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Class Notes for InMicro, 2018 Edition

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    Instructor’s Manual InMicro FIRST EDITION R. Glenn Hubbard Anthony Patrick O’Brien

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    Contents Chapter 1 : Economics: Foundations and Models 1 Appendix: Using Graphs and Formulas 12 Chapter 2 : Trade - offs, Comparative Advantage, and the Market System 14 Chapter 3 : Where Prices Come From: The Interaction of Demand and Supply 22 Chapter 4 : Economic Efficiency, Government Price Setting, and Taxes 34 Appendix: Quantitative Demand and Supply Analysis 42 Chapter 5 : Externalities, Environmental Policy, and Public Goods 45 Chapter 6 : Elasticity: The Responsiveness of Demand and Supply 56 Chapter 7 : The Economics of Health Care 69 Chapter 8 : Firms, the Stock Market, and Corporate Governance 79 Appendix: Tools to Analyze Firms’ Financial Information 90 Chapter 9 : Comparative Advantage and the Gains from International Trade 93 Chapter 10 : Consumer Choice and Behavioral Economics 109 Appendix : Using Indifference Curves and Budget Lines to Understand Consumer Behavior 119 Chapter 1 1 : Technology, Production, and Costs 122 Appendix: Using Isoquants and Isocost Line s to Understand Production and Cost 137

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    Chapter 12 : Firms in Perfectly Competitive Markets 141 Chapter 13 : Monopolistic Competition: The Competitive Model in a More Realistic Setting 156 Chapter 14 : Oligopoly: Firms in Less Competitive Markets 171 Chapter 15 : Monopoly and Antitrust Policy 188 Chapter 16 : Pricing Strategy 202 Chapter 17 : The Markets for Labor and Other Factors of Production 208 Chapter 18 : Public Choice, Taxes, and the Distribution of Income 222 Preface Features of this Instructor’s Manual Each chapter of this Instructor’s Manual contains the following elements:

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    Chapter Summary : An overview of the main economic concepts covered. Learning Objectives : A list of the student learning goals listed at the beginning of each chapter. Chapter Outline with Teaching Tips : Detailed descriptions of the economic conc epts in the course , key term definitions, and teaching tip boxes. The teaching tip boxes include recommendations on how to integrate key figures. Extra Solved Problems : Each chapter of the main course has a Solved Problem to support two of the chapter’s learning objectives. This Instructor’s Manual includes extra Solved Problems that you can assign as homework or present during classroom lectures. Extra Economics in Your Life : Each chapter of the course opens and closes with a special feature entitled Economics in Your Life that emphasizes the connection between the material and the students’ personal experiences and questions. This Instructor’s Manual includes an extra Economics in Your Life for each chapter to present in class. Extra Apply the Concept : Eac h chapter of the course has two or more Apply the Concept features to provide real - world reinforcement of key concepts. This Instructor’s Manual includes extra Apply the Concept to present in class.

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    Organizing Your Syllabus The Instructor’s Manual can be a valuable resource for both experienced and first - time instructors. Both the Revel course and Instructor’s Manual provide comprehensive coverage of economic theory, policy, and real - world applications. Th is course cover s relatively new developments in the field, such as the economics of information (Chapter 7, “The Economics of Health Care”) and personnel economics (Chapter 17, “The Markets for Labor and Other Factors of Production”). The authors include business applications in each chapter and have a dedicated chapter on firms, the stock market, and corporate governance (Chapter 8, “Firms, the Stock Market, and Corporate Governance”). The comprehensive coverage of microeconomics and business topics allows instructors to select chapters for diverse groups of students. Most instructors will not want to cover indifference curve analysis or isoquant and isocost curves, but those who wish to will find these topics covered in the appendices to Chapter 10, “Consumer Choice and Behavioral Economics,” and Chapter 11, “ Technology, Production, and Costs,” respectively. Chapter 14 of this instructor’s manual, “Oligopoly: Firms in Less Competitive Markets,” includes coverage of the kinked demand curve that does not appear in the main course. First - time users of the Revel course should be aware that some topics introduced in one chapter are applied in a later chapter. Chapter 4, “Economic Efficiency, Government Price Setting, and Taxes,” introduces consumer, producer , and economic surplus to describe the impact of government - imposed price controls. The appendix to C hapter 4, “Quantitative Demand and Supply Analysis,” explains in detail how consumer and producer surplus are calculated using linear demand and supply curves. Chapter 9, “Comparative Advantage and the Gains from International Trade,” uses the same tools to measure the effect of tariffs and quotas on international trade.

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    The following chart helps you organize your syllabus based on your teaching preferences and objectives: CORE POLICY OPTIONAL Chapte r 1: Economics: Foundations and Models Chapter 2: Trade - offs, Comparative Advantage, and the Market System Chapter 3: Where Prices Come From: The Interaction of Demand and Supply Chapter 6: Elasticity: The Responsiveness of Demand and Supply Chapter 9 : Comparative Advantage and the Gains from International Trade Chapter 11 : Technology, Production, and Costs Chapter 1 2 : Firms in Perfectly Competitive Markets Chapter 13 : Monopolistic Competition: The Competitive Model in a More Realistic Setting Chapter 1 4 : Oligopoly: Firms in Less Competitive Markets Chapter 15 : Monopoly and Antitrust Policy Chapter 4: Economic Efficiency, Government Price Setting, and Taxes Chapter 5: Externalities, Environmental Policy, and Public Goods This chapter may b e delayed until after Chapter 15 . Chapter 7: The Economics of Health Care Chapter 18: Public Choice, Taxes, and the Distribution of Income Chapter 1 Appendix: Using Graphs and Formulas Chapter 4 Appendix: Quantitative Demand and Supply Analysis Chapter 8 : Firms, the Stock Market, and Corporate Governance Chapter 8 Appendix: Tools to Analyze Firms’ Financial Information Chapter 10 : Consumer Choice and Behavioral Economics Chapter 10 Appendix: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Chapter 11 Appendix: Using Isoquants and Isocost Line s to Understand Production and Cost Chapter 16 : Pricing Strategy

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    CORE POLICY OPTIONAL M ay be covered after chapter 1 2 . Chapter 17 : The Markets for Labor and Other Factors of Production

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    Other Supplements for Instructors ▪ Test Item File ▪ TestGen Computerized Test Program ▪ PowerPoint Lecture Presentation ▪ Digital Interactives Test Item File (in electronic TestGen format) The Test Item File includes more than 4 ,000 multiple - choice, short answer, and graphing questions. Test questions are annotated with the following information: Difficulty: 1 for straight recall, 2 for some analysis, 3 for complex analysis Type: multiple - choice, true/false, short - answer, essay Topic: the term or concept the question supports Learning outcome AACSB (see description that follows) The Association to Advance Collegiate Schools of Business (AACSB) The test bank authors have connected select test bank questions to the general knowledge and skill guidelines found in the AACSB standards. What Is the AACSB? AACSB is a not - for - profit corporation of educational institutions, corporations, and other organizations devoted to the promotion and improvement of higher education in business administration and accounting. A collegiate institution offering degrees in business administration or accounting may volunteer for AACSB accreditation review. The AACSB makes initial accreditation decisions and conducts periodic reviews to promote continuous quality improvement in management education. Pearson Education is a proud member of the AACSB and is pleased to provide advice to help you apply AACSB Learning Standards. What Are AACSB Learning Standards? One of the criteria for AACSB accreditation is the quality of the curricula. Although no specific courses are required, the AACSB expects a curriculum to include learning experiences in such areas as: • Written and Oral Communication • Ethical Understanding and Reasoning

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    • Analytical Thinking Skills • Information Technology • Diverse and Multicultural Work • Reflective Thinking • Application of Knowledge These categories are AACSB Learning Standards. Questions that test skills relevant to these standards are tagged with the appropriate standard. For example, a question testing the moral questions associated with externalities would receive the Ethical Reasoning tag. How Can Instructors Use the AACSB Tags? Tagged questions help you measure whether students are grasping the course content that aligns with the AACSB guidelines noted above. In addition, the tagged questions may help instructors identify potential applications of these skills. This in turn may suggest enrichment activities or other educational experiences to help students achieve these skills. TestGen The computerized TestGen package allows instructors to customize, save, and generate classroom tests. The test program permits instructors to edit, add, or delete questions from the test banks; edit existing graphics and create new graphics; analyze test results; and organize a database of tests and student results. This software allows for extensive flexibility and ease of use. It provides many options for organizing and displaying tests, along with search and sort features. The software and the test banks can be downloaded from the Instructor’s Resource Center ( www.pearsonhigher ed.com ). PowerPoint Slides PowerPoint slides can be used by instructors for class presentations or by students for lecture preview or review. These slides include graphs, tables, and equations from the Revel course. They are presented in a step - by - step mode, in which you can build graphs as you would on a blackboard, and automated mode, in which you use a single click per slide. Digital Interactives Focused on a single core topic and organized in progressive levels, each interactive immerses students in an assignable and auto - graded activity. Digital Interactives are also engaging lecture tools for traditional, online, and hybrid courses, many incorporating real - time data, data displays, and analysis tools for rich classroom discussions.

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    CHAPTER 1 | Economics: Foundations and Models Brief Chapter Summary and Learning Objectives 1.1 Three Key Economic Ideas Explain these three key economic ideas: People are rational ; people respond to economic incentives ; and o ptimal decisions are made a t the margin. ▪ P eople must make choices as they try to attain their goals. People make choices because resources are scarce. 1.2 The Economic Proble m That Every Society Must Solve Discuss how an economy answers these questions: What goods and services w ill be produced? How will the goods and services be produced? Who will receive the goods and services produced ? ▪ A limited amount of resources will produce a limited amount of goods and services. ▪ The cost of producing more of one good is the value of w hat must be given up to produce it. 1.3 Economic Models Describe the role of models in economic analysis. ▪ Economists use models — simplified versions of reality — to analyze real - world issues. 1.4 Microeconomics and Macroeconomics Distinguish between microe conomics and macroeconomics. 1.5 A Preview of Important Economic Terms Define important economic terms. Appendix: Using Graphs and Formulas U se graphs and formulas to analyze economic situations. Key Terms Allocative efficiency . A state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it. Centrally planned economy . A n economy in which the government decides how economic resources will be allocated . Economic model . A simplified version of reality used to analyze real - world economic situations. Economic variable . S omething measurable that can have different values, such as the incomes of doctors . Economics . T he study of the choices people make to attain their goals, given their scarce resources.

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    2 CHAPTER 1 | Economics: Foundations and Models Equity . T he fair distribution of economic benefits. Macroeconomics . T he study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. Marginal analysis . Analysis that involves c omparing marginal benefits and marginal costs. Market . A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Market economy . A n economy in which the decisions of households and firms in teract ing in markets allocate economic resources. Microeconomics . T he study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Mixed economy . A n economy in which most economic decisions result from the interaction of buyers and sellers in markets but in which the government plays a significant role in the allocation of resources. Normative analysis . A nalysis concerned with what ought to be. Opportunity cost . T he highest - valued alternative that must be given up to engage in an activity. Positive analysis . A nalysis concerned with what is. Productive efficiency . A situation in which a good or service is produced at the lowest possible cost. Scarcity . A situation in which unlimited wants exceed the limited resources available to fulfill those wants . Trade - off . T he idea that , because of scarcity, producing more of one good or service means producing less of another good or service. Voluntary exchange . A situation that occurs in markets when both the buyer and the seller of a product are made better off by the transaction. Chapter Outline Will Smart Devices Revolutionize Health Care ? Scanadu, a California - based firm , developed a small disk that when pressed against someone ’ s head can read the person ’ s blood pressure, heart rate and temperature. Apple and other firms also have developed new consumer medical devices. These firms reacted to several trends. More people have become health conscious, as the population ages, more people are experiencing medical problems , and technological progress has made it possible for small electronic devices to monitor blood pressure and perform other tasks. These firms are responding to the economic incentives that a market system provides. New and improved goods and services increase the standard of living of the average person.

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    CHAPTER 1 | Economics: Foundations and Models 3 Teaching Tips There are special features in the course : 1. The introduction , or chapter opener, uses a real - world business example to preview the economic issues discussed in the chapter. 2 . A boxed feature titled Economics in Your Life complements the business example that opens the chapter. Economics in Your Life poses questions that help students make a personal connection with the chapter theme. At the end of the chapter, the authors use the concepts described in the chap ter to answer these questions. E xtra Economics in Your Life features are included in the Instructor ’ s Manual s . 3 . Don ’ t Let This Happen to You is a box feature that alerts students to common pitfalls covered in that chapter. 4 . There are between t wo and four Apply the Concept features in each chapter that provide real world reinforcement of key concepts by citing news stories that focus on business and policy issues. Extra Apply the Concept features appear in the Instructor ’ s Manual. 5 . Solved Problems use a step - by - step process f or solving economic problem s related to a chapter learning objective. Extra Solved Problems are included in the Instructor ’ s Manual . You can use these features as the basis for classroom discussion, homework assignme nts, and examination questions. People must make choices as they try to attain their goals. The choices people make represent the trade - offs made necessary by scarcity. Scarcity is a situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economics is the study of the choices people make to attain their goals, given their scarce resources. An economic model is a simplified version of reality used to analyze real - world economic situations. Teaching Tips Students will better understand what scarcity means if you give them examples of things that are not scarce. S uggest examples of “ free ” resources — sand on a beach, fresh air , etc. — and ask your students to contribute their own examples ; they will soon realize that t he list of free resources is much shorter than the list of scarce resources. 1 . 1 Three Key Economic Ideas Learning Objective: Explain these three key economic ideas: People are rational; people respond to economic incentives; and optimal decisions are made at the margin. A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. A. People A re Rational Rational individuals weigh the benefits and costs of each action , and choose an action if the benefits outweigh the costs. B. People Respond to Economic Incentives Economists emphasize that consumers and firms consistently respond to economic incentives.

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    4 CHAPTER 1 | Economics: Foundations and Models C. Optimal Decisions Are Made at the Margin Economists use the word marginal to mean an extra or additional benefit o r cost f rom making a decision. The opti m al decision is to continue any activity to the point where the marginal benefit equals the marginal cost. Marginal analysis is analysis that involves comparing marginal benefits and marginal costs. Extra Solved Problem 1. 1 A Doctor Makes a Decision at the Margin A doctor receives complaints from patients that her office isn ’ t open enough hours. So the doctor asks her office manager to analyze the effect of keeping her office open 9 hours per day rather than 8 hours. The doctor ’ s office manager tells her: “ Keeping the office open an extra hour is a good idea because the revenue from your practice will increase by $300,000 per year when the office is open 9 hours per day. ” Do you agree with the office manager ’ s reasoning? What, if any, additional information do you need to decide whether the doctor should keep her office open an additional hour per day? Solving the Problem Step 1: Review the chapter material. This problem is about making decisions, so you may want to review the section “ Optimal Decisions Are Made at the Margin . ” Step 2: Explain whether you agree with the office manager ’ s reasoning. We have seen that any activity should be continued to the point where the marginal benefit is equal to the marginal cost. In this case, the doctor should keep her office open up to the point where the additional revenue she receives from seeing more patients is equal to the marginal cost of keeping her office open an additional hour. The office manager has provided information on marginal revenue but not on marginal cost. So the office manager has not provided enough information to make a decision, and you should not agree with the office manager ’ s reasoning. Step 3: Explain what addit ional information you need. To make a correct decision, you would need information on the marginal cost of remaining open an extra hour per day. The marginal cost would include the additional salary to be paid to the office staff, any additional medical supplies that would be used, as well as any additional electricity or other utilities. The doctor would also need to take into account the nonmonetary cost of spending another hour working rather than spending time with her family and friends or in other leisure activities. The marginal revenue would depend on how many more patients the doctor can see in the extra hour. The doctor should keep her office open an additional hour if the marginal revenue of doing so is greater than the marginal cost. If the marginal cost is greater than the marginal revenue, then the doctor should continue to keep her office open for 8 hours. Teaching Tips You don ’ t need to spend a lot of class time with explanations of the material in this section; subsequent chapters will reinforce students ’ understanding of markets and the “ three key economic ideas. ”

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    CHAPTER 1 | Economics: Foundations and Models 5 Every society faces the economic problem that it has only a limited amount of economic resources , so it can produce only a limited amount of goods and services. Society faces trade - offs. A trade - off is the idea that , because of scarcity, producing more of one good or service means producing less of another good or service. Every act ivity has an o pportunity cost : T he highest - valued alternative that must be given up to engage in an activity. Trade - offs force society to answer three fundamental questions: 1. What goods and services will be produced? 2 . How will the goods and services be produced? 3 . Who will receive the goods and services produced ? A. What Goods and Services Will Be Produced? The answer to this question is determined by the choices consumers, firms , and the government make. Each choice made comes with an opportunity cost. B. How Will the Goods and Services Be Produced? Firms choose how to produce the goods and services they sell. For example, firms often face trade - off s between using more workers or more machines. C. Who Will Receive the Goods and Services Produced? In the United States, who receive s the goods and services produced depends largely on how income is distributed. An important policy question is whether the government should intervene to make the distribution of income more equal. D. Centrally Planned Economies v ersus Market Economies Societies organize their economies in two main ways. A centrally planned economy is an economy in which the government decides how economic resources will be allocated. A market economy is an economy in which the decisions of households and firms interacting in markets allocate economic resources. Today, only a few small countries, such as Cuba and North Korea, still have completely centrally planned economies. In a market economy , the income of an individual is determined by the payments he receive s for what he sell s . Generally, the more extensive the training a person has received and the longer the hours the person work s , the higher his income will be. E . The Modern “ Mixed ” Economy The high rates of unemployment and business bankruptcies during the Great Depression of the 1930s caused a dramatic increase in government intervention in the economy in the United States and other market economies . Some government intervention is designed to raise the incomes of the elderly, the sick, and people with limited skills. In recent years, government intervention has expanded to meet goals such as the protection of the environment , the promotion of civil rights , and the provision of medical care to low - income people and the elderly . 1 . 2 The Economic Problem That Every Society Must Solve Learning Objective: Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced?

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    6 CHAPTER 1 | Economics: Foundations and Models Some economists argue that the extent of government intervention makes it more accurate to refer to the economies of the U nited States , Canada and Western Europe as mixed economies rather than pure market economies . A mixed economy is an economy in which most economic decisions result from the interaction of buyers and sellers in markets but in which the government plays a significant role in the allocation of resources. F . Efficiency and Equity Market economies tend to be more efficient than centrally planned economies. There are two types of efficiency. Productive efficiency is a situation in which a good or service is produced at the lowest possible cost. Allocative efficiency is a state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it. Voluntary exchange is a situation that occurs in markets when both the buyer and the seller of a product are made better off by the transaction. Inefficiency arises from various sources . Sometimes governments reduce efficiency by interfering with voluntary exchange in markets . T he production of some goods damage s the environment when firms ignore the costs of environmental damage. In this case, government intervention can increase efficiency. Society may not find an efficient econ omic outcome to be desirable. Many people prefer economic outcomes that they consider fair or equitable even if these outcomes are less efficient. Equity is the fair distribution of economic benefits. There is often a trade - off between efficiency and equity. Teaching Tips Ask students for examples of government regulation of private markets in the United States. Responses m a y include: making the sale of cocaine and other addictive drugs illegal ; minimum age requirements for the purchase of alcoholic beverages and cigarettes ; the prohibition of the sale of new drugs before their eff ectiveness is demonstrated through government supervised tests. A sk students whether one of these examples of government regulation promotes equity or fairness. The difficulty in defining equity will be apparent. To show how students may value equity less than they claim, an economics teacher at a college in Western New York once told her students at the beginning of her course that their grades would be auctioned to the highest bidders. Because grades are typically normally distributed, she offered to sell a few A grades, a few more B grades, and so on . Although the announcement produced shock and grumbling, the auction proceeded , with frenzied bidding for A grades. As prices for A grades rose, bidding switched to B grades. Because few students bothered to bid for C grades, one enterprising student bid on several such grades in the belief that those who lost out on getting an A or B would have to buy their C grades from him — for a higher price than he paid! After about a week, the instructor informed the class the auction was intended only as an economics lesson; they would have to earn their grades the old - fashioned way . Extra Solved Problem 1. 2 Advising New Government Leaders Suppose that a country experiences a change in government leadership. Prior to this change , the country had a centrally planned economy. The new leaders are willing to try a different system if they can be can be convince d that it will yield better results. They hire an economist from a country with a market economy to advise them and will order their citizens to follow the economist ’ s recommendations for

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    CHAPTER 1 | Economics: Foundations and Models 7 change. The economist suggests that a market economy replace central planning to answer the nation ’ s economic questions ( what , how , and who ?). What will the economist suggest the leaders order their citizens to do in order to change from a centrally planned economy to a market economy ? Are there reasons why the leaders of this country might not accept the economist ’ s suggestions? Briefly explain. Solving the Problem Step 1: Review the chapter material. The problem is about different types of economic systems, so you may w ant to review the section “ Centrally Planned Economies v ersus Market Economies . ” Step 2: What will the economist suggest the leaders order their citizens to do? Market economies allow members of households to select occupations and purchase goods and services based on self - interest and allow privately owned firms to produce goods and services based on their self - interests. Therefore, the economist would advise the leaders of the country to not issue any orders. Government officials should have no influence over individual decisions made in markets. Step 3: Are there reasons why the leaders of this country might not accept the economist ’ s suggestions? Even democratically elected leaders may find it difficult to accept the new system. They may wonder how self - interested individuals will produce and distribute goods and services so as to promote the welfare of the entire country . This new system requires a significant reduction in government influence in people ’ s lives , but history has shown that most government officials are reluctant to give up this influence. Acceptance is most likely when the leaders have some knowledge and experience with the successful operation of a market economy in other countries. Ordinary citizens are more likely to accept the economist ’ s suggestions because they w ould have more freedom to pursue their own economic goals. 1 . 3 Economic Models Learning Objective: Describe the role of models in economic analysis. Models are simplified versions of reality used to analyze real - world situations. To develop a model, economists generally follow five steps. 1. Decide on the assumptions to use in developing the model. 2. Formulate a testable hypothesis. 3. Use economic data to test the hypothesis. 4. Revise the model if it fails to explain the economic data well . 5. Retain the revised model to help answer similar economic questions in the future. A. The Role of Assumptions in Economic Models Models are based on making assumptions because models must be simplified to be useful. W hen using models economists make behavioral assumptions about the motives of consumers and firms. Economists

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    8 CHAPTER 1 | Economics: Foundations and Models assume consumers will buy goods and services that will maximize their satisfaction and firms will act to maximize their profits. B. Forming and Testing Hypotheses in Economic Models An economic variable is something measurable that can have different values, such as the incomes of doctors. A hypothesis in an economic model is a statement that may be correct or incorrect about an economic variable. To test a hypothesis , we analyze statistics on the relevant economic variables. Economists accept and use an economic model i f it leads to hypotheses that are confirmed by statistical analysis. C . Positive and Normative Analysis Positive analysis is analysis concerned with what is. Normative analysis is analysis concerned with what ought to be. Economics is about positive analysis, which measures the costs and benefits of different courses of action. D. Economics as a Social Science Because economics studies the actions of individuals, it is a social science. Economics considers human behavior in every context, not just in the context of business. Economists have played an important role in formulating government policies in areas such as the environment, health care, and poverty. Extra Solved Problem 1.3 Sunspot Activity and the Market for Natural Gas Sunspots are sites of strong magnetic fields that appear as dark regions on the surface of the sun. The number of sunspots varies over an eleven - year cycle. Scientists have found that the Earth ’ s temperature declines when the number of sunspots decreases, so when the number of sunspots decline s there is an expectation that a period of lower temperatures will follow. British economist William Stanley Jevons (1835 – 1882) developed a model of economic growth based on the occurrence of sunspots. Jevons hypothesized that when the earth ’ s temperature varied throughout the sunspot cycle, agricultural output would change too . Today, most economists attribute changes in economic growth to factors other than sunspots. But some analysts believe that changes in sunspot activity could result in changes in the demand and price for natural gas in the United States. The development of new technology has resulted in a large increase in the production of natural gas in the U.S. in the twenty - first century. As a result, natural gas has replaced other sources of energy for businesses and households and lower temperatures could lead to an increase in the demand for natural gas. How can we deve lop a model that test s the relationship between sunspot activity and the market for natural gas? Source: Simon Constable , “ As ‘ Sun Spots ’ Cool Down, Natural - Gas Market Heats Up, ” Wall Street Journa l , July 1, 2013. Solving the Problem Step 1: Review the chapter material. The problem is about how to use models to analyze economic issues, so you may want to review the section “ Economic Models . ”

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    CHAPTER 1 | Economics: Foundations and Models 9 Step 2: To develop and test a model of the relationship between sunspot activity and the market for natural gas, follow these steps: 1. Decide on the assumptions to use in developing the model . Two assumptions of the model are: (a) Changes in the earth ’ s temperature are related to changes in the amount of sunspot activity, and (b) C hanges in the earth ’ s temperature cause variations in the demand for natural gas, which is an energy source for homes and businesses . 2. Formulate a testable hypothesis . All else equal, t he demand for natural gas and the price of natural gas will be higher in years when there is lowe r than average sunspot activity. All else equal, t he demand for natural gas and the price of natural gas will be lower in years when there is higher than average sunspot activity. 3. Use economic data to test the hypothesis . Compare changes in sunspot activity with changes in sales and the price of natural gas . Because sunspot activity varies in eleven - year cycles, data should cover at least one of these cycles. F or the United States , years of greater - than - average sunspot activity should be years of relatively low sales and prices for natural gas, while years of lower - than - aver age sunspot activity should be years of higher sales and prices for natural gas . 4. Revise the model if it fails to explain the economic data well . The model could fail because factors other than sunspot activity can have a significant effect the market for natural gas . These factors include : changes in the prices of other energy sources , changes in the cost of production for natural gas and changes in government policies towards energy markets . A revised model would examine the separate influence of sunspots and these other factors. The model could also fail if factors other than sunspot activity, such as an increase in the amount of “ greenhouse gases ” in the atmosphere, affect the Earth ’ s temperature. 5. Retain the revised model to help answer similar economic questions in the future . If the data support the model, one can assume that there is a relationship between sunspot activity and the market for natural gas. But tests of the model with data from different time periods could either support or refute these results. Acceptance of a model is always tentative pending the acquisition of new data or additional statistical analysis. 1 . 4 Microeconomics and Macroeconomics Learning Objective: Distinguish between microeconomics and macroeconomics. Microeconomics is the study of how households and firm s make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. Extra Solved Problem 1. 4 Microeconomic and Macroeconomic Views Sports fans are used to watching events on television from different camera angles. For popular events such as the Olympics, the World Series, and th e Super Bowl, network coverage captures action from ground level as well as higher locations. B limp s are frequently flown above the stadium s where the event s take place . The aerial view of the blimp ’ s camera is visually appealing but is never broadcast for very long because the athletes are barely visible. Coverage of games includes a view from a mobile or

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    10 CHAPTER 1 | Economics: Foundations and Models “ sideline ” camera that can zoom in on individual players or fans sitting in the stands, a degree of detail much greater than that provided by the aerial view. How do the different camera angles help to explain the difference between microeconomics and macroeconomics? Solving the Problem Step 1: Review the chapter material. The problem concerns the differences between microeconomics and macroeconomics, so you may want to review the section “ Microeconomics and Macroeconomics . ” Step 2: Compare the focus of microeconomics with television coverage of a sports event. Microeconomics focuses on how individual households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. This focus is similar to that of a sideline camera at a football or baseball game. Step 3: Compare the focus of macroeconomics with the television coverage of a sports event. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment , and economic growth. Macroeconomics does not study the decisions made by individuals but the consequences of the actions of all decision makers in an economy. This is similar to the blimp ’ s aerial view of the venue where a sports event occurs. One can see the entire venue, but the blimp ’ s point of view is too far away to see any individual player or fan. Extra Apply the Concept Macroeconomic and Microeconomic Analysis Economists separate the study of how households and firms make choices and interact in markets (microeconomics) from the study of the economy as a whole (macroeconomics). But some issues can be viewed from both perspectives. Labor productivity is one such issue. Labor productivity — the quantity of goods and services that can be produced by one worker or by one hour of work — is a microeconomic topic. Labor productivity increases when a firm invests in capital or experiences an improvement in technology . Increased labor productivity allows a firm to ear n higher profits and pay its workers higher wages. But m acroeconomists also study labor productivity because it determines the standard of living a country can achieve for its citizens. An increase in productivity is beneficial in the long run, but it can slow the growth of jobs in the short run. Following the recessions of 2001 and 2007 – 2009, many economists were concerned that the unemployment rate did not decrease as quickly as it did following previous recessions. One reason for this was an increase in productivity. The Bureau of Labor Statistics reported that output per hour worked of all persons rose by over 3 percent in both 2009 and 2010. Because workers were more productive, firms did not have to hire new workers to produce the same amount of goods and services. But productivity growth slowed to a bout 1 percent or less from 2011 to 2014. Some e conomists attribute the slowdown in productivity growth to a decline in investments in research by U.S. firms from the high levels reached after 1995, which resulted in advancements in computer - related applications. Other economists claim that many recent improvements in productivity escape measurement. Google Inc. ’ s chief economist Hal Varian has argued that many innovations — such as apps

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    CHAPTER 1 | Economics: Foundations and Models 11 that can be used via cell phones to track locations or hailing taxis — lead to improvements in productivity “ But I doubt that gets measured anywhere. ” Sources: Department of Labor (Bureau of Labor Statistics); and T imothy Aeppel , “ Silicon Valley Doesn ’ t Believe U.S. Productivity Is Down , ” Wall Street Journal , July 16, 201 5 . 1 . 5 A Preview of Important Economic Terms Learning Objective: Define important economic terms. This section provides a brief definition and preview of terms students will see throughout the course : firm (company, or business), entrepreneur, innovation, technology , goods, services, revenue, profit, household, factors of production ( economic resources or inputs ) , capital , and human capital. Extra Economics in Your Life: Is Cheating a Ration al Decision? In their best - selling book Freakonomics , Steven D. Levitt and Stephen J. Dubner stated: “ Who cheats? Well, just about anyone, if the stakes are right . . . . Cheating . . . is a prominent feature in just about every human endeavor. ” Evidence that some people cheat surfaced in the summer of 2011 when the superintendent of the board of the Atlanta school district resigned after a report documented widespread cheating on standardized tests that implicated officials from about 80 percent of Atlanta ’ s elementary and middle schools. In 2015 , an Atlanta jury convicted 11 teachers as a result of the cheating scandal. Steven Levitt and other economists assume that decision - makers — students and non - students alike — are rational. They compare the benefits and costs of their options and make choices for which the expected benefits exceed the expected costs. The benefits of (successful) cheating may be monetary; for example, K - 12 teachers in some states are eligible for bonus payments of up to $25,000 if their students perform well on standardized tests. New technology has made it easier for high school and college students to cheat. The widespread use of cell phones and Internet access makes it easier (less costly) to share exam answers and buy term papers. Sources: Steven D. Levitt and Stephen J. Dubner, Freakonomics New York: HarperCollins 2005, pages 24 – 25; Patrik Jonsson, “ America ’ s biggest teacher and principal cheating scandal unfolds in Atlanta, ” Christian Science Monitor , July 5, 2011; Mary Beth McCauley, “ Atlanta school cheating: When teachers cheat, what do you tell the kids? ” Christian Science Monitor , September 5, 2013; and Valerie Straus s , “ How and Why Convicted Teachers Cheated on Standardized Tests, ” Washington Post , April 1, 2015. Question : For the sake of argument, let ’ s assume that you would never cheat. Under what circumstances are students in general more or less likely to cheat on an economics examination? Answer : Y our economics instructor will be pleased if you would never cheat under any circumstances. But cheating is more likely when: (a) the positive consequences of receiving a high grade are significant (for example, a high grade is necessary to maintain a scholars hip, gain admittance to medical school, or get a good job offer), and/or (b) the probability of getting caught is low (the instructor gives the same multiple - choice exam to all students in a large classroom with no supervision). Reducing the benefit and increasing the cost of getting caught will reduce the incidence of cheating. If appeals to personal integrity are not enough to convince students not to cheat, a more effective deterrent may be for potential employers to let students know that they fire dishonest employees.

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    12 CHAPTER 1 | Economics: Foundations and Models Appendix Using Graphs and Formulas Learning Objective: Use graphs and formulas to analyze economic situations. Graphs simplify economic ideas and make the ideas more concrete so they can be applied to real - world problems. Graphs of One Variable Figure 1A. 1 displays examples of two common types of graphs: bar graph s and pie chart s . The height of the bars in the bar graph represents the market shares of automobile firms. The pie chart shows the same information with the market share s of each group of firms represented by the size of its slice of the pie. Information on economic variables can also be displayed in time - series graphs. These graphs are displayed on a coordinate grid. The vertical axis ( y - axis) of a coordinate grid measures the value of one variable. The point where the vertical axis intersects the horizontal axis is the origin. The horizontal axis of a coordinate grid measures the value of another variable. The points in a coordinate grid represent the values of the two variables. Figure 1A . 2 illustrates example s of time - series graph s . Graphs of Two Variables We often use graphs to show the relationship between two variables. Figure 1A . 3 illustrates the graph of a linear or straight - line demand curve where price is measured along the vertical axis and quantity is measured along the horizontal axis. A . Slopes of Lines The slope of a straight line indicates how much the variable measured along the y - axis changes as the variable measured along the x - axis changes. Slope can be measured between any two points on the line because the slope of a straight line has a constant value. The s lope can be expressed as the change in the v alue measured on the vertical axis divided by the change in the value measured on the horizontal axis; slope can also be expressed using the Greek letter delta (Δ) to stand for the change in a variable (slope = Δ y /Δ x ). The slope is also referred to as the rise over the run. Change in value on the vertical axis Rise Slope Change in the value on the horizontal axis Run y x  = = =  B . Taking i nto Account More Than Two Variables on a Graph The demand curve in Figure 1A . 4 shows the relationship between the price of pizza and the quantity of pizza sold , but the quantity of any good sold depends on more than just the price of the good. Allowing other variables to change will cause the position of the demand curve in the graph to change. The table in Figure 1A . 5 shows the effect of a change in the price of hamburgers on the quantity of pizza demanded. By shifting the demand curve we take into account the effect of changes in a third variable. C . Positive and Negative Relationships Sometimes the relationship between two variables is negative, as in the case with the price of pizza and the quantity of pizza demanded. The relationship between two variables can be positive, as in Figure 1A . 6 which shows values for disposable personal income and consumption spending in the United States for 2011 – 201 4 .

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    CHAPTER 1 | Economics: Foundations and Models 13 D . Determining Cause and Effect Inferring cause and effect relationships by observing graphs can lead to incorrect conclusions. One reason for this is that there may be an omitted variable that is n ot accounted for in the graph. A related problem in determining cause and effect is reverse causality; this occurs when we conclude that changes in variable X cause changes in variable Y, when changes in variable Y cause changes in variable X. E . Are Graphs of Economic Relationships Always Straight Lines? The relationship between two variables is linear when it can be represented by a straight line. Few economic rel ationships are actually linear. However, it is often useful to approximate a nonlinear relationship with a linear relationship. F . Slopes of Nonlinear Curves To measure the slope of a nonlinear curve at a particular point, we must measure the slope of a tangent to the curve at that point. A tangent line touches the curve at only one point. The slope of a tangent is measured in the same way as the slope of any straight line. Formulas This section reviews several useful formulas and show s how to use them. A . Formula for a Percentage Change The formula for a percentage change between two variables for any two periods is : Percentage change Value in the second period Value in the first period 100 Value in the first period − =  B . Formulas for the Areas of a Rectangle and a Triangle The formula for the area of a rectangle is B ase × H eight. The formula for the area of a triangle is ½ × B ase × H eight. C. Summary of Using Formulas Follow these steps when using a formula: 1. Make sure you understand the economic concept the formula represents. 2. Make sure you are using the correct formula for the problem you are solving. 3. Make sure the number you calculate using the formula is economically reasonable. Teaching Tips You can assign the appendix as “ on your own ” reading. But don ’ t assume students will understand the formula s for computing a slope or a percentage change. Reviewing these formulas in class will be time well spent, either at this point in the course or when these formulas are first applied. In particular, s tudents will need to use graphs of two variables and percentage changes often throughout the remainder of the course .

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    CHAPTER 2 | Trade - offs, Comparative Advantage, and the Market System Brief Chapter Summary and Learning Objectives 2.1 Production Possibilities Frontiers and Opportunity Costs Use a production possibilities frontier to analyze opportunity costs and trad e - offs. ▪ The model of the production possibilities frontier is used to analyze the opportunity costs and trade - offs that individuals, firms, or countries face. 2.2 Comparative Advantage and Trade Describe comparative advantage and explain how it serves a s the basis for trade. ▪ Comparative advantage is the ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than other producers. 2.3 The Market System Explain the basic s of how a market system works. ▪ Markets enable buyers and sellers of goods and services to come together to trade. Key Terms Absolute advantage . T he ability of an individual , a firm, or a country to produce more of a good or service than competitors, using the same amount of resources. Circular - flow diagram . A model that illustrates how participants in markets are linked. Comparative advantage . T he ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Economic growth . T he ability of the economy to increas e the production of goods and services. Entrepreneur . S omeone who operates a business, bringing together the factors of production — labor, capital, and natural resources — to produce goods and services. Factor market . A m arket for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability. Factors of production . Labor, capital, natural resources, and other inputs used to make goods and services. Free m arket . A market with few government restrictions on how a good or service can be produced or sold or on how a factor of production can be employed. Market . A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

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    14 CHAPTER 2 | Trade - offs, Comparative Advantage, and the Market System Opportunity cost . T he highest - valued alternative that must be given up to engage in an activity. Product market . A m arket for goods — such as computers — or services — such as medical treatment. Production possibilities frontier ( PPF ) . A curve showing the maximum attainable combinations of two products that can be produced with available resources and current technology . Property rights . T he rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it. Scarcity . A situation in which unlimited wants exceed the limited resources available to fulfill those wants. Trade . T he act of buying and selling. Chapter Outline Managers at Tesla Motors Face Trade - Offs All - electric cars have struggled in the marketplace because the batter ies that power them are costly and the y have to be recharged about every 300 miles. Although sales of all - electric cars made by Tesla Motors represented only 0.1 percent of the U.S. car market in 2015, the company planned to introduce a new, lower - priced model that would appeal to people who had bought gasoline - powered cars. Tesla initially sold its Model S sedan for a base price of $75,000. It began selling a second automobile — the Model X — in late 2015. The Model X was designed to compete with gasoline - powered SUVs but also sold for a very high base price. To gain significant market share Tesla must allocate resources to produce an all - electric car for about $35,000. Tesla ’ s managers must also decide how to sell and service the cars the company sells. T esla only sells cars online and relies on company - owned service centers for maintenance and repairs. Tesla will likely face increased competition in future years from Apple and other companies that are exploring the electric vehicle market. 2 . 1 Production Possibilities Frontiers and Opportunity Costs Learning Objective: Use a production possibilities frontier to analyze opportunity costs and trade - offs. A key fact of economic life is that scarcity requires trade - offs. Scarcity is a situation in which unlimited wants exceed the limited resources available to fulfill those wants. Goods and services and the resources, or factors of production, that are used to make goods and services, are scarce. A production possibilities frontier ( PPF ) is a curve showing the maximum attainable combinations of two products that can be produced with available resources and current technology. A. Graphing the Production Possibilities Frontier All c ombinations of products located on the production possibilities frontier are efficient because all available resources are being used. Combinations inside the frontier are inefficient because maximum output is not being obtained from available resources . Points outside the frontier are unattainable given the firm ’ s current resources. Opportunity cost is the highest - valued alternative that must be given up to engage in an activity.

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    CHAPTER 2 | Trade - offs, Comparative Advantage, and the Market System 15 B. Increasing Marginal Opportunity Costs A production possibilities frontier that is bowed outward illustrates increasi ng marginal opportunity costs , which occur because some workers, machines, and other resources are better suited to one use than to another. Increasing marginal opportunity costs i llustrate an important concept: T he more resources already devoted to any activity, the smaller the payoff to devoting additional resources to that activity. C. Economic Growth Economic growth is the ability of the economy to increas e the production of goods and services. Economic growth can occur if more resources become available or if a technological advance makes resources more productive. Growth may lead to greater increases in production for one good than another. Extra Apply the Concept Facing Trade - offs in Health Care Spending Households have limited incomes. If the price of health care rises, households have to choose whether to buy less health care or spend less on other goods and services. The same is true of the federal government ’ s spending on health care. The government provides health insurance to about 30 percent of the population through programs such as Medicare for people over age 65 and Medicaid for low - income people. If the price of health care rises, the government has to either cut back on the services provided through Medicare and Medicaid or cut spending in another part of the government ’ s budget. (Of course, both households and the government can borrow to pay for some of their spending, but ultimately the funds they can borrow are also limited.) About 54 percent of the population has private health insurance, often provided by an employer. When the fees doctors charge, the cost of prescription drugs, and the cost of hospital stays rise, the cost to employers of providing health insurance increases. As a result, employers will typically increase the amount they withhold from employees ’ paychecks to pay for the insurance. Some employers — particularly small firms — will even stop offering health insurance to their employees. In either case, the price employees pay for health care will rise. How do people respond to rising health care costs? Isn ’ t health care a necessity that people continue to consume the same amount of, no matter how much its price increases? In fact, studies have shown that rising health care costs cause people to cut back their spending on medical services, just as people cut back their spending on other goods and services when their prices rise. One academic study indicates that for every 1 percent increase in the amount employers charge employees for insurance, 164,000 people become uninsured. Of course, people without health insurance can still visit the doctor and obtain prescriptions, but they have to pay higher prices than do people with insurance. Although the consequences of being uninsured can be severe, particularly if someone develops a serious illness, economists are not surprised that higher prices for health insurance lead to less health insurance being purchased: Faced with limited incomes, people have to make choices among the goods and services they buy. The Congressional Budget Office estimates that as the U.S. population ages and medical costs continue to rise, federal government spending on Medicare will more than double over the next 10 years. Many policymakers are concerned that this rapid increase in Medicare spending will force a reduction in spending on other government programs. Daniel Callahan, a researcher at the Hastings Center for Bioethics, has argued that policymakers should consider taking some dramatic steps, such as having Medicare stop pa ying for open - heart surgery and other expensive treatments for people over 80 years of age. Callahan argues that the costs of open - heart surgery and similar treatments for the very old exceed the benefits, and the funds would be better spent on treatments for younger patients, where the benefits would exceed the costs. Spending less on prolonging the lives of the very old in order to save resources

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    16 CHAPTER 2 | Trade - offs, Comparative Advantage, and the Market System that can be used for other purposes is a very painful trade - off to consider. But in a world of scarcity, trade - offs of some kind are inevitable. Source s : Daniel Callahan, “ The Economic Woes of Medicare, ” The New York Times , November 13, 2008; Ezekiel J. Emanuel, “ The Cost – Coverage Trade - off, ” Journal of the American Medical Association , Vol. 299, No. 8, February 27, 2008, pp. 947 – 949; and Congressional Budget Office, A Preliminary Analysis of the President ’ s Budget and an Update of CBO ’ s Budget and Economic Outlook, March 2009 . Questions & Solutions 1. Suppose the U.S. president is attempting to decide whether the federal government should spend more on research to find a cure for heart disease. He asks you, one of his economic advisors, to prepare a report discussing the relevant factors he should consider. Use the concepts of opportunity cost and trade - offs to discuss some of the main issues you would deal with in your report. Solution: If the federal government has a fixed budget for medical research, then the opportunity cost of funding more research on heart disease is the reduction in funding for research on other diseases. The decision should be made at the margin: to maximize the benefits from government spending on medical research, the last dollar devoted to research on heart disease should result in the same marginal benefit — less disease and fewer deaths — as the last dollar spent on research for other diseases. If the additional funding for research on heart disease comes at the expense of other non - medical research expenditures, then the opportunity cost will be different, but a similar analysis should be conducted. 2. Uwe Reinhardt, an economist at Princeton University, wrote the following in a column in the New York Times : [Cost - effectiveness analysis] seeks to establish which of several alternative strategies capable of achieving a given therapeutic goal is the least - cost strategy. It seems a sensible form of inquiry in a nation that is dismayed over the rising cost of health care. . . . Opponents of cost - effectiveness analysis include individuals who sincerely believe that health and life are “ priceless. ” Are health and life priceless? Are there any decisions you make during your everyday life that indicate whether you consider health and life to be priceless? Source: Uwe E. Reinhardt, “‘ Cost - Effectiveness Analysis ’ and U.S. Health Care, ” The New York Times , March 13, 2009. Solution: Nothing is priceless. Every day we makes decisions, such as driving a car or flying in a plane, that increase by at least a small amount the chances that we will be hurt or killed. If health and life were literally priceless, every decision we make would have the sole objective of minimizing the chances of our being injured or killed. In a broader sense, we do not devote all of our resources to improving health care because resources devoted to, say, saving lives through medical res earch are not available for other needs, such as improving education. We always have to consider the opportunity cost of using resources in one way rather than in another.

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    CHAPTER 2 | Trade - offs, Comparative Advantage, and the Market System 17 2 . 2 Comparative Advantage and Trade Learning Objective: Describe comparative advantage and explain how it serves as the basis for trade. Trade is the act of buying and selling. T rade makes it possible for people to become better off by increasing both their production and their consumption. A. Specialization and Gains from Trade PPF s depict the combinations of two goods that can be produced if no trade occurs. We can use PPF s to show how someone can benefit from trade even if she is better than someone else at producing both goods. B. Absolute Advantage v ersus Comparative Advantage Absolute advantage is the ability of an individual, a firm, or a country to produce more of a good or service than competitors , using the same amount of resources. If the two individuals have different opportunity costs for producing two goods, e ach individual will have a comparative advantage in the production of one of the goods . Comparative advantage is the ability of an individual , a firm, or a country to produce a good or service at a lower opportunity cost than competito rs. Comparing the possible combinations of production and consumption before and after specialization and trade occur proves that trade is mutually beneficial. C. Comparative Advantage and the Gains from Trade The basis for trade is comparative advantage, not absolute advantage. Individuals, firms, and countries are better off if they specialize in producing the goods and services for which they have a comparative advantage and obtain the other goods and services they need by trading. Teaching Tips Even good students have difficulty understanding comparative advantage. A good example of comparative advantage is the career of baseball legend Babe Ruth. Before he achieved his greatest fame as a home run hitter and outfielder with the New York Yankees, Ruth was a star pitcher with the Boston Red Sox. Ruth may have been the best left - handed pitcher in the American League during his years with Boston (1914 – 1919), but he was used more as a n out fielder in his last two years with the team. In fact, he established a record for home runs in a season (29) in 1919. The Yankees acquired Ruth in 1920 and made him a full - time outfielder. The opportunity cost of this decision for the Yankees was the wins he could have earned as a pitcher. But because New York already had skilled pitchers, the opportunity cost of replacing him as a pitcher was lower than the cost of replacing Ruth as a hitter. No one else on the Yankees could have hit 54 home runs, Ruth ’ s total in 1920; the next highest total was 11. It can be argued that Ruth had an absolute advantage as both a hitter and pitcher for the Yankees in 1920, but a comparative advantage only as a hitter . 2 . 3 The Market System Learning Objective: Explain the basics of how a market system works. In the United States and most other countries, trade is carried out in markets. A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. A p roduct market is a market for goods — such as computers — or services — such as medical treatment. A f actor market is a market for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability. Factors of production are the labor, capital, natural resources, and other inputs used to make goods and services.

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    18 CHAPTER 2 | Trade - offs, Comparative Advantage, and the Market System A. The Circular Flow of Income A circular - flow diagram is a model that illustrates how participants in markets are linked. The diagram demonstrates the interaction between firms and households in both product and factor markets. B. The Gains from Free Markets A free market is a market with few government restrictions on how a good or service can be produced or sold or on how a factor of production can be employed. Adam Smith is considered the father of modern economics. His book, An Inquiry into the Nature and Causes of the Wealth of Nations , published in 1776, was an influential argument for the free market system. C. The Market Mechanism A key to understanding Adam Smith ’ s argument is the assumption that individuals usually act in a rational, self - interested way. This assumption underlies nearly all economic analysis. D. The Role of the Entrepreneur in the Market System Entrepreneurs are an essential part of a market economy. An entrepreneur is someone who operates a business, bringing together the factors of production — labor, capital, and natural resources — to produce goods and services. Entrepreneurs often risk their own funds to start businesses and organize factors of production to produce those goods and services that consumers want. E. The Legal Basis of a Successful Market System The absence of government intervention is not enough for a market economy to work well. Government has to provide a legal environment that allows markets to operate efficiently. Property rights are the rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it. To protect intellectual property rights, the federal government grants a patent that gives an inventor – often a firm — the exclusive right to produce and sell a new product for 20 years from the date the patent was filed . Books, films, and software receive copyright protecti on. Under U.S. law, the creator of a book, film, or piece of music has the exclus ive right to use the creation during the creator ’ s lifetime . The creator ’ s heirs retain this right for 7 0 years after the death of the creator. Business activity often involves someone agreeing to carry out some action in the future. These agreements often take the form of legal contracts. For the market system to work, businesses and individuals have to rely on these contracts being carried out. Enforcing contracts or property rights requires an independent court system and judges who are able to make impartial decisions on the basis of the law. If property rights are not well enforced fewer goods and services will be produced, leaving the economy inside its production possibilities frontier. Teaching Tips To initiate class discussion regarding intellectual property rights, ask students these questions: 1. How many of you have downloaded music via the Internet? 2. Should the government have the right to grant exclusive rights to musicians and other artists to produce and sell their creative works? 3. Should the government fine or prosecute individuals who illegally obtain music, books, movies, and other creative works in violation of property rights laws?

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    CHAPTER 2 | Trade - offs, Comparative Advantage, and the Market System 19 Extra Solved Problem 2.3 Adam Smith ’ s “ Invisible Hand ” Alan Krueger, an economist at Princeton University who served as chair of the Council of Economic Advisers in the Obama administration , has argued that Adam Smith “ . . . worried that if merchants and manufacturers pursued their self - interest by seeking government regulation and privilege, the invisible hand would not work its magic . . . . ” Source: Alan B. Krueger, “ Rediscovering the Wealth of Nations, ” New York Times , August 16, 2001. a. What types of regulation and privilege might merchants and manufacturers seek from the government? b. How might these regulations and privileges keep the invisible hand from working? Solving the Problem Step 1: Review the chapter material. This problem is about how goods and services are produced and sold and how factors of production are employed in a free market economic system as described by Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations . You may want to review the section “ The Gains from Free Markets . ” Step 2: Answer part a. by describing the economic system in place in Europe in 1776. At the time, governments gave guilds — associations of producers — the authority to control production. The production controls limited the output of goods such as shoes and clothing, as well as the number of producers of these items. Limiting production and competition led to higher prices and fewer choices for consumers. Instead of catering to the wants of consumers, producers sought favors from government officials. Step 3: Answer part b. by contrasting the behavior of merchants and manufacturers under a guild system and a market system. Because governments in a guild system gave producers the power to control production, producers did not have to respond to consumers ’ demands for better quality, greater variety, and lower prices. Under a market system, producers who sell poor quality goods at high prices suffer economic losses; producers who provide better quality goods at low prices are rewarded with profits. Therefore, it is in the self - interest of producers to address consumer wants. This is how the i nvisible hand works in a free market economy, but not in most of Europe in the eighteenth century. Extra Economics in Y our L ife : International Trade and Household Income Many people believe that o utsourcing — firms producing goods and service s outside of their home country — harms their nations ’ economies by increasing domestic unemployment and decreasing incomes. But most economists believe that free trade policies, including allowing goods and services to be produced in other countries, benefit domestic economies. In a letter dated March 5 th 2015 , 14 economists (including R. Glenn Hubbard) who served at chairs of the Council of Economic Advisers under seven Republican and Democratic presidents, wrote an open letter to congressional leaders expressing their

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    20 CHAPTER 2 | Trade - offs, Comparative Advantage, and the Market System support for the renewal of the Trade Promotion Authority in order to reach agreements with U.S. trading partners through the Trans - Pacific Partnership (TPP) and the Trans - Atlantic Trade and Investment Partnership (TTIP). The letter read, in part: “ International trade is fundamentally good for the U.S. economy, beneficial to American families over time, and consonant with our domestic priorities. ” Ben Bernanke, former c hairman of the Federal Reserve Board, cited a study that examined the effect of international trade on income in the U nited States since World War II: “ . . . the increase in trade . . . has boosted U.S. annual incomes on the order of $10,000 per household. The same study found that removing all remaining barriers to trade would raise incomes anywhere from $4,000 to $12,000 per household. ” Source: N. Gregory Mankiw, “ Economists Actually Agree on This: The Wisdom of Free Trade, ” New York Times , April 24, 2015; and Ben Bernanke, “ Embracing the Challenge of Free Trade: Competing and Prospering in a Global Economy, ” The Federal Reserve Board, May 1, 2007. http://www.federalreserve.gov/boarddocs/speeches/2007/20070501/default.htm . Questions : (a) Should the United States accept the advice of economists and support free trade policies even if this increases the risk of some workers losing their jobs to outsourcing? (b) What type of job would make you more or less vulnerable to outsourcing? Answers : (a) Given the opposition from firms and workers in industries that would be harmed by free trade, it is unlikely that the United States would eliminate all trade barriers. But stud ies such as the one cited by Ben Bernanke show that increased trade can significantly boost the incomes of U.S. households. (b) Another study Bernanke cited found twenty - one occupa tions that were most vulnerable to outsourcing were primarily for relatively lower - wage positions.

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