Thomson Learning™ is a trademark used herein under license.Thomson Learning™ is a trademark used herein under license.
ALL RIGHTS RESERVED. Instructors of classes adopting ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICSEXPLORING ECONOMICS, , 3rd3rd eeditiondition by Robert L. Sexton as an assigned textbook may reproduce material from this by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents publication for classroom use or in a secure electronic network environment that prevents
downloading or reproducing the copyrighted material. Otherwise, no part of this work covered downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, by the copyright hereon may be reproduced or used in any form or by any means—graphic,
electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the distribution, information networks, or information storage and retrieval systems—without the
written permission of the publisher. written permission of the publisher. Printed in the United States of America Printed in the United States of America
ISBN ISBN 00303423330030342333
A Lecture PresentationA Lecture Presentation
The Economic WayThe Economic Wayof Thinkingof Thinking
Chapter 2Chapter 2
Economics is primarily concerned withEconomics is primarily concerned with scarcityscarcity–how well we satisfy our –how well we satisfy our unlimited wants in a world of limited unlimited wants in a world of limited resources. resources.
As long as human wants exceed As long as human wants exceed available resources, scarcity will exist.available resources, scarcity will exist.
2.1 Scarcity2.1 Scarcity
The scarce resources that are used in the The scarce resources that are used in the production of goods and services can production of goods and services can be grouped into four categories:be grouped into four categories: laborlabor landland capitalcapital entrepreneurshipentrepreneurship
LaborLabor is the total of both physical is the total of both physical and mental effort expended by and mental effort expended by people in the production of goods people in the production of goods and services.and services.
LandLand is the natural resources used in is the natural resources used in the production of goods and services.the production of goods and services.
CapitalCapital is the equipment and is the equipment and structures used to produce goods structures used to produce goods and services. Office buildings, tools, and services. Office buildings, tools, machines and factories are all machines and factories are all considered capital goods. considered capital goods.
Capital also includes Capital also includes human human capitalcapital, the productive knowledge , the productive knowledge and skill people receive from and skill people receive from education and on-the-job training.education and on-the-job training.
EntrepreneurshipEntrepreneurship is the process of is the process of combining the labor, land and capital combining the labor, land and capital together to produce goods and together to produce goods and services.services.
The entrepreneur is the one who The entrepreneur is the one who makes the tough and risky decisions makes the tough and risky decisions about what to produce and how to about what to produce and how to produce.produce.
Entrepreneurs are always looking for Entrepreneurs are always looking for new ways to improve production new ways to improve production techniques or to create new products. techniques or to create new products. They are driven by the lure of positive They are driven by the lure of positive incentives—profits.incentives—profits.
We are all entrepreneurs when we try We are all entrepreneurs when we try new products or when we find better new products or when we find better ways to manage our households or ways to manage our households or our study time.our study time.
GoodsGoods are those items that we value are those items that we value or desire. or desire.
They can be They can be tangible goodstangible goods that that can be held, heard, tasted or smelled can be held, heard, tasted or smelled or or intangible goodsintangible goods such as fairness such as fairness for all, friendship, knowledge, for all, friendship, knowledge, security, and health. security, and health.
ServicesServices are the intangible acts for are the intangible acts for which people are willing to pay such which people are willing to pay such as legal or medical services. as legal or medical services.
The scarce goods that are created The scarce goods that are created from scarce resources are called from scarce resources are called economic goodseconomic goods..
If there are not enough economic If there are not enough economic goods for all of us, we will have to goods for all of us, we will have to compete for those scarce goods. compete for those scarce goods.
Because we assume that people want more Because we assume that people want more goods, it does not mean that economics goods, it does not mean that economics also presumes that people are selfish and also presumes that people are selfish and greedy.greedy.
People are willing to give up their money People are willing to give up their money and time for what they believe to be and time for what they believe to be important causes, revealing that charitable important causes, revealing that charitable endeavors are desirable goods. endeavors are desirable goods.
Self-interestSelf-interest is not the same as is not the same as selfishnessselfishness or or greedgreed..
We all face scarcity, because we We all face scarcity, because we cannot have all of the goods and cannot have all of the goods and services that we desire. services that we desire.
However, because we all have However, because we all have different wants and desires, scarcity different wants and desires, scarcity affects everyone differently. affects everyone differently.
Even the richest person must live Even the richest person must live with scarcity and must, at some with scarcity and must, at some point, choose one want or desire point, choose one want or desire over another. over another.
As we get more affluent, we learn As we get more affluent, we learn of new luxuries to provide us with of new luxuries to provide us with satisfaction. satisfaction.
There is no evidence that people There is no evidence that people would not find a valuable use for would not find a valuable use for additional income, no matter how additional income, no matter how rich they become. rich they become.
Even the wealthy individual who Even the wealthy individual who decides to donate all of her money decides to donate all of her money to charity faces the constraints of to charity faces the constraints of scarcity.scarcity.
If she had greater resources, she If she had greater resources, she could do still more for others.could do still more for others.
Scarcity never has and never will Scarcity never has and never will be eradicated. be eradicated.
The same creativity that permits The same creativity that permits new methods to produce goods and new methods to produce goods and services in greater quantities also services in greater quantities also reveals new wants. reveals new wants.
It is very possible that our wants It is very possible that our wants
grow as fast, if not faster, than our grow as fast, if not faster, than our ability to meet those wants, so we ability to meet those wants, so we still feel scarcity as much or more still feel scarcity as much or more than we did before.than we did before.
2.2 Opportunity Cost2.2 Opportunity Cost If we had unlimited resources, and If we had unlimited resources, and
thus an ability to produce all of the thus an ability to produce all of the goods and services anyone wanted, goods and services anyone wanted, we would not have to choose among we would not have to choose among those wants.those wants.
We are all faced with the fact of We are all faced with the fact of scarcity, and as a consequence, we scarcity, and as a consequence, we must make choices. must make choices.
Because none of us can afford to buy Because none of us can afford to buy everything we want, each time we do everything we want, each time we do decide to buy one good or service, we decide to buy one good or service, we reduce our abilityreduce our ability to buy other things to buy other things we would also like to have.we would also like to have.
People must choose. People must choose. The cost of a choice is the values The cost of a choice is the values
that must be foregone. that must be foregone. The highest or best foregone The highest or best foregone
opportunity resulting from a opportunity resulting from a decision is called the decision is called the opportunity opportunity costcost..
““To choose is to lose.” To choose is to lose.” To get more of anything that is To get more of anything that is
desirable, you must accept less of desirable, you must accept less of something else that you also something else that you also value.value.
The opportunity cost of going to The opportunity cost of going to college must include the opportunity college must include the opportunity cost of your time. cost of your time.
The opportunity cost of rearing a child The opportunity cost of rearing a child includes the opportunity cost of the includes the opportunity cost of the time spent in child rearing, time that time spent in child rearing, time that could be used pursuing a career or could be used pursuing a career or volunteering at a local mission. volunteering at a local mission.
““There's no such thing as a free There's no such thing as a free lunchlunch.”.”
A lunch may be free to you, but it is A lunch may be free to you, but it is not free from society's perspective.not free from society's perspective.
Some of society's scarce resources Some of society's scarce resources that could have been used to that could have been used to produce something else of value will produce something else of value will have been used in the preparation of have been used in the preparation of the lunch. the lunch.
2.3 Marginal Thinking2.3 Marginal Thinking Most choices involve how much of Most choices involve how much of
something to do rather than whether something to do rather than whether or not to do something.or not to do something.
Economists emphasize Economists emphasize marginal marginal thinkingthinking because the focus is on because the focus is on additional, or marginal, choices.additional, or marginal, choices.
Marginal choices involve the effects Marginal choices involve the effects of adding or subtracting from the of adding or subtracting from the current situation.current situation.
Watch out for the difference between Watch out for the difference between average and marginal costs.average and marginal costs.
Suppose an airline had 10 unoccupied Suppose an airline had 10 unoccupied seats on a flight from LA to New York seats on a flight from LA to New York and the average cost was $400 per and the average cost was $400 per seat ($100,000/250). If there are 10 seat ($100,000/250). If there are 10 people on standby each willing to pay people on standby each willing to pay $300, should the airline sell them the $300, should the airline sell them the tickets? tickets?
Another good example of marginal Another good example of marginal thinking is auctions.thinking is auctions.
Prices are bid up marginally as the Prices are bid up marginally as the auctioneer calls out one price after auctioneer calls out one price after another. When a bidder views the another. When a bidder views the new price (the marginal cost) to be new price (the marginal cost) to be greater than the value she places greater than the value she places on the good (the marginal benefit) on the good (the marginal benefit) she withdraws from further bidding.she withdraws from further bidding.
The The rule of rational choicerule of rational choice is is that that individuals will only pursue an individuals will only pursue an activity if expected marginal benefits activity if expected marginal benefits are greater than expected marginal are greater than expected marginal costs [or costs [or E(MB)E(MB) > > E(MC)E(MC)].].
NetNet benefitsbenefits—the difference —the difference between the expected marginal between the expected marginal benefits and the expected benefits and the expected marginal costsmarginal costs
We can use the concept of marginal We can use the concept of marginal thinking to evaluate pollution levels. thinking to evaluate pollution levels.
We have to weigh the expected marginal We have to weigh the expected marginal benefits of a cleaner environment against benefits of a cleaner environment against the expected marginalthe expected marginal costs of a cleaner costs of a cleaner environment. environment.
Zero pollution levels would be far too Zero pollution levels would be far too costly in terms of what we would have to costly in terms of what we would have to give up.give up.
Just as we can have optimal (or best) Just as we can have optimal (or best) levels of pollution that are greater levels of pollution that are greater than zero, the same marginal than zero, the same marginal thinking can be used to analyze thinking can be used to analyze crime and safety issues. crime and safety issues.
The result will not be either no crime The result will not be either no crime or perfectly safe products.or perfectly safe products.
The issue is not safe products The issue is not safe products versus unsafe products but versus unsafe products but how how muchmuch safety do we want. It is not safety do we want. It is not risk versus no risk but rather risk versus no risk but rather how how muchmuch risk do we want. risk do we want.
Additional safety comes at a higher Additional safety comes at a higher cost.cost.
2.4 Incentives Matter2.4 Incentives Matter In acting rationally, people are In acting rationally, people are
responding to incentives. responding to incentives. That is, they react to changes in That is, they react to changes in
expected marginal benefits and expected marginal benefits and expected marginal costs. expected marginal costs.
In fact, much of human behavior can In fact, much of human behavior can be explained and predicted as a be explained and predicted as a response to incentives.response to incentives.
For most policy purposes, the primary For most policy purposes, the primary concern is what causes the level of some concern is what causes the level of some activity to change. activity to change.
If the benefits of some activity, like If the benefits of some activity, like crime, rise and/or if the costs fall, crime, rise and/or if the costs fall, economists expect the amount of that economists expect the amount of that activity to rise. activity to rise.
Likewise, if the benefits of some activity Likewise, if the benefits of some activity fall and/or if the costs rise, economists fall and/or if the costs rise, economists expect the amount of that activity to fall.expect the amount of that activity to fall.
Positive incentivesPositive incentives are those that are those that either increase benefits or reduce either increase benefits or reduce costs and thus result in an increased costs and thus result in an increased level of the related activity or level of the related activity or behavior.behavior.
Negative incentivesNegative incentives, on the other , on the other hand, either reduce benefits or hand, either reduce benefits or increase costs, resulting in a increase costs, resulting in a decreased level of the related activity decreased level of the related activity or behavior.or behavior.
Human behavior is influenced in Human behavior is influenced in predictable ways by changes in predictable ways by changes in economic incentives.economic incentives.
Economists use this information to Economists use this information to predict what will happen when the predict what will happen when the benefits and costs of any choice are benefits and costs of any choice are changed.changed.
Would birth rates fall if the income-Would birth rates fall if the income-tax deduction for dependents was tax deduction for dependents was removed?removed?
Would a death sentence for drug Would a death sentence for drug traffickers reduce drug trafficking?traffickers reduce drug trafficking?
Would stricter penalties deter Would stricter penalties deter cheating?cheating?
Would stricter drunk driving laws Would stricter drunk driving laws reduce drunk driving?reduce drunk driving?
Incentives examplesIncentives examples
2.5 Specialization and Trade 2.5 Specialization and Trade
People are People are specializingspecializing when they when they concentrate their energies on only concentrate their energies on only one or a few activities. one or a few activities.
This allows them to make the best This allows them to make the best use of (and thus gain the most use of (and thus gain the most benefit from) their limited resources. benefit from) their limited resources.
If a person, a region, or a country If a person, a region, or a country can produce a good or service at a can produce a good or service at a lower opportunity cost than others, lower opportunity cost than others, we say that they have a we say that they have a comparative advantagecomparative advantage in the in the production of that good or service. production of that good or service.
They can gain by specializing in the They can gain by specializing in the production of the good in which they production of the good in which they have a comparative advantage.have a comparative advantage.
We all specialize to some extent We all specialize to some extent and rely on others to produce most and rely on others to produce most of the goods and services we want. of the goods and services we want.
The income earned for that work The income earned for that work can then be used to buy goods and can then be used to buy goods and services from others who specialize services from others who specialize in the production of those goods in the production of those goods and services. and services.
The primary advantages of The primary advantages of specialization are that employees specialization are that employees acquire greater skill from repetition.acquire greater skill from repetition.
They avoid wasted time in shifting They avoid wasted time in shifting from one task to another.from one task to another.
They do the types of work for which They do the types of work for which they are best suited.they are best suited.
Trade, or voluntary trade, directly Trade, or voluntary trade, directly increases wealth by making both parties increases wealth by making both parties better off (or they wouldn't trade). better off (or they wouldn't trade).
It is the prospect of wealth—increasing It is the prospect of wealth—increasing exchange that leads to productive exchange that leads to productive specialization. specialization.
Trade increases wealth by allowing Trade increases wealth by allowing a person, a region, or a nation to a person, a region, or a nation to specialize in those products that it specialize in those products that it produces better and to trade for the produces better and to trade for the products that others produce better.products that others produce better.
For example, the United States is For example, the United States is better at producing wheat while Brazil better at producing wheat while Brazil is better at producing coffee. is better at producing coffee.
The U.S. and Brazil trade these goods The U.S. and Brazil trade these goods with each other.with each other.
Imagine Tom had 10 pounds of tea Imagine Tom had 10 pounds of tea and Katherine had 10 pounds of and Katherine had 10 pounds of coffee. However, Tom preferred coffee. However, Tom preferred coffee to tea and Katherine coffee to tea and Katherine preferred tea to coffee. Could both preferred tea to coffee. Could both parties be made better off through parties be made better off through trade?trade?
If Tom traded his tea to Katherine If Tom traded his tea to Katherine
for coffee, both parties would be for coffee, both parties would be better off. Trade simply better off. Trade simply reallocates goods and the reallocates goods and the voluntary exchange increases voluntary exchange increases wealth by making both parties wealth by making both parties better off.better off.
2.6 Market Prices Coordinate 2.6 Market Prices Coordinate Economic Activity Economic Activity In a market economy, private In a market economy, private
individuals and firms own most of the individuals and firms own most of the resources.resources.
Property rightsProperty rights are the rules of our are the rules of our economic game. If well defined, economic game. If well defined, property rights give individuals the property rights give individuals the incentive to use their property incentive to use their property efficiently.efficiently.
The basis of a market economy is The basis of a market economy is voluntary exchange and the price voluntary exchange and the price system that guides people's choices system that guides people's choices and produces solutions to the and produces solutions to the questions of what goods to produce questions of what goods to produce and how to produce those goods and and how to produce those goods and distribute them.distribute them.
The market system provides a way for The market system provides a way for suppliers and consumers to allocate suppliers and consumers to allocate scarce resources through their actions scarce resources through their actions and inactions in the marketplace.and inactions in the marketplace.
Buyers and sellers indicate their Buyers and sellers indicate their wants through their actions and wants through their actions and inactions in the marketplace, and it is inactions in the marketplace, and it is this collective “voice” that determines this collective “voice” that determines how resources are allocated.how resources are allocated.
Market prices serve as the language of Market prices serve as the language of the market system and communicate the market system and communicate crucial information to both consumers crucial information to both consumers and suppliers. and suppliers.
These prices communicate information These prices communicate information about the relative availability of about the relative availability of products to consumers, and they products to consumers, and they provide suppliers with critical provide suppliers with critical information about the relative value that information about the relative value that consumers place on those products. consumers place on those products.
The Pencil The Pencil Where did the producer find the wood? Where did the producer find the wood?
graphite? eraser? paint? glue? and the metal graphite? eraser? paint? glue? and the metal piece that holds the eraser? Who knows?piece that holds the eraser? Who knows?
The point is that market forces coordinate The point is that market forces coordinate this production activity among thousand of this production activity among thousand of people from different countries speaking people from different countries speaking different languages to make a pencil. Why? different languages to make a pencil. Why? The market economy has provided the The market economy has provided the incentive for people to pursue activities that incentive for people to pursue activities that benefit others through the price system.benefit others through the price system.
Government Government price controlsprice controls sometimes sometimes force prices above or below what they force prices above or below what they would be in a market economy, short-would be in a market economy, short-circuiting the market's information circuiting the market's information transmission function. transmission function.
They effectively strip the market price They effectively strip the market price of its meaning for both consumers and of its meaning for both consumers and suppliers (examples: agricultural price suppliers (examples: agricultural price supports and the minimum wage).supports and the minimum wage).
The market mechanism is a simple The market mechanism is a simple but effective and efficient general but effective and efficient general means of allocating resources among means of allocating resources among alternative uses.alternative uses.
But But market failuremarket failure can lead the can lead the economy to fail to allocate resources economy to fail to allocate resources efficiently. efficiently.
Examples of market failure include Examples of market failure include pollution and scientific research. pollution and scientific research.
When the economy produces too When the economy produces too little or too much of something, the little or too much of something, the government can improve society's government can improve society's well-being by intervening. well-being by intervening.
Sometimes the market economy does not Sometimes the market economy does not always communicate accurately. always communicate accurately.
Some firms may have market power to Some firms may have market power to distort prices and without adequate distort prices and without adequate information, unscrupulous producers may information, unscrupulous producers may be able to misrepresent products to the be able to misrepresent products to the disadvantage of the unwary. disadvantage of the unwary.
These situations may also lead to These situations may also lead to government intervention.government intervention.
There is sometimes a painful tradeoff There is sometimes a painful tradeoff between how much an economy can between how much an economy can produce efficiently and how that output produce efficiently and how that output is distributed–the degree of equality.is distributed–the degree of equality.
There is no guarantee that the market There is no guarantee that the market economy will provide everyone with economy will provide everyone with adequate amounts of food, shelter and adequate amounts of food, shelter and health care. health care.
That is, not only does the market That is, not only does the market determine what goods are going to be determine what goods are going to be produced, and in what quantities, but it produced, and in what quantities, but it also determines the distribution of also determines the distribution of output among members of society. output among members of society.
This equity argument can generate This equity argument can generate some sharp disagreements, as what is some sharp disagreements, as what is “fair” for one person may seem highly “fair” for one person may seem highly “unfair” to someone else.“unfair” to someone else.
