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CHAPTER 1 Economics: Foundations and Models n this book, we use economics to answer questions such as the following What determines the prices of goods and services from bottled water to smart People Economi phones to automobiles? mean tha Why have health care costs risen so rapidly? Why do firms engage in international trade, and how do government policies decision. informat such as tariffs, affect international trade? efits and Why does the government control the prices of some goods and services, and the cost mists as what are the effects of those controls? Economists do not always agree on the answer to every question, and there are lively compan of $625 debates on some issues. Because new economic questions are constantly arising, econ at Appl mists are always developing new methods to analyze them. choosin All the topics we discuss in this book illustrate a basic fact of life: To attain our goals, we the assu must make choices. We must make choices because we live in a world of scarcity, which that pe Scarcity A situation in which unlimited wants exceed the limited means that although our wants are unlimited, the resources available to fulfill those Peop resources available to fulfill those People wants. are limited. You might want to own a BMW and spend each summer vacationing at five-star European hotels, but unless Bill Gates is a close and generous relative, you probably lack the While funds to fulfill these wants. Every day, you make choices as you spend your limited income consist on the many goods and services available. The finite amount of time you have also limits often your ability to attain your goals. If you spend an hour studying for your economics mid- could of an term, you have one hour less to study for your history midterm. Firms and the government guard are in the same situation as you: They must also attain their goals with limited resources. rier,' in Economics The study of the choices Economics is the study of the choices consumers, business managers, and government advice people make to attain their goals, officials make to attain their goals, given their scarce resources. to $2 given their scarce resources. We begin this chapter by discussing three important economic ideas that we will benef return to many times in the following chapters: People are rational, people respond to economic tive t tional incentives, and optimal decisions are made at the margin. Then, we consider the three funda- threat mental questions that any economy must answer: What goods and services will be pro- duced? How will the goods and services be produced? and Who will receive the goods and appl services produced? Next, we consider the role of economic models in analyzing economic whet Economic model A simplified version of reality used to analyze issues. Economic models are simplified versions of reality used to analyze real-world and real-world economic situations. economic situations. We will explore why economists use models and how they construct them. Finally, we will discuss the difference between microeconomics and macroeconom- ics, and we will preview some important economic terms. Three Key Economic Ideas Obe EARNING OBJECTIVE: Explain these three key economic ideas: People are and rational, people respond to economic incentives, and optimal decisions are mas made at the margin. Acc Market A group of buyers and a bo sellers of a good or service and the Whether your goal is to buy a smartphone or find a part-time job, you will interact with with institution or arrangement by which they come together to trade, other people in markets. A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Examples 201 labor, Most of markets for smartphones, houses, haircuts, stocks labor, Most of economics involves analyzing how people ; stocks and bonds, and adu frequently: ula in markets. Here are the three important ideas about markets that we'll return to obe 1. People are rational. hoices and inter- 2. People respond to economic incentives. the 3. Optimal decisions are made at the margin. sity and intaThree Key Economic Ideas 5 People Are Rational Economists generally assume that people are rational. This assumption does not mean that economists believe everyone knows everything or always makes the "best" es, decision. It means that economists assume that consumers and firms use all available information as they act to achieve their goals. Rational individuals weigh the ben- efits and costs of each action, and they choose an action only if the benefits outweigh the costs. For example, if Apple charges a price of $649 for its new iphone, econo- mists assume that the managers at Apple have estimated that this price will earn the company the most profit. Even though the managers may be wrong-maybe a price of $625 or $675 would be more profitable-economists assume that the managers at Apple have acted rationally, on the basis of the information available to them, in choosing the price of $649. Although not everyone behaves rationally all the time, the assumption of rational behavior is very useful in explaining most of the choices that people make. MyLab Economics Concept Check People Respond to Economic Incentives People act from a variety of motives, including envy, compassion, and religious belief. While not ignoring other motives, economists emphasize that consumers and firms consistently respond to economic incentives. This point may seem obvious, but it is often overlooked. For example, according to an article in the Wall Street Journal, the FBI couldn't understand why banks were not taking steps to improve security in the face of an increase in robberies: "FBI officials suggest that banks place uniformed, armed guards outside their doors and install bullet-resistant plastic, known as a 'bandit bar- rier,' in front of teller windows." FBI officials were surprised that few banks took their advice. But the article also reported that installing bullet-resistant plastic costs $10,000 to $20,000, and a well-trained security guard receives $50,000 per year in salary and benefits. The average loss in a bank robbery is only about $1,200. The economic incen- tive to banks is clear: It is less costly to put up with bank robberies than to take addi- tional security measures. FBI agents may be surprised by how banks respond to the threat of robberies-but economists are not. In each chapter, the Apply the Concept feature discusses a news story or another application related to the chapter material. Read this Apply the Concept for a discussion of whether people respond to economic incentives even when deciding how much to eat and how much to exercise. MyLab Economics Concept Check Apply the Concept MyLab Economics Video Does Health Insurance Give People an Incentive to Become Obese? Obesity is a factor in a variety of diseases, including heart disease, stroke, diabetes, and hypertension, making it a significant health problem in the United States. Body mass index (BMI) is a measurement of a person's weight relative to the person's height. According to the U.S. Centers for Disease Control and Prevention (CDC), an adult with a body mass index (BMI) of 30 or greater is considered obese. For example, a 5'6" adult with a BMI of 30 is 40 pounds overweight. The following two maps show the dramatic increase in obesity between 1994 and 2015. In 1994, in a majority of states, only between 10 percent and 14 percent of the adult population was obese, and in no state was more than 20 percent of the adult pop- ulation obese. By 2015, in every state, at least 20 percent of the adult population was obese, and in 44 states, at least 25 percent of the adult population was obese. Many people who suffer from obesity have underlying medical conditions. For these people, obesity is a medical problem that they cannot control. The fact that obe- sity has increased, though, indicates that for some people, obesity is the result of diet and lifestyle choices. Potential explanations for the increase in obesity include greater intake of high-calorie fast foods, insufficient exercise, and a decline in the physicalamon Jay B and " Less You of th Op 10 Percentage of adult population that is obese Sor 30%-34% 235% wh 25%-29% Percentage of adult population that is obese 20%-24% you you 10%-14% 15%-19% (b) Obesity rates in 2015 litt (a) Obesity rates in 1994 sav Source: Centers for Disease Control and Prevention, "Prevalence of Self-Reported Obesity among U.S. Adults." all. Sta activity associated with many jobs. The CDC recommends that teenagers get a minimum of 60 minutes of aerobic exercise per day, a standard that only 15 percent of high school and students meet. In 1960, 50 percent of jobs in the United States required at least moderate ing physical activity. Today, only 20 percent of jobs do. As a result, a typical worker today red who may work at a computer is burning off about 130 fewer calories per workday than a add worker in the 1960s who was more likely to have worked in a manufacturing plant. ber In addition to eating too much and not exercising enough, could having health ma insurance be a cause of obesity? Obese people tend to suffer more medical problems m and so incur higher medical costs. Obese people with health insurance that will reim- whe burse them for only part of their medical bills, or who have no health insurance, must we pay some or all of these higher medical bills themselves. People with health insurance the that covers most of their medical bills will not suffer as large a monetary cost from you being obese. In other words, by reducing some of the costs of obesity, health insurance In may give people an economic incentive to gain weight. mi At first glance, this argument may seem implausible. Some people suffer from medical gr conditions that can make physical activity difficult or that can cause weight gain even with inv moderate eating, so they may become obese, regardless of which type of health insurance they have. The people who are obese because of poor eating habits or lack of exercise prob- yo ably don't consider health insurance when deciding whether to have a slice of chocolate ap cake or to watch Netflix instead of going to the gym. But if economists are correct about do the importance of economic incentives, then we would expect that if we hold all other ple personal characteristics such as age, gender, and income-constant, people with health ria insurance will be more likely to be overweight than people without health insurance. Jay Bhattacharya and Kate Bundorf of Stanford University, Noemi Pace of the University of Venice, and Neeraj Sood of the University of Southern California, have analyzed the effects of health insurance on weight. Using a sample that followed nearly 80,000 people from 1989 to 2004, they found that after controlling for factors include ing age, gender, income, education, and race, people with health insurance were sig nificantly more likely to be overweight than people without health insurance. Having In private health insurance increased BMI by 1.3 points. Having public health insurance Se such as Medicaid, which is a program under which the government provides health Th care to low-income people, increased BMI by 2.3 points. These findings do not mean po that health insurance is the sole cause, or even the most important cause, of obesity. the The findings do suggest that people respond to economic incentives even when maki ing decisions about what they eat and how much they exercise. In Section 1.3, we will S see that economists modify conclusions as they collect additional data. St Note: The exact formula for the body mass index is BMI = (Weight in pounds/ Height in inches?) X 703.Three Key Economic Ideas 7 Sources: Centers for Disease Control and Prevention, "Prevalence of Self-Reported Obesity among U.S. Adults," www.cdc. gov; Katherine M. Flegal, Margaret D. Carroll, Cynthia L. Ogden, and Lester R. Curtin, "Prevalence and Trends in Obesity among U.S. Adults, 1999-2008," Journal of the American Medical Association, Vol. 303, No. 3, January 20, 2010, pp. 235-241; Jay Bhattacharya, Kate Bundorf, Noemi Pace, and Neeraj Sood, "Does Health Insurance Make You Fat?" in Michael Grossman and Naci H. Mocan, eds., Economic Aspects of Obesity, Chicago: University of Chicago Press, 2011; and Tara Parker-Pope, "Less Active at Work, Americans Have Packed on Pounds," New York Times, May 25, 2011. Your Turn: Test your understanding by doing related problems 1.7 and 1.8 on page 23 at the end MyLab Economics Study Plan of this chapter. Optimal Decisions Are Made at the Margin Some decisions are "all or nothing." For instance, when an entrepreneur decides whether to open a new restaurant, she starts the new restaurant or she doesn't. When you decide whether to attend graduate school, you either enroll in graduate school or you don't. But rather than being all or nothing, most decisions in life involve doing a little more or a little less. If you are trying to decrease your spending and increase your saving, the decision is not really between saving all the money you earn or spending it all. Rather, many small choices are involved, such as whether to buy a caffe mocha at Starbucks every day or just once a week. inimum Economists use the word marginal to mean "extra" or "additional." Should you watch h school another hour of television or spend that hour studying? The marginal benefit (MB) of watch- oderate ing more television is the additional enjoyment you receive. The marginal cost (MC) is the er today reduction in your test score from having studied a little less. Should Apple produce an y than a additional 300,000 iPhones? Firms receive revenue from selling goods. Apple's marginal nt. benefit is the additional revenue it receives from selling 300,000 more iPhones. Apple's health marginal cost is the additional cost-for wages, parts, and so forth-of producing 300,000 oblems more iPhones. Economists reason that the optimal decision is to continue any activity up to the point reim- where the marginal benefit equals the marginal cost-that is, to the point where MB = MC. Often e, must we apply this rule without consciously thinking about it. Usually you will know whether urance the additional enjoyment from watching a television program is worth the additional cost t from you pay by not spending that hour studying without giving the decision a lot of thought. urance In business situations, however, firms often have to make careful calculations to deter- mine, for example, whether the additional revenue received from increasing production is medical greater or less than the additional cost of the production. Economists refer to analysis that n with involves comparing marginal benefits and marginal costs as marginal analysis. Marginal analysis Analysis that irance In each chapter, you will see the feature Solved Problem. This feature will increase involves comparing marginal benefits your understanding of the material by leading you through the steps of solving an and marginal costs. prob- applied economic problem. After reading the problem, test your understanding by colate doing the related problems that appear at the end of the chapter. You can also com- about plete Solved Problems on www.pearson.com/mylab/economics and receive tuto- other rial help. MyLab Economics Concept Check health of the Solved Problem 1.1 MyLab Economics Interactive Animation have The Marginal Benefit and Marginal Cost of Speed Limits early clud- e sig In an opinion column in the New York Times, economists speed limit unlikely to be optimal? How could a state high- aving Sendhil Mullainathan of Harvard University and Richard way department use marginal analysis to decide whether ance, Thaler of the University of Chicago noted, "We do not to increase the speed limit on a highway from 55 to ealth post 10-mile-per-hour speed limits on all highways, even 65 miles per hour? mean though that would be safer." Why is a 10-mile-per-hour esity. mak- Solving the Problem will Step 1: Review the chapter material. This problem is about making decisions, so you may want to review the section "Optimal Decisions Are Made at the Margin," which appears on this page.B CHAPTER 1 Economics: Foundations and Models Step 2: Discuss how we can decide what the optimal speed limit is and why it is unlikely to be 10 miles per hour. The faster people drive, the more every likely they are to have accidents because the less time they have to react to ing les problems on the highway. In addition, the faster a car or truck is traveling, the or ser more likely it is that an accident will cause damage to the vehicles involved of any that I and injuries to the vehicles' occupants. These are the main costs of increasing the speed limit. These costs will increase with each additional mile per hour imp the speed limit is increased. In other words, the marginal cost from increase instar Ford ing the speed limit is positive. Increasing the speed limit has benefits as well. The higher the speed limit, this the faster people and freight will reach their destinations. These benefits will you this increase with each additional mile per hour the speed limit is increased, so the marginal benefit from increasing the speed limit is positive. The optimal speed limit will be the one where the marginal cost of decreased safety equals que the marginal benefit of faster travel. We know that we have reached the op- 1. timal speed limit when increasing the limit further would result in marginal 2 . 3 cost being greater than marginal benefit. A 10-mile-per-hour speed limit would result in very long travel times. So, we can reasonably conclude that a 10-mile-per-hour speed limit isn't optimal because the marginal benefit from increasing it is likely to be much greater brie than the marginal cost. Step 3: Explain how a state highway department could use marginal analysis to WI decide whether to increase the speed limit on a highway from 55 to 65 Ho miles per hour. Increasing the speed limit by 10 miles per hour will reduce sm travel times for people and freight-so there will be a marginal benefit-but do will likely also increase the number of accidents and the damage from those wh accidents. The state highway department should try to estimate the dollar val- ues of the marginal cost and marginal benefit of making the change. If the ser marginal benefit is greater than the marginal cost, the speed limit should be increased. Although it can be difficult to assign dollar values to the marginal ch benefit and marginal cost of an action, marginal analysis captures the steps m you can follow to make optimal decisions in many situations. sp Extra Credit: Suppose that the highway department calculates that increasing the rep speed limit will result in reduced travel time valued at $100 million. This information cy would not be enough to decide that the speed limit should be raised because it repre- Ar sents only the marginal benefit from the higher speed limit. If the dollar value of more be severe accidents from greater speed turns out to be $125 million, then the marginal cost of increasing the speed limit would be greater than the marginal benefit, and the speed H limit should not be raised. Marginal benefit and marginal cost both have to be consid ered in arriving at an optimal decision. Fi fa 2016. MyLab Economics Study Plan Source: Sendhil Mullainathan and Richard Thaler, "Waiting in Line for the Illusion of Security," New York Times, May 27, Your Turn: For more practice, do related problems 1.9 and 1.10 on page 23 at the end of this chapter. Aid sister blood wold dumbgo oriw sbloob on eladens to mort vewdgirl s no The Economic Problem That Every Society Must Solve LEARNING OBJECTIVE: Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? Because we live in a world of scarcity, any society faces the economic problem that it has only a limited amount of economic resources-such as workers, machines, and raw materials-and so can produce only a limited amount of goods and services. Therefore,The Economic Problem That Every Society Must Soive 9 Thy ore to every society faces trade-offs: Producing more of one good or service means produc- Trade-off The idea that, because of scarcity, producing more of one good the ing less of another good or service. The best measure of the cost of producing a good or service means producing less of another good or service. red or service is the value of what has to be given up to produce it. The opportunity cost of any activity-such as producing a good or service-is the highest-valued alternative ng that must be given up to engage in that activity. The concept of opportunity cost is very Opportunity cost The highest- Pur important in economics and applies to individuals, firms, and society as a whole. For valued alternative that must be given instance, suppose that you earn a salary of $100,000 per year working as a manager for up to engage in an activity. Ford. You decide to leave your job and open your own management consulting firm. In this case, the opportunity cost of the labor you supply to your own firm is the $100,000 you give up by not working for Ford, even if you do not explicitly pay yourself a salary. As in this example, opportunity costs often do not involve actual payments of money. Trade-offs force society to make choices when answering three fundamental questions: 1. What goods and services will be produced? 2. How will the goods and services be produced? 3. Who will receive the goods and services produced? Throughout this book, we will return to these questions many times. For now, we briefly introduce each question. What Goods and Services Will Be Produced? How will society decide whether to produce more economics textbooks or more smartphones? More daycare facilities or more football stadiums? Of course, "society" doesn't make decisions; only individuals make decisions. The answer to the question of what will be produced is determined by the choices that consumers and people work- ing for firms or the government make. Every day, you help decide which goods and services firms will produce when you choose to buy an iphone instead of a Samsung Galaxy or a caffe mocha rather than a chai tea. Similarly, managers at Apple must choose whether to devote the company's scarce resources to making more iphones or more smartwatches. Members of Congress and the president must choose whether to spend more of the federal government's limited budget on breast cancer research or on repairing highways. In each case, consumers, managers of firms, and government poli- cymakers face the problem of scarcity by trading off one good or service for another. And each choice made comes with an opportunity cost, measured by the value of the best alternative given up. MyLab Economics Concept Check How Will the Goods and Services Be Produced? Firms choose how to produce the goods and services they sell. In many cases, firms face a trade-off between using more workers and using more machines. For example, a local service station has to choose whether to provide car repair services using more diagnostic computers and fewer auto mechanics or fewer diagnostic computers and more auto mechanics. Similarly, movie studios have to choose whether to produce ani- mated films using highly skilled animators to draw them by hand or fewer animators and more computers. In deciding whether to move production offshore to China, firms may need to choose between a production method in the United States that uses fewer workers and more machines and a production method in China that uses more work- ers and fewer machines. MyLab Economics Concept Check Who Will Receive the Goods and Services Produced? In the United States, who receives the goods and services produced depends largely on how income is distributed. The higher a person's income, the more goods and ser- vices he or she can buy. Often, people are willing to give up some of their income- and, therefore, some of their ability to purchase goods and services-by donating to charities to increase the incomes of poorer people. Americans donate more than $370 billion per year to charity, or an average donation of about $2,900 for each household in the country. An important policy question, however, is whether the10 CHAPTER 1 Economics: Foundations and Models government should intervene to make the distribution of income more equal. Such intervention already occurs in the United States because people with higher incomes pay a larger fraction of their incomes in taxes and because the government makes payments to people with low incomes. There is disagreement over whether the cur- rent attempts to redistribute income are sufficient or whether there should be more MyLab Economics Concept Check or less redistribution. Centrally Planned Economies versus Market Economies To answer the three questions-what, how, and who-societies organize their econo- mies in two main ways. A society can have a centrally planned economy in which Centrally planned economy An the government decides how economic resources will be allocated. Or a society can economy in which the government have a market economy in which the decisions of households and firms interacting in decides how economic resources will be allocated markets allocate economic resources. From 1917 to 1991, the most important centrally planned economy in the world Market economy An economy in was that of the Soviet Union, which was established when Vladimir Lenin and the Com- which the decisions of households and firms interacting in markets munist Party staged a revolution and took control of the Russian Empire. In the Soviet allocate economic resources. Union, the government decided what goods to produce, how the goods would be pro- duced, and who would receive the goods. Government employees managed factories and stores. The objective of these managers was to follow the government's orders rather than to satisfy the wants of consumers. Centrally planned economies like that of the Soviet Union have not been successful in producing low-cost, high-quality goods and services. As a result, the standard of living of the average person in a centrally planned economy tends to be low. All centrally planned economies have also been political dictatorships. Dissatisfaction with low living standards and political repress sion finally led to the collapse of the Soviet Union in 1991. Today, only North Korea still has a completely centrally planned economy. All high-income democracies, including the United States, Canada, Japan, and the countries of Western Europe, have market economies. Market economies rely primar ily on privately owned firms to produce goods and services and to decide how to pro- duce them. Markets, rather than the government, determine who receives the goods and services produced. In a market economy, firms must produce goods and services that meet the wants of consumers, or the firms will go out of business. In that sense, it is ultimately consumers who decide what goods and services will be produced. Because firms in a market economy compete to offer the highest-quality products at the lowest price, they are under pressure to use the lowest-cost methods of produc- tion. For example, as we saw in the chapter opener, Ford moved some production to Mexico to lower its production costs in the face of competition from both foreign and domestic car firms. In a market economy, the income of an individual is determined by the payments he receives for what he or she has to sell. If you become a civil engineer, and firms are willing to pay a salary of $85,000 per year for someone with your training and skills, you will have this amount of income to purchase goods and services. If you also buy a house that you rent out, your income will be even higher. One of the attractive features of mar- kets is that they reward hard work. Generally, the more extensive the training you have received and the longer the hours you work, the higher your income will be. Of course, luck-both good and bad-also plays a role here, Someone might have a high income because she won the state lottery, while someone else might have a low income because he has severe medical problems, We can conclude that market economies respond to the question "Who receives the goods and services produced?" with the answer "Those who are most willing and able to buy them." The Modern "Mixed" Economy MyLab Economics Concept Check In the 1800s and early 1900s, the U.S. government engaged in relatively little regu- lation of markets for goods and services. Beginning in the mid-1900s, govern- ment intervention in the economy dramatically increased in the United States and other market economies. This increase was primarily caused by the highThe Economic Problem That Every Society Must Solve 11 Such omes unemployment and business bankruptcies during the Great Depression of the lakes 1930s. Some government intervention was also intended to raise the incomes of the cur- elderly, the sick, and people with limited skills. For example, in the 1930s, Congress ore established the Social Security system, which provides government payments to retired Check and disabled workers, and enacted minimum wage legislation, which sets a floor on the wages employers can pay workers in many occupations. In more recent years, government intervention in the economy has also expanded to meet goals such as no- protecting the environment, promoting civil rights, and providing medical care to ich low-income and elderly people. Some economists argue that the extent of government intervention makes it no an longer accurate to refer to the economies of the United States, Canada, Japan, and West- in ern Europe as pure market economies. Instead, they should be called mixed economies. A mixed economy is still primarily a market economy because most economic deci- Mixed economy An economy in sions result from the interaction of buyers and sellers in markets. However, the gov- which most economic decisions result from the interaction of buyers ernment plays a significant role in the allocation of resources. As we will see in later and sellers in markets but in which chapters, economists continue to debate the role government should play in a market the government plays a significant economy. role in the allocation of resources. One of the most important developments in the international economy in recent years has been the movement of China from being a centrally planned economy to being a mixed economy. The Chinese economy suffered decades of economic stagna- tion following the takeover of the government in 1949 by Mao Zedong and the Com- munist Party. Although China remains a political dictatorship, the production of most goods and services is now determined in the market rather than by the government. The result has been rapid economic growth that has lifted more than a billion people in China out of poverty. MyLab Economics Concept Check Efficiency and Equity Market economies tend to be more efficient than centrally planned economies. There are two types of efficiency. Productive efficiency occurs when a good or service is Productive efficiency A situation produced at the lowest possible cost. Allocationefficiency occurs when production in which a good or service is is in accordance with consumer preferences. Markets tend to be efficient because they produced at the lowest possible cost. promote competition and facilitate voluntary exchange. With voluntary exchange, Allocationficiency A state of both the buyer and the seller of a product are made better off by the transaction. We the economy in which production know that they are both made better off because, otherwise, the buyer would not have is in accordance with consumer agreed to buy the product or the seller would not have agreed to sell it. Productive effi- preferences; in particular, every ciency is achieved when competition among firms forces them to produce goods and good or service is produced up to the services at the lowest cost. Allocation efficiency is achieved when the combination point where the last unit provides a of competition among firms and voluntary exchange between firms and consumers marginal benefit to society equal to results in firms producing the mix of goods and services that consumers prefer the the marginal cost of producing it. most. Competition will result in firms continuing to produce and sell goods and ser- Voluntary exchange A situation vices as long as the additional benefit to consumers is greater than the additional cost that occurs in markets when both the of production. In this way, the mix of goods and services produced will match con- buyer and the seller of a product are sumer preferences. made better off by the transaction. Although markets promote efficiency, they don't guarantee it. Inefficiency can arise from various sources. For instance, it may take some time for firms to learn how to efficiently produce a good or service. When smartphones were introduced, firms did not instantly achieve productive efficiency because it took time to discover the lowest-cost method of producing this good. As we will discuss in later chapters, inefficiency can also arise if governments interfere with voluntary exchange in mar- kets. For example, many governments limit the imports of some goods from foreign countries. This limitation reduces efficiency by keeping goods from being produced at the lowest cost, a point we discuss further in the Apply the Concept on page 15. The production of some goods damages the environment, In this case, government inter- vention can increase efficiency because without such intervention, firms may ignore est possible cost. the costs of environmental damage and thereby fail to produce the goods at the low-12 CHAPTER 1 Economics: Foundations and Models Not everyone will consider a particular outcome to be desirable, even if the outcome is economically efficient. Many people prefer economic outcomes that they consider fair For or equitable, even if those outcomes are less efficient. Equity is harder to define than An efficiency because there isn't an agreed-upon definition of fairness. For some people, such Equity The fair distribution of economic benefits. equity means a more equal distribution of economic benefits than would result from an hy emphasis on efficiency alone. For example, some people support raising taxes on peo- inco ple with higher incomes to provide the funds for programs that aid the poor. Although inc governments may increase equity by reducing the incomes of high-income people and rest increasing the incomes of the poor, these policies may reduce efficiency. People have rect less incentive to open new businesses, work hard, and save if the government takes a sig- ers, nificant amount of the income they earn from working or saving. The result is that fewer rob goods and services are produced, and less saving takes place. As this example illustrates, pro there is often a trade-off between efficiency and equity. Government policymakers frequently eco MyLab Economics Concept Check sta MyLab Economics Study Plan confront this trade-off. low Economic Models rel LEARNING OBJECTIVE: Explain how economists use models to analyze us economic events and government policies. As mentioned at the start of the chapter, economic models are simplified versions of reality. Many professions rely on models: An engineer may use a computer model of a bridge to help test whether it will withstand high winds, or a biologist may make a physi- cal model of a nucleic acid to better understand its properties. Economists rely on eco- nomic models, or theories, to analyze real-world issues ranging from the effects of tariffs on the prices of imported goods to the most efficient policies for reducing pollution. (This book uses the words model and theory interchangeably.) One purpose of economic models is to make economic ideas sufficiently explicit and concrete so that individuals, firms, or the government can use them to make decisions. For example, we will see in Chapter 3 that the model of demand and supply is a simplified version of how the prices of products are determined by the interactions among buyers and sellers in markets. Economists use economic models to answer questions such as "How many people will be employed in manufacturing in 2024?" Economists at the U.S. Bureau of Labor Statistics (BLS) build models that allow them to forecast future employment in different occupations. The BLS models provide estimates of future demand for U.S. manufacturing production and estimates of how many employees manufacturing firms will require to produce that level of output. As mentioned at the beginning of the chapter, the BLS fore- casts that employment in manufacturing will decline significantly by 2024. Sometimes economists use an existing model to analyze a real-world problem or issue, but in other cases, they have to develop a new model. To develop a model, econo- mists generally follow these steps: 1. Decide on the assumptions to use. 2. Formulate a testable hypothesis. 3. Use economic data to test the hypothesis. 4. Revise the model if it fails to explain the economic data well. 5. Retain the revised model to help answer similar economic questions in the future. The Role of Assumptions in Economic Models Any model is based on assumptions because models have to be simplified to be useful. Economic models make behavioral assumptions about the motives of consumers and firms. Economists assume that consumers will buy the goods and services that will maximize their well-being or their satisfaction. Similarly, economists assume that firms act to maxi- mize their profits. These assumptions are simplifications because they do not describe the motives of every consumer and every firm. How can we know whether the assumptions in a model are too simplified or too limiting? We can determine the usefulness of assump- using real-world information. tions by forming hypotheses based on the assumptions and then testing the hypotheses MyLab Economics Concept CheckEconomic Models 13 itcome der fair e than Forming and Testing Hypotheses in Economic Models eople, An economic variable is something measurable that can have different values, Economic variable Something om an such as the number of people employed in manufacturing. In an economic model, a measurable that can have different peo- hypothesis is a statement about an economic variable that may be either correct or values, such as the number of people incorrect. An example of a hypothesis in an economic model is the statement that employed in manufacturing. tough e and increased use of industrial robots and information technology in U.S. factories has have resulted in a decline in manufacturing employment. The hypothesis may be cor- a sig- rect if the main effect of industrial robots has been to replace assembly line work- ewer ers, thereby reducing employment. Or the hypothesis may be incorrect if the use of ates, robots and other information technology has increased firms' demand for software ntly programmers and other technology workers, thereby increasing employment. An Check economic hypothesis is usually about a causal relationship; in this case, the hypothesis states that increased use of robots and information technology causes, or leads to, lower employment in manufacturing. Before we can accept a hypothesis, we have to test it by analyzing statistics on the relevant economic variables. In our example, we would gather statistics on how the use of industrial robots and information technology in manufacturing has changed over time, on employment in manufacturing, and perhaps on other variables. Testing a hypothesis can be tricky, For example, showing that employment in manufacturing declined at the same time that use of robots increased would not be enough to demon- strate that the increased use of robots caused the decline in employment. Just because two things are correlated-that is, they happen at the same time-does not mean that one caused the other. For example, suppose that at the same time that use of robots in U.S. manufacturing was increasing, U.S. manufacturing firms faced declining sales due to increased competition from foreign firms. In that case, the declining sales, rather than the increased use of robots, may explain the decrease in U.S. manufacturing employment. Over a period of time, many economic variables change, which compli- cates the testing of hypotheses. In fact, when economists disagree about a hypothesis, it is often because of disagreements over interpreting the statistical analysis used to test the hypothesis. Note that hypotheses must be statements that could, in principle, turn out to be incorrect. Statements such as "Increasing employment in manufacturing is good" or "Increasing employment in manufacturing is bad" are value judgments rather than hypotheses because it is not possible to disprove them. Economists accept and use an economic model if it leads to hypotheses that are confirmed by statistical analysis. In many cases, the acceptance is tentative, how- ever, pending the gathering of new data or further statistical analysis. In fact, econo- mists often refer to a hypothesis having been "not rejected" rather than having been "accepted" by statistical analysis. But what if statistical analysis clearly rejects a hypoth- esis? For example, what if a model leads to a hypothesis that increased use of indus- trial robots will cause a decline in manufacturing employment, but the data reject this hypothesis? In this case, the model should be reconsidered. It may be that an assump- tion used in the model was too simplified or too limiting. For example, perhaps the vionA model ignored the fact that the mix of products being manufactured in the United vienA Su States was changing. For example, perhaps the assembly of electric cars requires more workers than does the assembly of gasoline-powered cars. Or perhaps the model did not include the effect of tariffs on the demand for U.S. manufactured goods because such tariffs had typically been low. If tariffs sharply increase, the model may not be able to accurately estimate the relationship between changes in the use of industrial robots and changes in employment. As we saw at the beginning of the chapter, the U.S. Bureau of Labor Statistics (BLS) has forecast that total employment in U.S. manufacturing will decline from 12.3 million in December 2016 to 11.4 million in 2024, The BLS periodically analyzes the accuracy of its projections. It has had difficulty accurately projecting manufacturing employ- ment. For example, in 2000, the BLS projected that in 2010, 19,047,000 people would be employed in manufacturing. In fact, in 2010, only 11,529,000 people were employed mommen in manufacturing. The BLS concluded that this large error was the result of its model14 CHAPTER 1 Economics: Foundations and Models failing to account for the extent to which U.S. firms would move manufacturing oper. 20 m ations overseas, how quickly firms would improve their ability to produce the same output with fewer works, and the lasting effects of the severe 2007-2009 recession Analyzing its errors helps the BLS to improve its models and employment projections. The process of developing models, testing hypotheses, and revising models occurs not just in economics but also in disciplines such as physics, chemistry, and biology. This process is often called the scientific method. Economics is a social MyLab Economics Concept Check science because it applies the scientific method to the study of the interactions among individuals. Positive and Normative Analysis Throughout this book, as we build economic models and use them to answer questions, bear in mind the following important distinction: Positive analysis is concerned with Positive analysis Analysis what is, and normative analysis is concerned with what ought to be. Economics is about concerned with what is. positive analysis, which measures the costs and benefits of different courses of action. We can use the federal government's minimum wage law to compare positive and Normative analysis Analysis concerned with what ought to be. normative analysis. In 2017, under this law, it was illegal for an employer to hire a worker at a wage less than $7.25 per hour. (Some states and cities had enacted higher minimum wages.) Without the minimum wage law, some firms and workers would voluntarily agree to a lower wage. Because of the minimum wage law, some workers have difficulty finding jobs, and some firms end up paying more for labor than they otherwise would have. A positive analysis of the federal minimum wage law uses an economic model to estimate how many workers have lost their jobs because of the law, its effect on the costs and profits of businesses, and the gains to workers receiving the minimum wage. After economists complete this positive analysis, the decision as to whether the minimum wage law is a good or a bad idea is a normative one and depends on how people evaluate the trade-off involved. Supporters of the law believe that the losses to employers and workers who are unemployed as a result of the law are more than offset by the gains to workers who receive higher wages than they would without the law. Opponents of the law believe the losses are greater than the gains. The assessment by any individual depends, in part, on that person's values and political views. The positive analysis an economist provides would play a role in the decision but can't by itself decide the issue one way or the other. In each chapter, you will see a Don't Let This Happen to You box like the one below. These boxes alert you to common pitfalls in thinking about economic ideas. After read- ing this box, test your understanding by working the related problem or problems at the end of the chapter. MyLab Economics Concept Check Don't Let This Happen to You Don't Confuse Positive Analysis with Normative Analysis have jobs benefit from the minimum wage law because they "Economic analysis has shown that the minimum wage law is are paid a higher wage than they otherwise would be. In other a bad idea because it causes unemployment." Is this statement words, the minimum wage law creates both losers-the workers accurate? As of 2017, the federal minimum wage law prevents who become unemployed and the firms that have to pay higher employers from hiring workers at a wage of less than $7.25 per wages-and winners-the workers who receive higher wages. hour. This wage is higher than some employers are willing to pay Should we value the gains to the winners more than we some workers. If there were no minimum wage law, some work- value the losses to the losers? The answer involves norma- ers who currently cannot find any firm willing to hire them at tive analysis. Positive economic analysis can show the conse- $7.25 per hour would be able to find employment at a lower quences of a particular policy, but it cannot tell us whether the wage. Therefore, positive economic analysis indicates that the minimum wage law causes unemployment, (In Chapter 4, we'll policy is "good" or "bad." So, the statement at the beginning of this box is inaccurate. explore why economists disagree about how much unemploy- MyLab Economics Study Plan ment the minimum wage law causes.) But some workers who Your Turn: Test your understanding by doing related problems 3.6 and 3.7 on page 25 at the end of this chapter.Economic Models 15 er- me Economics as a Social Science on. Because economics studies the actions of individuals, it is a social science. Econom- ics is therefore similar to other social science disciplines, such as psychology, political ry, science, and sociology. Economics differs from other social sciences because it puts ial more emphasis on how the decisions of individuals explain outcomes such as the prices firms charge or the policies governments enact. Economics considers individual decision making in every context, not just in the context of business. Economists have studied issues such as why people have difficulty losing weight or attaining other goals, why people sometimes ignore relevant information when making decisions, and how couples decide to divide up household chores. Government policymakers have also increasingly relied on economic analysis when evaluating laws or regulations. As we will see throughout this book, economists have played an important role in influence ing government policies in areas such as the environment, health care, and efforts to reduce poverty. MyLab Economics Concept Check Apply the Concept MyLab Economics Video What Can Economics Contribute to the Debate over Tariffs? What effect would proposed tariffs on imports of goods from Mexico and other countries have on the U.S. economy? Governments typically impose tariffs to raise revenue or to discourage imports by raising the selling prices of imported goods. If imports of goods decline, production and employment at domestic firms that compete with imports may increase. For example, a tariff on imports of cars assembled in Mexico would raise their prices and lead U.S. consumers to buy more cars assembled in the United States. We can create a preliminary list of potential winners and losers in a country that imposes a tariff: The govern- ment gains from collecting the tariff revenue, and domestic firms and their work- ers gain from the higher prices of competing imported goods. Consumers lose because they pay higher prices for goods on which the tariff has been enacted. If some of the imported goods are used as inputs or are sold by domestic firms- for example, Walmart may sell imported tires on which Congress has enacted a Erika Skogg/National Geographic/Getty images tariff-those firms will also lose from the tariff Because of its fertile soil and warm Economics can provide valuable information to policymakers and the general pub- limate, Colombia has a comparative lic as they consider actions such as implementing tariffs. As we will discuss further in advantage in coffee bean production Chapters 2 and 9, economic analysis shows that trade between countries occurs pri- relative to the United States. marily on the basis of comparative advantage. A country has a comparative advantage if it can produce a good at a lower opportunity cost than competitors. For example, due to the climate and soil in Colombia, coffee can be grown there without requiring the transfer of significant resources from producing other goods and services-so the opportunity cost of producing coffee in Colombia is low. The United States is not well suited for producing coffee, so the opportunity cost of producing coffee in the United States is very high. We can conclude that Colombia has a comparative advantage rela- tive to the United States in producing coffee. Imposing a tariff on imports to the United States of Colombian coffee would reduce economic efficiency by shifting production of coffee from Colombia, where it can be grown at a low cost, to the United States, where it can only be grown at a high cost. Economists can use models to estimate the dollar amounts gained by the winners from the imposition of a tariff, the amount lost by the losers, and the size of the loss of economic efficiency. Economic analysis of tariffs typically shows that the dollar losses from the government imposing a tariff are larger than the dollar gains, so the tariff causes a net loss for the country as a whole. Although economic analysis can contribute to the debate over policy proposals by measuring their likely effects, it cannot by itself decide whether a proposal should be enacted. Policymakers and a majority of the general public may decide to enact a tariff because they place a higher value on the gains to some groups-workers and firms16 CHAPTER 1 Economics: Foundations and Models struggling to compete against imported goods-than on the losses to other groups consumers as a whole. In other words, policymakers and the general public would be making a normative judgment in favor of tariffs. Ultimately policymakers and the gen- eral public are responsible for weighing trade-offs and deciding whether a proposal Sources: John D. Stoll, "Donald Trump, GM, Ford and the Made-in-Mexico Car," Wall Street Journal, January 3, 2017; Man. should be enacted. Anastasia O'Grady, "Texas and the Real Forgotten Man," Wall Street Journal, February 12, 2017; and David Welch and Days Merrill, "Why Trump Tariffs on Mexican Cars Probably Won't Stop Job Flight," bloomberg.com, January 4, 2017. Your Turn: Test your understanding by doing related problem 3.8 on page 25 at the end of this MyLab Economics Study Plan chapter. Microeconomics and Macroeconomics EARNING OBJECTIVE: Distinguish between microeconomics and macroeconomics. Economic models can be used to analyze decision making in many areas. We group some of these areas together as microeconomics and others as macroeconomics. Microeco- Microeconomics The study of how nomics is the study of how households and firms make choices, how they interact in households and firms make choices, markets, and how the government attempts to influence their choices. Macroeconomics how they interact in markets, and how the government attempts to is the study of the economy as a whole, including topics such as inflation, unemploy- influence their choices. ment, and economic growth. Table 1.1 gives examples of microeconomic and macro- Macroeconomics The study of the economic issues. economy as a whole, including topics The division between microeconomics and macroeconomics is not a bright line. such as inflation, unemployment, and Many economic situations have both a microeconomic aspect and a macroeconomic economic growth. aspect. For example, the level of total investment by firms in new machinery and equipment helps to determine how rapidly the economy grows-which is a macroeco- nomic issue. But to understand how much new machinery and equipment firms decide to purchase, we have to analyze the incentives individual firms face-which is a micro- MyLab Economics Study Plan economic issue. MyLab Economics Concept Check Table 1.1 Examples of Microeconomic Issues Examples of Macroeconomic Issues issues in Microeconomics and How consumers react to changes in Why economies experience periods Macroeconomics product prices of recession and increasing How firms decide what prices to charge for the products they sell unemployment Which government policy would most . Why, over the long run, some economies efficiently reduce obesity have grown much faster than others The costs and benefits of approving the What determines the inflation rate sale of a new prescription drug . What determines the value of the U.S. The most efficient way to reduce air dollar in exchange for other currencies pollution . Whether government intervention can reduce the severity of recessions 1.5 Economic Skills and Economics as a Career LEARNING OBJECTIVE: Describe economics as a career and the key skills you can gain from studying economics. How do economists do what they do? The following analogy may be helpful: When people are thinking of buying a house, they may hire a structural engineer as a con- sultant to examine the house and prepare a report. The engineer's report is likely to both describe any problems with the house-like cracks in the foundation-and advise the potential buyer how to fix the problems and the likely cost. You have seen that economics is about making choices. Economists spend much of their time describing how individuals, businesses, and governments make choices and analyzing the results of the choices. Then, like a structural engineer advising