C h a p t e r

1 WHAT IS
ECONOMICS?

Key Concepts ♦ Capital: the tools, instruments, machines, build-

ings, and other constructions that businesses now
use to produce goods and services.
„ Definition of Economics ♦ Entrepreneurship: the human resource that or-
ganizes land, labor, and capital.
The fundamental economic problem is scarcity, which
is the inability to satisfy all our wants. Because the The third question is “For whom are goods and services
available resources are never enough to satisfy every- produced?” To earn an income, people sell the services
one’s wants, choices are necessary. of the factors of production they own. Land earns rent;
labor earns wages; capital earns interest; and entrepre-
Economics is the social science that studies the choices
neurship earns profit.
people, businesses, governments, and societies make as
they cope with scarcity.
♦ Microeconomics is the study of choices that indi- „ Three Big Macroeconomic Questions
viduals and businesses make, the way these choices Macroeconomics explores three big questions.
interact, and the influences that governments exert The first question is “What determines the standard of
on these choices. living?”
♦ Macroeconomics is the study of the effects on the ♦ The standard of living is the level of consumption
national economy and the global economy of the that people enjoy, on the average, and is measured
choices that individuals, businesses, and govern- by average income per person.
ments make.
The second question is “What determines the cost of
living?”
„ Three Big Microeconomic Questions ♦ The cost of living is the amount of money it takes
Microeconomics explores three big questions. to buy the goods and services that a typical family
consumes. A rising cost of living is called inflation
The first question is “What goods and services are pro-
and a falling cost of living is called deflation.
duced and in what quantities?” Goods and services are
the objects that people value and produce to satisfy The third question is “Why does our economy fluctuate?”
wants. The United States produces more services than ♦ The periodic but irregular up-and-down movement
goods. in production and jobs is called the business cycle.
The second question is “How are goods and services
produced?” The resources that businesses use to pro- „ The Economic Way of Thinking
duce goods and services are called factors of produc- A choice involves a tradeoff, that is, something is given
tion. There are four categories: up to get something else. Microeconomic tradeoffs in-
♦ Land: the “gifts of nature” such as land, minerals, clude the “what” tradeoffs, the “how” tradeoffs, and the
and water. “who” tradeoffs.
♦ Labor: the work time and work effort people de- ♦ The big tradeoff is the tradeoff between equality
vote to producing goods and services. and efficiency that occurs as a result of government
programs redistributing income.
1
2 CHAPTER 1

Macroeconomic tradeoffs include the standard of living things being equal”, to focus on the effect of one par-
tradeoff. ticular factor.
♦ The output-inflation tradeoff occurs because gov- In the development of theories and models, two falla-
ernment policy actions to lower inflation also lower cies are possible:
output and policy actions that boost output in- ♦ Fallacy of composition — the assertion that what is
crease inflation. true for a part must be true for the whole, or what
The opportunity cost of a choice is the highest-valued is true for the whole must be true for each of the
alternative foregone. Opportunity cost is not all the parts.
alternatives foregone, only the highest-valued alterna- ♦ Post hoc fallacy — the assertion that one event
tive foregone. All tradeoffs involve an opportunity cost. caused another because the first occurred before the
Choices are made in small steps, which means choices second.
are made at the margin.
♦ The benefit that arises from an increase in an activ-
ity is called marginal benefit. Helpful Hints
♦ The cost of an increase in an activity is called mar-
ginal cost. 1. CHOICES AND INCENTIVES : The basic assumption
When making choices, people compare the marginal made by economists about human behavior is that
cost of an action to the marginal benefit of the action. people try to make themselves as well off as possi-
Changes in marginal cost and/or marginal benefit affect ble. As a result, people respond to changed incen-
the decisions made. So choices respond to incentives, tives by changing their decisions. The key idea is
which are inducements to take a particular action. that an individual compares the additional (or
“marginal”) benefit from taking an action to the
additional (or “marginal”) cost of the action. If the
„ Economics: A Social Science marginal benefit from the action exceeds the mar-
Economists distinguish between: ginal cost, taking the action makes the person bet-
ter off, so the person takes the action. Conversely, if
♦ Positive statements — statements about what is. the marginal benefit falls short of the marginal cost,
These can be shown to be true or false through the action is not taken. Only the additional benefit
observation and measurement. and additional cost are relevant because they are the
♦ Normative statements — statements about what benefits and costs that the person will enjoy and in-
ought to be. These are matters of opinion. cur if the action is undertaken. Keeping straight the
Economic science is a collection of positive statements distinction between additional benefits and costs
that are consistent with the real world. Economic sci- versus total benefits and costs is a vital part of eco-
ence uses three steps to progress: nomics, particularly of microeconomics.
♦ Observation and measurement — economists ob- 2. MODELS AND SIMPLIFICATION : In attempting to
serve and record economic data. understand how and why something works (for ex-
♦ Model building — an economic model is a de- ample, an airplane or an economy), we can use de-
scription of some aspect of the economic world that scription or we can use theory. A description is a
includes only those features of the world that are list of facts about something. But it does not tell us
needed for the purpose at hand. which facts are essential for understanding how an
airplane works (the shape of the wings) and which
♦ Testing — a model is tested to determine how well
facts are less important (the color of the paint). Sci-
its predictions correspond with the real world. An
entists use theory to abstract from the complex de-
economic theory is a generalization that summa-
scriptive facts of the real world and focus only on
rizes what we think we understand about economic
those elements essential for understanding. These
choices that people make and the performance of
essential elements are fashioned into models —
industries and entire economies.
highly simplified representations of the real world.
When developing models and theories, economists use
In a real sense, models are like maps, which are
the idea of ceteris paribus, which is Latin for “other
useful precisely because they abstract from real
WHAT IS ECONOMICS? 3

world detail. A map that reproduced all the details Economics: A Social Science
of the real world (street lights, traffic signs, electric 13. A positive statement is about what is; a normative
wires) would be useless. A useful map offers a sim- statement is about what will be.
plified view, which is carefully selected according to
the purpose of the map. A useful theory is similar: 14. The idea of ceteris paribus is used whenever a post
It gives guidance and insight into how the im- hoc fallacy is being examined.
mensely complicated real world functions and re-
acts to changes.
„ Multiple Choice
Definition of Economics
Questions 11. The fact that wants cannot be fully satisfied with
available resources reflects the definition of
„ True/False and Explain a. the standard of living.
Definition of Economics b. scarcity.
c. the output-inflation tradeoff.
11. Scarcity is a problem only for the poor.
d. for whom to produce.
12. Macroeconomics studies the factors that change
national employment and income. 12. Studying the effects choices have on the national
economy is part of
Three Big Microeconomic Questions
a. scarcity.
13. Answering the question “What goods and services b. microeconomics.
are produced?” automatically answers the question, c. macroeconomics.
“How are goods and services produced?” d. global science.
14. An example of the “how” question is: “How does
the nation decide who gets the goods and services Three Big Microeconomic Questions
that are produced?” 13. Which of the following is NOT one of the three big
microeconomic questions?
Three Big Macroeconomic Questions
a. What goods and services are produced?
15. “For whom are goods and services produced?” is b. How are goods and services produced?
one of the big macroeconomic questions. c. For whom are goods and services produced?
16. A rising cost of living is called inflation. d. Why are goods and services produced?
17. In a business cycle, an expansion follows the peak. 14. The question, “Should personal computers or
The Economic Way of Thinking mainframe computers be produced?” is an example
of the
18. Tradeoffs mean that you give up one thing to get
something else. a. “what” question.
b. “how” question.
19. There is no such thing as a “how” tradeoff because c. “where” question.
a business uses only way to produce its products. d. “who” question.
10. The output-inflation tradeoff refers to the point
15. People have different amounts of income. This ob-
that lowering inflation increases output.
servation is most directly related to which of the big
11. The opportunity cost of buying a slice of pizza for microeconomic questions?
$3 rather than a burrito for $3 is the burrito. a. The “what” question.
12. By comparing the cost and benefit of a small b. The “how” question.
change you are making your choice at the margin. c. The “why” question.
d. The “who” question.
4 CHAPTER 1

Three Big Macroeconomic Questions 12. When the government chooses to use resources to
16. Of the following, which country or region has the build a dam, these resources are no longer available
highest standard of living? to build a highway. This choice illustrates the con-
a. Japan cept of
b. Central and Eastern Europe a. a market.
c. The United States b. macroeconomics.
d. Africa c. opportunity cost.
d. marginal benefit.
17. During an inflation, the cost of living is ____ and
the value of the dollar is ____. 13. To make a choice on the margin, an individual
a. rising; rising a. ignores any opportunity cost if the marginal
b. rising; falling benefit from the action is high enough.
c. falling; rising b. will choose to use his or her scarce resources only
d. falling; falling if there is a very large total benefit from so doing.
c. compares the marginal cost of the choice to the
18. Which of the following is the correct order for the marginal benefit.
parts of a business cycle? d. makes the choice with the smallest opportunity
a. expansion, trough, recession, peak cost.
b. expansion, recession, trough, peak
c. expansion, recession, peak, trough Economics: A Social Science
d. expansion, peak, recession, trough 14. A positive statement is
a. about what ought to be.
The Economic Way of Thinking b. about what is.
19. The fact that Intel decides to produce CPU chips c. always true.
rather than memory chips best reflects a ____ trade- d. one that does not use the ceteris paribus clause.
off.
a. what 15. Which of the following is a positive statement?
b. how a. The government must lower the price of a pizza
c. for whom so that more students can afford to buy it.
d. standard of living b. The best level of taxation is zero percent because
then people get to keep everything they earn.
10. The standard of living tradeoff reflects trading off c. My economics class should last for two terms
a. consumption in the United States for consump- because it is my favorite class.
tion in Africa. d. An increase in college tuition will lead fewer
b. higher inflation for higher consumption. students to apply to college.
c. current consumption for economic growth.
d. consumption and equality. 16. An economic model includes
a. only normative statements.
11. From 9 to 10 A.M., Fred can sleep in, go to his eco- b. no use of ceteris paribus.
nomics lecture, or play tennis. Suppose that Fred c. all known facts about a situation.
decides to go to the lecture but thinks that, if he d. only details considered essential.
hadn’t, he would otherwise have slept in. The op-
portunity cost of attending the lecture is 17. The Latin term ceteris paribus means
a. sleeping in and playing tennis. a. “false unless proven true.”
b. playing tennis. b. “other things the same.”
c. sleeping in. c. “after this, then because of this.”
d. one hour of time. d. “not correct, even though it is logical.”
WHAT IS ECONOMICS? 5

18. One student from a class of 30 can walk easily should a college education be free and guaranteed
through a door. Assuming that all 30 students si- to every American.” This statement can be analyzed
multaneously therefore can walk easily through the by using the economic concepts discussed in this
same door is an example of the chapter to answer the following questions.
a. opportunity cost fallacy. a. What would be the opportunity cost of provid-
b. fallacy of composition ing a free college education for everyone?
c. fallacy of substitution. b. Is providing this education free from the per-
d. post hoc fallacy. spective of society as a whole?
6. Indicate whether each of the following statements is
19. The post hoc fallacy is the
positive or normative. If it is normative, rewrite it
a. assertion that what is true for a part of the whole so that it becomes positive. If it is positive, rewrite
must be true for the whole. it so that it becomes normative.
b. claim that one event caused another because the
a. Policymakers ought to lower the inflation rate
one event came first.
even if it lowers output.
c. use of ceteris paribus in order to study the impact
of one factor. b. An imposition of a tax on tobacco products will
d. claim that the timing of two events has nothing decrease their consumption.
to do with which event caused the other. c. Health care costs should be lower so that poorer
people can afford quality health care.
7. In sciences such as chemistry, controlled experi-
„ Short Answer Problems ments play a key role. How does that relate to
economists’ use of ceteris paribus?
1. “In the future, as our technology advances even
further, eventually we will whip scarcity. In the
high-tech future, scarcity will be gone.” Do you „ You’re the Teacher
agree or disagree with this claim? Explain your an- 1. Your friend asks, “Does everything have an oppor-
swer and what scarcity is. Why does the existence of tunity cost?” Your friend has hit upon a very good
scarcity require choices? question; provide an equally good answer!
2. What are the factors of production? Focusing on 2. “Economic theories are useless because the models
the factors of production, describe the relationship on which they are based are totally unrealistic.
between the big microeconomic question “How are They leave out so many descriptive details about
goods and services produced?” and the question the real world, they can’t possibly be useful for un-
“For whom are goods and services produced?”. derstanding how the economy works.” So says your
3. How do you think the standard of living changes in skeptical friend. You’d like to keep your friend in
the different parts of the business cycle? your economics class so that you two can study to-
4. Why does your decision to buy a taco from Taco gether. Defend the fact that economic theories are
Bell reflect a tradeoff? Be sure to discuss the role much simpler than reality and help your friend re-
played by opportunity cost in your answer. alize that time spent studying economic theories is
5. “Education is a basic right. Just as kindergarten time well spent!
through 12th grade education is free, so, too,
6 CHAPTER 1

Answers 14. F Ceteris paribus, Latin for “other things being

equal,” is used in order to focus on the effect
from a change in one factor alone.
„ True/False Answers
Definition of Economics „ Multiple Choice Answers
11. F Scarcity exists because people’s wants exceed Definition of Economics
their ability to meet those wants, and this fact of
11. b Scarcity refers to the observation that wants are
life is true for any person, rich or poor.
unlimited but that the resources available to sat-
12. T Macroeconomics studies the entire economy; isfy these wants are limited.
microeconomics studies separate parts of the
12. c Macroeconomics studies the national economy
economy.
as well as the global economy.
Three Big Microeconomic Questions
Three Big Microeconomic Questions
13. F Almost always, goods and services can be pro-
13. d “Why” is not one of the three big microeco-
duced many different ways, so the “how” ques-
nomic questions.
tion must be answered separately from the
“what” question. 14. a The “what” question asks in part, “What goods
and services are produced?”
14. F The “how” question asks, “How are goods and
services produced?” 15. d People with high incomes will get more goods
and services than those with low incomes.
Three Big Macroeconomic Questions
Three Big Macroeconomic Questions
15. F The “for whom” question is one of the three
microeconomic questions. 16. c Of the areas listed, the United States has the
highest standard of living.
16. T A rising cost of living is the definition of infla-
tion. 17. b Inflation is defined as a rising cost of living and
when the cost of living is rising, dollars are
17. F A recession follows the peak. An expansion fol-
falling in value because each dollar buys fewer
lows the trough.
goods and services.
The Economic Way of Thinking 18. d Answer d is the correct ordering of the business
18. T The question gives the definition of a tradeoff. cycle.
19. F Businesses almost always can produce their The Economic Way of Thinking
products many different ways, so they face a
19. a The “what” tradeoff reflects Intel’s decisions
“how” tradeoff when they choose which method
about “what” to produce.
they will use.
10. c Economic growth will increase if people save
10. F The output-inflation tradeoff refers to the point
more, but saving more means cutting current
that lowering inflation decreases output.
consumption of goods and services.
11. T The opportunity cost is the burrito that was
11. c The opportunity cost of an action is the (single)
foregone in order to buy the pizza.
highest-valued alternative foregone by taking the
12. T The definition of making a choice at the margin action.
means that choice revolves around a small
12. c Because the resources are used to build a dam,
change.
the opportunity of using them to build a high-
Economics: A Social Science
way is given up.
13. F Although a positive statement is, indeed, about 13. c Comparing marginal cost and marginal benefit
what is, a normative statement tells what policies is an important technique, especially in micro-
should be followed. economics.
WHAT IS ECONOMICS? 7

Economics: A Social Science ple’s incomes. So, for example, if more land is used
14. b Positive statements describe how the world oper- to produce goods and services, then landowners’ in-
ates. comes will be higher so they will be able to acquire
15. d This statement is the only one that tries to de- more of the goods and services that have been pro-
scribe how the world actually works; all the oth- duced.
ers are normative statements that describe a 3. The standard of living is the level of consumption
policy that should be pursued. that people enjoy, on the average. The level of con-
16. d By including only essential details, economic sumption depends on the amount of goods and
models are vastly simpler than reality. services produced. During a business cycle, the
standard of living will be lowest at the trough, be-
17. b Ceteris paribus is the economic equivalent of a
cause production is lowest. It will rise during an ex-
controlled experiment: Its use allows us to de-
pansion and reach its maximum at the peak. During
termine the effect from each factor alone even
a recession the standard of living will fall.
though many factors might play a role in affect-
ing a variable. 4. The decision to buy a taco reflects a tradeoff because
you have given up your funds in exchange for the
18. b In this case, the fallacy of composition is arguing
taco. The opportunity cost of buying the taco is the
that what is true for a part must necessarily be
highest-valued alternative given up. For instance,
true for the whole.
suppose that if you had not decided to buy the taco,
19. b The usual post hoc fallacy is to claim that one you would then have used the funds to buy a burger
event caused another because the first event oc- from Burger King. In this case, the opportunity cost
curred before the second. of buying the taco is the forgone burger because that
is the highest-valued alternative given up.
„ Answers to Short Answer Problems 5. a. Even though a college education may be offered
without charge (“free”), opportunity costs still
1. This claim is incorrect. Scarcity will always exist.
exist. The opportunity cost of providing such
Scarcity occurs because people’s wants are basically
education is the highest valued alternative use of
unlimited, but the resources available to satisfy these
the resources used to construct the necessary
wants are finite. As a result, not all of everyone’s
universities and the highest valued alternative
wants can be satisfied. For instance, think about the
use of the resources (including human resources)
number of people who want to spend all winter
used in the operation of the schools.
skiing on uncrowded slopes. Regardless of the level
of technology, there simply are not enough ski b. Providing a “free” college education is hardly
slopes available to allow everyone who wants to free from the perspective of society. The re-
spend all winter skiing in near isolation to do so. sources used in this endeavor would no longer be
Uncrowded ski slopes are scarce and will remain so. available for other activities. For instance, the re-
sources used to construct a new college cannot
Because not all the goods and services wanted can
be used to construct a hospital to provide better
be produced, choices must be made about which
health care. Additionally, the time and effort
wants will be satisfied and which wants will be dis-
spent by the faculty, staff, and students operating
appointed.
and attending colleges has a substantial oppor-
2. The four factors of production are land, labor, tunity cost, namely, that these individuals can-
capital, and entrepreneurship. These are the re- not participate fully in other sectors of the
sources used to produce goods and services, so the economy. Providing a “free” college education to
question asking how goods and services are pro- everyone is not free to society!
duced asks which factors will be used. People earn
6. a. This statement is normative. A positive state-
their incomes by offering factors of production for
ment is: “If policymakers lowered the inflation
use. Land earns rent, labor earns wages, capital
rate by 1 percentage point, then output would
earns interest, and entrepreneurship earns profit.
fall by 1 percent.”
The answer to the question asking for whom the
goods and services are produced depends on peo- b. This statement is positive. A normative state-
ment is: “We should impose a tax on tobacco
8 CHAPTER 1

products in order to decrease their consump- 2. “Economic theories are like maps, which are useful
tion.” precisely because they abstract from real world de-
c. This statement is normative. A positive state- tail. A useful map offers a simplified view, which is
ment is: “If health care costs were lower, more carefully selected according to the purpose of the
poor people would receive health care.” map. No map maker would claim that the world is
7. Chemists can check the predictions of a model by as simple (or as flat) as the map, and economists do
conducting controlled experiments and observing not claim that the real economy is as simple as their
the outcomes. For instance, when determining the theories. What economists do claim is that their
effect of temperature on a particular reaction, theories isolate the effects of real forces operating in
chemists can ensure that, between different experi- the economy, yield predictions that can be tested
ments, only the temperature changes. Everything against real-world data, and result in predictions
else is held constant. Economists usually cannot that often are correct.
perform such controlled experiments and instead “I’ve got a book here that my parents gave to me by
must change one variable at a time in a model and Milton Friedman, a Nobel Prize winner in Eco-
compare the results. This approach involves the use nomics. Here’s what he says on this topic: ‘A theory
of ceteris paribus, wherein only one factor is allowed or its ‘assumptions’ cannot possibly be thoroughly
to change. So, economists face more difficult and ‘realistic’ in the immediate descriptive sense…. A
less precise model building and testing than is pos- completely ‘realistic’ theory of the wheat market
sible for the controlled experiments of chemists and would have to include not only the conditions di-
other scientists. rectly underlying the supply and demand for wheat
but also the kind of coins or credit instruments used
„ You’re the Teacher to make exchanges; the personal characteristics of
wheat-traders such as the color of each trader’s hair
1. “Virtually everything has an opportunity cost. Peo- and eyes, … the number of members of his family,
ple sometimes say that viewing a beautiful sunset or their characteristics, … the kind of soil on which
using sand from the middle of the Sahara Desert the wheat was grown, … the weather prevailing
have no opportunity costs. But that isn’t strictly during the growing season; … and so on indefi-
true. Viewing the sunset has an opportunity cost in nitely. Any attempt to move very far in achieving
terms of the time spent watching it. The time could this kind of ‘realism’ is certain to render a theory
have been utilized in some other activity and, what- utterly useless.’
ever the next highest-valued opportunity might have “I think Friedman makes a lot of sense in what he
been, that is the opportunity cost of watching the says. It seems to me that theories have to be simple
sunset. Similarly, making use of sand from the Sa- in order to be powerful and so I don’t see anything
hara also must have some opportunity cost, be it the wrong with the fact that economic theories leave out
time spent in gathering the sand or the resources a bunch of trivial details.”
spent in gathering it. So from the widest of perspec-
From Milton Friedman, “The Methodology of
tives, the answer is: Yes, everything does have an
Positive Economics,” in Essays in Positive Economics.
opportunity cost.”
(Chicago: University of Chicago Press, 1953), 32.
WHAT IS ECONOMICS? 9

Chapter Quiz 16. Which of the following is NOT a big macroeconomic

question?
a. How are goods and services produced?
11. The most fundamental economic problem is
b. What determines the cost of living?
a. reducing unemployment. c. Why does our economy fluctuate?
b. health and health care. d. What determines the standard of living?
c. scarcity.
d. decreasing the inflation rate. 17. The big tradeoff between equality and efficiency
reflects the point that
12. Studying how an individual firm decides to set its
a. policy actions to lower inflation also lower out-
price is primarily a concern of
put.
a. normative economics. b. if more of one good is produced, less of another
b. macroeconomics. can be produced.
c. microeconomics. c. taxing productive activities means producing
d. all economists. fewer goods and services.
d. None of the above answers is correct.
13. Which of the following is a macroeconomic topic?
a. Why has the price of a personal computer fallen 18. Opportunity cost is
over time? a. zero for services, because services do not last for
b. How does a rise in the price of cheese affect the very long, and positive for goods, because goods
pizza market? are long lasting.
c. What factors determine the nation’s inflation b. paid by society not by an individual.
rate? c. the highest-valued alternative given up by mak-
d. How does a consumer decide how many tacos to ing a choice.
consume? d. all the alternatives given up by making a choice.
14. When the economy produces fireworks for sale at 19. In economics, positive statements
the Fourth of July, it most directly is answering the
a. are only about facts that economists are certain
____ question.
(are “positive”) are true.
a. what goods and services are produced b. tell what policy the government ought to follow.
b. opportunity cost c. depend on value judgments.
c. for whom are goods and services produced d. in principle, can be tested to determine if they
d. how are goods and services produced are true or false.
15. When doctors have an average income that exceeds 10. The fallacy of composition is the (false) statement
$250,000, the economy most directly is answering
a. that theory is necessary to better understand the
the ____ question.
real world.
a. what goods and services are produced b. that models can be normative in nature without
b. opportunity cost any positive conclusions.
c. how are goods and services produced c. that people’s free will makes predicting their
d. for whom are goods and services produced behavior futile.
d. that what is true for the whole must necessarily
be true for the part.

The answers for this Chapter Quiz are on page 367

10