use mathematical and statistical tools to analyze data and reach valid conclusions.  Writing Skills: The ability to present ideas, conclusions, and reasons in succinct written reports appropriate for the target audience.  Oral Communication Skills: The ability to explain ideas, conclusions, and reasons to people with a limited background in economics. A Diversity Challenge in the Economics Profession  Minorities and women are under-represented in the economics profession.  The American Economic Association has introduced prizes and grants to give minorities and women more incentive to pursue economics as a career.

WHAT IS ECONOMICS?

Additional Problems 1.

You plan a major adventure trip for the summer. You won’t be able to take your usual summer job that pays $6,000, and you won’t be able to live at home for free. The cost of your travel accomodations on the trip will be $3,000, gasoline will cost you $200, and your food will cost $1,400. What is the opportunity cost of taking this trip?

The university has built a new parking garage. There is always an available parking spot, but it costs $1 per day. Before the new garage was built, it usually took 15 minutes of cruising to find a parking space. Compare the opportunity cost of parking in the new garage with that in the old parking lot. Which is less costly and by how much?

Solutions to Additional Problems 1.

The opportunity cost of taking this trip is $10,600. The opportunity cost of taking the trip is the highestvalued activity that you will give up so that you can go on the trip. In taking the trip, you will forgo all the goods and services that you could have bought with the income from your summer job ($6,000) plus the expenditure on travel accommodations ($3,000), gasoline ($200), and food ($1,400). The opportunity cost of parking before the building of the new parking garage is the highest-valued activity that you forgo by spending 15 minutes parking your car. The opportunity cost of parking in the new parking garage is $1 that you could have spent elsewhere. If the opportunity cost of 15 minutes spent parking your car is greater than the opportunity cost of $1, then the new parking garage is less costly.

Additional Discussion Questions 1.

Why are economists so concerned about the material aspects of life? Explain that this is a myth! Economists are often criticized for focusing on material well-being because of the general public’s view that economics is about money. Explain that there are economists that research social and emotional (or spiritual) aspects of life. You may also add that these parts of life often depend heavily on attaining material well-being. You may want to reference the Economic Freedom Index (www.freetheworld.com) and its explanatory power on issues of world hunger and poverty. Ask them to consider the need for life-enhancing goods and services such as health care or education to support spiritual or emotional well-being. Ask how protestors would be able to voice their opinions without low-cost air travel and the power of the Internet to coordinate the activities of hundreds of protesters. (Be careful not to seem to be either condoning or condemning these activities.) Most students will begin to see that the more efficient we are at producing material prosperity, the more time and opportunity everyone has to promote emotional (or spiritual) goals.

CHAPTER 1

Chapter 1 Appendix, Graphs in Economics Lecture Notes Goggle Theory Explain to students that you are going to ask them to use three sets of goggles to view math in the course. I have found this to be a great tool for students to understand why we present data in different ways. 1. Equation Goggles: Write an equation in slope-intercept form and explain that this is one way to show relationships between two variables. I like to use X and Y for this one and then quickly explain that economics is much more fun than math because we may be talking about X-rays and Yo-Yo’s. This helps some students break the barrier early on what “variable” means. 2. Graphing Goggles: Work through a graph of the equation you wrote highlighting slope and intercept. Indicate that this may be a Demand or Supply curve for instance. 3. Now you can explain that they will see all three of these forms of math at different times during the course and it is important for them to understand that you can move between all three anytime. We usually have it shown just one way for convenience. It is also fun during lecture to say, “I need you to pull out your graphing goggles.”

Graphing Data   

Graphs are valuable tools that clarify what otherwise might be obscure relationships. Graphs represent “quantity” as a distance. Two-variable graphs use two perpendicular scale lines. The vertical line is the y-axis. The horizontal line is the x-axis. The zero point in common to both axes is the origin. Scatter diagram—a graph that plots the value of one variable on the x-axis and the value of the associated variable on the y-axis. A scatter diagram can make clear the relationship between two variables.

II. Graphs Used in Economic Models 

Graphs are used to show the relationship between variables. Graphs can immediately convey the relationship between the variables:  A positive relationship (or direct relationship)—when the variable on the x-axis increases the variable on the y-axis increases. A straight line is a linear relationship.  A negative relationship (or inverse relationship)—when the variable on the x-axis increases, the variable on the y-axis decreases.  A maximum or a minimum—when the variable has a highest or lowest value.

III. The Slope of a Relationship 

  

The slope of a curve equals the change in the value of the variable on the vertical axis at the point where the slope is being calculated divided by the change in the value of the variable on the horizontal axis at the relevant point.  In terms of symbols, the slope equals y/x, with  standing for “change in.” The slope of a straight line is constant. The slope is positive if the variables are positively related and negative if the variables are negatively related. The slope of a curved line at a point equals the slope of the straight line that is tangent to the curved line at the point. The slope of a curved line across an arc equals the slope of a straight line between the two points on the curved line.

IV. Graphing Relationships Among More Than Two Variables 

When a relationship involves more than two variables, we can plot the relationship between two of the variables by holding other variables constant.

C h a p t e r

THE ECONOMIC PROBLEM

The Big Picture Where we have been: Chapter 1 introduced the economic reality that wants exceed the resources available to satisfy them— we face scarcity. Chapter 2 reinforces these central themes by laying out the core economic model, the Production Possibilities Frontier, or PPF, and uses it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 further details the concepts of marginal cost and marginal benefit, presenting a first look at the concept of efficiency. The second half of the chapter begins with a model of exchange between two people that shows the “win-win” situation created through specialization and free trade. The next sections show how those individual gains scale up to economy wide gains. Lastly the traditional circular flow model highlights transformation of resources into final goods and services along with the money used in those markets Where we are going: The key concept of opportunity cost and the widespread tendency for the opportunity cost of a good to increase as the quantity produced of that good increases returns in Chapter 3 when we explain the supply curve. For Micro classes, we see it again in Chapters 10 and 11 when we study a firm’s costs and cost curves. Preferences return and are treated more rigorously when we explain marginal utility theory in Chapter 8 and indifference curves in Chapter 9. Efficiency returns in Chapter 5 when we study the efficiency of markets and first preview the impediments to efficiency. The gains from trade are explored more completely in the context of international trade in Chapter 7 in Microeconomics and Chapter 15 of Macroeconomics. Finally, the role of markets and prices in allocating resources and coordinating activity is an ongoing theme throughout most of the rest of the text. The next task, in Chapter 3, is to develop the central demand and supply model.

New in the Fourteenth Edition In Chapter 2 the introduction includes some teaser comments about Covid-19 and how it led to empty airports and how vaccines brought recovery. Related, the “Economics in the News” has a new article on “Production Possibilities in and after Covid-19” and uses the PPF to analyze issues surrounding government infrastructure expenditure.

CHAPTER 2

Lecture Notes

The Economic Problem   

Scarcity creates the need to make choices. Economic choices can be evaluated in terms of their efficiency. We can expand possible choices through capital accumulation and specialization and trade.

Production Possibilities and Opportunity Cost  The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot given available resources and technology.  Consider the production choices for two goods: books and movies. The table with the data for the PPF is below and a figure showing the PPF is to the right. A B C D   

Books 0 200 400 600

Movies 600 500 300 0

Production points beyond the PPF are not attainable without increases in resources or technology (these factors shift the PPF); Production points on and within the PPF are attainable, but production points within the PPF, such as point Z, are inefficient. It is possible to get more of one good without giving up any of the other. The PPF illustrates how scarcity creates the need to make choices. Producing more books (moving from point A to point B) means producing fewer movies, and producing more movies (moving from point C to point B) means producing fewer books.

Using the PPF above, make a point outside the PPF and ask the students about it. Once they state it is not possible, ask them how we could get there. After they highlight a few shifters, summarize for them that the resources and technology we held constant when we drew the PPF now relocate it when they change. Now give them an example of a new movie camera invention and ask them if this will help us get more books? You will likely get an immediate round of “NO.” Reply, “Are you sure?” and you should be able to find a student who sees that the new resource frees up other resources that can now be used for more books. Show them graphically a shift that is pinned at the book axis and it will open their eyes to how technology and resource growth in any sector can make more of all goods! Production Efficiency Production is efficient only on the frontier.  We achieve production efficiency if we cannot produce more of one good without producing less of some other good.  Inside the frontier (point Z), production is inefficient. Resources could be better employed to increase production of both books and movies. Tradeoff Along the PPF  Moving along the PPF, there is always a tradeoff involved in diverting resources from the production of one thing to another. We gain one thing but at the opportunity cost of losing something else. The key here is to make sure the student understands that given scarcity, because we produce one thing, we cannot produce something else. Some students will see the tradeoff immediately as a cost (giving up something), but they will incorrectly interpret that cost as only that valued in money units. To eliminate this ambiguity (better now than © 2023 Pearson Education, Inc.

THE ECONOMIC PROBLEM

later), ask them to think about a meal they purchased recently. Now ask them what the money cost was as well as what else they might have picked for a meal? Most students pick up on this concept quickly with one or two more examples. And since this is a consumption example, tell them to put themselves in the place of an office manager, who must produce a service but can do so only given tradeoffs. While money costs are measurable and useful, propose to the students that opportunity costs are indeed even more useful in identifying the tradeoffs made in production. Opportunity Cost  The opportunity cost of an action is the highest valued alternative forgone.  Opportunity cost is a ratio; it is the cost of an additional unit of a good measured in terms of what was given up to obtain that additional unit. The formula to calculate opportunity cost is decrease in the quantity produced of one good divided by the increase in the quantity produced of a another good.  Efficiency means that the opportunity cost of producing more books or movies is the tradeoff along the frontier. Increasing Opportunity Cost  The “bowed-out” shape of the PPF reflects the principle of increasing opportunity cost.  Not all resources are the same, which is why the PPF bows out. Publishers are better at producing books and Hollywood studios are better at producing movies. Moving along the frontier and producing more movies inevitably means that more and more publishers must produce movies. As this happens, the increase in movies becomes smaller and the decrease in books becomes larger.  Emphasize the intercepts where the PPF crosses the axes. Take the vertical intercept in the figure. At this point all resources are used to produce movies. Basically, to get to that point the economy has crammed and slammed every resource into movie production. Now when the economy moves down the PPF to produce the first book, that book is really inexpensive—has very low opportunity cost—because the economy uses resources better suited for book production first rather than movies.  As more resources are diverted from production of one good to another, the smaller the additional increase in the production of the one good will be and the larger the decrease in the production of the other good. You can bring in the relationship of slope and opportunity cost here if you want. OPTION 1: A soft way to bring in slope is to offer it as a double check on calculating marginal cost: “The opportunity cost of whatever is being measured on the horizontal axis is equal to the magnitude of the slope of the PPF.” OPTION 2: You can also introduce the slope of a curve as the slope of a tangent line to the curve, that is, the slope of the line that is “just kissing” the curve at a single point. The bowed-out shape is a key feature of typical PPFs, often overlooked by the student (and too often not accentuated by the instructor). The key here is to link the ever increasing opportunity cost exhibited by the shape of a bowed out PPF with that of the marginal cost curve, which is upward sloping. Simply stated, some resources are better suited for the production of one good or the other. To make the PPF model useful, it was necessary to simplify. By considering the case where production of all goods other than two remain fixed, we can use a relatively simple picture to see how concepts apply to the real world. With three goods, we would have a 3-D frontier surface. With more than 3 goods, it would be impossible to represent the frontier using a graph. The cool thing is that all relevant results of the 2-D model are true in the N-good model.

CHAPTER 2

II. Using Resources Efficiently Which point on the PPF best serves the public interest? To answer this question, we must measure and compare costs and benefits of different points.

The PPF and Marginal Cost  

Marginal cost is the opportunity cost of producing one more unit of a good. As more books are produced, the marginal cost of a book increases. The table shows the marginal cost of producing books from the PPF data presented before and the figure shows the upward sloping marginal cost curve.

Books 0

200

400

600

Marginal cost of a book (movies per book) 0.5 1.0 1.5

Preferences and Marginal Benefit  Preferences are a description of a person’s likes and dislikes.  The marginal benefit of a good or services is the benefit received from consuming one more unit of it.  The principle of decreasing marginal benefits is why the marginal benefit curve in the figure above slopes downward. You might have some students that have had a microeconomics course in their past, and have already been introduced to the concept of marginal cost and marginal benefit. And, they might inquire if the marginal benefit curve is linked to the Law of Diminishing Marginal Utility. While this might be adequate discussion for an advanced undergraduate course, and certainly a graduate micro seminar, pass it up in your principles course. Let the student know that the goal is to employ demand side concepts, in a marginal sense. As such, key in on the fact that the marginal benefit curve can be characterized as a willingness to pay curve. Keep the discussion of marginal cost and marginal benefit separate and distinct, making sure that the student realizes these are in essence the foundation of market forces (supply and demand, respectively). While the PPF can tell us the opportunity costs in production, and the tradeoffs therein, it is the market that allows us to determine the allocatively efficient point. Allocative efficiency only occurs with a balance between benefits and costs, at the margin. Allocative Efficiency Allocative efficiency occurs only when marginal benefit equals marginal cost.  In the figure, when 100 books per month are produced, the marginal benefit from another book exceeds its marginal cost, which means that people prefer another book more than the movies they must give up.  When the allocatively efficient number of books, 200 per month, is produced, the PPF in the previous figure shows that the allocatively efficient number of movies is 500 movies per month.  When marginal cost equals marginal benefit it is impossible to make people better off by reallocating resources.

THE ECONOMIC PROBLEM

III. Gains from Trade Specialization and trade expand consumption possibilities Comparative Advantage and Absolute Advantage  A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else.  The PPF shows opportunity cost. In the figure the opportunity cost of a bushel of wheat in Canada is 1/4 of a computer and in Japan it is 1 computer. In Canada the opportunity cost of a computer is 4 bushels of wheat and in Japan it is 1 bushel of wheat. Canada has a comparative advantage in producing wheat and Japan has a comparative advantage in producing computers.  A person has an absolute advantage if that person is more productive than others in that activity or activities. A person (or country) can have an absolute advantage in all activities but that person (or country) will not have a comparative advantage in all activities. An easy way for students to remember the difference between comparative and absolute advantages is that with comparative advantage, the opportunity costs comparison matters. If one has a comparative advantage in producing something, they should specialize in production of that good or service. An absolute advantage can be characterized by being able to “absolutely out-produce” the other economic agent. Even though a country might have absolute advantages, it should not produce everything, and should focus on identifying its comparative advantages. Achieving the Gains from Trade  When countries specialize by producing the good in which each country has a comparative advantage more goods in total can be produced. If without trade Canada and Japan each produce at point A, a total of 8 computers and 16 bushels of wheat are produced. If they specialize according to comparative advantage, Japan produces at point B* and Canada produces at point B for a combined total of 12 computers and 24 bushels of wheat. 

Trade allows consumption to be different than production for each nation, so Canada can trade wheat for computers and Japan can trade computers for wheat. Because more computers and more wheat are produced, both nations can consume more than they can produce on their own. For example, suppose that the market price of wheat is ½ computer per 1 bushel of wheat. As illustrated, each country can now be consuming at point C along the trade line. Note that each country’s consumption point lies beyond its own PPF.



The gains from trade can now be easily seen in terms of Japan and Canada each gaining 2 computers and 4 bushels of wheat compared to their initial, no-trade consumption points. Note that it is more likely that point C for each country will be on a different point on the trade line according to preferences. In the end, the sum of consumption among the two countries must equal the sum of production (imports=exports). For simplicity, this example has points A and C equal for both countries.

CHAPTER 2

To show the gains from trade you can use candy or any kind of small trinkets. Make sure that each person initially gets Then: 1. Create several countries with approximately even student populations. Give each country at least 3 or 4 items such as different types of candy. You can have some fun and add in a few entertaining items. For example: a can of spam, sticks of beef jerky, bubbles, etc. 2. Students record individual happiness value from 1-10 on initial allocation (I use an Excel spreadsheet to easily aggregate data at the end but keeping track on paper is fine). 3. Allow the countries to trade with each other 4. Have the students record their new happiness level after trade. 5. Compare the “happiness” level after trade with that before trade. Here are the key points that come from the experiment:  Both parties become better off when they engage in voluntary trade.  Even without production, trade creates value. IV. Economic Growth Economic growth expands production possibilities and shifts the PPF outward.  Technological change (the development of new goods and of better ways of producing goods and services) and capital accumulation (the growth of capital resources, which includes human capital) lead to economic growth. You can have some fun and generate some discussion by getting the students to think about what life might be like after another 200 years of economic growth. Provide some numbers: In 2017, income per person in the United States was about $133 a day. In 1808 it was about 70¢ a day, and if the past growth rate prevails for another 200 years, in 2208 it will be $14,000 a day. Emphasize the magic of compound growth. If they think that $14,000 a day is a big income, get them to do a ballpark estimate of the daily income of Bill Gates (about $10 million!). Encourage a discussion of why scarcity is still present even at these large incomes. The Cost of Economic Growth  Economic growth requires that resources must be devoted to developing technology or accumulating capital, which means that current consumption decreases. The decrease in current consumption is the opportunity cost of economic growth. A Nation’s Economic Growth  Countries that devote a higher share of resources to developing technology or accumulating capital are more likely to grow faster.  Some nations, such as Hong Kong, have chosen faster capital accumulation at the expense of current consumption and so have experienced faster economic growth. Running through the above example can really help students catch on to how economic growth is linked to choices (less consumption now for more later). You may wish to demonstrate more consumption or more capital biased shifts of the PPF, to demonstrate changes in opportunity costs. Changes in What We Produce  In a low-income country, just producing enough food is a high priority, and the marginal benefit from food is high. So, in Ethiopia, agriculture accounts for a large 35 percent of total production.  In China, where production per person is 7 times that of Ethiopia, agriculture shrinks to 8 percent of total production and industry expands to 41 percent.  Further investment in capital and in advanced robot technologies expand production possibilities to the level in the United States, which today is 4 times (per person) its level in China.

THE ECONOMIC PROBLEM

V. Economic Coordination Firms and Markets  A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services.  A market is any arrangement that enables buyers and sellers to get information and to do business with each other. Property Rights and Money  The social arrangements that govern the ownership, use, and disposal of resources, goods, and services are called property rights. Types of property include real (buildings and land), financial (stocks and bonds) and intellectual (ideas and technology).  Money is anything generally accepted as a means of payment. Money’s main purpose is to facilitate trade. Students are usually fixated on money, but ask them to dig deeper. It is what we can do or buy with money that brings us happiness not the actual bills themselves. Our focus on money creates a “veil” that hides the real economic engine of capitalism. Circular Flows Through Markets  Firms and households interact in markets and it is this interaction that determines what will be produced, how it will be produced, and who will get it. Coordinating Decisions  Prices within markets coordinate firms’ and households’ decisions. Everyone knows what prices are. But not everyone knows why prices rise or fall. The point is that no one needs to know why a price has changed when making the choice to buy or sell. All that someone needs to know is what the price is relative to what he or she believes the item to be worth. 

Enforced property rights ensure that exchange is voluntary (not theft). Property rights and prices help insure that production takes place efficiently without waste because the owner of a firm has the property right to any profit the firm can earn.

Willingness to pay affects production and production affects willingness to pay. It would appear that we have the classic “which came first, the chicken or the egg” conundrum. However, in the next chapter, we will discuss the most powerful model in economics, Demand and Supply, which allows us to think clearly about the behavior of markets.

CHAPTER 2

Additional Problems 1.

Jane’s Island’s production possibilities are given in the table to the right. a. Draw a graph of the production possibility possibilities frontier on Jane’s Island. b. What are Jane’s opportunity costs of producing corn and cloth at each output in the table?

In problem 1, Jane is willing to give up 0.75 pounds of corn per yard of cloth if she has 2 yards of cloth; 0.50 pounds of corn per yard of cloth if she has 4 yards of cloth; and 0.25 pound of corn per yard of cloth if she has 6 yards of cloth. a. Draw a graph of Jane’s marginal benefit from corn. b. What is Jane’s efficient quantity of corn?

Joe’s production possibilities are given in the table to the right. What are Joe’s opportunity costs of producing corn and cloth at each output in the table?

In problems 1 and 2, Jane’s Island produces and consumes 2 pounds of corn and 2 yards of cloth. Joe’s Island produces and consumes 2 pounds of corn and 2 yard of cloth. Now the islands begin to trade. a. What good does Jane sell to Joe and what good does Jane buy from Joe? b. If Jane and Joe divide the total output of corn and cloth equally, what are the gains from trade?

Corn (pounds per month) 3.0 2.0 1.0 0

Corn (pounds per month) 6 4 2 0

Cloth (yards per month) and and and and

0 2 4 6

and and and and

Cloth (yards per month) 0 1.0 2.0 3.0

Solutions to Additional Problems 1.

Jane’s Island’s PPF is a straight line. To make a graph of Jane’s Island’s PPF measure the quantity of one good on the x-axis and the quantity of the other good on the yaxis. Plot the quantities in each row of the table. Figure 2.1 illustrates Jane’s Island’s PPF. The opportunity cost of 1 pound of corn is 2 yards of cloth. The opportunity cost of the first pound of corn is 2 yards of cloth. To find the opportunity cost of the first pound of corn, increase the quantity of corn from 0 pounds to 1 pound. In doing so, Jane’s Island’s production of cloth decreases from 6 yards to 4 yards. The opportunity cost of the first pound of corn is 2 yards of cloth. Similarly, the opportunity costs of producing the second pound and the third pound of corn are 2 yards of cloth. The opportunity cost of 1 yard of cloth is 0.5 pound of corn. The opportunity cost of producing the first 2 yards of cloth is 1 pound of corn. To calculate this opportunity cost, increase the quantity of cloth from 0 yards to 2 yards. Jane’s Island’s production of corn decreases from 3 pounds to 2 pounds. Similarly, the opportunity cost of producing the second 2 yards and the third 2 yards of cloth are 1 pound of corn.