Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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Principles of Economics will allow you to learn a new set of tools to use in personal, professional, business, and political decision making.

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Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Pricing

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Up to 40-60% more affordable

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$130

Hardcover print text only

$175

Hardcover print text only

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Content meets standard for Introduction to Anatomy & Physiology course, and is updated with the latest content

In-Book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

Read the fully unlocked textbook below, and if you’re interested in learning more, get in touch to see how you can use this textbook in your course today.

Chapter 1: An Introduction to Economic Analysis

Figure 1.1: When making the decision to attend university, one needs to consider the various opportunity costs involved. [1] ​
“Economics is a science for the service of mankind.”
                        - James Tobin [1]

Welcome to the amazing, incredible world of economics. Economics will allow you to learn a new set of tools to use in personal, professional, business, and political decision making, apply those tools to a variety of social and economic problems, and ideally develop a thorough understanding of what it means to think like an economist.

In studying economics, we will explore ideas such as:

  • why a movie theater may lower prices for the elderly and college students while charging everyone else a higher price.
  • what it takes to make profits in the business world.
  • why tariffs on steel imports increase employment in the U.S. steel industry and decrease employment in the production of orange juice.
  • why New York City increased its cigarette tax by $1.50 per pack, expecting to discourage sales and raise revenues at the same time.
  • why the few remaining bookstores may lower prices on their best-selling books and raise prices on the ones that do not sell as well.
  • why even the wealthiest nation in the world has so much unemployment.
  • why we have inflation—or is it deflation?
  • why we might experience deflation and why falling prices are so frightening.
  • why Microsoft, the designer of so many new and innovative products, has been accused of illegal behavior in court and may be forced to give away some of its products for free.
  • why a struggling major league baseball pitcher earns more than a transplant surgeon.
  • what is good and what is bad about free medical care.
  • why some honest, caring businesses may need to pollute or cheat in their accounting.
  • why mortgage brokers might sell mortgages to individuals who may not be able to afford them as well as why those individuals agree to take such mortgages.
  • why taxes are so high or so low.
  • why some countries are so rich and others so poor as well as why some economies grow faster than others.
  • why governments are blamed, and sometimes credited, for economic conditions as well as what governments can and cannot do.
  • why financial markets can fail.
  • why it makes absolutely no economic sense for policy makers, businesses, or individuals to make any decision without regarding the cost.
  • why large firms with highly paid employees in financial markets received government subsidies after our most recent recession.
  • how the Federal Reserve causes interest rates to increase and decrease.
  • how the federal government can use its spending and taxing powers to influence economic conditions and the common challenges faced in trying to do so.
  • why federal, state, and local government deficits matter – and when they may not.
  • why prices of stocks and bonds and currencies fluctuate.
  • And a wide variety of other issues.

Above all, we will learn what it means to make a rational decision and how to go about doing so in personal, family, professional, business, and political environments. Economics is about thinking; it is a way to think about and understand the world around us.

1.1 Learning Objectives

After reading this chapter, answering the questions, and doing the problems, you should be able to: 

  • Explain the concept of scarcity and its relationship to the study of economics.
  • Use the concept of opportunity cost in making a variety of personal, policy, and business decisions.
  • Define rational analysis and begin to use it in your own decision-making

1.2 Why this Book?

The purpose of this book is to explain economic concepts and provide significant opportunities for readers to use the concepts. These materials are put together in a very specific way. New concepts and topics are introduced with brief explanations. You will see problems and exercises throughout the reading. You will encounter news articles to analyze. You will need to be ready to think. We ask that as you read assignments, you stop to do the problems, answer the questions, and read the case studies. Answers are found after each question or activity, but they should be referred to only after you have chosen or written out your own answer. 

Economics is different from many other disciplines. It appears that most people learn economics best by doing economics; that is, by rehearsing, practicing, and solving problems rather than just reading and listening and memorizing. Reading and listening and memorizing are important – but you will need to do more. That is why this material is designed as it is. Learning economics is typically much easier if you do problems as you reach them than it is if you read the material straight through to the end.

The questions, problems, and readings are designed to get you involved and thinking – to give you practice. The majority of questions that you will find throughout and following each chapter are similar to those many instructors use on midterms and final exams. Answers are provided, but do not look at them before you have thought through the problem. Your success in the course depends on your active involvement.

Every few pages, a “What’s the gist” box will appear in the text. There will be a question below the box asking you to summarize a section of the chapter or to interpret a concept in your own words. Write out that explanation. These questions can be great self-tests and excellent practice for quizzes and exams. They can demonstrate to you whether you have more work to do or not. 

Practice questions can also help provide feedback about your own understanding. While reading, answer the questions. See how you did, then follow the recommendations for further study if necessary.

This is a course in thinking. In reading and working through these materials, and in class, you should continually be asking yourself– “Can I explain why?” Don’t just stop with a feeling that you understand the reading or the concept. Practice it! Try explaining why to a friend, writing out the answer, or making an outline for yourself.

1.3 Why Economics?

There are many reasons to study economics. A well-educated and well-rounded student should ideally have a basic understanding of a variety of ways of thinking. Virtually every problem or opportunity can be better understood and dealt with when you have a diverse and thorough education. Economics is an important component of that tool kit.

Figure 1.2: We all confront the challenges of making choices, like that between vacation and work. [2]

Individuals, family members, students, workers, and citizens make choices every day. Studying economics will provide a framework you can use to make decisions and help you understand the consequences of such choices. Economics is about how we decide to use our resources. It is the study of why some people earn high incomes, why some earn much less, why some countries are rich, why others are so poor, and why we produce so many computer games and robotic toy dogs when we have pollution problems that threaten lives and reduce longevity.

You will learn some answers to the most frequently asked questions in economics, such as why we waste resources, why we have unemployed labor, why oil prices have been rising or falling, and why house prices have been rising or falling. Answers will be provided as you study the markets that make economic decisions, the role of the government in our economy, and the Federal Reserve. As you study these models, you will learn how our monetary system and our federal government’s fiscal policy function. You will uncover the benefits and costs of trade among ourselves and across international borders, why prices of stocks and bonds change, why interest rates change, and even why currencies change in value.

We will try to explain many of the economic, social, and political events in the news. You should be able to understand international economic crises, the issues surrounding medical expenses, budget surpluses, and minimum wage, and whether daily fluctuations in the stock market make a difference to you. You will learn what causes prices to rise and fall and why unemployment is such a problem. You will learn how people acting in their own self-interests produce what others want them to produce. We will discuss the economic role of markets and governments. With this knowledge, you should be able to tell the difference between political arguments that make sense and those that do not. Many of the issues you will study will be related to political issues. The goal of the course is not to change or even influence your political or social values, but we do want to assist in your becoming an even more thoughtful and rational participant in civic affairs.

You will learn a new way to look at problems. You gain an increased ability to make rational decisions. You will better understand the economic world. You will be more prepared to make personal, business, and political decisions. You may even have fun.

1.4 A Structure

We are going to begin by studying how economic systems function. The text will concentrate on how markets work and what an economic role for government might be. That is what microeconomics is all about. In microeconomics economists study markets, firms, buyers, sellers, and workers on an individual or “micro” basis. When economists put all of the individual markets and economic actors together into the big picture, we label that study macroeconomics. In macroeconomics, economists study how fast the whole economy grows, what determines unemployment and inflation rates, and what policies might affect growth, inflation, and unemployment.

Paul Krugman, an economist, has suggested that economics can be divided into three categories: Greek economics, media economics, and airport economics. Greek economics is the kind that most academic economists do, with lots of mathematics and graphs (and Greek symbols). Media economics, or up-and-down economics to some, is what is reported in the press. Media economics mostly consists of forecasts of whether the economy will go up quickly, go up slowly, or go down. Finally, airport economics is named after the economic paperbacks one finds in airport bookstores, focusing on the next upcoming disaster or a New Economy that will supposedly grow faster than any other and never suffer another recession.

The purpose of this text is to use some of the traditional Greek economics to explain what happens as reported in the press and other media and to recognize the errors and exaggerations of some, if not much, of the airport economics. Let’s begin with how markets work and how they make decisions for us – decisions about what to produce, how to produce, and for whom to produce.

1.5 The Beginning of Economics Analysis

One secret to understanding economics and the economic way of thinking is to realize that economists are interested in efficiency – that is, the production of goods and services in a way that will maximize our satisfaction, given the existing amount of labor, machines, and other resources.

1.5.1 Limited Resources and Large Desires Lead to Scarcity

There are more than 320 million people in the U.S. Seventy-five million are under the age of 16; approximately 100 million are in the military or institutions or choose not to work for pay - they are attending school or college, retired, or perhaps at home, raising children. About one hundred and sixty million are willing to work for pay. We have a very large labor force that can produce a wide variety of goods and services.

We have large amounts of land and natural resources to use to help produce better lives for everyone. (Economists sometimes combine natural resources into a single grouping, simply labeled as land.)

We have massive amounts of capital- factories, tools, inventories, and machines. Our current levels of technology and business knowledge allow the U.S. to bring together our labor, our land and natural resources, and our capital to produce more than 18 trillion dollars’ worth of goods and services each year. Yet it isn’t enough. We are the richest economy on earth, and still many of us strive to earn higher incomes or ask for larger allowances. Our political leaders debate whether we tax too much, yet we want better highways, education, and police protection. Our wants continually seem to be larger than what our economic resources are able to produce. This phenomenon is what economists call scarcity.

Scarcity is not just about producing as many material goods and services as possible. It can be about producing goods and services while devoting time to families, friends, and leisure.

What is most important about that concept is that it implies a choice. Given that most people are not in the position to satisfy all of their wants, individuals, families, businesses, and governments must make choices about which wants to satisfy. I may have a number of things I would like to do tonight. I would enjoy each one – reading a novel, going to a movie, visiting with friends, and going to a concert. There are probably more. I cannot do all of them tonight. I simply do not have enough time. Thus, I must choose. I am confronting scarcity.

Anything becomes scarce if it uses resources that have an alternative use. That is what scarcity means in economics. It is not a shortage; it is not a lack of any one resource. Time, goods, services, resources, and other things are scarce if we have to give something up in order to spend time on an activity or use or produce a product or service.

Figure 1.3: Generation of electricity uses coal, water, and clean air. [3]

Question 1.01

Question 1.01

Is clean air a scarce good in economic terms? Explain why.

Hover here to see the hint for Question 1.01.
Click here to see the answer to Question 1.01.

Economics studies how we go about making decisions to give up resources, time, and other goods and services to have something like clean air – when clean air is a scarce good. Economics does not have anything to say about clean air in northern Canada, where clean air is not a scarce good. There is no cost. We do not give anything up to get it. Because it is not a scarce good, it is not an economic good.

If someone lives in a part of the world where there is no air pollution, then clean air is truly free and is not an economic good. Choices are not necessary to consume clean air. Clean air is not subject to economic thinking and analysis.

However, most of us do live in cities with varying degrees of air pollution. If we are to enjoy perfectly clean air, we have to move to an area that is basically a wilderness or away from large cities and power generating plants. Alternatively, we create and use nonpolluting automobiles, power generation, and production. Those are likely to require more resources and some other production and activities must be given up. What we give up is the cost of enjoying the clean air. 


1.5.2 Choosing What to Produce, How to Produce it, and for Whom to Produce 

The purpose of an economic system is to make choices about what to produce, how to produce the goods and services chosen, and for whom to produce those goods and services. The “what” question investigates how much food, clothing, automobiles, entertainment, and education, among many other possibilities, the economy should produce? To be as well off as possible, we should want our society to use our limited resources to produce as many goods and services as possible, but also to produce the ones we most enjoy. If most of us enjoy live concerts more than we enjoy movies, and both take about the same amount of resources to produce, then we should produce more live concerts and fewer movies. 

Figure 1.4: Machines are a way of producing material goods for people to consume in the economy. [4]

The “how” question is the choice between possible combinations of machines and labor and land to produce goods and services. If an economy is to use resources in a manner that will make all of us as well-off as possible, it will aim to minimize the cost of producing specific goods of a given quality and quantity. Another way to evaluate whether an economy is using its resources wisely is to ask if resources are being wasted. If in the process of producing a good, we are using more labor and more machines than we have to, we are wasting those resources. They could be used to produce other goods and services, and we would be better off.

The “for whom” question concerns for whom goods and services are produced in an economy that relies primarily on markets as a means of deciding who gets which goods and services. In our economy, most goods and services go to those willing and able to pay for them – that is, to the people who want the goods, are willing to pay the prices, and have the income to do so.

Not all goods and services are produced in markets. Some goods and services are produced and then provided by governments to specific groups of individuals or, in some cases, to anyone who wishes to use them. Public streets and sidewalks and police and fire protection are good examples of the latter.


Question 1.02

If a good or service is scarce, which of the following is true?

A

There is a shortage at the going market price.

B

Buyers cannot afford to purchase the product

C

We must give something up if we want more of the good.

D

It is difficult to find the product in stores.

E

Production is very rare.


Question 1.03

Clear skies and clear rivers are scarce goods. True or false?

A

True, we don’t have enough of either one.

B

False, we don’t have to give up anything to them.

C

False, only economic goods produced by workers and capital are scarce.

D

Maybe, but only if they are in those areas of the world where we may have to give something else up in order to enjoy clear skies or clear rivers.

E

They are gifts from nature, not economic goods.


1.6 The Result of Scarcity – Opportunity Cost

Figure 1.5: A student would consider the opportunity cost between studying and viewing a movie. [5]​

Economics is the study of how we as individuals, families, businesses, governments, and societies go about making choices. Scarcity means that when we choose to do something, whether it is with our time, our income, or some other resource, we also choose not to do something else. The enjoyment or the benefit gained from the activity we choose not to do is the actual cost – specifically, an opportunity cost. We give up an opportunity to do, buy, or produce an alternative. The opportunity cost is the value of the forgone opportunity - the one best alternative to the choice we make.

Question 1.04

Question 1.04

What is the opportunity cost of washing dishes every night for your family? Not just ½ hour; but what would you do with that time?

Hover here to see the hint for Question 1.04.
Click here to see the answer to Question 1.04.

Question 1.05

Question 1.05

What is the opportunity cost of also doing your neighbor’s dishes? a second neighbor’s dishes? a third? a fourth? Does your opportunity cost increase or decrease as you do more dishes? Why?

Hover here to see the hint for Question 1.05.
Click here to see the answer to Question 1.05.

Question 1.06

Question 1.06

Suppose that you are considering purchasing a ticket to go to a concert with some friends. What is your opportunity cost?

Hover here to see the hint for Question 1.06.
Click here to see the answer to Question 1.06.

Suppose that I already have purchased a ticket for $50 to a sold-out concert. I could turn it back into the box office and get a refund, or I could sell it for $120 on eBay or Craigslist to someone who does not have a ticket.

Question 1.07

Question 1.07

What is my opportunity cost of attending the concert?

Hover here to see the hint for Question 1.07.
Click here to see the answer to Question 1.07.

Finally, consider perhaps the most difficult concept connected to opportunity cost. Suppose that you have purchased the ticket for $50. There is no scalping market. (People can buy tickets at the box office and it is illegal to buy or sell tickets from or to anyone else.) Also, suppose that the box office will not refund the ticket price once the ticket has been purchased.

Question 1.08

What is your opportunity cost of attending the concert in this case?

A

Zero, plus what I would have done with my time.

B

$50, plus what I would have done with my time.

C

$120, plus what I would have done with my time.

D

None of the above


Figure 1.6: A sunk cost is irrelevant to any current decision since the expense has already been incurred.​


Question 1.09

What is the opportunity cost of college? Determine whether the following costs are opportunity costs or not.

Premise
Response
1

Tuition

A

Not an opportunity cost

2

Student fees

B

Opportunity cost

3

Transportation

C

Opportunity cost

4

Books

D

Not an opportunity cost

5

Salary

E

Opportunity cost

6

Insurance

F

Not an opportunity cost

7

Room and board

G

Opportunity cost

H

Opportunity cost

Room and board in the cost of college question is a good example of costs similar to sunk costs. Should room and board costs be considered in an analysis of whether to go to college? The answer is no. One would pay room and board regardless of whether one attends college. Those costs are fixed costs– costs that do not change regardless of whether one goes to college. If room and board are more expensive at college than what you would use if you did not go to college, the increase in cost is a real cost of going to college. If room and board at college are less than the alternative, there is an additional benefit from enrolling in college – saving on room and board costs.

There is no more important concept in economics than opportunity cost. If you are to learn how to use and apply economic analysis, you must know, feel, believe, and breathe this concept. There is almost always a cost, and that cost is what one gives up. It is true for individuals, families, businesses, governments, and societies. If you think something is free, that it has no cost, then you are most likely wrong. So be cautious. Think about what you are giving up to engage in a choice; that is the cost of your decision. 


Question 1.10

Your college purchased a building east of campus for $500,000. Given changes in the city’s real estate market, the current market value of the building is now $2 million. The total value of the use of the building for the college is estimated to be $1.5 million. What should your college do? Explain why.

A

Not use the building. It would be a loss of $2 million.

B

Use the building. The gain would be $1.5 million.

C

Not use the building. Using the building would mean losing $ .5 million in doing so.

D

Use the building. They only paid $500,000. Its value is $1.5 million. They gain $1 million.


Question 1.11

Last year, you purchased land to build a retail store. You paid $20 million for the land, but you haven't built a retail store on the land yet. Another business has now offered $8 million for the land and that is the highest price your business should now be able to get for the land. Which of the following costs is relevant for your decision as to whether or not you should build a retail store on the land?

A

$8 million

B

$12 million

C

$20 million

D

$28 million


Question 1.12

Tickets to a sold-out basketball game originally cost $50 each and cannot be returned. I bought one, and now scalpers are willing to pay $125 for the ticket. The cost that should be considered if I am deciding whether or not to go to the game is _____.

A

0

B

$50

C

$75

D

$125

E

$175


Question 1.13

I started a business last year. My revenues were $100,000. My rent and materials costs were $60,000. My best alternative was and is to go to work for a company in a job that would pay me $30,000. The “true” profits from my business were _____.

A

$10,000

B

$30,000

C

$40,000

D

$90,000

E

$240,000


Question 1.14

A business has spent $50 million dollars on development of a new laptop. It must spend an additional $20 million to bring the finished computer to market. What are the minimal acceptable returns (after spending $50 million) for management to bring the new laptop to market?

A

Any amount over $20 million.

B

Any amount over $50 million.

C

Any amount over $70 million.

D

The value, if any, of the results of the $50 million spent so far.

E

The value, if any, of the results of the $50 million spent so far, plus the $20 million.


Question 1.15

Is tuition a part of the cost of deciding to go to college?

A

Yes

B

No

C

Part of room and board may be part of the cost.


Question 1.16

Is room and board part of the cost of the decision to go to college?

A

Yes

B

No

C

Part of room and board may be part of the cost.


Question 1.17

Is the income you could earn after going to college part of the cost of going to college?

A

A portion of it is

B

Yes

C

No


Question 1.18

Is the money, you could have earned instead of going to college, part of the cost of going to college?

A

Yes

B

No

C

A portion of it is


Question 1.19

A classic movie about the end of the world showed a floating island on what was the Pacific Ocean. In the middle of the movie filming, the set sank in a hurricane. The producers who had already spent $70 million on the set were faced with a new cost of $50 million to rebuild the set. Expected additional costs continued to be $100 million. The expected revenues were $160 million. Should they have rebuilt the set and finished the movie?

A

Yes. The set sank. What is it about sunk costs that you do not understand?

B

No. the loss on the movie was $160 million minus $220 million, a loss of $60,000.

C

One cannot tell. They may have thought that revenues would be higher.

D

One cannot tell. They may have thought that costs from that point on might have been lower.


Question 1.20

I am thinking about going out to visit some friends tonight. Given what I have learned in economics, I am comparing my costs with my expected benefits. My alternatives in order of preference are to stay in my room and watch TV; stay in my room and study economics; have my friends over to my room; or go to bed early tonight. What are the MOST relevant costs to my decision?

A

The benefits gained from going out to visit some friends

B

The benefits gained from staying in my room and watching TV

C

The benefits gained from watching TV, studying economics, having my friends over, and going to bed early

D

The benefits gained from one or two of the alternatives, but not all of them

E

None of the above is correct


Question 1.21

Some friends and I are heading to a concert. We all have purchased $50 tickets. I just realized that I lost my ticket on the subway ride to the concert. I am confronted now with a decision of whether or not to buy a new ticket and go to the concert. Which of the following best describes that decision?

A

Is the concert worth paying $100 to attend?

B

Is the concert worth paying $50 to attend?

C

Is the concert worth paying $150 to attend?


1.7 Comparing Benefits with Costs in Making Rational Decisions

Economists use the terms marginal benefit to describe the addition to benefits resulting from a decision and marginal cost to mean the addition to costs resulting from a decision. The concepts are “marginal” because they result from changes in benefits and costs; they are “on the margin.” We use these concepts in making rational decisions. Rational decisions are those that make us better off than we were before the decisions were made.

If I gain a lot of satisfaction from one more hour of sailing and the additional hour does not cost very much – that is, I am not giving up very much – I will be better off sailing than not sailing. However, if the hour costs a lot – that is, I really value what I could be doing – I may be better off if I do the next best alternative instead of sailing. 

Figure 1.7: Whether we write on boards or just think it through, we should be comparing costs and benefits​

The decision-making rule for a choice or a decision is: if the marginal (additional) benefit of a potential action is greater than the marginal (additional) cost, the decision should be a positive one. We will gain more than we will lose. We will be better off as a result. If the marginal benefit is less than the marginal cost, then we should decide not to spend the time or buy the good or take the job. We will give up more than we will gain and thus be worse off if we choose to undertake the activity.

A rational decision to go to college requires you to compare the marginal benefits (all of the benefits you gain from the decision – financial gain, social opportunities, future abilities to enjoy life and learn, etc.) with the marginal costs (the opportunity costs) that you identified in the questions above.

If you are using your time or money in such a way that your opportunity cost is less than the benefits you gain from an action, then you are better off as a result of the action. If the economy is using resources in such a way that the value of what is given up is less than the value gained, then the economy is better off. In both cases, our well-being is enhanced. We are using our scarce resources in a way that benefits us. The same is true for your family, your school, your college, your business, and your organizations.

Question 1.22

Question 1.22

“When [Warren] Buffett graduated from Columbia, he asked Benjamin Graham for a job (for no salary) at the Graham-Newman Co. According to Buffett, ‘Ben made his customary calculation of value to price and said no’.” Warren Buffett Speaks. Janet Lowe. Wiley, p. 31. Can you explain the irony in this story? Use rational consideration of costs and benefits. What was Benjamin Graham really saying? Why might you be turned down for a nonpaying internship?

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Question 1.23

Think of what happens to your marginal benefits of going to a movie if you were to go to the same movie more than once. One way to think of it is to ask yourself how much you would pay – not what you have to pay, but what would be willing to pay – to see a complete, exciting new movie series. Consider the graphics below. Select which graph is most likely to represent the marginal benefits of attending a movie.


Question 1.24

Why is it so difficult to ignore costs we have actually already paid?

A

Because they are explicit and we actually handed over a check.

B

Because we should not count them as costs.

C

Because they are not actually costs.


Question 1.25

Why is it so difficult to consider costs that we have not physically paid as part of the cost of the decision?

A

Because they are not actually costs

B

Because they will only be costs once they are paid.

C

Because we have not directly paid someone.


Question 1.26

Question 1.26

In your own words, summarize the connection between opportunity cost, marginal cost and benefit, and rational decision-making.

Hover here to see the hint to Question 1.26. 
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One of the fundamental goals of this book is to help you know what it means to use the tool kit of economics in making decisions. Part of that understanding is the development of a thorough, complete knowledge of the real cost of a choice.

One of the automatic and quick reactions a successful economics student should have in confronting any decision is knowing that the cost of that choice is not simply the $.99 cost of a downloaded song, the $10 price of a movie ticket, or the $200 price of an airline ticket. The cost is what you could have done instead – with the money and the time. The cost to a business of a new investment is the cost of not just the dollars spent, but also what could have been earned with those resources or whatever the next best alternative is. The cost of a new government program is not just the $100 billion the government must pay for the program, but also what the government (or individuals) could have done with those resources.

Question 1.27

Question 1.27

Why are some seemingly obvious, explicit costs of a choice not really costs of that choice? Why are other, much less obvious, and only implied, costs actually significant costs of a choice?

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Question 1.28

Good economic decision-making means which of the following?

A

Comparing all of the benefits with all of the costs related to the production and enjoyment of a good

B

Thinking about marginal benefits and marginal costs of the good and services

C

Thinking about average benefits and average costs of the goods and services

Question 1.29

Question 1.29

I have been invited to dinner and a free concert with some friends. I told one of them that “I have nothing better to do and I will join them.” My friend was insulted and said if that was my attitude, I should not come along. Did my friend understand rational decision-making?

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1.8 How Are Scarcity, Specialization, and Trade Related?

Scarcity and the desire to be as well off as possible lead us to specialize. Specialization means that we produce one or two goods or services rather than attempting to produce everything we need. However, if we specialize, we need to trade with others to enjoy a variety of goods and services. 

One form of trade is bartering. That is, I could trade the teaching of economics for a meal at a restaurant tonight. However, in order to barter, I will have to find a restaurant owner who wants to learn economics. This may take a lot of time. I may have to trade economics for a piece of clothing, trade the clothing for a hammer, and trade the hammer for the meal because the restaurant owner wanted a hammer, not an economics lesson.

Figure 1.8: Markets, like this one in Spain, allow farmers and consumers a place to exchange food for money and money for food. Markets are the coming together of buyers and sellers, each with their own interests. In so doing, we determine what prices will be charged and paid and how much will be sold. [6]

Markets are where we trade. In the U.S. economy, the vast majority of economic decisions are made through markets. Even if those markets are not obvious, most of the prices we pay and receive are being set in some market somewhere. Sometimes it is easiest to think of markets as physical places, like farmer’s markets for fruits and vegetables – places where buyers and sellers come together. However, markets are not necessarily specific physical places. I can buy clothing, furniture, and books by browsing on my computer or looking at a catalog and ordering on the phone. Markets are simply the coming together of buyers and sellers, during which they determine the prices of goods and the quantities that will be exchanged.

If we barter in markets, we must find someone who has what we want and who wants what we have. That may be time-consuming and complicated. It is much easier and takes much less time if I can sell what I do for money and subsequently buy what I want with that money in another market. In fact, money makes markets work better in that we save time. The purpose of money, then, is to make the process of buying and selling our labor, goods, and services easier.

1.9 Is there an Economic Role for Governments in Economies Dominated by Markets?

We use markets in our economy to determine what we produce, how we produce, and for whom we produce. Economic analysis will demonstrate that markets can often result in outcomes that maximize our well-being. We will explore how that happens. Economics also shows us that markets may not be efficient in some other ways. In those cases, economics can lead us to change those markets through economic roles for governments.

For example, one of the questions that economies answer is for whom we are producing goods and services. In a market system, we answer that question by letting incomes be determined primarily in markets. Most of our incomes are determined by how markets value our labor. If we produce goods and services that people are willing to pay for, we will likely earn a reasonable living. If we can produce goods and services that people value highly, then we will likely earn even more. If we can do that at a very low cost, then we are even more likely to earn a very high income. Sometimes people will argue that the outcomes of a market economy are not fair or are not equitable. Economics is not very good at defining what is fair. There are many more value judgments in that determination than most economists are willing to make. When the distribution of incomes is thought of as unfair by a large number of people, governments often change the income distribution through taxes or subsidies.

Figure 1.9: Governments play large roles in economies with a wide variety of purposes. [7] ​


The economic roles for government in a market economy are many, and often subject to political debate. We will explore them in much more detail as we develop our understanding of how markets work and, in some instances, do not work. The primary economic roles for government are: 

  • Private property rights and contracts - There is a need for a government to provide a basic set of laws protecting the right of private property and guarantees that contracts will be enforced. These roles can help markets function well, and they make businesses easier to run and work easier to do.
  • A monetary system - Money that is widely accepted and used assists people in carrying on their daily business. Money allows individuals to specialize and trade while avoiding the costs of barter. Misuse of this function can lead to inflation. One economic role for government is to establish money that is widely accepted and has a stable value.
  • Unemployment and capacity utilization - Markets may not use all available resources; there may be unemployment of labor, of capital, and of natural resources. Governments can sometimes help.
  • Competition - Markets may not always produce the best possible outcomes, and when they do not, the results may be enhanced through regulation. For example, markets are not always competitive and may charge higher prices and produce less of some goods. Policies may be aimed at increasing competition or sometimes at producing goods or services that markets otherwise will not pursue.
  • Incentives - Businesses may not have incentives to produce some goods. Information for consumers may be unavailable or difficult to obtain in other markets. In cases like these, there may be economic roles for governments.
  • Fairness - Markets may not produce fair outcomes, and governments may redistribute incomes from those with higher incomes to those with lower incomes.


Question 1.30

In every economy, resources are limited, but wants are large and increasing. What is this condition called?

A

The opportunity cost of resources

B

The opportunity cost of wants

C

Scarcity

D

Marginal cost


Question 1.31

Which of the following does not represent an opportunity cost of attending college?

A

Tuition paid

B

Amount that one could have earned instead of going to college

C

Food

D

Books purchased at college


Question 1.32

A small clothing firm currently produces 50,000 shirts and blouses per month. The costs of its factory, raw materials, and labor are $500,000 per month. If the company is to increase production by 5,000 and that requires an additional labor and raw material expense of $100,000, what is the best estimate of costs of the increased production?

A

$100,000

B

$400,000

C

$500,000

D

$600,000


Question 1.33

In question 1.32, what is the cost per shirt before the increase in production? Part of the information is repeated for you below.

A small clothing firm currently produces 50,000 shirts and blouses per month. The costs of its factory, raw materials, and labor are $500,000 per month. If it is to increase production by 5,000, that requires an additional labor and raw material expense of $100,000.

A

$5

B

$10

C

$20

D

$50

E

$100



1.10 Summary

  • Scarcity means that we cannot satisfy all of our wants. Because we have a long list of possibilities but not enough resources to undertake all of them, we have to make choices.
  • If we want to be as satisfied, happy, or well-off as possible, we have to make those choices in a rational and thoughtful manner.
  • A rational decision-making process compares the benefits with the costs of a choice. We should choose to do something when the benefits are greater than the costs. We are better off as a result of a rational decision. We should choose not to do something if the costs are greater than the benefits.
  • Defining benefits and costs is not always easy. Cost is often the most difficult to determine. Economists view the cost of a choice as what one gives up to pursue the choice.
  • The true cost of anything is the opportunity cost – what must be given up. Sunk and fixed costs are irrelevant for rational decision-making.
  • When people specialize in order to become better off, they become dependent upon others. Because they do not produce the full variety of goods and services they want, they must trade what they produce for other goods and services that they do want. That trading takes place in markets.
  • Most of our economic decisions are made in markets. Others are made through the political process of defining an economic role for government.
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1.11 Key Concepts

Capital
Fixed cost
Economic resources
Labor
Macroeconomics
Marginal benefit
Marginal cost
Markets
Microeconomics
Opportunity cost
Rational decision-making
Scarcity
Sunk cost

1.12 Glossary

Capital: The factories, machines, tools, and inventories in an economy. (Education is sometimes referred to as human capital; factories, machines, etc., as physical capital.) Capital is used in producing other goods and services.

Decision-making rule: If the additional benefits (correctly measured) are greater than the additional costs incurred (correctly measured), go for it. If the additional costs are greater than the additional benefits, do not do it.

Economic resources: Labor, capital, and natural resources that can be used to produce goods and services.

Fixed costs: Costs that do not change as a result of a decision.

Macroeconomics: The study of the economy as a whole. Growth of economy-wide production, changes in unemployment, and rates of inflation are the most common concerns.

Marginal benefit: The increase in benefits resulting from an action, or the increase in benefits resulting from producing one more unit of output.

Marginal cost: The increase in costs resulting from an action, or the increase in costs resulting from producing one more unit of output.

Markets: Methods through which buyers and sellers come together and determine the prices and quantities of goods and services that will be exchanged.

Microeconomics: The study of individual consumers, workers, producers, businesses, and industries.

Opportunity cost: The value of the best-forgone alternative. What one really gives up when making a choice.

Rational decision-making: The process of comparing the marginal benefits and marginal costs of an action. If the marginal benefits are greater than the marginal costs, a rational decision is to undertake the action.

Scarcity: Our wants are greater than our abilities to satisfy them. This leads to the necessity to make choices about how we use our resources.

Sunk cost: A cost that has already been paid and cannot be recovered.





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Answer to Discussion Questions

Answer to Question 1.01

Clean air is scarce in many circumstances, but perhaps not all. In northern Canada and in the middle of the Pacific and the middle of the Atlantic, there is an abundance of very clean air. It exists, and we do not have to give up any activity in order to have that clean air exist.

However, in Los Angeles, clean air is a scarce resource. We have to give up production of certain goods and services, resources used to make automobiles run with less pollution, and resources to make gasoline burn in a cleaner fashion. Because we must give up something in order to have clean air, clean air is what we call a scarce good.

Click here to return to Question 1.01.









Answer to Question 1.04

Whatever you would choose to do instead of washing dishes is the opportunity cost.  It is the best alternative. 

Click here to return to Question 1.04.













Answer to Question 1.05

There is no one right answer to this question because the one best alternative for one person, the opportunity cost, may be very different than that for the next person. For person A the opportunity cost may be watching TV, while for Person B the opportunity cost may be spending a half-hour in an office working. This distinction is important.

It is safe to assume that the opportunity cost increases as you choose to wash the neighbors’ dishes. We have limited time to do the things we want to do. If we spend more and more of our time doing our own or someone else’s dishes, the value of other forgone opportunities will become increasingly high. The first half-hour may be giving up a chance to catch up with some work; the second may be giving up visiting with some old friends (an important opportunity); and the third might be missing the finish of the Bulls game (and that is important).

Click here to return to Question 1.05.









Answer to Question 1.06

The opportunity cost is what you would have purchased with the money you will spend on the concert and what you would have spent your time doing if you did not go to the concert. We cannot always assign dollar values to opportunity costs, but occasionally we can. If the cost of the concert ticket is $50 and I would have spent those three hours working for $10 per hour, the opportunity cost of going to the concert is what I could have purchased for $80 (the $50 plus 3 hours times $10). That is what I am giving up.

Note that in this case and in all others, opportunity cost does not include all possible alternatives. The opportunity cost of any choice is what you actually give up – the next best choice. If tonight you would like to go to a movie, visit with some friends, go to a concert, watch a television concert, catch up on sleep, or even study for next week, those are not all opportunity costs if you decide to go to a party instead. The opportunity cost of the party is the one single thing that you would actually have done instead.

Click here to return to Question 1.06.








Answer to Question 1.07

Once again, the cost is what I give up by going to the concert. So, it is the cost of the ticket plus what I would have done with my time. In this case, however, the ticket cost has changed. Now, I do not give up the original $50. Assuming that the best price I can get for the ticket is $120, that is the real cost of the ticket for me now. 

This is a much more difficult concept. You didn’t pay $120, but in a very real sense that is what you are giving up to go to the concert now. That, in that very real sense, is the real cost of the ticket. The $120 is the opportunity cost (along with what you would have done with your time). 

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Answer to Question 1.22

For those who do not know of him, Warren Buffett is the billionaire investor and entrepreneur, CEO of Berkshire Hathaway. Perhaps the second richest person in the world, he is reported to be very talented. It seems strange that he would not be hired for a job when he was not even asking for a salary. It is possible that the company did not see Buffett’s future potential. It is also possible and highly likely that Buffett would have been of little use to the company. It may have been more trouble than it was worth for the company to spend time training Buffett. The marginal cost of the time it would have taken to train Buffett exceeded the marginal benefit that the training would have created. Graham made a rational economic decision.

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Answer to Question 1.26

​A rational decision maker will choose to do something whenever the marginal benefit exceeds the marginal cost. Such a decision makes the decision maker better off. The marginal cost of doing something is the opportunity cost - the value of the best-forgone alternative

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Answer to Question 1.27

A past explicit payment seems very real but is irrelevant to my decision about whether or not to keep doing something now. That past payment is not affected by my choice now. What is affected by my choice now is how much I could save now if I did not choose not to do something now. Or how much I could sell something for now, if that is part of the decision. 

If I actually paid for an automobile three years ago, that is, wrote a check or handed over cash or paid a credit card charge, it seems and actually was at the time a real cost. But now, I cannot undo that. It is not part of the cost of driving that car now. The actual cost now is what could I get for the car if I sold it today. That is what I am giving up and is the real, effective, and meaningful measure of what it costs me now to drive that car. 

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Answer to Question 1.29

 If I had something better to do, I should do it. My statement is that this is the best thing I can imagine. Just not worded in the nicest fashion possible. I am not having to give up anything that is more valuable.

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Image Credits

[1] Image courtesy of Ulrich Lange under CC BY-SA 3.0.

[2] Image courtesy of Snapwire under CC0 1.0.

      Image courtesy of tpdave under CC0 1.0.

[3] Image courtesy of Lynne Kirton under CC BY-SA 2.0.

[4] Image courtesy of Mixabest under CC BY-SA 3.0.

[5] Image courtesy of Tulane Public Relations under CC BY 2.0

      Image courtesy of Tulane Public Relations under CC BY-SA 4.0.

[6] Image courtesy of Felivet in the Public Domain.

[7] Image courtesy of AgnosticPreachersKid in the Public Domain


References

[1]​ Musgrave, Richard A. "Hansen, Alvin (1887–1975)." The New Palgrave Dictionary of Economics. Second Edition. Eds. Steven N. Durlauf and Lawrence E. Blume. Palgrave Macmillan, 2008. The New Palgrave Dictionary of Economics Online. Palgrave Macmillan. 28 November 2017 http://www.dictionaryofeconomics.com/article?id=pde2008_H000014&edition=current&q=alvin%20hansen&topicid=&result_number=1 



Microeconomics: the study of markets and their consequences, choices made by consumers and firms, and the role of government in influencing the outcomes of markets.
Macroeconomics: The study of the economy as a whole. Unemployment, inflation, economic growth, and related economic policies are central topics.
Labor force includes those with a job and those who want a job but don't have one.
Capital: Factories, machines, inventories, and tools in an economy. Sometimes described as physical capital. Capital is used in producing other goods and services.
Economic resources: Labor, capital, and natural resources that can be used to produce goods and services.
Scarcity: Our wants are greater than our abilities to satisfy them. This necessitates making choices about how we use our resources.
Do we have to give up anything to have clean air?
Opportunity cost: What one actually gives up doing when making a choice. It is the value of the best forgone alternative.
What would you actually do with the time given up? Compare what you give up for the first washing with what you would have to give up with the second. And on and on.
There is no one right answer to this question because the one best alternative for one person, the opportunity cost, may be very different than that for the next person.
It is not the $50. What would you do with the time and money?
What do I actually give up with this decision?
Sunk costs: A cost that has already been paid and cannot be recovered.
Fixed costs: Costs that do not change as we make a decision.
Marginal benefit:The increase in benefits resulting from an action. Or the increase in benefits resulting from producing one more unit of output.
Marginal cost: The increase in costs resulting from an action. Or the increase in costs resulting from producing one more unit of output.
Decision-making rule: If the additional benefits (correctly measured) are greater than the additional costs incurred (correctly measured), go for it. If the additional costs are greater than the additional benefits, do not do it
Think about the cost to the business of bringing you on. What are benefits to the business? Why would the comparison lead to a recommendation not to offer you a non-paying internship? This is a tough one. Think it through.
A rational decision maker does what is best. How did we use marginal cost and marginal benefit to determine what is best?
What is it about past costs? What is it about costs that I do not pay by check or turning over cash?
What is really a compliment embedded within this statement?
Markets: methods through which buyers and sellers come together and determine the prices of goods and the quantities that will be exchanged.