Economic Way of Thinking, The (Pearson Series in Economics) The authors expose readers to a method of reasoning that makes them assume like an economist by means of occasion and software and in addition reveals them the best way to not assume, by exposing errors in trendy monetary reasoning.
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Book Description: Apollo Root Cause Analysis is about effective problem solving. It is truly a new way of thinking that will ensure effective solutions to almost any kind of problem. Discover new communications tools that are revolutionizing the way people all around the world think, communicate, and make decisions together. Economics is divided into two branches, microeconomics and macroeconomics. In microeconomics, economists look at the small picture. In microeconomics, economists look at the small picture. They study the behavior and choices of relatively small economic units, such as an individual or a single business firm. New London) touched on the issue of eminent domain. In a 5-to-4 ruling, the U.S. Supreme Court held that local governments may force property owners to sell to make way for private economic development if city officials decide that such a sale would benefit the public. The Student eBook contains the entire Economics: New Ways of Thinking text. It has a fully linked Contents panel as well as the ability to create your own bookmarks to specific pages. The eBook also allows you to highlight text, type notes, and jump from page.
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These shop owners can own the property on which their business is built, make their own business decisions, and enjoy the profits of their hard work if their business is successful. The economic system that provides them with these opportunities is free enterprise.
Why It Matters
Free enterprise can be examined in two ways. One way looks at it much the way Winston Churchill, a former prime minister of Great Britain, looked at democracy. Churchill said it’s not that
democracy is so good, but that the other political systems are so bad. In other words, democracy is far from perfect, but it is the best system we have. Some people feel the same way about free enterprise: it’s not that free enterprise is so good, but that it’s the best system we have.
Others take a different view. To them, free enterprise is not only the best of a bad lot; it is good in an absolute sense. Free enterprise is not only an economic system that puts the “bacon on the table” but also a system that does so in
an ethically desirable way. No matter what you think of
free enterprise, it is an economic system to reckon with. As you know from reading Chapter 2, in the late 1980s and early 1990s countries that had not yet adopted free enterprise ways began to do so. As an economic system, free enterprise has always played a major role in the development of economic wealth in the world. As globalization spreads, free enterprise promises to play an even bigger role in the twenty-first century.
The following events occurred one day in May.
7:38 A.M. Danielle is reading a story in her local newspaper about a billionaire who hired a major rock band for his son’s 12th birthday party. It turns out that the total cost for the party is more than $7 million. Danielle thinks: It is absolutely ridiculous to spend that much money on a kid’s birthday party. I mean, people in the world are starving, and this guy spends $7 mil-
lion on a birthday party ?
• What does a $7 million party have to do with free enterprise?
11:02 A.M. James wants to buy a new sports jacket for summer. He is currently looking at jackets at a clothing store in the mall. The jacket he is looking at is
nice, and he’d like to buy it, but the price is a little high. A salesman walks over to James and asks if he can help him. James says that he is just looking. James thinks that
he is going to look for a new jacket at another store.
• What does deciding to go to another store have to do with free enterprise?
2:33 P.M. Tory is in her economics class at Binghampton High School. Her teacher is talking about the role of the entrepreneur in the economy. He says, “The entrepreneur is one of the most important persons in the economy. Without the entrepreneur, we wouldn’t have many of the goods
and services we enjoy.” As her teacher talks on, Tory wonders whether she should study economics in college if she wants to be an entrepreneur.
• What do you study if you want to be an entrepreneur?
6:42 P.M. Lisa is in her car delivering pizzas. Her radio is up loud and she is listening to a Gwen Stefani song. The windows of her car are rolled down as she is stopped at an intersection. Her head is going left and right as she sings along with the song. The gentleman in the car next to Lisa’s looks over at her. He wishes she would turn the music down. Lisa doesn’t notice him. She sings it again and she just keeps on singing. The light turns green and Lisa moves off.
• What does listening to a Gwen Stefani song have to do with free enterprise?
Focus Questions
What goods will be produced in a free enterprise economy?
Who decides what goods will be produced in a free enterprise economy?
For whom will goods be produced in a free enterprise economy?
What are five major features of free enterprise?
What is the circular flow of economic activity?
Key Terms
private property public property household
circular flow of economic activity
How Does Free Enterprise
Answer the Three Economic
Questions?
You read about the three key economic questions that every economic system must answer in Chapter 2. Now let’s look at how these questions are answered in a free enterprise economy.
What Goods Will Be Produced?
In a free enterprise economy, business firms will produce the goods that consumers want to buy. For example, suppose consumers are willing and able to buy goods A, B, and C at a price and quantity that will earn profits for business firms. Also suppose that consumers are either unwilling or unable to buy goods D, E, and F at a price and quantity that will result in profits for the businesses that produce the goods. Business firms will produce goods A, B, and C, but they will not produce D, E, or F.
E X A M P L E : In the United States, General Motors and Ford Motor Company
decide what style and make of cars they will produce. Each company bases its production on what it thinks the car-buying public wants to buy.
How Will These Goods Be Produced?
The individuals who own and manage the business firms decide how goods will be produced. For example, if the owners and managers of an automobile company want to use robots to produce cars, then they will purchase the robots and produce cars with them. If a company prefers that its secretaries use computers produced by Apple instead of computers produced by HewlettPackard, the secretaries will use computers produced by Apple.
For Whom Will the Goods Be
Produced?
In a free enterprise economy, goods are produced for those people who are willing and able to buy them. Notice that it takes both willingness to buy and the ability to buy. A person has the ability to buy a
$25,000 car if that person has $25,000 to spend, but if the same person is unwilling to spend $25,000 for the car, he or she will not purchase the car. Also, no purchase will occur if a person has the willingness to buy something but is unable to do so. For example, Shelly may be willing to spend $800 to buy a computer but may currently be unable to do so because she does not have the money.
QUESTION: Aren’t some goods and services produced in a free enterprise economy that we would be better off not producing? Harmful products, such as pornography and drugs; and showy, unnecessary products like a $20,000 watch, or a $1 million diamond ring, or a solid gold faucet for the bathroom? Should these goods and services be produced?
ANSWER: Probably everyone can find some good or service produced, bought, and sold in a free enterprise economy that he or she thinks we would be better off without. Some people dislike hip-hop and think the country would be better without it; some people think that big Hummers on the road are something we would be better off without. The free enterprise economic system doesn’t really make value judgments; it simply produces goods and services that individuals (maybe not all individuals) want to buy. Look at it this way. You might be in favor of free speech, but still not like everything that people say. Similarly, you might be in favor of free enterprise, but still not like everything that people produce, sell, and buy.
Five Features of Free
Enterprise
Five major features or characteristics define free enterprise: private property, choice, voluntary exchange, competition, and economic incentives. (See Exhibit 3-1.)
Private property
FREE
ENTERPRISE
Voluntary
exchange
Economic incentives
Competition
Economic systems are often defined by their characteristics. Five characteristics that define free enterprise are private property, choice
(or freedom to choose), voluntary exchange, competition, and economic incentives.
Private Property
Any good—such as a car, house, factory, or piece of machinery—that is owned by an individual or a business is referred to as private property. Any good that is owned by the government—such as the Statue of Liberty—is referred to as public property. Under free enterprise, individuals and businesses have the right to own property. Furthermore, they may own as much property as they are willing and able to purchase, and they may sell whatever property they own.
The right to own private property is not, however, absolute in all cases. Suppose the government wants to run a new road through the private property of some homeowners. The government offers to buy the property from the homeowners, but a few owners refuse to sell. What happens next? Generally, under the right of eminent domain, the government can take ownership of the land even without the consent of the owner. In such cases the government will compensate owners for the loss of their land.
private property
Any good that is owned by an individual or a business.
public property
Any good that is owned by the government.
E X A M P L E :
Why is this car, rather than a different model, being produced? Who decided how it should be built? For whom is it being built?
In 2005, a fairly controversial Supreme Court ruling (Kelo v. New London) touched on the issue of eminent domain. In a 5-to-4 ruling, the U.S. Supreme Court held that local governments may force property owners to sell to make way for private economic development if city officials decide that such a sale would benefit the public. The local officials can do this even if the new project’s success is not guaranteed.
Opponents of this ruling argued that forcibly shifting land from one private owner to another, even with fair compensation, violated the Fifth Amendment of the U.S. Constitution, which prohibits the taking of property except for “public use.”
Justice John Paul Stevens, of the Supreme Court, argued that “public use” could be interpreted to include not only traditional projects like highways or bridges, but also things such as slum clearance and land redistribution. He said that even such things as creating jobs in a depressed city could be interpreted as satisfying “public use.”
Justice Sandra Day O’Connor, of the Supreme Court, disagreed with the ruling.
She argued that the ruling favors the most powerful and influential in society and leaves small property owners with little recourse. She stated that the “specter of condemnation hangs over all property. Nothing is to prevent the State from replacing any Motel 6 with a Ritz-Carlton, any home with a shopping mall, or any farm with a factory.”
Choice (or Freedom to Choose)
Choice is a key element of free enterprise. Workers have the right to choose what work they will do and for whom they will work. Businesses have the right to choose the products they will produce and offer for sale. Buyers have the right to choose the products they will buy.
Morgan, living in a free enterprise economy, wants to buy some vitamins, tofu, barbells, and a classic novel by William Faulkner. Ashley, also living in a free enterprise economy, wants to buy a CD by 50 Cent, a tattoo of an eagle, a book by Ayn Rand, and a motorcycle. Both Morgan and Ashley can buy what they want in a free enterprise economy.
Voluntary Exchange
In free enterprise, individuals have the right to make exchanges or trades they believe will make them better off. For example, suppose Mei has $10, Michael has a book, and they trade. We conclude that Mei believes she is better off having the book than the $10, and Michael believes he is better off having the $10 than the book. Individuals make themselves better off by entering into exchanges—by trading what they value less for what they value more.
Competition
Under free enterprise, individuals are free to compete with others. Suppose you live in a town with five bakeries. You think you would like to open your own bakery and compete for customers with the other five bakeries. In a free enterprise system, no person or law stops you.
As a consumer living in a free enterprise system, you are likely to benefit from com-
“Some see private enterprise as a target to be shot, others as a cow to be milked, but few are those who see it as a sturdy horse pulling the wagon.”
petition between sellers. You will probably have a bigger selection of products from which to choose, and sellers will compete with each other for your dollars by increasing the quality of the goods they sell, offering lower prices, providing better service, and so on. Although consumers in a free enterprise system may still have justified consumer complaints, the system usually provides major advantages. It may also have some disadvantages, which may or may not be present in other economic systems.
As a worker in a free enterprise economy, you may benefit from competition in another way. The competition between employers for your labor services will often result in your earning a higher wage or income than you would without competition. For example, suppose you are an accountant working for one of the five accountancy firms in town. A person opens up another accountancy firm and wants you to come to work for her. How might she get you to quit your present job and come to her firm? She may offer you a higher income than you are currently earning.
Economic Incentives
As we learned in Chapter 1, an incentive is something that encourages or motivates a person toward action. Under free enterprise, money acts as an incentive to produce. If you produce goods and services that people are willing and able to buy, you receive money in return. As you learned in Chapter 2, Adam Smith wrote about the usefulness of economic (or monetary) incentives in a free enterprise economy. He explained that business owners are interested in making themselves better off. This desire to earn an income strongly motivates them to produce for others.
Laws, Institutions, and
Regulations
A free enterprise economy (such as the U.S. economy) does not operate in a vacuum. Free enterprise operates in countries, which have different systems of laws, institutions, and regulations. What a particular country’s legal system permits and prohibits
affects the “economic climate” of that country and determines, to a large degree, how free enterprise operates in
that country.
Legal systems and institutions can either help or hinder free enterprise. For example, imagine a country in which the banking sector is somewhat undeveloped, and private prop-
erty is not viewed as important. In this country the free enterprise system would have a difficult time operating (and doing what it does well). In a country such as the United States, however, laws have been developed to regulate banking and protect private property, which helps promote free enterprise.
As you read along in this text, you will learn how some of the institutions and laws in the United States influence the economy. For example, the last section of this chapter introduces you to government’s role in free enterprise; Chapter 8 discusses antitrust laws; Chapter 9 describes certain business regulations; and Chapter 10 examines the banking system.
The owner of a fast-food franchise might prefer fewer competitors nearby.
How might competition benefit you as a worker when you join the workforce?
The circular flow of economic activity shows the relationships between different economic groups. For example, in this circular flow diagram we see that households buy goods from businesses and sell resources to businesses. We see that both businesses and households pay taxes to government and receive benefits from government.
E X H I B I T 3-2The Circular Flow of Economic Activity in the U.S. Economy
household
An economic unit of one person or more that sells resources and buys goods and services.
circular flow of economic activity
The economic relationships that exist between different economic groups in an economy.
The Circular Flow
Much of what characterizes a free enterprise economy has to do with how the key economic sectors—government, businesses, and households—deal with each other. Does government play a big role in the economy, or a small role? Are businesses free to produce what they want? What goods do businesses produce in order to sell to the household sector?
A Snapshot of an Economy
A picture of what an economy can look like in action might help us answer these questions. Look at Exhibit 3-2, which shows the circular flow of economic activity in the U.S. economy. The picture shows who the key players are in the economy, the relationships they have with each other, and the ways in which they interact. At first sight, it simply looks like a picture with lines going every which way, but those lines tell a story.
1.As mentioned above, it is customary to think of an economy as composed of
businesses, government, and households. In the exhibit, businesses, government, and households are visually represented in the center of the diagram.
2.An economic relationship exists between businesses and households. Businesses sell goods and services to households (purple arrow), for which households must make monetary payments (blue arrow). For example, a consumer decides to buy a sofa from a furniture company.
3.Businesses and households have another economic relationship: individuals in households sell resources (such as their labor services) to business firms (red arrow), and in return, businesses pay individuals for these resources (green arrow). For example, a business pays a worker a day’s wage.
4.Both businesses and households have a certain economic relationship with the government. Households pay taxes to the government (yellow arrow) and in
return receive certain goods and services (gray arrow). For example, the government provides individuals with roads, schools, and national defense. The same kind of relationship holds between businesses and the government: businesses pay taxes to the government (orange arrow), and the government provides certain goods and services to businesses (brown arrow).
Now look at Exhibit 3-2 as a whole rather than focusing on any of its parts. Notice in particular the relationships between different economic individuals, businesses, and institutions.
•Businesses and households. Households sell resources to businesses, and businesses pay for those resources. It is also the case that businesses sell goods and services to households, and then households pay for those goods and services.
•Government and households. Households pay taxes to the government, and the government provides goods and services to households.
•Government and businesses. Businesses pay taxes to the government, and the
Why Is the Circular Flow
Diagram Useful?
Suppose you are watching the news one night on television. An economist who works for the president of the United States is stating that the president is seriously considering raising people’s taxes. Look at Exhibit 3-2 and ask yourself which arrow will be affected by this action. It is the yellow arrow labeled “Households pay taxes,” which goes from households to the government. If all other things remain the same, this arrow grows larger, because more tax dollars will flow through it.
Next, ask yourself this question: If more tax dollars flow through the yellow arrow from households to government, will fewer dollars flow through some other arrow? The answer is yes—through the blue arrow that moves from households to businesses. In other words, because households pay more of their income in taxes, they have less of their income to buy things such as television sets, cars, and computers. The circular flow diagram helps us see how a change in one economic activity (such as paying taxes) will lead to a change somewhere else in the economy
Defining Terms
1.Define:
a.private property
b.public property
c.households
d.circular flow of economic activity
2.Use the word incentive correctly in a sentence.
Reviewing Facts and
Concepts
3.According to the circular flow of economic activity, in what economic activities is the government engaged? (Look at Exhibit 3-2 to help you answer the question.)
4.In a free enterprise economy, how would you answer this question:
For whom are goods produced?
5.Under free enterprise, everyone has the right to own property. Does it follow that everyone will own property? Why or why not?
6.How does voluntary exchange benefit a person?
7.What advantages do consumers get from the competition between sellers?
Critical Thinking
8.Would Adam Smith agree that the benefits of free enterprise are a consequence of the human desire to make life better for others? Explain.
Applying Economic
Concepts
9.Teachers want students to do their homework completely, carefully, and on time. Identify an incentive that you think would increase student efforts toward reaching these objectives.
Focus Questions
What roles do profits and losses play in a free enterprise economy?
What do profits, losses, and resources have to do with one another?
How do profit and loss operate as signals to business firms?
Key Terms
profit loss
profit
The amount of money left over after all the costs of production have been paid. Profit exists whenever total revenue is greater than total cost.
loss
The amount of money by which total cost exceeds total revenue.
Profits and Losses
In a free enterprise economy there are no guarantees. A business can either succeed or fail. Whether a business is successful or not depends on whether it generates profits or losses.
Profits
Suppose that a computer company spends $800 to produce a computer, and then sells the computer for $1,200. In this case the company earns $400 in profit. Profit is the amount of money left over after all the costs of production have been paid.
Profit can also be described in terms of total revenue and total cost. Total revenue is the price of a good times the number of units of the good sold:
Total revenue
Price of a good Number of units sold
For example, suppose you sell radios at a price of $50 apiece. On Monday you sell five radios, so the total revenue for Monday is $250.
Total cost is the average cost of a good times the number of units of the good sold:
Total cost
Average cost of a good Number of units sold
Suppose the average cost of the five radios you sell is $30 per radio. The total cost is $150. For the five radios, the difference between total revenue ($250) and total cost ($150) is $100. This $100 is profit.
Losses
Notice that profit results any time total revenue is greater than total cost. When the opposite is true—when total cost is greater than total revenue—a loss occurs, stated in terms of the amount of money by which total cost exceeds total revenue. For example, suppose that in a given year, a clothing store has a total revenue of $150,000 and total costs of $200,000. If we subtract the store’s costs from its revenues, we get –$50,000, a loss for the year.
Profit Total revenue > Total cost
Loss Total cost > Total revenue
QUESTION: How many new businesses start up in the United States each year? How many business failures happen each year?
ANSWER: About 3.4 million new businesses start up each year (including businesses of all sizes, even one-person businesses) and about 3.2 million businesses fail each year. The source for these data is the Statistical Abstract of the United States which you can find online at www.emcp.net/businesses.
Profit and Loss as “Signals”
At any time in a free enterprise economy, some business firms are earning profits, and some are taking losses. Profits and losses are
(1) signals to the firms actually earning the profits or taking the losses and (2) signals to firms standing on the sidelines.
Suppose the NBC television network airs a comedy show on Thursday night that earns high ratings. Because companies will pay more to advertise on high-rated shows, the comedy show creates more profits for NBC. The CBS network airs a crime show on Thursday night that receives low ratings and losses. What are NBC and CBS likely to do now?
NBC will probably do nothing new; it will continue doing what it has been doing. The comedy show is earning high ratings, and the network is earning high profits. CBS, in contrast, will probably cancel its crime show, because the public does not like it. CBS might replace the crime show with a comedy, because NBC already showed that a comedy does better than a crime show.
So far the third major network, ABC, remained on the sidelines watching what was happening to NBC and CBS on Thursday night. ABC is thinking about developing a new program. Will what happened to NBC and CBS influence ABC’s decision as to what type of program it will
In a free enterprise economy there is no guarantee that a new business will succeed. Why do you think more than 3 million businesses fail each year?
The Tonight Show with Jay Leno is a profitable show for NBC. How do one company’s profits affect decisions made by its competitors?
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E X A M P L E :
conomists think in terms of Eboth benefits and costs. For
example, attending college has both benefits and costs. Usually, the
benefits far exceed the costs. To learn more about colleges, go to the following Web site: www.emcp.net/college.
Once at the site, click on “College Directory” and then “United States.” The next screen you see will list the 50 states and Washington, D.C. Click on the state in which you think you may want to attend college. From there, click on the names of a few colleges, and read about them. After spending some time looking at different colleges, identify what you think are the benefits and costs of attending college. Finally, do you think the benefits are greater than, less than, or equal to the costs?
marginal
In economics, marginal means additional.
incentive
Something that encourages or motivates a person to take action.
major? According to the economist, we know that when she made the decision to major in psychology, she thought that the benefits to her of majoring in psychology would be greater than the costs. When economists study a problem, weighing the costs and the benefits, they refer to this process as a cost-benefit analysis.
John has been studying four hours for his English test tomorrow. It’s now 10:30 at night. John considers studying one more hour. The benefits to studying another hour might be a higher grade on the test. The cost of studying another hour is one less hour of sleep, which could adversely affect his ability to concentrate during the test (which, in turn, could adversely affect his grade). He thinks the costs of studying an additional hour are greater than the benefits, so he goes to bed.
Thinking at the Margin
An important economic term will come up throughout this text when discussing costs and benefits. That word is marginal, which means “additional.”
Why is the term marginal so important? It is because economists believe that when
people make decisions, they do not think of the total costs and benefits involved in the decision. Instead, they think about the additional, or marginal, costs and benefits.
You have just eaten two chicken tacos for lunch and are trying to decide whether or not to go back for a third. You are still hungry, but if you get another taco now, you will have no money left for a soda after school. Are you really that hungry?
In making the decision described above, you are comparing the marginal benefits of one more (an additional) taco against the marginal costs of one more taco. If you decide that the marginal benefits are greater than the marginal costs, you will buy the additional taco. If, on the other hand, you decide that the marginal costs are greater than the marginal benefits, you will keep your money and go without the additional taco. An economist would say that you were “making decisions at the margin,” a process that you will encounter in several of the following chapters.
Thinking in Terms
of Incentives
Economists often speak of incentives in reference to actions. An incentive is something that encourages or motivates a person to take an action. For example, suppose that Amy lives in a country where every dollar she earns is taxed (by government) at 100 percent. With a tax rate of 100 percent, an economist might argue that Amy does not have an incentive to produce anything for sale. Why work all day to produce a good that is sold for, say $100, when you will have to turn over the full $100 to the government in taxes?
Now let’s lower the tax rate in Amy’s country from 100 percent to 20 percent. In your mind, has the lower tax rate provided Amy with an incentive to work and produce? An economist would say it has. The lower tax rate encourages or motivates Amy toward a particular action—working and producing—because now Amy can keep 80 cents out of every dollar she earns.
E X A M P L E :
“Most of economics can be summarized in four words:
E X A M P L E :
Kenneth, who is 15 years old, and lives with his parents, does not have an incentive to mow the lawn. There is absolutely nothing that encourages or motivates him toward mowing the lawn. Then one day Kenneth’s father offers him $10 to mow the lawn. The $10—the money—is an incentive for Kenneth to mow the lawn. It encourages or motivates him toward mowing the lawn.
Jimmy lives in country A, where people are not permitted to own property, so Jimmy rents a house from the government. Adam lives in country B, where people are permitted to own property, so Adam owns his house. Who is more likely to take care of the house he lives in? The answer is Adam. The reasoning is simple: Adam can sell the house he lives in (because he owns it); Jimmy cannot sell the house he lives in. Any damage Adam does to his house lowers the selling price of the house. The moral of the story? Private property ownership acts as an incentive to taking care of things.
Thinking in Terms
of Trade-Offs
As you learned in Section 1, trade-offs involve opportunity costs. When more of one thing necessarily means less of something else, we have a trade-off. For example, when we drive our cars, we pollute the air. One way to cut down on
the amount of pollution is to drive less. In other words, more driving means less clean air, and less driving means more clean air.
More of one thing (driving) necessarily means less of something else (clean air). We have a trade-off between driving and clean air.
Individuals Face Trade-Offs
You might notice that when trade-offs arise in life, you sometimes have to stop and think what course of action you want to take.
Like individuals, societies face trade-offs. What trade-off is represented by these two photographs?
E X A M P L E :
Suppose Mary Ann loves to eat, but she has recently put on (what she considers to be) a few too many pounds. She wants to lose some weight for two reasons:
(1) to feel more comfortable in her clothes and (2) to reduce the risk of heart disease, which is linked to being overweight. So Mary Ann goes on a diet and cuts her calorie intake from 2,500 to 1,800 calories a day.
Does Mary Ann face a trade-off? Sure she does. On the one hand, if she doesn’t go on a diet, she gets to continue eating what she wants to eat (that’s good), but she won’t feel as comfortable in her clothes and she increases her risk of heart disease (that’s bad). Of course, on the other hand, if she does go on the diet, she will likely feel more comfortable in her clothes and be healthier (that’s good), but she will have to avoid some of her favorite foods and feel hungry much of the day (that’s bad).
No matter what Mary Ann decides, Mary Ann gets something she likes and something she doesn’t like. She gets more of one thing (comfort and health) and less of something else (enjoyment from eating what she wants) if she chooses to diet. If she chooses not to diet, she still gets more of one thing (enjoyment from eating what she wants) and less of something else (less comfort and health).
Societies Face Trade-Offs
Just as individuals face trade-offs, so do societies. At any one point in time, the federal government has only so much money from tax revenues. If more tax dollars go for, say, education, it means fewer tax dollars to spend on roads and highways. If more tax dollars go for national defense, then fewer dollars can be spent on health and welfare.
Trade-offs sometimes lead to conflicts in society. One group may think it better to spend more money on national defense and less on health and welfare. Another group might prefer the opposite. A conflict arises. In a household, some members of the family might prefer to spend more of the family budget on boats, plasma TV sets, and computers. Other members might prefer to spend more of the family budget on education, vacations, and furniture. A conflict arises.
Thinking in Terms of What
Would Have Been
Economists often think in terms of “what would have been.” It is important to be able to think in terms of what would have been, because only then do we know the opportunity costs for “what is.”
The Story of the Broken Window
A famous economist-journalist once wrote a book in which he told the story of a boy who threw a rock through a baker’s shop window. In the story the townspeople gather around the baker’s shop and complain about the actions of today’s youth. Then one person has a quite different perspective. He says that because the boy broke the window, the baker now has to buy a window, which means the window maker will now have more business. And because the window maker has more business, he will earn more money. And because he has more money, he will spend more money. And because he spends more money, someone else in the town will sell more goods, and on and on. So, says the person with the different perspective, what the boy has done is a good thing: he has generated economic activity for the town. After listening to this different view of the situation, the townspeople are happy. What had at first seemed like a tragedy (a boy breaking a window), now clearly appears to be the beginning of an economic boom for the town.
What do you think? Did the boy set off a chain reaction that will create work, income, and profits for many people in the town? And if so, should the townspeople hope that more boys throw more rocks through windows?
Before you begin encouraging people to throw rocks in your town, stop and ask, as the economist did, this simple question: If the baker didn’t have to buy a new window, what would he have purchased with the money he would have spent on the window? Suppose that he would have spent the money for a new suit. But, now that the window is broken, the baker will have no
E X A M P L E :
money for the suit, so the suit maker will earn less money (than otherwise). Without that money, the suit maker will be able to make fewer purchases, which will translate into fewer sales for others, and so on and so on.
Simply put, the economist urges us to see “what would have been” if the boy had not broken the window. The economist urges us to see more than “what will be” because the boy broke the window.
It is easy for all of us to see “what will be”: we will actually see with our eyes the window maker selling a window and getting paid for it. It is not so easy, though, to see “what would have been.” We can’t see with our eyes the suit maker not selling the suit.
Seeing with Your Mind
It takes a certain kind of vision to see “what would have been.” It takes your mind (and not your eyes) to see what would have been. You have to think your way to understanding that one new window means one fewer suit.
Suppose the federal government sets aside funds for a new interstate highway system. Thousands of people are hired to work on the project. Local newspapers in the towns along the highway write lots of stories on all the increased job activity, and soon there are more and better highways in the area. It is easy to see the “what will be” benefits of more jobs and better roads.
We need to remind ourselves, however, that someone—namely, the taxpayers—had to pay for the new highway system. What did these taxpayers give up by paying the taxes to fund the new highway? They gave up the opportunity to buy goods for themselves, such as clothes, computers, and books. We now begin to think in terms of all the products that “would have been” produced and consumed had the highway not been built. If, say, more clothes would have been produced instead of highways, more people would have worked in the clothing industry and fewer would have worked in highway construction.
Building and improving highways is expensive. What sorts of things might not exist as a result of this highway being built?
Thinking in Terms of
Unintended Effects
Economists often look for the “unintended effects” of actions that people take. Has anything ever turned out differently from what you intended?
On an average day a shoe store sells 100 pairs of shoes at an average price of $40 a pair, thereby earning $4,000. One day the store owner decides to raise the price of shoes from an average of $40 to $50. What do you think he expects the effect of his action to be? He probably expects to increase his earnings from $4,000 a day to some greater amount, perhaps to $5,000 (100 pairs of shoes $50 $5,000). The store owner might be surprised by the results. At a higher price, it is likely that he will sell fewer pairs of shoes. Suppose that at a price of $50 a pair, the owner sells an average of 70 pairs of shoes a day. What are his
E X A M P L E :
ABOUT IT
Do ?
Seatbelts
Cause
Accidents?
Most states have mandatory seatbelt laws for drivers.
Seatbelt legislation was passed to save lives. That was its intent.
Soon after states started adopting mandatory seatbelt laws, an economist undertook a study. He wanted to find out if seatbelt laws really did save lives. His study showed that the number of car deaths before seatbelt laws was the same as the number of car deaths after seatbelt laws. This finding perplexed him because common sense tells us that if you are in an accident you have a better chance of surviving if you are wearing your seatbelt. So, what explained the economist’s finding? The answer is this simple equation:
Number of car deaths Number of accidents Probability of being killed in a car accident
What seatbelt laws did was lower the “probability of being killed in a car accident.” Yet, if they lowered this probability, and the number of car deaths was still the same
(before and after the seatbelt law), then the only thing that could
accidents increased. (Economists are interested in unintended effects.)
Why did the number of accidents increase? Some have suggested that drivers feel safer wearing a seatbelt and that drivers who feel safe are more likely to take risks on the road than drivers who do not feel safe. (Might drivers in large Hummers take more risks than drivers in Honda Civics?) Obviously, the way to be safe while driving a car is to wear your seatbelt and drive as carefully as you would if you weren’t wearing your seatbelt. In other words, don’t let wearing the seatbelt lull you into driving recklessly.
explain this finding was that the “number of accidents” had to rise. This change is exactly what the economist found. In other words, one unintended effect of the seatbelt law was that the number of
The intended effect of placing a safety cap on medications is so that children don’t
get into the medicine and eat it because they mistakenly think it is candy. Can you think of an unintended effect of placing safety caps on medications?
average daily earnings now? ($3,500 = 70 pairs of shoes $50) The owner did not intend for things to turn out this way; he intended to increase his earnings by raising the price of shoes. The decrease in his earnings is an unintended effect of his actions.
Suppose that U.S. citizens are buying some Japanese goods (such as Japanese cars), and that Japanese citizens are buying some goods produced in the United States (such as U.S. computers). Then things change: the Japanese government decides to place a $200 tax on every U.S. computer sold
in Japan. People in Japan who buy U.S. computers will have to pay $200 more than they would have paid without the tax. Why might the Japanese government impose this tax? It may want Japanese computers to outsell U.S. computers; it may want to generate higher profits and greater employment in the Japanese computer industry. To accomplish these goals, the government deliberately makes U.S. computers more expensive than Japanese computers by placing the tax on U.S. computers. This action ends up hurting U.S. computer companies, because they sell fewer computers.
The United States could decide to retaliate by placing a tax on Japanese cars sold in the United States. Japanese cars will be more expensive, and fewer will be sold. This action will hurt Japanese car companies.
Do you see what has happened? Japan initially takes an action—placing a tax on U.S. computers sold in Japan—hoping that the Japanese people will buy more Japanese computers and fewer U.S. computers (the intended effect of the action). The intended effect is realized: the Japanese people actually do buy more Japanese computers and fewer U.S. computers. But there is an unintended effect too: the United States places a tax on Japanese cars, which ends up hurting Japanese car companies. When the Japanese placed a tax on U.S. computers, they did not intend to do harm to Japanese car companies.
Do unintended effects matter? The answer is yes, they matter a great deal. That is why, for any action, economists think in terms of both intended and unintended effects. Can you see the advantage of being able to think about and anticipate unintended effects when making decisions?
Thinking in Terms of the
Small and the Big
Economics is divided into two branches, microeconomics and macroeconomics. In microeconomics, economists look at the small picture. They study the behavior and choices of relatively small economic units, such as an individual or a single business firm. Economists who deal with macroeconomics look at the big picture, studying behavior and choices as they relate to the entire economy (see Exhibit 1-4). For example, in microeconomics, an economist would study and discuss the unemployment that exists in a particular industry, such as the car industry; in macroeconomics, an economist would investigate the unemployment that exists in the nation. In microeconomics, an economist would look at the buying behavior of consumers in regard to a single product, such as computers; an economist dealing in macroeconomics would study the buying
E X H I B I T 1-4Two Major Branches of Economics
ECONOMICS
Economists divide economics into two major branches: microeconomics and macroeconomics.
behavior of consumers in regard to all goods. We might say that the tools of macroeconomics are telescopes, while the tools of microeconomics are microscopes. Macroeconomics stands back from the trees to see the forest. Microeconomics gets up close and examines the tree itself, including its bark, its branches, and the soil in which it grows. In this book you will learn to look at the world from both “micro” and “macro” perspectives.
Thinking in Terms
of Theories
Some questions have obvious answers, and others do not. For example, if you hold a ball in your right hand and ask someone what will happen if you let go of it, the person will likely say that the ball will drop to the ground. Right answer. If the classroom clock reads 10:12 and you ask someone in the class what time it is, that person will say 10:12. Again, right answer.
Now suppose you ask someone any of the following questions:
•Why is the crime rate higher in some countries than in other countries?
•What causes the stock market to rise or fall?
•What causes some nations to be rich and others to be poor?
microeconomics
The branch of economics that deals with human behavior and choices as they relate to relatively small units—an individual, a business firm, or a single market.
macroeconomics
The branch of economics that deals with human behavior and choices as they relate to the entire economy.
E X A M P L E :
U.S. Representative James Sensenbrenner Jr. (left) and Senator Charles Grassley (right) meet with President Bush to discuss economic policy. Do you think these men make use of economic theories? If so, how?
theory
An explanation of how something works, designed to answer a question for which there is no obvious answer.
You probably would agree that these questions have no obvious, easy answers.
Because some economic questions do not have obvious answers, economists build theories. Think of a theory as a mechanism that an economist uses to answer a question that has no obvious, easy answer. Here are only five of hundreds of questions for which economists have built theories:
1.What causes inflation?
2.What causes the unemployment rate to rise or fall?
3.How do business firms operate?
4.What causes the prices of goods and services to rise, fall, or remain stable?
5.Why do countries experience good economic times in some years and bad economic times in other years?
Suppose you are living in the days before anyone has heard the word calorie. Over a period of three years, you notice that your weight changes. At one time you weigh 140 pounds, then 145 pounds, then 155 pounds. You wonder why you are gaining weight.
Along comes a person who gives you a simplified explanation of what is happening.
She says that there are things called “calories,” and that we can measure food in terms of how many calories it has. Some foods have more calories than others. She then says that every day you use up, or burn, calories when you walk, run, and clean the house. You even burn them, she says, when you are sitting still on the couch watching television. Finally, she says that your weight depends on how many calories you take in compared to how many you burn. If you consume more calories than you burn, you will gain weight.
This calorie theory is used to explain one’s weight. You will notice that this theory explains how things work (how your body takes in and uses up calories) in order to answer a question. All theories have this structure. A theory always offers some explanation of how things work in order to answer a question that does not have an obvious answer.
QUESTION: I’ve always thought that theories were difficult to understand because they contain a lot of mathematics. Is this correct?
ANSWER: Some theories contain mathematics, but many do not. Your impression of a theory is the common one. Many people think that a theory has to be abstract, mathematical, and almost impossible to understand. But this is a misconception. To a large extent, a theory is simply a
“best guess” offered to explain something. Anyone can build a theory; in fact, you may (unknowingly) do so.
Suppose your best friend always eats lunch with you. Then, one day he doesn’t. You may wonder what explains his change in behavior.
Once you have a question in your mind—What led to the change in his behavior?—you are on your way to building a theory. Your “best guess” may be that he doesn’t like you anymore, or that you said something to upset him, or something
altogether different. Trying to answer your question by offering your “best guess” is really no different from an economist creating a theory about some aspect of economics. The economist puts forth his or her “best guess” as to what causes inflation, high interest rates, or economic growth.
Is It Reasonable?
Many people evaluate a theory based on whether it seems reasonable. However, many theories that at first seemed very unreasonable to people turned out to be correct. Think about how it might have sounded to you if you had lived before microscopes were invented and someone told you that people were getting sick because of tiny “things” (which today we call germs) that no one could see. You might have thought that sounded ridiculous. Or suppose you had lived during the days of the Roman Empire and someone proposed the round-earth theory to answer a question. You might have said, “There is no such thing as a round earth!”
Does It Predict Accurately?
Scientists believe that we should evaluate theories based not on how they sound to us, or whether they seem right, but on how well they predict. If they predict well, then we
Many of these people are unemployed and looking for work. Why do you think economists propose theories to explain unemployment?
should accept them; if they predict poorly, then we should not. No doubt, as you read this text, you will come across an economic theory here or there that you think sounds wrong. You are urged to adopt the scientific attitude and hold off judging any economic theory until you learn how well it predicts.
Defining Terms
1.Define:
a.incentive
b.microeconomics
c.macroeconomics
d.theory
2.Use marginal costs correctly in a sentence.
Reviewing Facts and
Concepts
3.According to economists, almost everything we do has costs and benefits.
Identify the costs and benefits of each of the following: going to the dentist for a checkup, doing your homework, and getting an extra hour of sleep.
4.Give an example of an unintended effect.
5.What is the difference between microeconomics and macroeconomics?
Critical Thinking
6.If there were zero opportunity cost to everything you did, would you ever face a trade-off? Explain your answer.
Economic Way Of Thinking Examples
Applying Economic
Concepts
7.Describe a recent situation in which you weighed marginal costs versus marginal benefits to make a decision.
Many people underestimate the power of saving. That’s because they don’t realize the large
gains one can earn by saving— especially if they start saving when they are young.
Save Now, or Save Later?
You are probably 17 or 18 years old if you are reading this book. Suppose you go to college and when you are 22 you get your first full-time job, earning $45,000 a year. If, in that first year after graduating college—and only in that year—you
save $2,000, at an annual interest rate of 5 percent, and your interest is compounded quarterly (which means you earn an interest payment every three months), how much money will you have when you retire at age 65? The answer is $16,942. In other words, a one-time savings of $2,000 when you are 22 will turn into $16,942 by the time you retire at 65.
It is likely, however, that if you are able to save money when you are 22, you will be able to save some when you are 23, 24, and so on. So,
let’s suppose that instead of saving $2,000 only once, when you are 22, you save $2,000 every year between the ages of 22 and 65. We will assume again that your annual interest rate of return is 5 percent and that interest is compounded quarterly. How much will money will you have at 65? The answer is $319,526.46.
Saving now—even if you save only a small amount—will pay off later. Have you opened a savings account yet?
interest rate of 6 percent, compounded quarterly). What is the opportunity cost to smoking? Is smoking costly? It appears to be not only costly when it comes to your health, but also when it comes to your wallet.
One Last Point
If you find it hard to save, then perhaps you need to know what sav-
ing really is. It is not, as some people think, the same as not spending. Instead, it is postponed spending or future spending. In other words, because you have saved today, you have more money to spend in the future. Your decision is not between spending and saving; your decision is between spending now and spending more later.
Most of us spend small amounts of money every day that could become large amounts later in life. What could you give up in favor of regular deposits to your savings account?
Now, just to show you how much it matters to start saving when you are young, suppose that instead of beginning to save when you are 22, you wait until you are 40 to start saving. At 40 and each year after until you reach 65, you save $2,000. How much money would you have at 65? $106,694.68. So, how important is it to begin saving early? By setting aside just an additional $36,000 ($2,000 a year for each year between age 22 and age 40), you end up with an extra $212,831.78.
Smoking or Saving?
Now let’s look at saving in a different way. Recently, a person who purchased a pack of cigarettes every other day ended up buying 182 packs a year at a cost of $4 a pack. That’s a total of $728 per year spent on cigarettes. If that person had simply saved that $728 each year, instead of spending it on cigarettes, it would have ended up being $45,493.32 after 25 years (at an
Way Of Thinking Definition
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The Economic Way Of Thinking Quizlet
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