If you've just run a marathon, or you've been walking in the desert sun for three
hours, the ... One is to compare the vacation with what you would do in its place.
... That's true, but if you don't spend the additional $1 million, you won't have any
sales and your .... In other words, economics is based on the scientific method.

Part of the document

ECON !)!
Chapter 1


Quick Quizzes

1. The four principles of economic decisionmaking are: (1) people face
tradeoffs; (2) the cost of something is what you give up to get it;
(3) rational people think at the margin; and (4) people respond to
incentives. People face tradeoffs because to get one thing that they
like, they usually have to give up another thing that they like. The
cost of something is what you give up to get it, not just in terms of
monetary costs but all opportunity costs. Rational people think at the
margin by taking an action if and only if the marginal benefits exceed
the marginal costs. People respond to incentives because as they
compare benefits to costs, a change in incentives may cause their
behavior to change.

2. The three principles concerning economic interactions are: (1) trade
can make everyone better off; (2) markets are usually a good way to
organize economic activity; and (3) governments can sometimes improve
market outcomes. Trade can make everyone better off because it allows
countries to specialize in what they do best and to enjoy a wider
variety of goods and services. Markets are usually a good way to
organize economic activity because the invisible hand leads markets to
desirable outcomes. Governments can sometimes improve market outcomes
because sometimes markets fail to allocate resources efficiently
because of an externality or market power.

3. The three principles that describe how the economy as a whole works
are: (1) a country's standard of living depends on its ability to
produce goods and services; (2) prices rise when the government prints
too much money; and (3) society faces a short-run tradeoff between
inflation and unemployment. A country's standard of living depends on
its ability to produce goods and services, which in turn depends on
its productivity, which is a function of the education of workers and
the access workers have to the necessary tools and technology. Prices
rise when the government prints too much money because more money in
circulation reduces the value of money, causing inflation. Society
faces a short-run tradeoff between inflation and unemployment that is
only temporary and policymakers have some ability to exploit this
relationship using various policy instruments.

Questions for Review

1. Examples of tradeoffs include time tradeoffs (such as studying one
subject over another, or studying at all compared to engaging in
social activities) and spending tradeoffs (such as whether to use your
last ten dollars on pizza or on a study guide for that tough economics

2. The opportunity cost of seeing a movie includes the monetary cost of
admission plus the time cost of going to the theater and attending the
show. The time cost depends on what else you might do with that time;
if it's staying home and watching TV, the time cost may be small, but
if it's working an extra three hours at your job, the time cost is the
money you could have earned.

3. The marginal benefit of a glass of water depends on your
circumstances. If you've just run a marathon, or you've been walking
in the desert sun for three hours, the marginal benefit is very high.
But if you've been drinking a lot of liquids recently, the marginal
benefit is quite low. The point is that even the necessities of life,
like water, don't always have large marginal benefits.

4. Policymakers need to think about incentives so they can understand
how people will respond to the policies they put in place. The text's
example of seat belts shows that policy actions can have quite
unintended consequences. If incentives matter a lot, they may lead to
a very different type of policy; for example, some economists have
suggested putting knives in steering columns so that people will drive
much more carefully! While this suggestion is silly, it highlights
the importance of incentives.

5. Trade among countries isn't a game with some losers and some winners
because trade can make everyone better off. By allowing
specialization, trade between people and trade between countries can
improve everyone's welfare.

6. The "invisible hand" of the marketplace represents the idea that even
though individuals and firms are all acting in their own self-
interest, prices and the marketplace guide them to do what is good for
society as a whole.

7. The two main causes of market failure are externalities and market
power. An externality is the impact of one person's actions on the
well-being of a bystander, such as from pollution or the creation of
knowledge. Market power refers to the ability of a single person (or
small group of people) to unduly influence market prices, such as in a
town with only one well or only one cable television company. In
addition, a market economy also leads to an unequal distribution of

8. Productivity is important because a country's standard of living
depends on its ability to produce goods and services. The greater a
country's productivity (the amount of goods and services produced from
each hour of a worker's time), the greater will be its standard of

9. Inflation is an increase in the overall level of prices in the
economy. Inflation is caused by increases in the quantity of a
nation's money.

10. Inflation and unemployment are negatively related in the short run.
Reducing inflation entails costs to society in the form of higher
unemployment in the short run.

Problems and Applications

1. a. A family deciding whether to buy a new car faces a tradeoff
between the cost of the car and other things they might want to
buy. For example, buying the car might mean they must give up
going on vacation for the next two years. So the real cost of
the car is the family's opportunity cost in terms of what they
must give up.

b. For a member of Congress deciding whether to increase spending
on national parks, the tradeoff is between parks and other
spending items or tax cuts. If more money goes into the park
system, that may mean less spending on national defense or on
the police force. Or, instead of spending more money on the
park system, taxes could be reduced.

c. When a company president decides whether to open a new factory,
the decision is based on whether the new factory will increase
the firm's profits compared to other alternatives. For example,
the company could upgrade existing equipment or expand existing
factories. The bottom line is: Which method of expanding
production will increase profit the most?

d. In deciding how much to prepare for class, a professor faces a
tradeoff between the value of improving the quality of the
lecture compared to other things she could do with her time,
such as working on additional research.

2. When the benefits of something are psychological, such as going on a
vacation, it isn't easy to compare benefits to costs to determine if
it's worth doing. But there are two ways to think about the benefits.
One is to compare the vacation with what you would do in its place.
If you didn't go on vacation, would you buy something like a new set
of golf clubs? Then you can decide if you'd rather have the new clubs
or the vacation. A second way is to think about how much work you had
to do to earn the money to pay for the vacation; then you can decide
if the psychological benefits of the vacation were worth the
psychological cost of working.

3. If you are thinking of going skiing instead of working at your part-
time job, the cost of skiing includes its monetary and time costs,
which includes the opportunity cost of the wages you are giving up by
not working. If the choice is between skiing and going to the library
to study, then the cost of skiing is its monetary and time costs
including the cost to you of getting a lower grade in your course.

4. If you spend $100 now instead of saving it for a year and earning 5
percent interest, you are giving up the opportunity to spend $105 a
year from now. The idea that money has a time value is the basis for
the field of finance, the subfield of economics that has to do with
prices of financial instruments like stocks and bonds.

5. The fact that you've already sunk $5 million isn't relevant to your
decision anymore, since that money is gone. What matters now is the
chance to earn profits at the margin. If you spend another $1 million
and can generate sales of $3 million, you'll earn $2 million in
marginal profit, so you should do so. You are right to think that the
project has lost a total of $3 million ($6 million in costs and only
$3 million in revenue) and you shouldn't have started it. That's
true, but if you don't spend the additional $1 million, you won't have
any sales and your losses will be $5 million. So what matters is not
the total profit, but the profit you can earn at the margin. In fact,
you'd pay up to $3 million to complete development; any more than
that, and you won't be increasing profit at the margin.

6. Harry suggests looking at whether productivity would rise or fall.
Productivity is certainly important, since the