Class Notes for Survey of Economics: Principles, Applications, and Tools, 7th Edition

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Instructor’s Manualto accompanySurvey of EconomicsSeventh EditionbyArthur O’SullivanLewis and Clark CollegeSteven M. SheffrinTulane UniversityStephen J. PerezCalifornia State University, SacramentoPrepared byJeff PhillipsColby-Sawyer College

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iiiContentsChapter 1Introduction: What Is Economics?1Chapter 2The Key Principles of Economics12Chapter 3Demand, Supply, and Market Equilibrium25Chapter 4Elasticity: A Measure of Responsiveness43Chapter 5Production Technology and Cost56Chapter 6Perfect Competition67Chapter 7Monopoly and Price Discrimination81Chapter 8Market Entry, Monopolistic Competition, and Oligopoly92Chapter 9Market Failure, Imperfect Information, External Benefits, andExternal Costs113Chapter 10The Labor Market and the Distribution of Income136Chapter 11Measuring a Nation’s Production and Income150Chapter 12Unemployment and Inflation163Chapter 13Why Do Economies Grow?174Chapter 14Aggregate Demand and Aggregate Supply187Chapter 15Fiscal Policy196Chapter 16Money and the Banking System207Chapter 17Monetary Policy and Inflation218Chapter 18International Trade and Public Policy228

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vPrefaceThis Instructor’s Manual was written to be used withSurvey of Economics,7th Edition, by O’Sullivan,Sheffrin, and Perez. A fully integrated teaching and learning package is necessary for today’s classroom.Our supplement package helps you provide new and interesting real-world Applications and assessstudent understanding of economics. The supplements are coordinated with the main text through thenumbering system of the headings in each section. The major sections of the chapters are numbered (1.1,1.2, 1.3, and so on), and that numbering system is used consistently in the supplements to make itconvenient and flexible for instructors to develop assignments.Instructor’s Manual FeaturesEach chapter of the Instructor’s Manual contains the following features:Chapter SummaryThis overview of the main economic concepts in the chapter shows you how to make connectionsbetween the chapters and lists the questions the students should be able to answer when you have finishedthe chapter. These questions are based on the Applications in the chapter.Approaching the MaterialThis section summarizes a general approach to use to present the concepts in the chapter.Chapter OutlineThe chapter outline contains the following features:Detailed descriptionsof the economic concepts in the chapter.Key term definitionsas they appear in the text, allowing you to have the same points of reference asthe students.Teaching tipson how to present specific concepts in the chapter. New approaches, classroomactivities, and teaching approaches are presented on a topic-by-topic basis.Figure referencesand tips on how to use them to explain economic concepts. The figures are all availableinPowerPoint®formatfordownloadfromtheInstructor’sResourceCenteratwww.pearsonhighered.com/irc.Application summariesthat help you present one of the key features of the book—real-worldapplications that Answer key questions presented at the start of each chapter.Solutionsto end-of-chapter exercises. Several of the exercises support the Applications.Teaching Tips for EconomicsOne of the challenges of teaching principles of economics is that most students bring no prior knowledge ofthe subject to the classroom. It has been shown that we learn by making connections between priorknowledge and new information. It is easier to make those connections when we see relationships betweennew information and prior knowledge. The traditional “guns or butter” and “widget factory” approaches toexplaining economic principles does little to alleviate this problem. Use strategies that will enable students

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viO'Sullivan/Sheffrin/Perez,Survey of Economics,7eto make connections between what they do know—fast food, concert tickets, cutting classes—and economicprinciples. The “dismal science” as a description of economics did not originate with principles ofeconomics students. Many would not disagree with that statement, however. Student descriptions ofeconomics range from boring to impossible. One of the reasons that some students have trouble withprinciples of economics may be the way it is presented. By adjusting the method of delivery as well asimproving parts of the lecture, principles of economics instructors may be able to improve outcomes.The First Day of ClassThe first class meeting sets the tone for the rest of the semester. Students leave the classroom with aperception of how the class is likely to unfold for the semester. Most students in principles of economicsclasses have not had previous exposure to the study of economics. Given this, most instructors areinclined to give a definition of the study of economics. Invariably, some variation of the followingemerges: “…The study of how scarce resources are allocated to satisfy unlimited wants.” A discussion ofbasic human needs and allocation of natural resources follows. One can almost visualize students sinkinginto their chairs and the tone for the semester is set. The “dismal” science has begun for another semester.Students without previous exposure to economic principles have nothing to grab onto.Consider this alternative. The instructor begins the first day of class with the following question. “Howmany of you ate breakfast this morning?” A direct, simple question designed to engage all of the students.The question is effective in a classroom of 20 or 200. Assuming a normal distribution of students, therewill be both affirmative and negative answers. Begin by asking those who said no, why not. Invariably,some one will answer, “I didn’t have time.” Now the economics lesson begins. Ask the student if he orshe has only 24-hour days. Explain that all of us have the same number of hours in the day, and we haveto decide how to use them. Those who did not eat breakfast decided to use the time differently—to sleep,to study, to take a morning jog. The students have made a fundamental economic insight. They have madea decision to allocate a scarce resource—time—to satisfy unlimited needs. The discussion can continue toillustrate other economic concepts. What did they have for breakfast—tastes and preferences? Do theymake different decisions on the weekends than during the week? Do Saturday and Sunday have more than24 hours? Or, is it a different allocation decision?The students have learned about resource allocation. They have used their own experiences to illustrate aneconomic concept. The students have used something they are very familiar with—the decision to havebreakfast or not—to learn a basic economic theory. No mention of guns and butter or widgets. Thestudents may leave the classroom with the idea that maybe economics is not so dismal after all.Keep Them Coming to ClassOne of the challenges that all instructors face is how to encourage students to do things that you believewillenhancetheirlearning—fromclassattendancetohomeworktopracticeexams.Economicsinstructors know the answer. People respond to incentives. You must reward whatever behaviors youwant from your students. Class attendance is one behavior you want to reward. Here are some strategiesto think about:•Mandatory attendance: Take attendance everyday. Students are allowed one or two absences.After that, points are taken off final grade.•Attendance as part of the grade: Slight variation as above, same concept. A certain percentage(10 percent, for example) of the final grade is based on attendance. Establish a scale (1 or 2classes missed equals a …).•Class participation: Attendance plus. Students need to be there and participate.•Random unannounced quizzes. Give an occasional quiz without prior notice. Those who arenot there earn a zero—no makeup.

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Prefacevii•Most important: Make the classes interesting and important. “Interesting” speaks for itself.“Important” means that what goes on in the class appears in the exam. Students will quicklyfigure out (after the first exam) whether or not the test is straight from the book and classattendance is not necessary.The same strategies apply to any other behavior you want from students. If you want students to dohomework, you have to keep track of it and make it part of their grade. The same with practice tests,online visits, or anything else. You have to provide the student with an incentive.Overall ApproachThe overall approach to teaching economics is to take what students are familiar with and use thesesettings to explain economic principles. Use the students in class as live participants in your lectures.Economics is a social science that makes predictions about human behavior. The more the instructor caninvolve students in the presentation of the theory, the more effective student learning can be.Jeff PhillipsColby Sawyer College

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11Introduction:What Is Economics?Chapter SummaryChapter 1 provides a basic illustration of what economics is and why it is useful. Economics is the studyof the choices people, firms, and governments make when resources are scarce. Economic analysis helpsus understand the consequences of these choices. Here are the main points of the chapter:•Most of modern economics is based on positive analysis, which answers the question “Whatis?”or “Whatwill be?”•Economies must answer three questions: What products do we produce? How do we produce theproducts? Who consumes the products?•Normative analysis answers the question “Whatought to be?”•To think like an economist, we (a) use assumptions, (b) use the notion ofceteris paribus, (c) thinkin marginal terms, and (d) assume that rational people respond to incentives.•Macroeconomicshelpsusunderstandwhyeconomiesgrowandunderstandeconomicfluctuations. Microeconomics helps us understand how markets work.Learning Objectives:1.What is Economics? List the three key economic questions.2.Economic Analysis and Modern Problems: Discuss the insights from economics for a real-worldproblem such as congestion.3.The Economic Way of Thinking: List the four elements of the economic way of thinking.4.Preview of Coming Attractions—Macroeconomics: List three ways to use macroeconomics.5.Preview of Coming Attractions—Microeconomics: List three ways to use microeconomics.Approaching the MaterialThe first classes are very important in determining your students’ attitudes towards economics. You haveto find out their attitude and use real-world examples that help them understand that economics relates totheir lives. Stating to the class that economics is “The study of how scarce resources are allocated tosatisfy unlimited wants” is accurate but is also one of the reasons why some people still refer toeconomics as “the dismal science.” Try the following definition of economics instead: “Economics is thestudy of how you, your friends, the stores where you shop, and your mayor make choices.” Every studentin front of you makes choices everyday—what to wear, what to have for breakfast, or whether to sleep in,whether to study or play video games. Students allocate resources all day long. Time is the one resourcethat everyone can relate to and everyone has the same amount of. Use what students know to teach themwhat you want them to know.

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2O’Sullivan/Sheffrin/Perez,Survey of Economics,7eChapter Outline1.1 What Is Economics?A.Scarcity:the resources we use to produce goods and services are limited.Economicsis the studyof choices when there is scarcity.Teaching TipStudents have scarce resources they have to allocate. Ask the class who had breakfast thismorning. You should have a room full of both breakfasters and those who did not eat. Askthose who did not eat breakfast why not. Someone is sure to say they did not have the time.Explain that we all have the same amount of time (a scarce resource), but we choose toallocate it differently. (i.e., sleep in, workout, study, eat breakfast).B.Factors of ProductionFactors of production:the resources used to produce goods and services, also known asproduction inputs.Natural resources:the resources provided by nature and used to produce goods and services.Labor:the physical and mental effort people use to produce goods and services.Physical capital:the stock of equipment, machines, structures, and infrastructure that is used toproduce goods and services.Humancapital:theknowledgeandskillsacquiredbyaworkerthrougheducationandexperience.Entrepreneurship:the effort used to coordinate the factors of production—natural resources,labor, physical capital, and human capital—to produce and sell products.C.Positive versus Normative Analysis1.Positive analysisanswers the questions “what is?” or “what will be?”a.For example: What is the effect on poverty of a living wage ordinance? Or, What is theeffect on a city’s costs of a living wage ordinance?2.Normative analysisanswers questions of “What ought to be?”a.For example: Should a city implement a living wage ordinance?Teaching TipTell the students that Mr. Alumni Bigbucks has donated 50 million dollars to the university.The following question is an example of positive analysis: Should the donation be used tobuild a new stadium or a state-of-the art library/technology center? The following questionis an example of normative analysis: What do they think should be built and why?D.The Three Key Economic QuestionsThe choices made by individuals, firms, or governments answer three fundamental questions:1.Whatgoods and services do we produce?2.Howdo we produce these goods and services?3.Whoconsumes the goods and services that are produced?

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Chapter 1: Introduction: What Is Economics?3Teaching TipNow is a good time to introduce the concept of markets indirectly. Consumers decide whatis produced and for whom; businesses decide how the products are produced..E.Economic ModelsAneconomic modelis a simplified representation of an economic environment, often employinga graph. For example, economists use the model of a market to analyze the effects of publicpolicy on economic outcomes.1.2 Economic Analysis and Modern ProblemsEconomic analysis can provide insights into real-world problems such as:A.Economic View of Traffic Congestion: problem is solved by paying tolls.B.Economic View of Poverty in Africa: economic growth helps the poor.C.Economic View of the Current World Recession: policymakers can draw on many years ofexperience in economic policy to guide the economy during the current times.1.3 The Economic Way of ThinkingA.Use of Assumptions to Simplify and Facilitate LearningB.Isolate Variables—Ceteris ParibusAvariableis a measure of something that can take on different values. Theceteris paribusis aLatin expression meaning other variables being held fixed. The assumption is that when weconsider changes in one variable, we hold all other variables constant.Teaching TipAsk the students to recall doing experiments in high school science (chemistry) classes.Remind them that in order to obtain reliable results, they had to change only onecomponent while holding other components constant.C.Thinking at the MarginEconomists consider small, incremental changes to determine whether or not it is desirable tochange the level of economic activity. A small, one-unit change in value is known as amarginalchange. For example, should you eat the fourth piece of pizza if you aren’t hungry?D.Rational People Respond to IncentivesTeaching TipSelf-interest is not the same as selfishness. Ask the students to think about all of the thingstheir parents have done for them over the years. Not selfish but certainly in the parent’sself-interest.E.Example: London Addresses Its Congestion ProblemThe City of London imposed an $8 per day tax to drive in the city between 7:00A.M. and6:30P.M. The tax reduced the congestion significantly, cutting travel times in half. The city’seconomy thrived.

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4O’Sullivan/Sheffrin/Perez,Survey of Economics,7eTeaching TipAskthestudentswhatotherpricingschemesLondoncouldhaveusedtoreducecongestion—free public transportation, alternative work hours, higher parking rates.Teaching TipAlmost every college campus in America lacks enough spaces for those who want to park.Discuss the current parking policy at your university. Ask the students to use economicanalysis to come up with alternative policies to solve the parking problem (small groupsshould work well here). The possible solutions should include raising parking fees, restrictingparking by types of parkers (no freshman, faculty/staff only), remote parking with freeshuttles, altering class schedules, rewards for car pooling, and expanding parking spaces.Review these key questions and their related Applications:Question 1: How do people respond to incentives?APPLICATION 1: INCENTIVES TO BUY HYBRID VEHICLESHybrid vehicles are more fuel efficient but also more expensive than gas-powered ones. When gas pricesincrease, hybrid vehicles become more popular. Another factor influencing the increase hybrid vehiclepurchases was the federal subsidy of up to $3,400 per vehicle. The efficiency of the hybrid vehiclesubsidy in reducing greenhouse gas carbon dioxide (CO2) is questionable. There are less costly ways todo this, such as building insulation, energy-efficient lighting, and switching to electric power systems.Question 2: What is the role of prices in allocating resources?APPLICATION 2: HOUSING PRICES IN CUBAThe Cuban government confiscated most housing in 1960 and did not allow homeowners to sell theirproperty. As a result, the housing stock deteriorated because there was little incentive to repair it.Housing reforms allowed the sale and purchase of homes in Cuba in 2011. These reforms increaseincentives and are expected to increase construction of houses.1.4 Preview of Coming Attractions: MacroeconomicsMacroeconomicsis the study of the nation’s economy as a whole; it focuses on the issues ofinflation, unemployment, and economic growth.A. Why Study Macroeconomics?1.To understand why economies grow2.To understand economic fluctuations3.To make informed business decisions

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Chapter 1: Introduction: What Is Economics?51.5 Preview of Coming Attractions: MicroeconomicsMicroeconomicsis the study of the choices made by households, firms, and the government, andhow these choices affect the markets for goods and services.A. Why study microeconomics?1.To understand markets and predict changes2.To make personal or managerial decisions3.To evaluate public policiesAdditional Applications to Use in ClassQuestion: Does a real estate agent have an incentive to get you the highestprice?ADDITIONAL APPLICATION: FREAKONOMICSSource: Motley Fool audio interview with economist Steven LevittInterviewed by David Gardner“Freakonomics”Summary: Key Points in the ArticleThis audio clip features an interview with one of the authors of the best-selling bookFreakonomics.Economist Steven Levitt answers a host of questions typically not tackled by most economists. One of thequestions is related to realtors and agency relationships. In other words, do realtors really work for realestate sellers?According to Levitt, it is in the best interest of the realtor to convince sellers to take an offer lower thanthey would receive if the property remained on the market. Since the percentage of the sales price thatreal estate salespersons receive from selling a house is a very small fraction, a $10,000 increase in salesprice might net a real estate professional another $150 commission for a tremendous amount of additionalwork. Therefore, it is in the real estate salesperson’s best interest to convince the seller to make the quicksale and take the first reasonable offer. Levitt points toward evidence that real estate professionals tend toleave their own properties on the market longer and receive 2% to 3% more in sales price.Levitt addresses many other issues including market efficiency, horse racing, and drug dealing in thisinterview. Listen to the clip for Levitt’s economic explanation of numerous topics.Analyzing the NewsLevitt’s primary contribution is his application of economic thought to a number of topics typically notaddressed by economics. As you will hear, economics is truly a social science that can be used to explainquite a bit of human behavior.Thinking Critically Questions1.What is “freakonomics”?2.Why would the illustration of “realtors” and not maximizing sales price for sellers be aneconomic topic?3.Are the stock markets efficient according to Levitt?

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6O’Sullivan/Sheffrin/Perez,Survey of Economics,7eTeaching TipThis is a great example of how people’s incentives are often not the same. Although thereal estate agent works for the seller, their interests regarding holding out for a higher priceare not the same.Question:Howdoesatighteningofdiscretionaryincomeaffectluxuryindustries?ADDITIONAL APPLICATION: SPORTSBIZ: GOLF INDUSTRY GETS HIT HARDSweet, David“SportsBiz: Golf Industry Gets Hit Hard”Posted 12/3/2008 on MSNBC.comSummary: Key Points in the ArticleGolf courses are not only on hold in the United States, but also many are being converted to other uses.The 1990s saw tremendous expansion in the sport, which is now being reversed as many people forgo thegame due to tight budgets. More courses are closing this year than are opening, and openings are thelowest in 20 years.In addition, many new courses are tied to housing projects that are currently mothballed due to theflagging housing market. Equipment sales are down as well as rounds played. The one bright spot appearsto be China. One course designer formerly in high demand in the United States is now focusing onChina’s growing appetite for the game.Analyzing the NewsGolf is a game that consumes discretionary income. As more people look for ways to reduce spendingeither due to job loss or conservation of cash, golf may be one of the first luxuries to go. It appears thatthe recession may be impacting all levels of income. You may begin to see a reduction in price as shownin the graph as golf courses attempt to draw customers back to the green. Of course, if the number of golfcourses in the United States falls even further, you would see a leftward shift in supply that might help thesurviving courses.Thinking Critically Questions1.What is causing the leftward shift in demand for golf?2.How do expectations cause demand shifts?3.Why is China experiencing a golf boom?Question: Should people invest in low-cost health insurance?ADDITIONAL APPLICATION: IS LOW-COST HEALTH INSURANCE WORTH IT?McCormack, Karyn“Is Low-Cost Health Insurance Worth It?”Posted 8/04/2008 on MSNBC.comBusinessweek

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Chapter 1: Introduction: What Is Economics?7Summary: Key Points in the ArticleSome of the low cost health insurance plans currently being pitched on television may not be worth theprice. A couple of options limit coverage so that any surgery or hospitalization is capped at less than$1,200. The primary coverage is minor medical instead of major medical.Critics maintain that policies of this nature do little for the insured since any major medical event wouldresult in thousands of dollars of expenses not paid by the plans. However, representatives at one of thecompanies said that company representatives will negotiate large bills on behalf of their clients. Thecompany, iCan, maintains that their network pricing clout and negotiation will reduce a typical $50,000bill to around $10,000 to $12,000.Currently, 47 million uninsured Americans may opt for these low cost mini-medical plans. However,even at the low end price of $160 a month for individuals and $260 a month for families these plans maystress a lot of budgets.Analyzing the NewsAccess to medical care is a critical issue in the United States. Does everyone have access to treatment?Probably not equally and many people are forced into bankruptcy every year due to high medical bills.Expect to see continued debate over this issue after the presidential election.Thinking Critically Questions1.Why is this issue important?2.What are some options for the government to debate?3.What forms of nationalized health care currently exist?Appendix AUsing Graphs and Percentages1A.1 Using GraphsA.Graphing Single Variables1.Pie charts2.Bar graphs3.Line graphsStudents who are not familiar with graphs will need lots of time here. Give them simple data,and let them create their own pie charts and bar graphs.B.Graphing Two Variables1.Two variable graphs use both the horizontal and vertical axis.2.Play “connect the dots” to determine points on the line.Teaching TipHave the students create graphs without numbers. Using concepts they are familiar with(Hours of study, G.P.A.) have them draw the line that shows the general shape of therelationship.

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8O’Sullivan/Sheffrin/Perez,Survey of Economics,7ePositive relationship:a relationship in which two variables move in the same direction.Negative relationship: a relationship in which two variables move in opposite directions.C.Computing the SlopeSlope of the curveis the vertical difference between two points (the rise) divided by thehorizontal difference (therun).Teaching TipMost students should be familiar with the concept of slope, but it is worth your time to gostep by step for at least a few problems.D.Moving along the Curve versus Shifting the Curve1.Variables in the graph versus variables not in the graph2.Changing variables in the graph—movement along the curve3.Changing variables not in the graph—movement of the curveEmphasize that the Y-intercept represents variables not in the graph.E.Graphing Negative RelationshipsIllustrate the negative relationship between downloads and CDs purchased. Most studentsshould not have a problem with the concept of a negative relationship.Teaching TipAsk students to come up with three pairs of variables that have a negative relationship.F.Graphing Nonlinear RelationshipsShow students what a nonlinear relationship looks like. Unless you have an unusual class,you should avoid using calculus to explain nonlinear relationships. An explanation of howthere may not be a constant relationship between variables would be useful.1A.2 Computing Percentage Changes and Using EquationsA.Computing Percentage ChangesUse the formulas to show students how to compute percentage change. Several examples maybe necessary.Teaching TipMost students are shoppers. Use concepts like “20 percent off” sales to help themunderstand this concept.

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Chapter 1: Introduction: What Is Economics?9Review this key question and the related application:Question 3: How do we compute percentage changes?APPLICATION 3: THE PERILS OF PERCENTAGESThis Application explains how in the 1970s the government of Mexico City repainted highway lines tomake a four-lane highway into a six-lane highway and then turned it back into a four-lane highway. Whenreporting on the results of those changes in lanes on the highway, the government incorrectly reported thepercentage changes of the effects of re-doing the highway because they used the simple approach tocomputing percentage changes. This shows that percentage calculations can be inaccurate, if you’re notcareful. It’s important to remember that the midpoint formula accurately records percentage changes.B.Using Equations to Compute Missing ValuesFollow the formulas in the book. As this is basic algebra, students should be well-versed, buta few in-class problems should be helpful.Solutions to End-of-Chapter ExercisesChapter 1SECTION 1.1: WHAT IS ECONOMICS?1.1what, how, who1.2natural resources, labor, physical capital, human capital, entrepreneurship1.3statement “a.” is TRUE1.4a. normativeb. positivec. normatived. normativee. positiveSECTION 1.2: ECONOMIC ANALYSIS AND MODERN PROBLEMS2.1b.2.2legal system, regulatory environmentSECTION 1.3: THE ECONOMIC WAY OF THINKING3.1the earth is flat, the roads are flat3.2assumptions, use ofceteris paribusto isolate variables, margin, incentives3.3b.3.4one fifth3.5housing repair and maintenance3.6false

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10O’Sullivan/Sheffrin/Perez,Survey of Economics,7eChapter 1 Appendix1.a.b.$5.00, hours/monthc.$15.00d.6 additional hours2.$20, $4.00, 10, $60, $80

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Chapter 1: Introduction: What Is Economics?113.a.b.–2.0 movies, CD4.a.Number of DeliveriesTotal Costs050590101301517020210b.$8.00, deliveryc.Drivers’ wages and the rental cost of the truck. In addition, the other costs of delivery, such asthe price of fuel, insurance, and taxes.d.deliveriese.drivers’ wages, the rental cost of the truck, or the price of fuel5.along, shifts6.10.0%, –2.0%, 6.0%7.112, 54, 238.40% = 20/50, 33% = 20/60

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122The Key Principlesof EconomicsChapter SummaryChapter 2 introduces the key principles that are central to all economic theory:•Theprinciple of opportunity coststates that the opportunity cost of something is what yousacrifice to get it. Opportunity costs in production are generally increasing, and thus, theproduction possibilities curve is bowed outward.•Themarginal principlestates that any activity should be increased as long as the marginalbenefits of the additional activity exceed the marginal costs.•Theprinciple of voluntary exchangestates that a voluntary exchange between two people makesboth people better off.•Theprinciple of diminishing returnsstates that, in the short run, if use of one input is increasedwhile all others are held constant, production will eventually increase at a decreasing rate.•Thereal-nominal principlestates that what matters to people is the real value or purchasingpower of money or income, not its face or nominal value.Learning Objectives:1.The Principle of Opportunity Cost: Apply the principle of opportunity cost.2.The Marginal Principle: Apply the marginal principle.3.The Principle of Voluntary Exchange: Apply the principle of voluntary exchange.4.The Principle of Diminishing Returns: Apply the principle of diminishing returns.5.The Real-Nominal Principle: Apply the real-nominal principle.Approaching the MaterialContinue the approach you developed in the first chapter, reaching students where they are. The decisionto go to college is a great illustration of opportunity costs because students forgo earnings that they wouldhave received from a full-time job. Apply the concept of diminishing returns to hours studying: If astudent studies for five hours, will studying one additional hour really benefit him or her? Most of thestudents will have had jobs, so use the price of a gallon of gas or a burger per hour worked to explain realwages. Most students will have trouble with the marginal principle, so have plenty of examples ready. Aseat on a bus or train that is not full is a good example. An extra passenger in a car for a road trip oranother person watching a movie will also work.

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Chapter 2: The Key Principles of Economics13Chapter Outline2.1 The Principle of Opportunity CostA.Definition1.Theopportunity costof something is what you sacrifice to get it.2.What you sacrifice is thenext bestalternative.3.For example, if you choose to buy a cup of coffee, you are giving up the money it costs tobuy it. What else would you have used the $2.00 for? The opportunity cost of the coffee is theone thing (or next best alternative) that you would buy if not the coffee.Teaching TipAsk the students what they would be doing if they weren’t in class. Answers will rangefrom sleeping, working, watching TV, studying, etc. You can make the point that thealternatives are infinite and computing the cost of them all is impossible. However, sincethey could only be doing one thing (not all of them) if they were not in class, determiningthe opportunity cost requires only knowing the one thing they would be doing.B.The Cost of College1.The classic example of opportunity cost is the costs of going to college. Be sure to illustratethe implicit opportunity cost of forgone income as well as tuition, books, etc.Teaching TipIt’s also helpful to have a discussion about whether room and board should be considered acost of college. If the person has to pay the same amount for room and board whetherhe/she goes to college or works, it should not be considered a cost of college.C.The Cost of Military SpendingD.Opportunity Cost and the Production Possibilities Curve1.Theproduction possibilities curve: A curve that shows the possible combinations ofproducts that an economy can produce, given that its productive resources are fully employedand efficiently used.2.Discussion of relevant points on the production possibilities grapha.Points on the curve are efficient and indicate an economy is utilizing all resources.b.Points inside the curve are inefficient and indicate an economy is not utilizing allresources or resources are not used in the least-cost manner.c.Points outside the curve are not feasible given current technologies and resources.3.Shifts in the Production Possibilities Curve. Show how points outside the PPC are feasible inthe future if it shifts out due to increases in resources or technological innovation. It is alsouseful to discuss what might make the PPC shift in: a natural disaster, the Y2K bug, etc.a.Increased resourcesb.Technological innovation

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14O’Sullivan/Sheffrin/Perez,Survey of Economics,7eTeaching TipUse something students are familiar with to construct their first production possibilitiescurve. Pick two classes, such as Economics and Marketing. Tell them they are going toallocate study time to produce grades in the classes. The choice involves how much studytime to allocate for each class. You can start with an all-or-nothing scenario producing anA|F outcome and make adjustments from there. Once they are comfortable, remind themthat everything else was held constant. Ask them what would happen to the curve if theprofessors were better teachers, if students had better study skills, smaller classes, bettertextbooks, upgraded computers, or more time to study.Review this key question and the related application:Question 1: What is the opportunity cost of running a business?APPLICATION 1: DON’T FORGET THE COSTS OF TIME AND INVESTED FUNDSThis Application gives an example of a business to explain how we can use the principle of opportunitycost to compute a business’s costs. In a business, the total costs are affected by the costs of raw materials,the opportunity costs of funds invested, and the opportunity costs of time. This Application shows that wemust include not just the costs of materials but also the opportunity cost of funds invested, as well as theopportunity costs of time in computing the true cost of running a business.2.2 The Marginal PrincipleA.Definition1.Marginal benefitis the additional benefit resulting from a small increase in some activity.2.Marginal costis the additional cost resulting from a small increase in some activity.3.Choose a level of the activity such that marginal benefit of the last unit equals the marginalcost of the last unit.B.Using the Marginal Principle: Movie Sequels, Renting College Facilities, Automobile EmissionsStandards, Driving Speed and SafetyTeaching TipThere are several easy-to-understand examples of the Marginal Principle in the world ofcollege students. An easy way to start is with examples where the marginal cost is zero:The amount of food consumed at a particular meal in the cafeteria; Internet minutes in thecomputer lab; cell phone weekend minutes with some plans. Given that the marginal costsare zero, the student’s decision to consume is based on positive marginal benefits. You canthen introduce situations where there are positive marginal costs, such as fast food thatneeds to be paid for.

Class Notes for Survey of Economics: Principles, Applications, and Tools, 7th Edition - Page 22 preview image

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Chapter 2: The Key Principles of Economics15Review this key question and the related application:Question 2: How do people think at the margin?APPLICATION 2: HOW FAST TO SAIL?This Application explains the factors that go into the decision regarding how fast to sail an ocean cargoship. We can use the marginal principle to see that the increase in a ship’s speed depends on the marginalbenefit of delivering more cargo compared to the cost of additional fuel. If the marginal benefit (theincrease in revenue from delivered cargo) is greater than the marginal cost (the increase in fuel cost), theship operator will increase the ship’s speed.2.3 The Principle of Voluntary ExchangeA.The assumption is that people act in their own self-interest.A voluntary exchange between twopeople makes both better off. Markets work because they are based on the principle of voluntaryexchange.Teaching TipCollege students easily understand the principle of voluntary exchange because they areconstantly engaged in voluntary exchanges. Work and consumption are two examples fromtheir world. If they are employed, they voluntarily exchange their time and effort for themoney they earn. Nobody kidnaps them and forces them to work. Their employer paysthem voluntarily as well. Both the student and employer are better off. Any time individualspurchase anything, they exchange money for a product or a service, making both the buyerand the seller better off. Ask students what they purchased yesterday or today: Coffee orsoda? Candy? Newspaper? Why did they purchase it?B.Exchange and Markets1.A market is an institution or arrangement that allows buyers and sellers to exchange goodsand services.Teaching TipCreate a market in the classroom. Do the experiment described in the book or inMyEconLab.C.Online Games and Market Exchange1.Online games such as EverQuest illustrate how markets and exchange develop on their ownbecause of the desire to trade.

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16O’Sullivan/Sheffrin/Perez,Survey of Economics,7eReview this key question and the related application:Question 3: What is the rationale for specialization and exchange?APPLICATION 3: RORY MCILROY AND WEED-WHACKINGRory McIlroy is one of the best golfers in the world as well as a skillful weed whacker. He can whackdown all the weeds on his property in one hour, making him 20 times more productive than the bestgardener. Rory should still hire the less productive gardener because of the lower opportunity cost. If heearns $1,000 per hour playing golf, by paying the gardener only $200 ($10 an hour × 20), he would endup saving $800. This shows how the principles of voluntary exchange and specialization are beneficial.2.4 The Principle of Diminishing ReturnsA.Principle of Diminishing Returns: Suppose that output is produced with two or more inputs,and we increase one input while holding the others constant. Eventually, output will begin toincrease at a decreasing rate.Teaching TipHave the students picture the front end of a fast-food franchise, such as McDonald’s,Burger King, Wendy’s, or another franchise near you. Ask themwhat would happen if youkept on adding more and more workers at McDonald’s. All the equipment is fixed. Thenumber of workers is the variable input. Ask students what would happen to the number ofhamburgers served as you increased the number of workers from 1 to 3 to 5 to 50.Eventually the restaurant would be so crowded that none of the workers would be able tomove or serve any hamburgers. (Make sure to point out that this is well beyond the point ofdiminishing returns.)B.Diminishing Returns from Sharing a Production Facility1. A good example of diminishing returns is when a company tries to add workers to an existingproduction facility. Eventually, the facility will become overcrowded, and the additionaloutput resulting from additional workers will fall.Review this key question and the related application:Question 4: Do farmers experience diminishing returns?APPLICATION 4: FERTILIZER AND CROP YIELDSThis Application illustrates how the notion of diminishing returns applies to all inputs to the productionprocess. For a farmer, continuously increasing the amount of fertilizer applied to a fixed amount of landeventually reduces the increases in output. The farmer will experience diminishing return because, whileeven though the amount of fertilizer was not fixed, the other inputs to the production process are fixed.

Class Notes for Survey of Economics: Principles, Applications, and Tools, 7th Edition - Page 24 preview image

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Chapter 2: The Key Principles of Economics17Teaching TipA classroom full of urban or suburban students might not relate very well to this example.You can use watering the lawn instead. An excessive amount of water will not help thelawn grow faster.2.5 The Real-Nominal PrincipleA.Definition1.What matters to people is the real value or purchasing power of money or income, not its facevalue.2.Thenominal valueof an amount of money is its face value. Thereal valueis the value of anamount of money in terms of what it can buy.B.The Design of Public ProgramsC.The Value of the Minimum WageWhen the government publishes statistics about the economy, it takes into account the real-nominalprinciple. For example, the value of “real wages” shows what has happened to the purchasing power ofworkers over time. The nominal wage shows what has happened to the sum on the worker’s paycheck,but it cannot show what has happened to purchasing power.Teaching TipAsk the students how many of them would be happy to earn $500,000 per year. Most willsay yes. Then tell them that a case of soda pop costs $100, a CD costs $250, and a new carcosts $500,000. Are they still happy? You can now proceed to explain the differencebetween nominal and real variables.Review this key question and the related application:Question 5: How does inflation affect lenders and borrowers?APPLICATION 5: REPAYING STUDENT LOANSThis Application shows how inflation can impact the value of money paid back over time. Using changesin annual salaries, the Application demonstrates the work time it takes someone to pay back the loanunder various inflation assumptions.Teaching TipAnother way to illustrate this concept is to ask students if they know their parents’ monthlymortgage payments and when they purchased their homes. Inflation in home prices affectsthe amount that people will have to borrow. An older home usually will have a smallernominal mortgage payment. However, your students’ parents’ salaries have presumablyrisen partly due to inflation. Therefore, inflation has helped those who have been debtors.

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18O’Sullivan/Sheffrin/Perez,Survey of Economics,7eAdditional Applications to Use in ClassQuestion: Has fish production reached the point of diminishing returns?ADDITIONAL APPLICATION: SO LONG SEAFOOD? EXPERTS WARN OF DISASTERMSNBC Staff and News Service Reports“So Long Seafood? Experts Warn of Disaster”Posted on MSNBC.comFinancial Timeshttp://www.msnbc.msn.com/id/15532333/Posted 11/03/2006Summary: Key Points in the ArticleAccording to some experts, overfishing and pollution will virtually wipe out all the world’s fisheries bythe year 2050. A team of economists and ecologists arrived at that conclusion by extrapolating currenttrends. The team warned that unless fisheries management practices radically change, we were in the “lastcentury of wild seafood.”The team spent four years using controlled experiments and existing data to arrive at their conclusions.However, industry professionals do not appear to share the concerns. The National Fisheries Instituteissued a statement that said, “Fish stocks naturally fluctuate in population,” and “By developing newtechnologies that capture target species more efficiently and result in less impact on other species or theenvironment, we are helping to ensure our industry does not adversely affect surrounding ecosystems ordamage native species.”Seafood consumption is up in the United States, with the average American eating 16.6 pounds ofseafood in 2004 versus 15.2 pounds in 2002. Fishing accounts for more than $80 billion in revenueworldwide.Analyzing the NewsNote that the National Fisheries Institute did not deny declining fish stocks. Instead the organizationindicated the decline was part of a natural cycle. Could it be that the increasing global demand for seafoodhas pushed fishing to the point of diminishing returns?Thinking Critically Questions1.It appears that fish harvests are increasing, but overall fish stocks may be declining. Whateconomic principle is exhibited?2.How can we increase production?3.At what point would we cease to add fishing boats?

Class Notes for Survey of Economics: Principles, Applications, and Tools, 7th Edition - Page 26 preview image

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Chapter 2: The Key Principles of Economics19Question: How can people invest in themselves?ADDITIONAL APPLICATION: “SHORT ON CASH, SOME PUT A PRICE ONTHEMSELVES”Aleccia, JoNelPosted 12/5/2008 on MSNBC.comSummary: Key Points in the ArticleThe shrinking economy has had an impact on people’s willingness to donate plasma, sperm, and fertileeggs. Hair sales are up as well. While the practice of selling most body products is illegal in the UnitedStates, there are instances where people are considered “compensated donors.” For example, manyplasma centers will pay $20 for donor time and travel. The sudden spike in donor applications begs thequestion of whether the motives are altruistic or financial.Donating fertile eggs can be lucrative. One nursing student reported being able to graduate from collegedebt free due to the $28,000 she received for four cycles of fertile eggs donated since February. Viablesperm donors can earn $600 a month for a cycle of ten donations.While the practice can earn some cash, only a small fraction of donors make it through the rigorousmedical and life history screens for fertile eggs and sperm. In any case, applications to be donors are up20 to 30 percent at most clinics with plasma donations up as much as 50 percent in some areas. Theuptick appears to be consistent with the recession.Analyzing the NewsSince “price” appears fixed for these items you simply see an increase in overall quantity. However, thisarticle begs the question of whether body parts and products should be available for sale instead of merelycompensation for time and travel. What do you think?Thinking Critically Questions1.What is driving the increase on “donations” for certain body products?2.How do clinics compensate donors, since it is illegal to buy plasma?3.Should this practice be outlawed?Solutions to End-of-Chapter ExercisesChapter 2SECTION 2.1: THE PRINCIPLE OF OPPORTUNITY COST1.110, 1801.2arrow up1.3arrow up1.4$22,0001.5safe drinking water for 5 million people1.6outbidding, $1/hectare1.7$86,000 per year

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20O’Sullivan/Sheffrin/Perez,Survey of Economics,7e1.8Scientists and engineers will be used to execute the mission, so part of the opportunity cost mightbe measured in science and engineering education (or any other non-mission-related scientificproductivity) forgone.1.9The cost of holding wealth in non-interest-bearing form is higher where the interest rate is higher.1.10a.The loan cost me the interest I could have earned by investing the $100.b.The opportunity cost is the current market price, not the historical price.c.The cost of the stadium is $50 million plus the forgone earnings from renting the land or theinterest that could be earned on the proceeds from sale of the land (whichever is higher).d. The cost would also include the time difference between alternative methods of commuting1.11a.b.c.6, 101.12current value of the furniture, current rate of return on alternative investment(s)SECTION 2.2: THE MARGINAL PRINCIPLE2.1Yes, the marginal benefit ($300) is less than the marginal cost ($200).2.2Yes, the marginal benefit ($135) exceeds the marginal cost ($125).2.3Yes, the marginal benefit ($50 million) exceeds the marginal cost ($30 million).2.4marginal, marginal

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Chapter 2: The Key Principles of Economics212.5a.Draw MB and MC curves crossing at 40 mphb.Shift MB to the right and show an increase in speedc.Shift MB to the left and show a decrease in speed

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22O’Sullivan/Sheffrin/Perez,Survey of Economics,7ed.The MC curve should have a kink making it steeper to the right of 35mph. This lowers thespeed that he drives.2.6a.It made sense if the marginal revenue of $3,100 was greater than the marginal costsb.cost, less, 3,1002.7a.yes, marginal revenue 2500 > marginal cost 2000b.no, marginal revenue 1500< marginal cost 20002.8Three officers should be hired, since the marginal benefit of the third officer ($40,000) equals theconstant marginal cost of $40,000, but the marginal benefit of the fourth officer would fall belowthe constant marginal cost.2.9a. 26b. yes

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Chapter 2: The Key Principles of Economics232.10a.Pick 5 pints.b.Pick 3 pints.SECTION 2.3: THE PRINCIPLE OF VOLUNTARY EXCHANGE3.1False3.2$15, $153.3Up arrow3.4softer3.5a.No, the cost of forgone surgeries exceeds the benefit of clean drains.b.$1,150 per hour (= ($20 per minute × 60 minutes/hour) – $50 per hour)3.6a.50 fishb.Assign the tribe’s least productive fishermen to build the boat. The cost of the boat decreasesto 20 fish.3.7The tree-cutter paid the neighbor to compensate for lost shadeSECTION 2.4: THE PRINCIPLE OF DIMINISHING RETURNS4.13004.2False. Diminishing returns means that output increases at a decreasing rate.4.3less than, at least4.4inflexible, flexible4.5arrow up, arrow down4.6This is true, so long as there are no limitations on availability of resources other than soil.4.7a.Yes, because employment of some resources is inflexible within a week.b.Possibly not, because employment of all resources used in production of memory chips islikely to be flexible over a period of two years.4.8a.No, because of the principle of diminishing returnsb.Yes

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24O’Sullivan/Sheffrin/Perez,Survey of Economics,7e4.92, 154, 48, 113, 172, 36, 114, 184, 24, 115, 190, 12, 116, 193, 6, 11Ted should work five hours, since MB < MC for the sixth hour of work.SECTION 2.5: THE REAL-NOMINAL PRINCIPLE5.1$1 in purchasing power5.2negative $20 in purchasing power5.3down arrow, 3%5.4$65,0005.5No5.6Inflation, since it lowers the real cost of the debt repayment.5.7Number of baskets per week: 4.10, 3.05So the real value of welfare payments decreased5.8a.130.488%, 117.287%, 136.497%, 122.469%, 120.753%b.Wage increases lagged consumer price increase in three of four groups.c.Real wages fell in every sector except professional services.5.9a.—, 5 months$5,000, 4 months$2,000, 10 monthsb.Inflation5.10a.55 tunes, $55, 10%b.55 tunes, 66 dollars, 32%

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