pARr

oryC

Basic Concepts

The Central Concepts of Economics

'l-he

;lgc ol Ohit,ah i.s gont; thut of'.softlti.ttrr'.s, rntttortri,sl.s, rutrl

rultuktlors has surreulal.
Ildnrund l]rr'kc

A. WHY STUDY ECONOMICSI

\

rorr o;err tlris tcxtlrook. \'()u nltt\ llt' trorttlt'tirtg.

\{ lrv slrorrkl I strrtlr cctntrnirs? l.t't rs (1)unt tllc \\'irvs.
I\lulr\ str.r(h t'torrrrrrics to lrclr tlrcrrr gct a go<ld

.job.
Sorrrc rt'oplt'

li'cl tllcv

slr<rrl<l

rulrlt'stanr[ nrort'

<lt'crlv rvlrat lit's lrt'lrirr<l r'('lx)r(s ()n inflati<>ll ancl

tu

l('

l)l( )\

('r r t.

()r'.rt'orlt'r\':urt l() ru l(l('r-stal r<i ulrat kin<ls <>f poli< ics rrright slou gkrbal rr':u'rnins rr rvhl it rllt:uts ro
sur lrr

il'txl is 'rrir<[c in (]hin;r."

ForY{hom the BellTolls

All tlrcsc r('irs()ns. anrl rn:ulr nrore. rlk<'goorl st'rrst'.
Still, as rr't' ltat t' conrc to le:rlize. tht-l-r' is trrt' tr'<'r't irlirtg lt'itsort t() l('an) the basic less<rrs <f ccorrtlrics:
\ll rrtrr lifi'-lionl cr':rdle t< gr:u t- irrrl lrt'rrrrrrl-rorr
rvill lrrn rrr against the bnrtal trlllhs ()l ('( ()n()tni( s.
As a rrrter. rr:r r.ill rrr:rLc rlt'cisions or issrrt's lllal
cann()t lx' rrnderstood rrntil rrlr lrav' rrrirslcrt'rl tht'
l rr<lirncnts of tlris srrbjt'< t. \\'ithrrt strrrlring ('(-()n()nr-

trn

citnn<t bt'lirllr inlir nr'rl ;rlrout iIrtcI Ir:rtirrIr:rI

U'a(lc. tax p0licr, ol tltt'r-arrscs of r-t'r'r'ssitrs :rrrrl lriglr
ulle lll Dl()\'nlell t.
ics.

(ihoosing rorrl Iife's occtrrirtion is tlrc llrost

irnI)()r'lar)t econonlic dt'r'ision v<rr rr'ilI rnakc. \irrrr'
litttu'e depcrtds rtrt oltlr'on \'()llr rrvn abilitics ltrrt
also on Irtrv nati()Dirl alrrl r'<'gitllrrl t'r'tlllIni< fi -t <'s
all'c'ct r'<ltu rvafes. Also, r'otu knrrr'lcdgr'rl t'r'ononlics can hclr rrrrr nrake rrisc rlccisi<rrrs ;rlrrrrt llorr
f o brr' a hotrtt'.
r:tr' lor r'orn chilrllcrr's ctlrcatiorr,
attd st't asidt' ir lr('sl ('ufl fir' r'<'tilt.rlt.lrt. ()l corr's<.,
sttrch ing ccononrit-s rvill rrol rn:lkt' \r,r a gcnirrs.
Brrt rr'ithorrt ccorlonrics tlrc rlir c ol Iilc alc lotlctl
;r{il||rsl

\()ll.

Thclt' is rro nt't'rl to ltt.l:rlror tht' roint. \\'c

holt' r'orr rr,ill lirrrl thrt, in arlrtitiolr to ltcirrg rrsc

frrl, t'crnrrrics is t.r'cll r l:rsrirratilrg ficlrl. (icll('rirli)ns rf slll(l('nts, l}llcr to tlrt'iI srrr'-lrisr.. lrurc
<lis< <r't'r-<'rl lrorr stirrrlatilrq it is lo look lx'rrr.atlr
llrt' srrrl;rcr' ;urrl rurrlcrst:rrrl tlrt' frrrrdalrrcrrr:rl lrrvs
<ll r'< oltllli<

s.

SCARCITY AND EFFICIENCY:THE

TWINTHEMES OF ECONOMICS
Definitions of Economics

l,et rts begirr rvith dcfinition ol ccorrrnlits. ()rt.l

tlrc last htlllc('ntun, tltc srrdv rl cr rnonlics ll;rs

exparrded to irr'lrdt' a \':lst I alrg(' of torics. Hcl r. :rr<'

cHAPTER | ' THl (:llNTR\1. (l()N(IUPTS OF H(lONOllf I(lS

sorne of the majrlr srrbjects that are c<lvcrctl

book:l

ilt

tltis

Econonrics explores thc behavior ol tlrc finrllcial

rnar-kets, ir.rclrrding interest rrtes, excl)ang(' rittes,
and stock prices.
Thc srrbjcct examines the re:rsons rvlty sotttc pc<lple or cour)tlics havc high illcol'rt's rvhilc othcts
are poor; it gocs otr to analvze rvays thal P()vctlv
can lc rcclucctl rvithotrt lrartnine lhe ec()ll()ttl\'.
lt strrrlics brsincss cycles-the flttctttrrions irt
c r c<lit, trncrrrploymc tr t, atrcl ir flatiort-alotr g witlr
policics t() nro(l('ratc thcl.n.
Econolnics sttttlics irttcrnationaI traclc arrd fin:rrrce
and thc irrrpacts ol globalization, arrrl it particlllaly cxalrrirrcs Iht tlrol rv issucs involvt'd in opening trp bortlcrs t() flcc tra(lc.
It asks lrt;tv govcrnttrcrrt tolicics can ht' ttst'd t<

r
.

prlrsue irnportarrt goals stttlt as raritl ccollonric

growth, efficiclrt rsc of rcstttttccs, Iirll t'nlrlovment, pricc stability. arrtl a liir'(listril)rrti()tl ()f
If

lcoIIlc.

'l'his

is a long list, l)rt wc could cxtt'rrd il rn:rnl'tines.

Howcvcr, i[ rvc boil clown all thcst' dt'finitirlts, rvt'
find onc conrrnon tltcttrc:

hol srcit tit's tls('s( rr'( ('

qoorls a rtrl st'r''t it t's rlrl
valturblc
r cs()ur.c('s to rrotlttcc
Economics is tlrc slrttlv ol

<listr-illrte

tlrell aluortg tlillclcllt inrliritlrrals.

Scorcity ond Efliciency

ll wc think al)cul thc dt'finitions, we find

twc ket'
iclcas that run thrrlrrgh all ol'ecorronrics: fhrt f{()()ds
ar-c scarcc anrl that srcicN'lnrrst rrse its resorrrces efficicnll,t. Ind.w , lht unrcrn.s ol entnontir.s uill nol go ulal
brcuuse oJ tluJittl tl xtrtit' and lln dt:ire.lin-ejlirienr'.
Corsiclcr a wor ld with()ut scarcit'r,. f I'infinite qu:rtr-

titics ol cvcry good corrkl lrt' :tt-odtt<'ccl o if httln:rn

dcsircs wcrc lullv satislicd, whaf wottld bt'flre consequerrccs? Pcoplc wotrltl n()t w()n) about strctclritrg
otrt tlrcir lirltitetl ittorllcs bccattsc thcy cottlrl lravt'
evcrlthing tlle,v rvarttccll lusirrcsses wttld ll()t ll('c(l (o

This list contais scvcral srttializttl l('rIrs rlrirt rorr nill Irtr'<l
tr rrnclerstrrtd, lf yr)u lre n()t fDrili.ir rrith u r:tr_trr ttlrtr trotrl
or phmsc. yorr shoulrl <ortsrtlt tlrc (ikr::rr t tltr'lrirrl rl this
b<xrk. l-lrc (ilossrrT corrtains ost {rl thc nrlrjor' t( l1r1ra:tl ( r'rF
n<nric tt:nnsus<rl irr this look. All tcrrrrs rtirttctl itt lolrlltt
re dclinctl il thc (ilrssn:

li ct Uvcl thc cost of labor or hcalth c?lre; governmeltLs

wrtld not rrcctl to stlueglc ovcr taxcs or spending
or polltrtiorr lccausc rtobocly wotrlcl carr'. IVloreover,
sirrcc all ol trs coulcl lravc as trruch as wc plcascd, no
rrrc rvorrltl l.rc corrccrrrcd al)out thc clistribttion of
incornes arrrong difll'rent pcoplc or classcs.
In such rn Edcn of allluelrce, all goods rryottld bc
f ree. likc sand in the desert or seawater at thc lraclr.
All prices would be zenr, irnd markels wotrlcl be
l ln ncccsslr-t'. Incleed, econornics wottltl t<.r IoIIger be
a trscfirl subiect.

Brrt no sociery has reuched a utopia of lirnitof scarcity, full of

cconomic goods. A sitrration of scarcigv is one in
n'h ich goods :rre limited relrtive to desires. An objective ()bserver w(rrld have to rgree that, even afler hv<-l
ct'trrries <f'rapirl econonic gr()wth, production iu
rhe [.tnited Slates is sirnpl,v not high enotrgh to meet
cvelnone's desires. lf r'orr add trp all the rvlnts. yott
qrrickl,v find that there are simply not enouf{h goods
rncl senices t() srtis cven :r stlall frtction of eret.r'
()ne's corsumption desires. ()ur national output
rvotrld have to be many tinres lirrger trefirre thc aveI.
:rgt: Arnerican cotrld live at the level of the average
d<ct<r or majorJeagtre baseball plaver. Nloreover,
otrsirle the Llnited States, particularlv in iica, htu
drcds of milli<ns of people sufler liom ltttnger alrtl
nraterial deprivation.
(iivt:n unliurited wanls, it is irnportant that :rn
('con()nrv nrake the best trse of its limited resources.
Tlrat brings us to the critical notion of efficiency.
Efficiency denotes the Inost effective use of a s<-rciless possibilities. Ours is :r world

cty's les()rlrccs in satisffing per)ple's wanLs ard needs.

Ilv c()ntftrst. consider

rr] econom)-

with unchecked

nronopolit's ol rnhealtlry pollution or government

cornrpti()n. Srrclr :rn econom)'nlny produce less than
worrld he possible without these factors, or it ma,v pr<>
duct' a distorted brrndle of goods tlrat leaves consumers \{orse ofl than they other w-ise c()uld be-either
sitrrrtior.r is an irefficit'nt rllocalion of resources.

Economic efficicncy rt'rr rircs lll:rl lu) ccononlv

rIodrrcc thc lrighest <'<rrr lirra t i()rr r>f qttatttitV atrd
qrr:rlitr ol goods arrd scrli<'t's qilcn its tccltttol<l'
rlrl scalcc re\()lllces. All t'<'onrnlv is r'ocltrcirr4 t:fficit':llh'rr'lren ro irrdividrr:rl's ccrnr>rnic rrcll:u c clut l)c
irrrrrrxr:d rnless sonrr"rrlc clse is nr:rrle rvtt'sc <>fI.
Tlrer essence of ecoromics is to acknowledge thc
lcality of scarcity and then figure ottt how to orgirnizc

TH F:

l.(X;l(: ()':C()NOl\,f

l(.S

socicty in a wa\, !r'hicll pr'(xlrces the rn()st cflicicnt.

usc rf resotrrces. Tllat is wlrcre ectrtlnics nirkcs ils
rrnitue corrtbution.

Microeco no mics on d Mo croe con o mics

Ectnornics is today dividecl into trtr rnajor srbfields,
microeconornics :rnd macroeconomics. Aclaln Smith
is usurllv considered the founder of microeconomics.
the branch of econ<mics which to<lay is concerned
with the behavior of individual entities srrch as markes, firms, and h<;useholds. ln 'l'h \\ballh of Naliorts
( 1776), Smith considered how individrral prices are
set, studied the determination of prices of land,
labor, and capital. and inqrrired into the strengths
and weaknesses of the narket nechrnism. I,f<st
important, he irlen tified the 't'rnarkrble efficierrcy
properties <>f mirrkes :rrrd expl:rined horv thc selfinterest of inclividuals working tl.rrough rhe c()rnperitive lnarket can produce a s()ciet l economic henefit.
Nf icro<cor-rrm ics todat,has moved bevord the early
conc(,rns to include the strrdy of nrr:nopoly, the role
of international tracle. finrlrce, and manv other vital
subjects.

The other major branch of our srrbjt'ct is macroeconomics, rvhich is concerned witl tle overall perf'<rnance of the ec()n()mr'. IVlacroecon<nr ics did not
even exist in iLs rnodt rn form rntil | {)3ti. when.f ohn
IVlrynard Kerrres published his reroluti<taw ()encrnl
'l'heory of Emplolmml, Inlt
and I'lont1. At the time,
"sl
England and the United States rvere still strck in the
(ire:rt Depressior of the 1930s, rvith ()\'er one-qlrrrter
<f the American labor fbrce rrnernpkx'ed. In his nerv
the<1ry Kclnes developed an analvsis of rvhat cruses
business clcles, $ith alternating spells of high unernployment and high inflation. T<rday, macroeconornics examincs ir wide variery of rreas, such as horv l()tal
investment and consurnptiorr :rre determined, how
central banks manage rnoney and interest rates, wlrat
cattses international financial crises. and wlrv s<me
nations grow rapidlv lvhilc ()thers stagnate. Although
macroecononrics has progressed far since his first
insigh ts. the issues rddressed by Keyres still define
the strdr, of macroeconomics todu,.

THE LOGIC OF ECONOMICS

F.cononric life is an enormorrsly cornplicated l.rive
of activin', n'ith pcople hrn'ir.rg, selling, bargaining,
irrvesting, and persrrading. The rrltirnatc prrrpose of

cconomic science and of this text is to rnderstand

this complex undertaking. How do econonrists go
about their taski
EconomisLs t$e the scien.lifc alrlnon.h lo undcrsurd economic life. This involves obsening economic

aflnirs and drawing upon starisrics and rhe historical

record. For complex phenomena like the impacts o[
brrdget deficit-s or the causes of inflation, histolical
research has prorided ;r rich mine of insights.
Often, economics relies rrpon analyscs ancl thcories. Theoretic:rl approacl.res allow ecol.lornist-s t<r
make broad generalizations, srrch as tllose coltccnling the advirntages of international trarlc and spccialization or the disarlvantagcs o[ tarifls and quotas.
ln addition, cconomists Iravc dcvclopt-d a spccial-

ized techniqrre known as eronondrirs, rr'hich applics

the tools rf statistics to economic problcms. Lising
econonrelrics, econrmists can sift tl.rr-orrgh rnorrrrtains of d:rta to extract sirnple relationships.
Rrrdcling econornists Inust also lr alcrt to coltrmon firllacies in econornic reasoning. Bccarrsc cco-

o[ten conrplex, involving

it is easy to becolne corrfised aborrt the exrct reason behind evelrts or tlre
inrpact of policies on the econorny. The lolloring arc
some of the comnron lallacies encorrntered in ccc
nonric

rel:rf ior.rships ar-e

mant' diff'erent variables,

n()m tc reasol.I tlg:

'l-h(

Post hoc fallacy.

The first frllacy involves

tl.re

inference of' crusrlin. The post hor fallag orrurs

utltn ue assrm( llmt, bcruse ott atenl ocrurnl
bclorc anolltn tutn| lh? firsl @nrl raused lln srrond
et'enl.! Att exarnple of this syndrome occrrrred

ill

the Gre:rt Depression of the 1930s in the United

States. Some people had obsen'ed that periods

of

business expansion lvere preceded or acconrpanied bt,risirrg prices. From this, they corrclrrded
lhat the appropriate remedy for depression u:rs
to r.rise wnges and prices. This idea led to ir host

of legislation and regulations to prop up rvages

and prices in an incfEcient manner. Did these
rneasrlres promote economic recovery? Almost
surelv not. Indeed, thev probably slowed recovery', rvhich did not occrlr until tonl sper.rding
began to rise:t.s the government. increased miliury spending in preparation for \4orlrl !!hr .
r "flrs hr" is shrrrthur<l k\t
lrosl hor, ftgo l,trft?t hoL Iirnslated
lirrr tle lti, tlrc firll exrrerriorr r<'ars "l'tcr this, tlrclclr)re necesurilr tx.cusc r)l this."

cHAPTER

I'uilurc to hokl olha lhings ron.stnnt. A second Pitfnll is lailrrrc to hold otlrer things colrst?rltt r\'hen
tlriukirrg about an issrre. For example, tt'rrlight
\\alrt to kr)ow rvhcthcl- r:rising tax rates rvill laise

or lolvcr tAX lc-vcllucs. Sorne people h;rrc llttt

lirrtlr tlre scdrrctir t- argunlent that we cln (':lt
orr list al crkc ancl h:r'r'c it too. Thev argrrt' tltat
ulting tax ratcs rrill al lhe sanle tittte t':tisc 4ornlrrcnt lcvclrucs and lon'er the btrdget rk'fir-it.
'l'hcr
()f
-loirrt tr thc KennedlJolrnson tax cllts
Itlti4. wlliclr lowcrccl tax rates sharplv and nttrlbllowcrl by irn incr-ease in gcr'enrInerrt revertu('s
irr tlXil-r. Hcnce, tlrev argrre, lower t:rx rates l)r'(F
(

cl

rlr

rcc higher levenl res.

\\'hv is tllis rersolring

frllaciorrs? The:rrgtrIlt(.nl ilssllnre\ llr;rl ()ll)er' lhings u'( l'(' coltslanl-

irr ralticrrlar-, it

tlre rxrvtlr in tht'

ovt'rrll econorrry lirrni i964 tr I0(lir. Ilecause
rcrrple's incor.nes grelv chrrir-tg that pcli(xl, totzll
llx rcvcllucs f{rcw even thortglr tar rilf('s $,cre
<verlo<ked

ecrnonletric stttdies irrrlicatt' tlt:rt

l()l:rl lax revelllles rrorrld hirve beelt rz'r hi{ht it'l
llXi5 if-tax rates h:rd been helcl at tlre szrul(' level
as irr lfXi.t. Hence. this:rnalvsis fails to h<>ld other
tlrings c()nstnnf in lnakinq the cirlcrtl:rtiorrs.
Rnunl'r lo hokt olhrr things ronslnnl irlu'n ut
trc tnul:ing the intltnrl ol a utnahle on lltc 'rotonic
lorvt.r-. ( l:u-ehrl

'I

h| fallaq of eompositiott. S('r)r('rirnes r{c ;lssrlnr('

thl $'lral holrls trLre for pir-t of-a systt'nr also
lrolds tr-tc lir- thc rvhole . Irr rctnomics. ltorvct cr-.
rvc oficn lirrtl that thc lvholc is rliffcr-cnt fr-unr tlrt'
srun trl llrc r:rlts. 14hal lou s\u/tt.'lhul utlut! i.: lrut
lin llu lnrl is nl-w lr ue .lor lhr utlntlt, )tnt utz' ttt.tnill i tr g' l he Ju lluq oJ r onlto.sil ion.
Hcrt' art' sorne [nte statelnenls that rnight
srrr'rrisc t,orr if yoLr ignored thc lallacv rl conrr<lsitiorr: ( l ) ll onc lilrucr has a brrrnpcr crop. shc has
lr lriglrel irtcornc; il all lhrnrcls rrrxlttcc u rccortl
crrrr. lir rrr incollcs will lall. (2) lf onc pt'r-son
Iccci!t's:r glt':rt tlt':rl rIX)lt trlollc\', thrt PCI\() lrill
lx' bcttel ofll il cvclrrrrt' r-cccivcs r glcat rlc:rl rnolc
nront r. tlre societr, is likclv to lre rvonc ofl. (11) 11 a
lrilr t:rrif l is put on ir rro<ltrct such r.s shocs <>r' stccl,
tlrc prrrtlru cls in that in<lustn are likelv to rrofit: if'
lriglr t:rrif l! al c prrt ()ll nll rn.rclucs, the ccolorlric
wclllrc of tlrt'n:rtion is likcly to lrc rvtrsc oll.
'llrcst t'x:rrnplcs cont:rin no rr-icks or rrragir'.
Ralh<'r, lhcv arc the r-esults ol sr,stels ol irrtcra< tiDr.l

| . THll CUfiTR.\l- ( ON(,EPTS

OF l.(:( )N()Nf I(:S

individuirls. Often the beharior of the

a{grcg:rte

kroks ven,different from the behtvior ol'indiviclrr:rl people.

\\'e rnentior.l these f:rllacies onlv brieflv in this

irrtrodrr<'ti<lr. Later, as \ve il)trodrce the l(x)ls ()f
econornics, rve rvill provide exzrnrples of holv inattetrfion to the losic of econonrics crn lead to frlse atrcl
sonretinres c()stly errors. \|herr vorr reach thc end ol'
this book. \'orr cillr lork back t< see wlrv eacll of thcsc
r;iradoxical t'xiu.nples is tr-ue.

Positive Economics versus Normative

Economics

When considering economic issues, we

must carefully distinguish questions of fact

from questions of fairness. Positive economics describes

the facts of an economy, while normative economcs
involves value iudgments.

Positive economics deals with questions such as:

Why do doctors earn more than janitorsl Did the North
American Free Trade Agreement (NAFTA) raise or lower
the incomes of most Americansl Do higher interest rates
slow the economy and lower inflation? Although these may
be difficult quesrons to answer, they can all be resolved
by reference to analysis and empirrcal evidence.That puts

them in the realm of oositive economics.

Normative economics involves ethical precepts
and norms of fairness. Should unemployment be raised
to ensure rhar price inflation does no become too rapid?
Should the United States negodate further agreements to
lower tariffs on importsl Has the dsrbution of income
in the United States become too unequal? There are no
right or wrong answers to these questions because they
involve ethics and values rather than facts.While economic
analysis can inform these debates by examininS the likely
conseeuences of alternative policies, the answers can be
resolved only by discussions and debates over society's
fundamental values.

COOL HEADS ATTHE SERVICE

OFWARM HEARTS
Ecorrornits lras, over tlle last ccrltrlr\', grotvtt litrn
a linv acrr'n into a nielltv oak. LTtrclcr its srt'arlirrg br:urclrt's *'c find cxplanirtions of tht' eirirrs
li-onr intcr-natiolral trade. advice on how to tt'rlut e

(:(x)l_

lAl)s

Al

THU StRVI(;t: ()l'WARi\f It.tAt{ls

il ginticilcn i;ir-tll

rrrerrpl()\'mcnt an(l inf lati()n, lbnt ulas lirr investirrg

vorrr rcliremcDt f uncls, and pr<lposals to atrction lirDited <'arhon dioxirlt'ctnissi()ns pcrtnit.s to lrelp sl<lw
global rvirrrning. 'l hxrtr5horrt tlrc workl, cc()notlisls
are laboring to collcct <lata rrrtl inrprovc orrr trndersfalrdi rrg of' ccorrouric t rcllrls.
l'orr rnight u'cllzrsk, What is thc prrrpose ol thisanny
of econornists rncasrrr ing, anah'ting, and calcrrlrtins?
'l'hz ullimule goul ol economir scittrt is to impnnu'tfu liuittg
rcntLiliotts tl lrullt in lluir nn1du1 /i,r. Irrcrr:-sins rht:
gross tlorrrcstic produtt is r.t<tt.jrrst :r numb('ni gante.
Higlrer intorncs nrcirrr or>d food, warm horrst's,:rnd
llot rrtcr. Thcy mean saf'c drinking water and in()rrrlatiorrs irgainst the percnnial plirf{lr('s of hrrrn:rrriry.
Highel irrcomes pr()duce m()r(' th:rn frxrd:rrd
slrcltcr: fuch c()untrics have the r('s()ltrces to lrrild
sclrools so that yortng pc()plc can lt::rrr to rt'ad arrrl
dcvclop the skills necessar) ro rrse nrodcrn lrracllinen, llnd comprtcrs. As inconres risc firrthcr, lratiolrs
can aflbrd sciettific rese:rrclt to dctt'rrrrirrc aglitrrlturill tcchniqucs appropriate ftrr :r corutrr''s clinr:rtc
and s<ils <r to dr:r'clop v:rc<'ines against kc:rl discascs.
\'4'ith thr: resor rces fteed rrp by cc()ltonlic l{r owtlt. p('c}.
ple have fi'ee tinrc ftrr artistic rrrrsrrits, suclt s poctn'
irnd rnrsic, and fhc rotrrlation has tlrc lt.isure tintc

to

rerd,

to listt'lr, alrrl to pcrlirlrn. Althorrglr therc

is

no single p:lltern of-cc()norrric rlcvcloprrrcnt, irn(l cultrres dffi'r' :rrounrl I hc wolkl. li ct.rkrnr liorn hrrngc
diseas<., arrd thc cl('n)cnts is a rutivcrs:rl lrtrrrran goal.

mrirt:rirr a lrealthy ccor)()nl), governntcnts must pr(L

sen'<' incentiv<'s filr-tr-oplc tt work:rrr<l to save.

Socit:ties calr sul)p()r't thc trncnrploycd lbr a rvhile.

but wht:rr rnerrr rloyrncn t irsrralrcc pays too much
f <lr trxl long, pcoJrlc rrrav c()rnc to depcnd lrpon the
t{ov(:rll lllcll t and stop lookirrg lilr wtrk. ll'thcv begin
to believe that fhc g()vcrnlnct)t ()rves thctn a living,
this nray drll thc cuttir)g c(lgc of enterprise. .f rrsr
h<:carrsc g()vc|lllncrIt progranrs pursue lofty goals
c:lnn()t ('x(. lpt lhcln liorn carcltl scrutiny:rnd effir

rcnt nlanagcncnt.

S()(ict\ n)llst stlirt' l< r'orrrbirr<, tlrc rliscirlirrt. ol tlrc

tlltt Lt'trllttc rritlt tllt torrrr;rrsi,rrI ,,1 .,u l;ril)tr,{.irlt\.
llv rsing t ool lrt'lrrls to illfirrn rvtrr-nr It(';lrls, ('( onon) ir
scit'r rct cln rlo its palt irr firrrling t lrt' ;rrrrorr iarr. b:rl:utt <' lirr :ut cllit ictrt, l)t ()slx'r()rs, :rrrrl jrrst socit.tr.

B. THE THREE PROBLE]IS OF

ECONOIrI IC ORGAN IZATION
Even lrrrrnan societv-rvh<'thcr it is :rn aclvalrcetl
indusrrial rati()n, t centrally plarrrrt-rl cc()notn\,, ()t'
an isolatt'd tribal natiol.l-lntrst corf i ollt antl rcsolvc
three fiuldantenf,;rl t,cononric rroblcrrrs. Ulcrv sor ict\ Inust lt:rve r wav of-dctcrrrrirring zzll colrurrodities arc prodrrced, / thcsc gootls alc rrra<lc, and y'rr
uhom lhey are prodrrct'rl.

Rut cclrtrrrics of llrrrnan Iristrry :rlso slrow that

rv:trln hca1s alorc uill lrot fl.c<l thc hungry or heal
the sick. ,,\ li-cc alrrl cllicicnt llral kct will tr()t ncccssarilv producc a distlilLrtion ol ilrtotnc that is socialll
acccptablc. [)r'tcr.rnir r ir rg tlrc bcst r()ute to ec()n()mic
proglcss or :rn etrrititblc distribrrtitr of s(xioty's

cc<ltrrnric ()rq:ln izati()n-uhal, hozu, and for zahonarc :rs cnci:rl todal'rs th('y wcl'c at tllc dawrr ol hurnrr
t'ivilizrt iorr. Lct's look tn()rc closclv at tllcrn:

()ut[)ut rc(luircs crcl hcatls that objectivelv weigh

flr(' c()sls :rrrd bcllcf its of tliflererrt upproaclres, tr1ing as hard as hrrnanlr,;ossiblc to kt.cp the arralysis
fi-et' fronr thc taint ol'rvislrlirl thirrkirrg. Sonretirncs,
econornic pr()grcss will rcrrrilc slluttirrg dorvn arr
orrlrnodcd fhctoly. Soructirncs. as n'lrcrr centrally

qlrarlfitics? A socicty trrst dctclnrirre horv ntuch

<f etch ol lllc nr;urv ltossiblc gootls arrcl scrr,iccs
it rvill rnakc;rrrd rvhen thcy ll'ill lrt'rlorlrrccrl. Will
rvc prodrrr'<' pirz?rs ()r slrir-ts torlay? A fcw lriglrquality shins ()t'rnany clrcat shilts? Will wc trsc

plarrncd corrrtrics acloptctl rrrarkct prirrciples, tlrings

get vyorse belbr-t thcy gct bcttc. Clloircs ale pat'tictrlarlv difficult in thc Iickl ol hcalrh c:rrc, rvhere linlitcd lcsorrlcr-s litcrallv irn'olve lifc rnd death.
!brr rrray Ilil,c lrca tl thc sarring, 'From each
accor'<ling tt his llilitr', to cat h irccor-ding to his

nced." (i rvt-r'nnrcrr ts Iravc lcat rrctl that lro societv

car long ()pctatc solcly on this rrtopi:rn principle. T<r

Indet:rl, these lhr(.c findanlcrrtal qu(.stions of

o llhrtr

cornrrroditics arc producctl arrd

irl

rvhat

(' l-esr)ll'( ('s l(} lnxlrrcc r :trtr t ()lrsrrrrrptiolt

g(x)ds (like l)irlas)? ()r rvill rvc tlotlucc lc'rvcr
c()nstunpli()lr goods irrrrl rnorc invcstl crrt gtxttls
s(:rr'(

(like pizz:r-rnaking rnachirrt-s), n'lliclr rvill boost

prodrrction arrd corrsrutr :tiorr lorntl rorv?

Houztte grxrds rrodrrcctl? A socictv rnrst dctcr-

min(: wlr() will do tlrc rro<lrrcrion, witll n'hat

res()lu'c('s, alrd $hat procltrction tccltrriqtrcs tlrey
rvill

rrsr:. rr!'ho

farlrrs alrd whr tt'acltcs? ls clcctricity

CHAPTER

fcnerated

fionl oil. li0rrl coal, tlr fi-oltr the stttli'

V[ill factories be ntrt by .rcoplc or r obots?

qoods rrotlttcctl? \\/lto gcts lo cat
the fruit of econonric activitv? ls tltc tlistl ilrrrtirn
o[ inconre and lvealth fiir:rrrtl cttritablc? How
is the national product diride<l arrtong tlillclcrrt
lroust'lrolds? Are ul:tnt peoplc poor att<[ a li'w
riclr? l)o high incornes,() t() tcachers tr irtltlctcs

o lior uhont:rre

arrtoworkers ()r'ventlrc caDitalists? \\'ill socictr, ->rolirlc rninirual ( ()nsrIt)pti()tl to th(: P()()r, ot'

ol

ntU\l l)(1)l)lc rlok if the\. ill('l(, ('ittr

MARKET, COMMAND, AND MIXED

ECONOMIES
Wlrat ar t' tlrc <lilli'rtrrt w:rys tlr:rl a socictv cll) ansrtcl'
tlrc (lucstions ol ulut.l., lor, atd for uhon? Diftt'rclrt
socictics al c t.rrgarrizcrl thr-otqlr ahettnl u' ronontir s\s
ls, :rrttl ccottorttics sttrlit's tht' rariotrs lllt'challistlts
ir s()( ict\ ( iul us(' lo all()t ttt' its sc:tt t t' res()tlr( ('s.
\4/t' gcrrcr':rlly rlistinurrish tu'o [t ttrcl:ul.t'n tallv rliflbrwavs ol olgirnizirrg zln ('( ()n()n)\'. \t <ltte extrctlc.

thttl

cnl

g()\'cI'nrDcnI lrakcs 11()sl t'<'<trontic dccisi<llls. rvitlt

Ilrosc on tor of thc hit'ralcht givirtg t'cotronric ct>lltrrrarrrls to tlrost'litt-th<'r-dorvrl the larlrlcr. At thc ()tlcr
cxtlcrnc, tlt'cisions :r-r' rn:trle irr tnar-kt'Ls. rvhcrc itrdivitlrr:rls ol ('rrtcrpris('s rrrlrtnt:rrilv irf{r(:e t() excltatrge

gootls arrrl st'r-r,iccs. usrrallv thnrttgh pat'ttrctrts of

rrrorrcv. l.ct's bliclly crarnirte t'a< lt of thesc trvt f<lrtns
of ccorrorrric olgart iza tion.
lrr tlrc Llnitc<l S(at('s, and irt creasingll' :rt-otttld the
wtrkl. lnosl cconorni< qllesti()r)s irre settle(l l)\'thc
rrralkct ntccltitnisln. Hcrtce tltcir ecoltorllic svsteltts
:rlc callcrl nrar-kt't t'collonties- A market economv is
onc irl rrlrich irlrliriclrrals and private hrrrls rr:rke the
rrrajor tlccisions alrottt rt-odttt tiott attd cottst ttttptiott.
A svstt'rrr ol pr iccs, ol rnar-kcts, of -rrofits anrl losses, tf'
inccntivcs anrl rcwirr-ds dclt'rttitres uhtt, hou,, nnd fr
rror. linlls rr-orlrrcc tlre <ornnroditit's that field tlrc
highcst profits (thc rrilrnl) hv the techrriques of protlttction tlrat alc lt'ast costlr (thc ,/ralr). (iottstttrtpliott
is tlctcnrinctl ll,irrrlivirluals' tlccisi<ns abottl ltorl l<l
spcnrI tlrc *agt s :rrrtl l)r()lx'rtv irtcolrtt's gt'treralcd lx'
tlrt'ir l:rbor arrtl lrort'rtl ot'trt'rsl.tit (tlte .ltn' ulnn).
'l lrc cxtle rlt' cast' oI a tnarkt'l ecottor'rr'. iIr uich tlre
g()\'cr r)ln('nt kt'crs its lrands ofl t'r'olr()rtlic dticisi()trs.
is t:rllctl a laissez-faire ('( ()n()r.t')\.

lll conlr-;rst, a command cconomy is oltt'ilt wlticlr

tlrc govclrrnrt'rrt rrak<'s all irnportatrl dt'cisi<>Irs altotrt
rrorlrc ( it rr alrd dist rilt r t i<lt. f n r contrniuld cc()l)()nl\'.

such:rs the one which ()pclatc(l irl tllc Sovict L]rriorl

drrring most <>f' the trvenlietlt ccttttrr,-1, tlrc govt-t-trnrcnt or4'ns rnost of the rne:rrts Of protltrctiorr (laIt<l
arrd <'apital); it:tls< owtrs and direcLs tltc operatiorts
()l ('nterpris('s in most indrtstries; it is the ctttploYcl'
of lnost wrrkt'rs irnd tclls tlrem lrorv to do thcir.jol->s;
arrrl it decirles horv thc ()lltput of'tlrc societv is to ltc
<livirlt'd anrorre difl-elen qoods atrd sen'ices. In short.
irr a conlrranrl ccoll()nt\', llte g()\'(:rnment alrsrvers the
rrrajol cconornic qrr('sti(,ns through ils clrvncmlrip of'
r cs()ulc('s anrl its rorvcr t() enf()rc(i clecisi<trs.

No corr tcln ror-:u-l societt' falls completeh' inttt

citlrcl ol tlrcsc polal catcgorit's. Rather, all societies
irre mixed economies, rtith clcrnt:tlts of ntarket and
ctnrIIt:urtl.

I'lt.nonric lili' is or gartizt'rl t'itht'r' tltt,rtrglt Ilit'l rtl'

llit lrl t onullarlrl ol dcc<'rt l r':tlizcrl voltutllttt llral kt'ts.
-lirrl:rr nrost tlttisi,tns in tlrr' (rnitt'rl St;ttt's;trlrl otltt'l
t

Iriulr-in(()nl( ttrlronrit'r ,rtt' rrtrlt' irl tllt' Irl:ttkct

rl:tct'. IlLrt Iltt gort t nttrt'ttt l)lit\.s :tll itttrortaltl Irrlt'
ir rr't rsct'ilru llrc lrulr tiottittg ol ll)(' lr)itr-k(it: g()\'( r'rtr1l( nts lJirss lltss tltat lt'gttl;rlt' t't trlortti< lilt'. ;rtttltrtt'
t'rlrt.rtional ;rrrrl roli<t' sr'-r.ict's. atttl tottttol tolltt'
tion. l\lost sot iclics t{)(l:r\ ()l)('r;t(' ltlixt'rl t'ttttotltit's.

C. SOCIETY'S TECHNOLOGICAL
POSSBILITIES
llutl is utdc, na t- t!(rshiP lnuttrhctl,
nt) o(hel frred siltilies, in the Jinul \(n.\(. tt
lheli frorn t.hos uhr h.urtgtt'ftnd utr nol .fed.

lircry

gtt.rt.

I'rcsitlcl t I)rvieht l). l.iscnhowt'r

Eutll et<rtotttv lras a stotk tl lirnited lesolllce{labor', teclrrical krrotlcrlgc. fhctorics and to<ls, l:utd.
energt,. ht tlccitlirrg ar,/rl erlltl /totrr thitrgs shorrld lte
prodrrced, thc ccortonl is in realitr'(l('ci(litrg hort t()
allocate iLs lcsorrrces arn()nj thc [hottsaltds ol clifl-cr-cttt oossiblc corrrttro<litics itlt<l scl vict's. How trttlch
lancl rvill go irrto gtrrwittg rvlrcar? ()r'irrto hortsitrg tlre
roprrlatiort? How Ittattv lirt tol ics uill trodttct' cotnrrrtcls? How lllanv rvill rrrakt';izzasi' Horv rlartv clrilclrcrl rvill gr ()rt up to plav lnrf i'ssiotr:rl srot1s ()r t() be
lxlf essirrn:rl t't rttorttisls or lr ) l)r otlt attl ctttttttttt'rs/
Facctl witl tltc Lut<lt'rtiablc lhcl fhat ottds :tre
s<artc lt'lltirt t() w:ults, an ('c()n(,nl]' tlltlsl decide

ll.

I'R()t)L

()N-f ( )sst Rll.tTl t

R()N

trR

lrorr' to <ope u,itlr linritc<l l'es()llrces. It llrrsl clrrxrsc

arnorrg differclll potenlial brnrdlcs of'tttorls (thc
irlrzl). st'lt'r't li'ort diflcrtnt tcclrrriqrrcs ol trotlLrt tion
(tlle rr). and rlt'ridc irr thc cn<l rvlro rrill torrsrunc
tfrt' g<rrrrls (thc .f rtr ithon\.

llrt tllrtt ttonorrir'rrolrlt'rrrs ilr tht'st'

tr llrrrst rlt't itlt' (.1) u,htl ()ull)uts t() l)t1F
tltttt. :urrl irr rrlurt qullntit\': 12l ltou,. ol nitlr rr'll:rt
R( \trling

It r rns. socit

itrrrrts :rnrl tct lrrrirrrt's. to tlorluct' tlrt' rlt'sircrl orrrrrts: :rrr<l lli.l frn'itlton tlrt. orrtrrrts slrorrlrl b<' rrrr
r

ltr t tl tul<l rlistr

INPUTSAND OUTPUTS
To l lsttt'l lllesc tll t' rtt|sli('lts. ('\('t \ s{x i( l\ tI|llsl
nrakt. clrtticcs;rlout tllc ('(()l()ln\ s irrptrts irrrtl 0trtl)uts. Inputs arc ronrnlorlitics tr' strritcs tllitt atc
ttscrl to trotlrrcc gootls alr<l sctvitt's. AIt ecottotnt
trst's iLs cristirrg tcrlurologv tt ronrbirre ittptrt-s to pr-r>
tlrrt c orrtprrts. Outputs iu c tlrc r':rliotrs rrsefirl grxlds <lr'
scrvirts tllat csLlt firrrr tlre plodtrcrion pr'occss nnd
are citltet consrurcd or crrrpl<lverl in lirrth<'r pr()dlction. (lortsidcl the "prodtrction" of pizza. !\t'sa'r,thrt
tlle cggs. florrr, heat. pizzu ()\'('tr.:rnd clref''s skilled
labor :u c thc irrpuLs. Tht' tastr rizza is tltc orrrpur. Ilr
c(lLlcati()n. tlle inputs:lr'(' the lilrre cf thc fircrrltt and
strrdellts. tlle lalroratorics u)(t cl:rssr(x)ll)s, tll(' t('xll<loks. anrl s<l on, rtlrilc the ()utDuls at e inf ()nlled,
prrrdrr< tivt'. :ln(l \\'rll-p:li(t citiz<'ns.
Anr>tlrer ternr fi)r inptrts is factors of production.
Tllese <an be cl:rssified ir't< thrt'c Jlro:rrl <:rtetolit's:
larrd. labor, arrd ca rital.

o [,l-1, rlor-t' gerr<'r'allv. nalulal r(.s()urr(.(Iepr('s('lrls tht' gifi ol'nalrlr(' t() oru s<tictics. lt
<'or.tsist s r f I lr

t' l:rlrrl rrsr.rl lbr

l:r

nn irrg or' li

r- r

nrlc r.

rirrtring llotscs. f:tctrr-it's, arrrl r-oads: tll(. cr)clttr

f('s()ltfc('s that fir'l orrr (;lrs arrrl hcat orl ltoltt.s:

alrd lh(, n()ll('n('rg.r rcs()ulccs likc coppcr arrtl

iron ort' n(l san(1. ln trrlar"s corrgcstctl rlorltl.
\\'(' Inusl brrrarlcn lltt' str,tt' ol ll:rtrrral l('s()ruCcs
to int-ltrk orrr t.r'rrirolrlllt.ltt:tl Lt'sorrrccs. strclr as
clt'arr ail anrl rllinkablc rv;rtcr.
) Lulxt tollsists ol tltc lrtrnrnll tirnc sD(.ltt in
rlrxlrtr lion-rrorkinu irr lrrlolrrrltilt littt,,ies.
rvritittg solirvarr'. lt'rchilrr.T stlrool. ol baking piz.l-housarrds

ol or'ctrt:rtiorts irrrrl tasks. :rt lrll

skill lt'r't'ls, :rr-t' rt'r'lirrrncrl lr' lal:xrr'. lt is rt olrcc
lh(' rnost arriliar- arrd tlrc nlost cr rt ial irrprrt lirr
an :trlr'ulct'rl iltrlrstrial ('colr()ul\'.
e (tltilll r('s()ur('('s lrnr tlrt' tlrrrablc gtxrtls ol itrr
('c()nonr\', rr',r<lLrccrl ilt or<lcr to rrotlrrtt.\'ct ()(llcr
zas.

gr x rrls. (

):trital gor xls

ir rt lrrrlc n raclri lcs. rrra(ts, t or rrrtttc'ts, solirratt'. tlurks. stct'l rnills. urrtorrrolrilt s.
rrasltirrg nrtlrints, arr<l llLriltlirrgs. As rrt' rvill sce
l:ltcI. tlr( a( ( unrttlirtiott of speci:rlizecl < lrpital g<xrrls
is csst'lrtilrl to tlrt task of ctorr<nric rlcveloprneltl.

illltt'rl.

THE PRODUCTION-POSSIBILITY
FRONTIER

\\t'

lcarrr carh. in lift'that w(' can I h:rre ert'r1thing.

crn have chrr'olrte rr r':rnill:r icc cr-r'arn..\o.
not b()th." we mif{ht he:rr. Sirnilarlr', thc t orrstrrl>
tion orportrrnifies of crrrrtr-ics arr' limitcrl lr' tlrc

'\llt

res()lrrces alr(l the t<'< hrrologics availal)lc t() tlrcrn.

Tlte necrl to choost'arr<rru lirnitctl oppoltrrrritics
is drantatized drrring u'rrtirrrt.. In <lt.batillu wlrt.tlrcr
rhe I'nited Stalt's shorrlrl invark' Ilac irr 2(X)3. rcoplc
rvart<'rl l< ktt()w hr'rv rrrrclr llrc rr'aI rr,rrltl c()st. l lre
adnr irr isf r'rtiolr s:rid it rroUlcl c()st onl\, $50 llilliorr.
rr'lrile solnt, ccononlisls sairl it rtriglrt cost as lltrt ll ls
-l'ht'sc
a c n()t just nroullt:rirrs ol rlollar
$2000 billion.

bills. Tllcsc rrunrlx'rs r('l)rcscnt rcsonr(cs rlivcrtcd

firrnr othcr- prrrchirscs. As tlrc nrulrlcrs ltegarr t<r
clirnb, rt'orlc natrrallr, irskc<I. \\'llv ar e rrc policing
tsaghclatl r:ltllcr tllnlt Ncrr,\ilk. ol rcpailing tlrc
clcctlical s\slcrn in the \{iddle lllrst ratht:' than in
tlrc L.S. Nlirlrvcst: I)coplc rurtlerstarrrl. as clid f<rrrnel'
gt'rrt lal arrrl plt'sirtcnt EiscrrIlorr'er. tllat wlr(.n ()rtput
is rk'rutctl to rnilitrr tasks. tlretc is lcss il:rilable filcivilir r c()l rstr lrrpti( )ll itl l(l irlvcs ncrrt.
l.ct rrs ttranurrirc this cll()ice lx. consi<lclirrg arr
ec()n()rn\ rvlriclr prrrtltrces ()nlv tw() ccononric goods,
gr.ul:i an(l l)uttcr. T'he grrns. of c()ut'se, rcpresent
nrilitar.r' sre rrrling. :urtl the lrtttel sratrds fil civiliatt sperttlitt. Srrpposc that or.ll ec()n()rrlv decidcs t<r
thl <>rv irll its cne r-gv into proclucing rhc civilian g<xrd,
l;ttttcr: Tllerc is a rnaxinrutn iun()ur)t <l'brttcr tlrat
tarr lrt'prodtrtc<l per vear'. Thc nraxinral anlorrrt of'

lrtrttt'r'<lcperrrls ()n tllc (luantitr, and qualitv ol rlre

('c()ll()lrr\'s res()ur(cs anrl tlrc lrodrrctivc efficicltcr'
rrith rllrir'lr tllcr,:rrc rrscd. Surposc 5 rlrilliorr >orrnds
()l l)uttcr is thc rnaxirrrrun ant()ultt thirt ( lllt lte ulnrltrtctl rvitlt tltc cxistin4 tcclrnologr' lnd rcs()urc('s.
At tltc otlter e xu eruc. itnaginc that ull resotu-<'cs
at t' irtste:rrl tlevotc<l to tl)c pr()duction of grrns. Again,
llt't:tttsc ol l esotr cc linritrtiorts, tlrt' t'corr<)nl\' ( a l)t'(F
drrcc onlv a limit('(l quantit\, of'quns. For this eralrrpl<', nssrrrrrc tliat tlre ec()ll()rlv carr prrrdrrcc 15,(XX)
grrns of a c('r'tain kin(l if'rrri lxttel is Jrxrduce<[.

t0

CHAPTER

.THF,

(:I]NTfu\I, (:ONCT:PTS OF I](:ONOMI(]S

Alternative Production Possibltes

Butter

Possibilities (rnilliqns6fpsrrds)

Gurs

(thousands)

l5

14

t2

TABLE l-

l.

Limitation of Scarce Resourccs Inplies the

Guns-Butter Tradeoff
Scarce inpuLs and technology- imply that the productiott
ol guns and butter is limitect. As rve go from A to B . . .
to F, rvc arc transfclring labor, rnachires. and lrnd f-<nr
the grrn industry to butter an(l can llr('r('llv in( | case btttct'

Droduction.

012345
Butter (millons of pounds)

FIGURE l-1. Thc Production Possibities in a Graph

This figrrre displays the alternativc corrtbinations of prr>

drrction

These are two extrerne possibilities. In between

are malry others. lf w'e are willing to give tp some butter, rve can have some guns. If rr'e are lvilling fo [Ti!
up still more butter, we can have still more grns.
schedule of possibilities is given in Table l-1.
Combination F shows the extreme, where all butter and no glrns are produced, while A depict-s the
opposite extreme, lvhere all resources go into guns.
In betu'een-at E, D, C, and B-increasing arnouns
of butter are given up in return for more guns.
Hon', vou might well ask, can a nation turn butter
into grrns? Butter is transformed into guns not physically but by the alchemy of cliverting the economv's
resotrrces from one lrse to the other.
,A.

We can represent our economy's production

possibilities more vividly in the di:rgram shown in
Fi5ure 1-1. This diagram measures butter along the
horizontal axis and guns along the vertical one. (lf
you are unsure about the different kinds of graphs
or atrout how to turn a table into zr graph, consult
the appendix to this chapter.) \4e plot point 1,'in Figure l-l fiom the data in Table l-l by counting over
5 butter rurits ro the right on the horizontal axis rnd
goirrg up 0 gun units on the vertical axis; sintilarly, /i
is obtained by going 4 butter rr.rits to the light arrd
going up 5 gun unit-s; ancl nally, we gef ,4 hv going
over 0 brrtter urils aucl rrp l5 grrrr rrrtit-s.
If we fill in all intermedi2rte positions with nerv
green-colored points represerrting all the difTerent

nrirs

fronr Table l-1.

combinations of guns and butter, we lrave thc continuntrs greerr cun'e shorvn 's Lh.: lrodudionlossibility
ftanlin: or PPl, irr Figurc l-2
Thc productiorpossibility frontier (or PPf ) shoss
the rnuximrrn quurtity of goods that c:rrr be cfficicnth
produccd bv arr cc<>n<lrnr', given its tcchrtolosical
knorvlcdgc and the qrlntit) of arailable inprrts.

Applying the PPF to Society's Choices

is the me nu of choices tflat an ec<.rn<my has
to choose from. Figr.rre l-2 shows a choice beteen
grrns and butter, bur this concept can be applied to
ir broad mnge of economic choices. Thus the rnore
resources the government. uses to spend on public

The /'/']/r

highways, the less will be left to produce private goods

like houses: the more we choose to consutre ol lbod,
the less we can consume of clothing; the rnore an
economy consumes toda,v, the less can be is produc-

tion of capiutl g<lods to turn ()ul morc cortsrrnr ptit-rt

goods in the future.

The graphs in Figures 1-3 to l-5 present some

inrporrrnt applications of PPI\. Figure l-3 shows the
effecr of econ<>mic growth on a country's production possibilities. An increase in inpurs, or improved
technological knowledge, enables a countrv to ploduce rnore of all goods and services, thus shifting

tl

THE PRODUCTION-POSS BII,ITY FRONTI ER

The Productlon-Posslblllty Frontler

G

FIGURE l-2. A Smooth Curve C.onnecfs the Plotted Poina

of the NumcricI Production Pocsibilities
This frontier shorvs the schedule along which society can cho<xe
to substitute guns for butter. [t assumes a given state of technology and a given quantity of inpue. Poins outside rhe frontier
(such as point /) are infeasible or unattainble. Any point inside
the cuwe, such as U, indicates that e economy has nor atrained
productive efficiency, as is the case, for instance, when unemployment is high during severe brrsine'ss cycles.

!lg
.

.c,

Butter (millions of pounds)

(e) Poor Natlon

(b) Hlgh-lncome Natlon

a
:

o
t)

o
o

q,

o
to
|9

o
o
I

o
f

l
J

Necessities (lood,.

..)

Necesslies (food, .

..)

FIGURE | -3. Economic Gmw Shifts the PPF Outwrd

(a) Before developmentr the nation is poor. lt must devote almosl dl its resources to food
and enjoys few comforrs. (b) Grow of inputs and technological change shift out the PPE
With econornic growth, a nation movcs from A to B, expanding its food consumption little
compared wi its increased consumpdon of luxuries. It can increase ils consumption of
both goods if it desires.

t2

CHAPTER

THE (]EiTRAL C]ON(:EPTS OF E(:O\IONIICS

(b) Urban Society

(a) Frontier Society

-(!

c
o

(!
o)

_q

o
o
tfl

o,

.9

Privale goods (food, . .

Private goods (food,. . .)

.)

FIGURE l-4. Economies Must Choose between Public Goods and Private Goods
(a) A poor frontier socicry-' lives fionr hard tr nrrrrth, witlr littlc lt:fl ovcr lirr rrrblic gocxls
like clean air or public health. (b) A modern rtrbanized ec<tromv is morc prosperous arrtl
chooses to spend more of is higher income on prrblic goods and government senices
(roads. err-ironmental protecdon, and education).

(b) Future Consequences

(a) Today's Choces

0)

.E

:o

(!
o.
(E

Currenl

consumption

Future consumplion
consumplon

FIGURE l-5. Invesuncnt lor Fulurc Consumpon Requircs Sacrificing Current Corxumpon
A nation can prodrrce eitlrer crrrrenGconsrtmpti()u goocls (pizzas and conccrts) or invtstment goods (pizza ovens lnd conccrt halls). (a) Three corrntries strrt olrt even. They havc
the same PPli shown in the panel on the left, brrt tlre,v have dillerent inyestment rates.
Oountry | does not inlest lir the lrtrrs and -errrins at A, (merelv leplacing nrachines).
(ixrntr;.. 2 alrstains nrorl<'slly fiorn corrsrrrrr lll iort anl invcsls at 4,. (irrrrlrf 3 sacrificcs
irct deal of crrrrcrt consunrption an(l inv('sts hcavily. (b) Trr tlrc firllorr5 vcrrs. orrntrit:s
that invesr more healv forge ahead. Thrrs thrift'r,(irrrrtn':J has slrifled its ,f'l'l'fr out,
while Country 1's PPI- has nrt mol'ed :lt all. Counrries that irvest lreavily can hve loll
higher investmenr irnd consumption in the firture.

II It. t'R( )t)t ( i

)N-t'( )sstBlt.t

l-\'lfR()\'l:R

t3

()ut tlre II'I'. The figure also illrstr:rtes that poor

c()untries must dev()te rnosI of their resrrrrces to
fbocl orodtrcrion rvhilc rich corr'rtlit:s can afford
rrrrt: luxrrries :rs prodrrctivt' potential i rrcr-t';rscs.
Figrrr-e l-4 depicts tlre choice l-x'trr,ecn plivatc

goods (horrght:rt a prcc) and public goods (pairl ftrr'

bv taxes). Pror conrtries call afIord littlc of prrblic
goods like puhlic healtlr arrd prirnan' cdrrcation. thrt
rvifh <'crrrrn.ric groh'tlr. l)llhlic go()ds as wcll as cnvironnt('l'rt:rl qualiry rake :r largr-r- sharc ol'output.
Figrrrc l-5 p()rtrays an ccor)()nrv's choicc bctwccrr
(n) cu r-rcrr t-consrr nr ptiorr goorls and () irrvcstrncrrt
in capital grxrtls (rttachint's, lirctolics, ctc.). By s:r(rilicirrg crrrlcrrt c()rrsurnptior) :rrrd prodrrcirrg lnorc
capiul go()(ls, ir nation s e con()nly c:rn grow nl()t c
ntpidlr', Inaking possible rtore of o1lr goods (corrsulnpti()n nd irrvestrrtent) in the fitrrre.

Be Not Time's Fool

The great Amercan poer Carl Sandburg

wrote, "Time is the coin of your life. lt is
the only con you have, and only you can
derermine how it will be spent. Be careful lest you let other
people spend it for you." This emphasizes that one of the
most mportan! decisions that people confront is how to
use ther me.

We can illustrate this choice using the productionpossibility frontier. For example, as a student you might
have l0 hours to study for upcomng tests n both economics and history. lf you study only histor you will get
a high grade there and do poorly in economics, and vice
versa.Treating the grades on the two tests as the

of your studying, sketch out the

PPF

"output"

for grades, given )rour

limited time resources. Alternatively, if the two student

commodites are "grades" and "fun." how would you draw
this PPF?Where are you on this frontierl Where are your
friendsl
Recentl the United States collected data on how
Americans use ther time. Keep a diary of your me use
for two or three days.Then go to www.bls.govltuslhome.htm
and compare how you spend your tme with the results
for other people.
lazy

Opportunity Costs
Whcn Rolx'rt l'r()st wrl)l(' ()l thc r'oa<l n()t ulk(.n, lt('
p<lirrtc<l to orrc rf- thc (lc('l)cst c()nccl)ts ol ct orrornics,
oPlotlutril\ rarl. BctaLrst ()rlr t ('s()ru ccs ilrc liluitc(I, wc
rrlrst rlt'cirlc lron' t() all()(rtc ()ul in( ()llcs ()t tinlc. \\ltctt

lorr decide rvhethel to strrdv cconnrnits, llrry a car', or

g() to college. r'ou will rivc sonrcthin up-tllcre will
hc a or-gclnc oppoltunity. I'hc rrext$est rxrd tlrar is
lirrg0nc lcprcscnLs tltc ()pp()rtuniN cost of a decision.
'lltc corrcc-rt ()l ()pp()rturrit\ c()st cult be illustrat('(f rfsing tlrc Pl'l') Uxrrrrirre the lnrnticr in Figrr-c l-2, wlrich slrou's [lrt' Lt attcofl betucen guns and
btrttt'r. Srrppose tlrc corrrrtl dccides to incrcase its
gun rLrlchascs lrorrr 9000 grurs ;rt 1) to 12,(X)0 rrnits ar
(1. \\'h[ is [ll( opportunirv c()st of this decision.-, \irr
rrright calcul:rtc tlle cost in dollar terns. Bur in ecr>
norrrics wc:rlwavs rreed to "pielce the veil" of tn()ney
to exinrin(' tlte n,al impacrs <f allernrtir,e decisiolls.
On the nrost frrrrdrrnental levt'I, thr: opportllnirv c()sf
of movins frour 1) to ll is the brrtter tlrat rnust bc
given llp to rrodrrce the extr:r grrrrs. In this cxarnrlt.,
the opportrrnitv (osf of: the 3000 cxtra guns is I nlillion porrnds of' l'rrt ter fbrgont'.
()r consirlcr tlre real-rvorld t'xarrrrk'<lf thc cost l'
opening r gold nrne rrear' 't't-llowstonc \atirnal Pal k.
The developr.r :rrgucs that thc rnine rvill lravc lrrt a
srnall cost llccausr. \t'llol'stonc's rc!cnucs will hartlll,
be aflected. Brrl an ccrrrolnist worrl<l atrswct tllaI tltc
dollar rt'cei'lts:rx. ((x) narr()w A tncilstrrc ol tust. \\t'
slrrrrld ask whctlrr.r' tlrc rrniruc anrl prct iorrs rrralics
of \t'lkxvstonc nright lrt'rlcgratlcrl il a gol<l lniltc rr,cre
to ()l)clatc, nitlr tlrc a( c()r npal lyil lg lroisc. rvuter lrnd
air lollrrtiorr, arrrl tlcclilrc it irnrcnitv vllrrcs fir-r,isiton.
\1'lrilt tlrc rlollar ctst nligltt lx.sl:rll, the r4tpor-trrnitv
f

cost ilr l(,st rviklcr-rress rttlrrcs rriglrt ltc lttrgc irrdecd.

Irr rr rrolltI ol st:Lrcitr. tlroosirrg orre tlrirrg rnr.ltrrs

ttir irrg rrr sonrctlrirrg clst'. TIrc opportunity cost ()f :l
<k'cisiorr is tlrc r:rlLrt'()l tll('g(xxl <r sen-icc f org<.lnt..

Efftciency
tcorrorrrists rlt'r'ote rrrrrclr <l tllcil studv to expl()ring
thc cflicicrrtv tl rlilli'lcnt kinds 0l-nrarkct structures,

ilrtcrrtivcs. iulrI taxes. RerrrerrrJrer- tlrat cflicicncv

lncalrs tlrat tltc ccottolllv's Ies()urccs lrte beittg ttse<l
as cfii'ctivcly as xrssiblc to sutisl\, rcoplc's rlesircs.
()nc irrrportarrt irspcct ()l ()r'erall ctrrronrit cllicicncv
is rrrrluctivc cllicicntr, rvlriclr is ('asily [)ictrrre(] rl
tcl lrts ol tlrc P/'/'. t lIicit'ncr rncalrs [lrat tlrt' ctorronrv
is l tlre frorrticl ratllt'r tll:rr irrsl/ tllc rrrrtlrctiorrlossibilitl, liurrticr.
Prochctive efficiency orcrrrs rvlrcn ;rn ('(()n()rn\
(:unr()t l)r()(lu(c rnott' rl otrt' goorI r|itltoLt )r()rlttt.
itrg lt'ss of :urothcr gor>rl; this irnplics tlr:rt th('('c()nr>nr\ is on its rrodrrcrion-ossibilitv fiontit'r'.

t4

CHAPTER

Lct's scc wlrv productivt't'f ficicncy leqrtires being

on tllc PP1'l Start in thc situation shown by point /)

in Figtrrc l-2. Sav thc rnar-kct calls for another rnillit.rn 1-roun<ls ol buttcr'. ll wc ignor-cd tlre cottstrritrt
slrorvn ll'the PPll rvc rnight think it possiblc to prG
duce more butter withott redttcittg gun pro(luctiotr,
sa)', b), m()\'irg to point /, to thc light ol roint /).
But point / is ousidc the lnxrticr-, in thc "infi'asiblc"

region. Starting fiorn 1), wc canllot gcl r)ror('l)uttcr

without giving up sorne guns. He Itcc poirrt D disrlays
prodrrctive e fficiencl', while poin t ,f is inf casiblc.
One further point about prodtrctivc cfficierrcy
can be illustrated using the PPII Beirtg on the PPI'
rneirns that prodrrcing more of onc good inevitably
reqtrires sacrificing other goods. rr4'hen we producc
more guns, I{e are substittrting guns for butter. sz/,strlion is the law of'life in a fr,rll-e nrplovment econonrv,
and the production-possibiliq frontier depict^s the

nrenu of society's choices.

Y(oste from Business Cycles ond Environmentol

Degrodotion. Economies suffer fiom inelficiclrt
use of resources for many reas()ns. When there are
unemploved resources, the economy is not on its
production-possibility frontier at all brrt, rather,
somewhere insiit.ln Figrrre l-2, point L/ reprcsen Ls
a point inside the PPI at {.1 societf is producing only'
2 rniLs of butter and 6 trnits of g'uns. Sonle resources
are unemplo,ved, and by prtting them to work, we
can increase our output of all g<lods; thc ecorlollr,v
can rnove from U to I producing rnore butter and
more guns, thus improring the cconotrty's cf ficictcy.
\{'e can have our pllns and eat more butter too.
I listoricalh,, one source of inefficiency occun
during business cycles. From 1929 to 1933, in the
Great Depression, the total outprrt produced in the
American econonry declined b;-' 25 percent. The ecorromy did not srfl'er from an irward shif t <,f the 1'14
because of technological fbrgetting. Rather, panics,
bank failures, bankruptcies, and redrrced spending
nroved the econom)' insid is P1*l A decade later, the

military expenditures for World \'t'ar II exparnded

demand, and output grew rapidlv irs the ec()llorllv
pushed back to the PPII

Similar situations occur periodically during

business<vcle recessions. The latest growth slowdo*n

occurred in 2007-2008 when problems in housing

and credit markets spread through the entire econom1'. The economy's trnderlying productivity had

| .

',l

llt.

(:l.lN lRAl.

c()N(:lil'ls ()l :(:()N()l\ll(:s

not suddenly declined drrring those I'ears. Rather,

reduced overall spending prrshed the economy tcmporarilf insicle its PPffor that period.
A diflerent kind of inelficiency occurs when
marker.s are failing to reflect true scarcities, as rrith
cnvirorrnlcntal degradation. Srrppose thaf an lrnregtrlatcd business decides to durlp chemicals in a river,
killing fish arrd nrirring recreational opportunities.
Thc firrn is not necessaril,v doing this because it has
cvil irrtcnt. Ratller, tlre prices in the mzrrketplace do
not r cf lcct lr.rc social plioritics-thc rricc or.r pollutirrg irr an unrcgrrlatcrl cnvironnrcnt is zcr-o mtherthal thc truc opp()l tunit'l' cost iu tcrms o[ lost fish
arrcl rccrcation.
f,nvir orrrncnlal dcgladation carr also prrsh the
ccor)onry insidc its PPhl'lltc situation is ilhstratcd in
Figure l-1(). Bccatrsc busilrcsscs do nol fcc corlcct
prices, thc ec()n()nly rrtves fi orn point B to poirtt O.
Private goods ae incrcascd, btrt pr.rblic goods (likc
clean air and water) arc tlccreasccl. Ellicicnt rcgulati<n of'tlre envirorrrcrrt cruld nrovc rtor thcast back
to thc dashc(l cflicicnt li'onticr'.
As wc closc this ilrtroductorv clraptcr; lct us lctttrrr
brief ly to otrr opcrrirrg thcrnc, Wlrv str.rdv cconotrrics?
Pcrhaps thc bcst answcr to lhc tucstion is a fhtnotts
orrc giverr by Kcvucs in tltc final lincs ol- 'l lp ()ntnnl
'l hcorl oJ linplqnznl, lntrr+l un Mot'i:
'I llc irlt'irs ()l ec()nonlisLs ard political plrilosoplrers,
lxrth wlrt'r thcv alc liht arr<l wllr:n tltt:v atr: tvtrrng,
arc In()r(' xlwcr[rrl tlran is crrrrrnonly rrrr<h'rsloorl.
Incleed rhe workl is ruled by littlc clst'. l't a< t it al nrt'rt,
whr believe themselves to be quite exerDpt from an)'
ir t<'ll<'ctral inllttcrrccs, art'ttsually the slrves of sonre
<lt'fiurt t r'< onorrrist. Matlnclr irt arrthorit;", rrho hear
voices ir tlrc air. arc distillirrg tht ir [r'r'rrzy frrrrrr sorrtr'
:rcademic scribbler of a few 1-eani back. I arn slllc tl)al
tlre power ol'vcsted interesrs is vastlv exaggerated
comparcd with the gradual errcxrachment of ideas.
Not, incleecl, irnrnecliately. but rfrer a cerurin inrerv;rl;
firr irr tlrc lir'lrl ol rrrmrnric and roliLical philosophy
tlrcrt'arc rr()( nrant wlr() a11'irrllr<'rct'rl by rrr-w tlt<'r>
ries afier thcv nre twen6.fivc ()r (hirtt' ycar s o[ agr', so
th:rt thc ideas which civil sen:rnLs and politicians :rrrrl
eveu agiurtors appll'to ctrrrent e\cnts rre not likel)" to
llr: thr' rr.wt'st. Brn, sr'orr or latc, it is ideas, not vested
i t('r('sts, whi< lr ar'rlant'rOrrs for grxr<l or <'r'il.

Tt undcnulnd how thc powerfil iders of ecollolnics appl,v to the central isstcs of hutan socictiesultimatelv. this is whv we sl.rdv econorrics.

l5

SUMMARY
rrrrlrinations of comlnand and mitrket: irll s<cictics
lre rnixrd cc<nomies-

A. Why Study Economics?

<

l. Wh:rt is economics? [,c<nonrics is thc strrdv

<>f lrow

s<cieties choose t< use scarce pr<rductivc rcs()lrrc('s

tllat lrav(' alterrrative rses, to l)r(xh( (: r rrnnrrxlitir.s rl'
var iorrs kirrrls, arrl to <list illrtc tlrcrrr arrrong rlifli'rcrrt
glorrrs. IAi' strrrly ccrrrrorrrics lo rurdcrstarcl not only
thc world we livc in brt also thc many potential w()rlds
thlt rclirlmers arc consurntly proposing ro us.
2. (kxrcls:ue scrrce beciurse peorle desire nlrch nore thrn
tlrt' t'rrrrtorny carr rrtxhr<r'. E<orrrric grxxls art' valr',
not ln r', an<l s<x iclv rrllsl ( ll(x)s( arnong thc iimitcd
goods that can bc pr<rlrrced th irs available resources.

Microeconomics is crnccrned u.ith tlre behavior of

incliridual entities srrclr s nr:rrke6. lirurs, and househrlds. lVfacroectronrics views the pcrfornrancr: of thc
({-r)nonly as a wltlk'. Tlrrrlrrglr all crrrrrrrrir s, lrcwr'r'
of tlrt' fallarl, of t orrrlositiorr an(l lll(' J)()st lo< fallart,,
and rcmcml)('r to kccr othcr thittgs r ortstarrt.
B. The Three Problems of Economc Organization

socictv nlrst answ('r' thr''t' f rr<lanrcntal rrr<'shol\ anrl lor uhorn ? l4?l kinds and qtrantides :rre produced among the r\ide rangc of rll p()ssiblc
goods :rnd sen'ices? Ho, aLe resorrrces rsed in pr()drcing these goocls? flt'tcl ln whouarc tht' gorxls l)r(xh{ c(l
(lhat is, wllat is tlrc rlistrihution of incorlc an<l rrrrrsunrption amOng different indiviclttals :rnd classes)i'
5. Srcieties arrswer these quesons in different wir)s. Thc
rn()st impolurnt f<rnns of economic organization today
ze rotLutanrl and nark"l..lhe conrnrand econorny is
(lr('( t({l by r'<'rt t ralizt'rl f{()v('rnrn('nt <ontrrrl; a urarkt't
c(()n()rly is guidcrl l.t, an infornlal slrtem ()f prices
and prohs in rlhich most decisions are made by prirate indidrrals irnd firms. ,A.ll societies have different
4. F)vcry

dons:

l1,

c.

Society's Technological Possblties

6. With givcrr r('s()utes and technokrgl, the producti()n

choices betwcen two goods srrch irs brrtter and grrns can
b't' strnrnrarizt.d irr rlrc ptodttd iott 7)ossiltilil Jronlier ( l'H" \.
f'hc /'/'/t slrows how the proclrrction ol one good (srrch
as grrrts) is tr a<k'rl ofl agairrst tlrr' lrrxlrrrtiorr ofalrothcr
grxxl (srrclr as lrrrttcr). ln a world of scarcitv. choosing
onc tlring nrcnns giring irp s()rnething else. The ralue

of tlrc grx;d

<r senicc firrgorre is it-s opportunity cost.

Prodrctivc cflicictrc;-' <ccrr-s rvhen pr-oduction ol one
g()od cann(l bc itclr:ascd wiIltorl crrlailir rlrxlrrr.

ti<rr <f arotlrt'r'q(xxl. Ths is illrstratcrl lry thc PPII

()norrv is ()n its /r),f,. it can produce more
ofone good only by prodrrcirrg lcss of anothcr good.

rvl4rt rr arr (.(

8. Producon-possibilit,''

lir>nden; illtrstlate manv basic

economic processcs: h<lw economic gro\vth puslres out

the fiontie how a ration chooses elrtivcly l<'ss lixxl
an<l otlrt'l nt'r't'ssitics as it (l('vcl()ps, lrow a corrntrv
chooses berw-een private goods and prrblic goods, and
h<w societies cho<se benr.een consumption goods and
cirpital gorrds lhat errlrance lirtrrrc consrrrnrlion.
9. Socictics

ar(' s()nl('tinr('s insi<lt' tlrt'ir' rrodrrctiorr-

xrssibilitv frorrticr becalrse of macroeconomic brsiness

cyclcs or microeconomic marker faihrres. l!'hen credit
c<ndidons :rre trglrt or spending suddenly declines, a
society nrorrs inside irs PPf in recessions; this occurr
lx'cartst' of n;rclt<,conon it rigiditics, n()l b(:caus(' ()f'
tcchrrokrical lirr{('tling. A sx it'lv t:an alsr bc insi<lc
its /'/T if nrarkels lil becarrse prices do not reflect
socill priorities, srrch l-s rri th enrironmental degradati()n from rir ar)d \iater pollution.

CONCEPTS FOR REVIEW

Fundamental Concepts

Key Problems of Economic

and effi cienc,v

vs. econonric g(nds
nlar I ot t olt<lnlit:s antl ulictot'ttlnornrcs
I rorrnativc vs.
.lositivc ccQnorrics
firllacv of composition, post hoc fallacy"kcep other thirgs constant"

Organization

scrrciry

lice goods

uhul, hou, xtrl lor ulnnt

r' rnotli< svslt'ltts:
crmnand vs. lnarkct

allt rnativ<'

laisscz-firire
rnixcd cc(rn()n)cs

Choice among Producton

Possibilities
in pul-s

an(l ()ut puls

rrrxIucIion-rossibiI ity frr rrr t i<'r ( PPI'

prodlrcti\'(' eftir iclr< r arrrl irlcfli i<'nt y

Opportunltv cost

CHAPTER

t,.

(:l.tN

IR{t

(,()N(.F.PTS OF F_CO\O! cS

FURTHER READING AND INTERNET WEBSITES

Further Reading
Robert Heilbroner, -fh.e lVnltll I>hilotolr:r. Ttlr trl.
(Toucl.tstone Books, 1999). provides u lilclv bioglarlrv ol
the great economism along with thcir irlcas artd intract.
'.l

he arrthoritative work on tlre lristotl ol ccttrr>rnic lurlvsis

Histul ol h otont. ,'lnuh.l.s (lr{c(iraw-

is.frrst:rlr Sclrrrnrpeter,

Hill, Neu'York, l9li4).

Websites

ol the greatest

ol rll econorrtics is -\drm

Srnith. 7'l ll'culth ol .\llrr (larl >rrlrlishtls. l77li).
Everv ccorronrics sttrdent sllorrld r-ead a li'w ragt's to
()rrr.-

books

get the fla\'()r of his rvritinr. 'l.hr ll''tllh o/,\nlicrns catt bt'

irtnr<f

uittut.

h i h l.i m

a n i.t

rt

l.-o n l;i

c l i

on

/Sn

i t h.

lVc t

lth

Log rrn lo orrt <lf- lll( lnt( r r)( t lt f<'r't'ncc sites lor cc()n(rnics
srrclr rrs Rvrrs fitr [iononisls tm lhc llrnl (turnt. rfi. u-g) .
Bxru'sc thxrlrgh sole of the scctions t() fhmiliarize l()rlrself

rvith the site. \i)r.l nrigl)t want to l()ok up,voul college or

rrirr.tsitr. l()k;rt r(.( ('ll tr.r,is in rr r'tr.\\sl):rpcr ol rnag,,tzine.
ol chcck sore ccorrollrit <latr.

'fuo sitcs Iir' cxct'llcnt

((r)n()nri(s

nrlr-scs

rl public polic) issltes in

irr( tlr)s( of tlrc

Brorkings Inslilttliorr
bruoh.tdu) und ol thc ,{nrcricarr Hntclprise Institute

(rzzr
(

rarz

arr.org). l'-ath rl tlresc pul)lishcs books and has policy

bt iels

<

tt li t r'.

QUESTTONS FOR DTSCUSSTON

I

TIrc gr-eat English econornist ,\lli cd Nlar slirll ( l ll.l2192-1) invented manr'of the totls of notlctr c(1rnr)nlics, brt he rvLs nrost concer-ned rrith the arplit atiorr ol'
thcs('lools to the problerls ol srrcietr. ln lris inaugrrlal
k t trrr t'. \farshall rrrolc:
It uill bcmvnosr<hc shrl ethitirrr to irrr rr':rrt tlrt
rtrrrbers whr (larnlrr_i<lgt' LIrrir< rsirr scrrrlr,rrrt irtr tllr.
rrrl<l u ith <rxrl h< arls lrrt rr,arrrr lrt l. w illirg to girt

[)t'firrt' t irch ol tlrc firllorrirr terrns calefirllY irnd gi\c

/??, scarcitr. productivc efficicucr. ilrJrrts,

outl)u ts.
.t. Rt'arl the specirl secti()n on tin)e use (p. l:3). Thcn d()
tht' t'xt'r cisc in the last l)anrgrrph. (i)Dstnlct a tal)l('
llrl ( ()rrl)irr('s vour linl(' use \{ith tht o[ the ltrcagr
t'xarrrJrlcs:

,\trcrir'tr. (For

of thcir brst porrcrs to 9r:rrrlrrrg rlitll thc srx ilrl srrlferiDg arorrnd thcn: rrsrlvccl rrrl l{, rr'st rrlltt'nt till thcr
harc opcnctl up to lrll tlrr'rrlrl< r-iirl nrcl\ ()l rclirrc<l rrl
nohlc lifi-. [ \ltruntal: ol Allnl \lnnlall, \. ( i. l'igorr. r'rl.
(\lacillr nrl (,r., l.orrk'rr l1)2i). r. l7 l. with nrirror
srnre

eclits.l

2.

c('l)t

lr

<>f

tlrt' role ol the tcrcher-i l)r

vrrrr

,7

is clt;rlle'rtge?

'l'ht'latc (irorgc Stiglt-r. iul clninelrt conserlati\ c (lhit ir3o c< orrorrrist, rvrrrtc lrs

firlltrts:

l1)(;(ii.

l'rit. !\i trl. ( Ilrrt rrrrllirr r, \r'r

r'('s()ur'( cs ir l>rrtter

plodrrction

rvitlrrrrrl irltt'r irr3 llrt rr rxlrrctiritl rrl grrn uranulactrrre.

Rcrlrirrr sr< i'tr's rrorlrr< tiorrlrossillililv fi()nti(:r irl FiBut l-? to illrstratc tllc rrcrv tradcofl.
Sonr<'scicntists lrclicvr: that rr'c llc rapidl-v depleting
rru nrltrflrl r'('sou c('ri Assunrt' that there itre onlv tw<
irrlrrts (l;rlror' n(l r)atulal resorrrces) ploducirg tlv()

goorls (tortrt'rts ;rnrl gasoline) rvitlr no irnprorerttrrtt

s(,( i( l\"s tt r lrrr<tlo;] orcl (irrr'. Slrrlrv rrltal rvrrkl
hirl)lx'n t() tlre /'l7rler titrre as nntrra] rcs()ur-(cs ilr('
t'xhlrrstc<1. IIrw rvorld inrentiol :lrd tccll n( )l()gi( al
irrr rlovcrrrcn t nroditl yorr':rlsrvcri ()rr lhc lrasis ol tlris

in

N.) tll(f)lrghll ('girlit.-ilrrr societr hlrs cvcr bcc|l l]lc tO

(()rt\tu(l ()r nririrtairr al clfieierrt lrrr<l rrogrt'ssirl' ttoD()nli( syslenl. It hiis been ttttirt r'sl trrtricrtr( tl):rts(,r(
s\st( ln (rl dilli'rclrtial lcurls is rt'r t ssn tr stitLrlrtt

nrrrkcrr. [72r77ra,,/

()l-

tlllrt scit'ntifit irlrcntions hlrve dorrblcd the

rxrdrrctivitr ol s<cictr''s

lrlv tlrc cool lrt'rl rrriglrt .rrrrvi<lt' tlrt't'sst'ltial

positive cc<rrrorrtir lultllsis to iutrlcrrtcnt tltc n()lntttivc value.jtrdgnrcrr ts t>l tlrt \\'ilnr) h('irrl. Do yotr:.rglt't'
tixrlairr

it(

rrrxlrrctiorrlossihili n hrrnticlr
6. Assrnrr

witll Italsltall's vit'rv

a urarlrir;rl iurirlrsis. st'r'qrt('sti(,n

thc aprcrrdix to tlris clraJrtcr. )

5. ,\sLrne th;rt l-corol;urrl pr()duces hlrilcrts alrrl shirts
u'itlt in pu ts ol labr r. !l< orrlarcl has l l)01) hours <l Iabor
urilabl<'. .\ ltairrrrt rertrirt's 7l hru rl lalror, rvhile a
slri r t r crrri lt s :- horr s <l l:rlxr. ( irrslr trct Ec<rrolancl's

\irr

L,

p l9.l

Ale lltcse stalentettts rosititt trr rt(rfrritli\c { r'{rr(rrnr's,

l)iscrrss Stigler's ricrr in liglrt of Alfi t'rl I! alshall s <rrott'
irr qrrestiorr l- Is thclt. it r1'nll( t:

E.

t'xarnrlc, cxplairr rvhr it rs sairl that econornic r<rrrlh

is t< r' llt'ltrct rr rlt rk tirlrt rld irrlt rrtiorr."
Sr' that I)ilieent has l0 htur-s tr strrdl lirr rrrtrrrnirrg
tcsts irr cconornics :rrlr[ histon' l)r'arr a /'/',f'firr qr:rrlt's,

uircrr l)iligents linrrtcd tirnc

r('sr)ur( es,

lf

l)ilicrrt

t7

QUESTIONS FOR DTSCUSSTON

your discussion wi a carefully drwn PPI'for

studies inefnciendy by listening to loud music and

chatting with friends, where will Diligent's grade

'output" be relative to the PPF? What will happen to
the grade PPF if Diligent increases study inputs from
l0 hours to l5 hours?

9.

Consider the PPf'for clean air and automobile travel.

Explain why unregulated air pollution in autom(>
biles would push a country inside its PP,i{ lllustrte

a.

these two goo(Ls.

b.

Next explain how putting a price on harmful auto

mobile emissions would increase both goods and
move the counEy to its PPIT Illusrrc by showing
how correcting the 'market failure" would change
the final outcome.

' EtBu0Ttct l|uffi

Ap
HOW TO READ GRAPHS
il ltictwe

is uorth a tltousrnd uords.

Chinese Proverb

Before you can master economics, you must have a

working knowledge of graphs. They are a-s indispensable to the ec()nomist as a hammer is to a carpenter.
So if you are not familiar with the use of diagrams,
invest some time in leaming how to reacl them-it
will be time wel'l spent.
What is a grcQh? lt is a cliagram showin how tw<
sets of data or variables are related to one
another. Graphs are essential in economics because,
among other reasons, they allow Lrs to analyzc cc(>
nomic concepls and examine historical trends.
Yorr will encounter many differen t kinds of graphs
in this book. Some graphs show how variables chang<r
over time (see, f'or example, tl.re inside o[ the fr<lrrt
cover); other graphs show the relatiolrsl.r ip benvecrr
different variables (such :r-s the example we will trrrr
to in a moment). Each p;raph in the book rvill help
you understand an important economic relationship

P ro d u

lA-l can also be presented

graph. To construct the graph, we represent each
of the table's pairs of data by a single point on a twc>
dimensional plane. Figure lA-1 displays in a graph
as a

Aternatye Production Possibilities

Possibilities

or more

or trend.

cti o n- P ossibility G rop h

The data shown in Table

A
B

(;
D
E
F

TABLE lA- | . The Pain of

Food

Machines

150

10

140

20
30
40
50

120

Pr.sible

m
50
0

Ouputs of Food and

Machines

'l'hc urble shots six potential pairs ol outputs rat can be

pr<xltrced witl.t thc giv'en es<lrrrces ol a counlry. The corrntr] ( an ch(x)s(: ont: of th<: six lxrssilrl<- r:ornbirratiorrs.

THE PRODUCTION.POSSIBILITY
FRONTIER
The firsr graph that vou encollntered in this text
production-possibiliry frontier. As wc strowcd
in the trody of this chapter, the prorluctionlossibility
frontie or PPfl represents the maxir.nurn arnounts
of a p:rir oF goods or selwices that can both be pr-cr
was the

with an economy's given resorrrces, :rssrrrning

that all resources are fully employed.
[,et's follow up an important appliczrtion, that of
choosing between food and machines. The essential data for the PPlrare shown in Table lA- I , which
is very much like the example in Table l-1. Recall
that each of the possitri'lities gives one level of kod
prodrrction and one level of machine production.
As the qrrantity of tood producecl incrcascs, thc
prodrrction of machines falls. Thus, if thc cconomy produced l0 unirs of food, it corlcl prodrrcc
a naximum of 140 machines. brrt when thc output of food is 20 units, onlv 120 machines can bc
manufactured.
clrrcecl

t8

o90
E
o
OU

Food

FIGURE lA- l. Six Possible Pais of Food-Machine

Production Levels
'I his ligure shows the data olTable lA-l in gmphical lbrnt.
ar-r: t'xa< tly thc sanrc, but thc visual rlisplay prescnts tht: <lala rrrorc lir.idl_v

Tlrc rlata

||Il.. t'tr()l)t cll()\-l'()ssllill.l

t9

I\ l.R()\ fll.l{

tltt' tr'llliorrslrir lrt tr't t'lt tltt foo<l artrl ttl:tt llillc rttl'
rrrtr slrorvrr ill T:rlrlt l-.\-1. l-rrclr lrtir of tttttttlrcts is
r-('l)r'('s('rrl('(l lrv a siuglt rr'itrt irt tltt elrt)lt l lrts llrt'
rrrv lalrclt'tl "'\" in Tlrlrlt' l.\-l isgr;rrlrttl rts r,itrt.I in
F igrrrr' l,\- 1. ;ul(l sinlil:u lv lot' roitrts /j, (.. ;ttttl so orl.
lrr Fiqrrlt' l.\ l. tlrc vcrtical lin(' ltt lt'lt :urtl tltt'
Irrr izorlll lirt' :rt tllt' l)()ttoln c()r'r('slx)l)(l t() (llc t1\()
rr'i;rlrl<'s-lirorl :rnrl rn:t< llitrcs. .\ vaable is alr itt rtt
ol inlt'r'cst tll;rt (;ul bc dt'lint'd iln(l l))('itsulc(l rul(l
tlr:rt takt's ()n (lifli'r1'llt r:tlttt's ltt rtillt'rcllt tiltlt's tr
rl:rr t s. lrnror t:u) l \;u iill)l('s st tlrlit'rl ilt t't olltittlics al t'
rr ircr. rrrlrrttitics, lrotr-s tl urr'k. ;u r-r's rl lltrld. rl<tll:rl, ol irrr ontt'. :rrtrl so firrtlt.
llrt lr.r'iz.rrt;rl linc rn ir tr-a>lr is rt'ler't'rl tr :ts
Ilrc hntnlttl r\!, (,r s()nl('tin)('s ll)(' -\ arlr. lrr I'igrrt' l.\-l.lrr.rl orrtlrt is nlr';tstur'<l ()n lltc l)liI('k h()r-il()ntirl :r\i\. l ltt' rtltir':rl lint' is ktorr'r :ts Ill(' ?)11l
r.rir, or l r.rlr lrr Figrur' |'\-1. it rrrr':tstr-('s lll(' rrttlll
lrt'r of rrurt lrint's rrrrrlttccrl. l'irrt ..1 ()rr llr(' \('r'ti( ltl
ris strurrls Irr l5(l nrit< ltirtcs. -I'ht' lorr't't lt fi-lralrtl
<orrt'r, rrlrt rt' llrt' tnrr ;rxcs nt('('t, is cirll<'rl tltt' rrligirt.
It sigrrifits 0 lootl rutrl 0 nr;tt littt's irr Figrrx' l.\ l.

A Smooth Curve
rrrost t'torrorrit rr'l.ttiortslttls.ritrilrlrlt'st;trr clrttgt'
lrr srrrlrll :ulr{,unls :rs rv'll lts l)r tltt' l;tlut iltt tt'lltt'llts
slrrr*n in liurr'r' I\-1. \\i' llrt'rcfort gttlt'r':tlh drarr
trorrorrit rt lirtiottsltirs :rs tottitlttotts tttl'rt's. Figrut' l.-\-2 sltotrs tltt' lrl'l ;ts;t srrtxrll) r'ttr'\t'irl rthi<h
tlrt'poitrts li otn .l to / llrt'ltt't'lt ( (,IIII('( |('(I.
llr tornlrrirrg .l;rlllt' I\-l ;urrl Figrrn' l.\2. rtt'
tlrn sct rrlrr ur;rrlrs;ttc so rllcrr ttst'rl ltl t'c<lllllti< s.
I llc snrortlr /'/'/' rlllt't ts tl)(' t)t('l)lr rl clroitt' liil tllt'
('(()llrllr)\. lt is lr rist;tl rlcvit c f,rt sltortitrg rrltitl tr>t's
ol gotls lut lrr.rillrlrlt' itt rrlt:tt ttr:tttlitit's, \ittt <'rt'
(rut \c(' :rt :r gl:rutt'llrt'r't'l;ttiottsltir lrt'lrtt't'tl ltl:tt lriltt'
;ttrrl lootl lt orlttcliort

Il

Slopes ond Lines

lrgrrlr' l.\-2 (l( l)i( ts tll('tt'l;tliottslti.r l>t'trttt rr lrtrtr.inlrrnl lorrl lrrrI tla<'llirtt' >rrr<lttt lion. ()rtt itttrottltttt
\\:I\ l() (l( s(fil)(' tll(' t('lllli()tlsltit llt'trrtt tt lt\{) \illiirblcs is lrr thc skrrt' ,rl tltt gllrh Iint'.
Ilrt slopc ol a lilrt' r'('l)t('s('t)ts tltt't llrtrlgt' ilt ottt'
rlu ilrblc lh:rl (x ( rl s tr llt't ;urotltt'l \:t i:ll)l( ( Irrtrr{('s.
\l'rr' rrtr isr'lr'. it is tllc r'ltartgc itl tltt vrtr-ittblt' ) orr
t lrt' rtr ticirl aris rt'r' tulit r'ltatrgt' itr tlrt' r'rtr i:tlrlt -\ otr
tlrt'lrrriurintl :rris. I-ot ('\:ltr)l)l('. irr I'igrnt' l,\--2. srrr
tllrt lirrrl rlo<IrrcIiorr lrst'fjont:lr-) l() !(i tnlits. Iltt

The Production-Possibilily Frontier

90
.g

>ou

10

20

30

40

50

Food
FIG U RE

A-2. A Prodr<'tion-Possihilitl Fronticr

rt tll( l)l()tt('(l rrlittts,tttatittu
,'lttirl.

\srrr()Ilr trrrrc lillsin lr'l$'r't

tlrr'

rt r

rrlrt, t irtrr-p,'.'.il'rlrtr

tlrt'trrrrt iu Figtrt' l.\-2 ttlls us llr('l)t1'(-isr'

clr:rnr' in ltr:rtIritrtrr rtotlLttti,rtt tllltt trotlrl l;tkt'
rf:ttt'. ,S/rr/,rr'i un rtutl tttturntul nutttrrt rtl lht nlttlitt'
til bt'ltttr'tt lltt t lttrtgt itt\ tttttl lltr r lttttrgl irt \.
\\'<' tlul ttst' ligtrrt l-\-ll [o slrorr ltorr ltr tllt':tstttt'
tltc slor<'tf l strtiglrt littt. srl. tlrt slox rl tltc lillr'
slolt' of

llt'lrrt't'lr roirrts 1i :rntl 1). l llrrrk ol lltt' ttlr't'rtrt'rtl

flrllt /J to 1) rs ot t ru l nru in l\\o sl:rg( s. l ir sl < ttllt's .t
Irrr'iorl:rl rn{,\( rn('nl f rrrn /J t llirrrltt-ittittg ;t l-tttlil
incrt':rst ill tlrt -\ r;tlttt (rvitlr rl' t lr;ttl-lt ilr )'). St'tolltl tolltt's:t t onrrt'trsatiltt rt'rlit rtl ltlott ttl('t)l lll) ()l
rloln. sllor.rr :rs r in l'igtttc l.\-lt. ( I ht' r))()\('rrr('rrl (,1
I lrolizoutll urrit is rtttt lr lor ourt t)it tt< t . Ilt<' fil'
Intrllr lrrlrls lirr rlrorcrrrt'rtIs rf .ur sizt .) 1'ltc trrrr stt't
II)()\( ||l( ||| lri qs l|s f tol rnt' loitrt t<l:tll(,1lt('l ()ll
t

lrc

st

r rr

igll t lint'.

tllt'/J(lnlovt'utt'nt is;t l-ulrit int rt':tst'it -\.

tlrr'lt'ngth of (l,l) (sllrrln its r itt I:igttrt' l.'\-il) itrrlit:rtts
tlrc r lr:rrrgc irr )'r<'r' llrtil (ltal)g(' irr -\. ()rl;t gtitl-llt.
tlris t lr:ulgc rs c:rll('(l tlrt r/ry'rr'ol tht'lirrc.l1ll)1:.
()licrr rlorc is rlr'lirt'rl ;ts ll)(' ris('rrt t lltt' tttlt."
llrt rr,,, ir tltc rctlir:rl rlist;tlr<t': irt I-igttn' l.\-ll. tllc
rist is rlrt' rlist:rrt t' fr.rnl (.lr 11. l-ht'Itrn is tlrt' lrorizrnlll rlrst;urrt'; ir is /J(. irt ["irttlt' l,\-lt. l'lrc tisc ottl
-l'lltrs
rlr( r un rr tltis inst;ult c rrrttl<l ltt' (,/) olt r /Jl,
lJt <;rrsc

20

APPENDIX

(a) Inverse Relatlon

HOW TO READ GRAPHS

(b) Dlrect Relatlon

FIGURE lA-3. Calculaon of Slope for Straight Lincs

to calculate slort:s firr straiht lincs as "risc over nrn.'Thus in both (a) and (b), the
numerical valrrc of tlrt: slox.is risc,/rrn = CD/ BC= s/l = s. Note that in (a), CDis negative,
intlicating a negative slope, or an inverse relationship betneen X and 11
It. is easy

(a)

(b)

FIGURE lA-4. Steepne*s Is Not the

Same as Slope

Notc that cvc,n though (a) looks steeper

than (b), thcy displa,v the same relationship. Both have a slope of r, but rhe X
axis has been stretched our in (b).

the sf ope of 8D is LD/BC. (For those who have studied calculus, question 7 at the end of this appendix
relates slopcs to derivatives.

Thc key points to understand about slopes are

thc Ibllowing:

l.

The slope can be expressed as a number. It measures the change in Y per unit change in X, or

Dircrl relnt.iorcltips occrrl wher variables move

in the same clircction (that is, thev increase or

decrease togcthcr); iruerse rlationsdps occur
whcn thc valiables rnove in opposite directions
(that is, orre irrcreascs as the other decreases).
Thus a ncgative slope indicates the X-Y relation

constanr

is invclsc, as it is in Figure lA-3(a). \{'hy? Because an

increasc in X calls fbl a decrease in X
Peoplc sornctirnes c<.nf use slope with the appear-

3. Thc slope of the line indicates wherher the relationship between X and f is direct or inverse.

ancc ol stccpness. This conclusion is often but not

always ralid. 'I'hc steepness depends on the scale of
the graph. Pancls (a) and () in Figure 1A4 both

"tlrc rise over the run."

2. I[ thc line is straight, its slope

is

everyrvhere.

2l

TH I: PRO DU(]TIO}'-POSSI BI I.f TY FRONTIER

portra)' cxac tl)' thc saDrc rclationship. Rut in (D), the

horizontal scalc has bccn strctchcrl ortt corlpared
rvith (). lf 1'ou calctrlate carcfirlly, you rvill scc that
the slopes are exactlv tlte satrtc (aIrtl arc cctral to 7:r).

Slope of o Cuved Line

,{ crrrled or nonlinear line is otte rvltosc slope

ch:rnges. Sornetimes ue
gnten

lninl,

\yrn

t to know the slope at

srrch as point B in Figure lA-5. 1{'c see that

the slope at point /i is positive, but it is not obviotts

exactlv holr to calculate the slope.

To ncl the slope of a smooth curved line rt a

point. wc calculate the slope of the straight line that
just tor.lchcs, brrt cloes r.rot cross, tlre curved line rt
thc point irr question. Srrch a straight line is called a
tungnt ro the cun'ed line. Prt differentll', the slope
of-a cru-vcd line at:r point is given by'the slope of the
straight lirrc that is langent to the cun'e rt the given
point. Oncc wc clra* the tangent line, we find the
slopc ol thc tal)gcrrt linc r+'ith the rrsrtzrl right-artgle
rnc:rstrliug tcclruiqtrc disctrssed eal'lit'r.
'lb firrrl tht- slopc at point B irr Figrrre I A-l'r. rce
sinrply corrstrtrct straight line /'7l as :r tangent to the
ctrlvcrl lirrc at point /j. \'!t'then calcttlate tht: skrpe of
tlre tangcrrt as.\'//,&lN. Similar-11', th('t2rtgerrt line (jll
givcs thc slopc of tllc ctrlc<l linc at point /).
Arrotlrcr cxarrrrlc ol tlr<' slorc o[:r n<trlitrer' Iint'
is slrown in F igrrrc lr\-ti. This shows r typical nricrt>
ccorrornics ctulc. wl.ticlr is clonre-slr:rped and has a
rrrrxinlrurr at poirrt ll. 1\'e cart use ()ur rnefhod of
slopt's as tangcrrts t() s('e llrat the slope of the cttne
is alt'ays positivc in thc rcgion whele the cttrve is rising antl ncgativc in the fallir.rg region. r\t the peak
or-lnaxinrtnl of the crl-le, the slope is exactly zero.
A zclo slopc sigr-rifies that a tiny movement in the X
valiablc around the maxitnum has no effect on the
vallrc ol- t he Yvariable.l

FIGURE lA-5. Tangcnt

as

Slopc of Curved ne

lly c<>rrstnrcting r trrrgerrt line. we crrr c;rlcttlate the slope

r crrrvcd linc at a givcrt xrirrt. Thrts tlrc line /'Ii!f/ is
tafg('lt ro sl(x)th crrrvc Alll)li ttt point ,f.1. l'he slope at
/J is calcrrlat<'l as tlrc slorc ol thc tarrgent lil.re, th;rt is. s
Nl/,\tN.

<l

For thrsc u'ho ctt;or tlgcbtir. thc slol' t[a lirc crrrr lx' t nrt r
bt'r'cd s lollws: A st-:right lir(' (or lint'ar rclationship) s $rittcr :r\ ) - r * ,{. Fo this linc. tlc skrpc rl thc cur'r'c ls 1r,

r*hich nrcsrrt's thc chlrngc rn l''r rrrrit < lrartg< irr ,Y.
,\ crrrlctl lic tr trrrtlinc.tt lclati<rnship is onc involving
t( r'rs ()thcr Ihan constants and rh(' Xtcrrr. ;\tr cratttrle <l-a
rtllinca rclatiortship is tltc qttadrltic cqrratiotr l = (-t - 2)r.
\ilr cr vcrilr tlrat tltc slort'ol this cqttatiott is ncgaliv( li)l
X < 2 arrtl positirc firr X > 2. \4'lrat is its sLrpc lirr.X 2':
F<rr thost'rhrr kow clctrlrrs: A ztro slopt otnt's whcrr'

thc dt irat ivc rf a srxx)tlt ctr !c i:\ ('(ltral tr e r. [irt clantplc.

plot an<l rrsc crlctlrrs tl find thc zcr-r>slopc p()irrl r)l ;t ctnc

dclirrcd b,r rlrt furrclirn

l'-

(X

2)!.

FIGURE lA-. Different Slopes of Nonlinear Crrves

Nlanv ctrrcs irr t<oronrics firs risr', thr:n reach a nrrxinrrrnt. tht'n f;rll. In rc risitrg regiott fr<tn ..1 lo litht'sl4rt'iri
positive (scc point 1.1). In the falling region from l]k) lrthe
slorr.is rr<':rtirr' (scc xrirrt,f)). At thc ctrvc's lnlximttnl,
poinr li. rlrc slorc is zt'ro. (What aborrt a U-slraped curve?
\4'lrat is thc slorc at its nrirrinrrrrr?)

22

APPENDIX

Slope os the MorginolYolue

HO\ ' TO RE.{D GR{PHS

210

Olre of the rnost irnpol tar)l corccl;ts irr ccononrit s is

narginal, rvhich alwavs mcans "addititnal" or'"cxtra."
l'or cxamplc, wc talk abort "rnarginal cost," rvhiclr
tneans the extra cost tlrat is incrrr|cd wlrcrr a lirrrr
produces an extra trnit ol'output. Sirnilarly, iD fiscal
economics, rre discuss thc "rnarginal tax latc," lvlriclr
denotes the additional taxcs that arc paid whcrr arr
indil'iclual earns an additional dollar of incornc.

180

150

o
c 12l)
-"
IE

>90

Wc can calctrlatc tlie rnargirral value in a I elationsl-r\r from thc slopc. Figrrle lA-3 shows the
nrarginal values for tu'o straight lines. Look first at
Figur-e lA-3(). Perhaps thc l valiablc is taxcs arrd
the Xvariable is income. Thcn thc slopc s lr-prcscrrLs
the nrarginal tax mte. For- cve n'rrnit ol .l taxes go up
b-v s units. For many taxpavct's, thc rnargiual tax rate
lvould be between 0.20 and 0.40.
Next exarine Figurc lA-3(a). Hclc, thc rrrar-ginal
raltre is negatir.e. This might rcplcsctrt what happcrrs
when a particular area is over-llshccl, whtrc tl)c Xvariable is nrrnrber ofboats and thc )'raliallc is tr;tal Iisll

catch. Because of overfislrirrg, the rnarginal catch tt r'

boat is acttulh' negatiye becarrse tlre stock of lish is

in

being depleted.
\l'e can also applv this concept ro <'rrrved lines.
W-}rat is the marginal valre at poitrt 1J it.r Firrrre lA-5?
ltl can calculate that each ,llN rrnirs of' .X pxrclrrce ,{
rurits of li The nrargitral value at R is als< tlre slope,

sanre c()rurtr-\,in 2000. \ve see thrr the PPI; has shiftd
fionr tlre inner I{XX) cur.r(' ro ihe ()uter 2000 cnrlc.

which is NJ/XIN. \ote that the m:rrginal valrre is

declining as Xincreises becaruse the crrn'e is coll<ave
or dome-shaped.
Qza'r.. \\?rat is the marginal r':rlue of rhe t'elatio.rship in Figure l.{-6 at point (,'? N{:rke slrre vou cltl
explain why the rnarginal valrre is zero.

Shifts of ond Movement olong Curves

An important distincrion in economics

is f hrt hetween
crrrves. \.['e r:arr
Fisure I A-7. The irt rrer

shifts of cur-ves and rnovernent

30

010203040506070
,:ood

FIGURE lA-7. Shift of Curves ycrsus Movcmcnt along

Curves
Irr rrsirrg grarlrs, it is essenrial to distinguish notanmtl alotg
< rrne (such as 1)'orn h igh-irrvesttnent 1) to lolv investntent
1: ) f onr a r,lrf/ of :r cru ve (;rs frrrnr /) in irn earl-v yeal to C
r

latel ve;rr).

(This shifi u'rrrld occur becarrse of technological

ch:rnge ol bec:rrrse of'an irrcrcasc in labor or capital
availahle.) In thc latcr vcar, socicty nright clroose to
be ar point G, r'itlr .norc lborl ancl rnachines tharr at
either' /l or ll.
The ;oint oI this cxarnplc is thaI ill the filst case
(rnoving frorr 1) to i) u.c scc ltto\culclll along the
crrrve, while in the second casc (frorn lJ to G) wc see
a sl.rift of the cttlc.

zrlor.rg

examine this distinction in

production-possibility flontier reprodrrces the PPliirr
Figure lA-2. At point 1) sociery clrooses tr) pl'()ducc
30 rrnits of food rr.rd 90 unit-s of ln:tchirrcs. lf'socictv
decides to consunle rnor e firrrrl with it givcrr PPd thcrr
it cttt rr., nlong the PPli to roirrl .f,,.'I'lris rnovcrut'rrt
along the cul-ve represents cho<rsing nron. fixrrl lrr<l
fewer machines.
Suppose thrt the innt'l- 1'Pli rel)rcscnls s()ci(.ty's
production pnssibilities fttr- 1990. Ifrve retrrn ro thc

Some Speciol Grophs

The /'1'lr is onc ol' thc lnost irnpoltalrL graphs of ecc
rt<llrics, orrc dcpictirrg thc rclatiorrship bctween tlvo
<'cortorrric val iablcs (srrch as lbod and nrachines cr
grrns :rrr<l 1)rrtter). lbu rvill encounter other types of
glaphs irr the pages that follorv.

Time Seies Sorrre graphs show horv ir prrticular

valiablt'has clrarrge<l orer tinre. [,ook, for example.
al th(' f{r'alllls on lhc inside liont cover of this texr.

23

SUMMARY TO APPENDIX

The lcft-hand graph shows a tnle series, sirce the

American Rc'volution, ol' a significant nlacroeconomic lariable, thc I atio of' thc f cclclal govct tllnent
debt to total gross tlolltestic product-this rati() s the
dbt-CDP lio. Tin'rc-scries graphs ltavc titnc ott the
horizontal axis and v:rriatles ol ilttcrcst (in tl.ris casc,
the debt-GDP ratio) on the vertical axis. '['[ris graph
shows that the debt-GDP ratio has riscn sharplv cluting every major war.

2,000

.e

0,000
a1
o
f

8,000

o
o)

6,000

o
oE

4.000

Scotter Diogroms Sometinres individual data poinLs

will be rlotted, as in Figure lA-1. Often, combinrtions of variables for different years will be plotted.
An important cxarnplt' of a scatter diagr:rnr fronr
macr<lecorr<rnics is thc runsutrtpliott Jiut.rlor, shoun in
Figure lA$. This scattcr cliagrarrt slrows thc nation's
total disposable illcolnc otl thc horizotrtal :rxis and

2,000
0

q)

(I

2,000 4.000 6,000 8,000 10,000 12,000

Personal disposable income (bllions)

total consumption (srnding ltv horscholds on goods

FIGURE lA-8. Scalter Diagram of Consumption

Function Sho*s Important Macroeconomic Iw

like food, clothing, and hotrsing) or) thc vertical

Thc dom show a scatter diagram of income anc'l con-

axis. Note that consumption is very closcly litrkctl ttl

srrrnrtiorr. Notc lrrw <krsr'thr: rclationship is between tlre

rwo. This fir'nrs tllc basis liu lhc I otsut: titnt [urtcliott ol'

income, a vital cltrc fbr ttndcrstancling chatrgcs irr

national income and ouLpttt.
Diogroms with Moe than One Cuve Oiicrt it is tlseful to put trlo curyes in the sante graph. thtrs obtaining a "mtrlticttne diagranr." Tlte rrttst itltPorlalrt

example is the supp|t-and<lemnnd diagrum, sltorvtr iu

Chapter 3 (see page 55). Strch graplts catr show two
different relationships simttltateortslr', sttch as how
consumer pttrchases respond to price (dcrnand) arrd
how business production responds t() pricc (supplv).

SUMl'IARY

mlcroecon()nlrcs.

Bv glaphirrg the nlo relationships together, we can

dctcrlnine the price and quantitl that will hold in a
rnarket.

Tlris conclrrdes our bdef excursion into graphs.

()nce,vorr lrave mastered these basic principles, the
graphs irr this book, and in other areas, can be both
frur and instnlctive.

APPENDX

t. Graphs arc n esseniial t<ol ol n.tode'n ecor<tnics.

They pr-()liric a ( ()nv(inienl l)t csetltati()n oI drta or ol
the relationshirs atnotrg variabl<:s.
inrportant poinLs lr) lln(l('rsttrrl ab<ttI a glarh irre:
\t'hat is on each <f the tw( axcs (lrrrizottlal n<l v<'ltF
cal)? What are the unils on each axis? What kir<l rf-

2. The

relatiorrship is depicted iu the cttt've or ctrrves sllrlvtt

in tht: glaph?
.'. The relationship lx twc('Ir thc two variablcs itr a crtt've is
given bv its slope. The slope is dcfirtctl as "lltt' rist' t vt'r

4.

the nrn." or thc itrcrcasc irt l'rcr rrnit itrcrease in X. lf

it is rrpw:rrd- (ol positivcly) skrrittg. lhc two variables
are dir'('ct[y relatctl: the,v move ttpwat<l oI tlowuward
togethef. ll thc cun'e has a dorvtrwal d (or ncgativc)
slope, tl.rc'two valiables irre invelsely related.
In addiLion, we sornetil)lcs see special types ofgraphs:
tirnc st'rics, uhich show how a particular vriable nroves
ovcr tinrc: stattcr rliagrarrts, which shorv obsen'ations
on l pair of vari:rbles; and multictrvc tliaglams, which
shory t1,,'() rr mol,e relationships in a single graph.

z4

APPENDIX

H0W To RF,AD GR{I'I

IS

CONCEPTS FOR REVIEW

Elements of Graphs

Examples of Graphs

llor irrtal, <lr ,\, axis

vcrtical, or li axis
slope as "rise over rull"

time-series graphs
scittter dragrtnls
ln t|lticrlr-vc gmphs

slopc (negatrve, postive, zer())

talrg('nt as slopc of rrrrvt'rl linc

QUESTTONS FOR DTSGUSSTON

l.

2.

(lonsidcr the fbllorving pr<>blcnr: Alicr vour fl hours a

dav t>f sleep, yotr have | (i h<rrr :t dv t(, divi(l(' llt:twct'rr
leisurc and stucly. [-et lcisrlt, llorrrs lx' tht. X varialr]t'
ancl strrdy houls bc tlrr: lvarialrl<.. l)lot the straighrlirrc
I elatir)nslri[) lrtwct'lt all rrlrr]rinatitns of Xand I'oll a
lrlank piece ofgraph papei lle clrrcfirl to label the rxes
and mark the <rigin.

Tblt.s." Cli< k on "Table L? (Real (iross Domesric

Prorluct)," which is rhc t<ttirl ()utpu( ()f the econom\,.
This will probahlv cornt. rrp witlr tirt qrrarter.ly clata.
a. (l()nstlrct a grirph that shows the tilne series lir
real GDP for the last sx qrmrt(,rs. Is thr: ucnr.rdl
trcnd trpward ol dorvltwarrl? (ln rnacroeconomics, wc will lclnr tlrat tllc skrnc is clownw..rd in

Irr question l, rvhirt is the skrpe ol rh<' lint- showing rlrc

rcllltionship berrvecn strdl,alr<l lt.isrrre lroLus--, Is it a

b.

3. [,et

rrs sa!' that !()u absolrrtr.ly nt.rrl 6 lrorrs of lcisrre

per dati no Inor r. n() k'sr. ()n tlrt. glaph, mar-k tlre
p()int that corrcsporr<ls to li horrs of leisrre. Now con-

4.
5.

ncw polnt
Next shorr a sht! oJ llt runu,;Yorr lincl that vou nccrl lt.ss
sleep. so,vou hve ll.l llorls a rlav tr rlcvote tr leisrrt'
and stu(h- Dr au' tlle llt'rv (shiftcd ) cur-r,c.
Ar srrgcsted in the sp<'cial secrion on time use, keep
a dian' of your time rsc bv halllhorr irrcrenretrts lbr
3 davs; record studving, sleerirrg, rvor-king, leistrr.e, anrl

other

tses. Then draw:r titn(' l)r(xhlctionlossibilitv

cune. like Figure lr!2, betrrcr.l l<.isrrrr.arrl all othcr
cti\ities. Locate eacll tl yrrrr 3 rlays on the ime l,l,l"
'l'hen put tlrt' avr:ra;t. fil all Anrericans on rhe sanre

6.

graph. How do yorr tornparc with the average persorri,

Go to the website of rhe Btu'eiru of Economic ,A.n;rlysis
ar uztttl.bce.K,u. Then click on "(ixrss l)omestic Plodr.rct." On the next page, click orr "lntcractive NIPA
(lala." Then click or "Frcqucntly Requested NIPA

straight line?

xi<lt'r a normnl ulon.g lhc cunte: Xtsume rhat yorr dccide

llrat yotr need onlv 4 horrs ol lcisure it day_ Plot the

( (1'sst()ns.

(instnrcr

7.

scltter plot showirrg "lmporS" on the

\'ertical axis ard "Grrss d<nlcstic procluct'on the
hodzrr.rtal axis. Describc the rclationship between
the numbers. (In macroecorrornics, this
mlrgrn;rl propenst,v t() imp(rrt. )

l.ill

be the

I'lrr. sloor: of a srnootlr

arc thc
('(lratiors frrr two iltvt.rst'<lrtnand cur.lr's (where price
is a ftnction of output), For cach cun, assume that
thc firncrion holds only wher.r l, > 0 and X > 0.
l'n' tholc uho hauc

.st

udied

lnh.

lirt or r'rrr ve is its tk r ivaivt.. Tlrr. firllirng

a. 1'- 100-5X
b. /'j- 100 - 20X+ lX:

Fo t'ach rk'rrrand crn'e. tlt'termine its slope rvhen

X - 0 and when .Y = l. F<r linelr demand cunes

such as a. what is the c()nditi()n rrnder which the larv ol

dorvnrvlrd-sloping dcmancl holds? ls cune b concale

(likc a donte) or convex (like a cup)?
E. The marginal value ol a crrvt.is its slox:, rvhich is thc
srnre as the firut rlt-rivativ<' 0f a frrrcti<tr1. Calculatc
algcbraicallv 1hc rrrar4irral t'flt't t of otrtput on price for
tlr< inverse denrarrd crrrves a and b in question 7. Pr.ovidc the rrrrerical marginal values at X = l0 for borh
denrand cnrles.