pARr oryC

Basic Concepts

The Central Concepts of Economics

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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.

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4sorne of the majrlr srrbjects that are c

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socicty in a wa\, !r'hicll pr'(xlrces the rn()st cflicicnt.usc rf resotrrces. Tllat is wlrcre ectrtlnics nirkcs ilsrrnitue corrtbution.

Microeco no mics on d Mo croe con o micsEctnornics is today dividecl into trtr rnajor srbfields,microeconornics :rnd macroeconomics. Aclaln Smithis usurllv considered the founder of microeconomics.the branch of econ

6I'uilurc to hokl olha lhings ron.stnnt. A second Pit-fnll is lailrrrc to hold otlrer things colrst?rltt r\'hentlriukirrg about an issrre. For example, tt'rrlight\\alrt to kr)ow rvhcthcl- r:rising tax rates rvill laiseor lolvcr tAX lc-vcllucs. Sorne people h;rrc lltttlirrtlr tlre scdrrctir t- argunlent that we cln (':ltorr list al crkc ancl h:r'r'c it too. Thev argrrt' tltat( ulting tax ratcs rrill al lhe sanle tittte t':tisc 4or-cl nlrrcnt lcvclrucs and lon'er the btrdget rk'fir-it.'l'hcr -loirrt tr thc KennedlJolrnson tax cllts ()fItlti4. wlliclr lowcrccl tax rates sharplv and nttr-lbllowcrl by irn incr-ease in gcr'enrInerrt revertu('sirr tlXil-r. Hcnce, tlrev argrre, lower t:rx rates l)r'(Frlr rcc higher levenl res.

\\'hv is tllis rersolring frllaciorrs? The:rrgtr-Ilt(.nl ilssllnre\ llr;rl ()ll)er' lhings u'( l'(' coltslanl-irr ralticrrlar-, it

(:(x)l_ H lAl)s Al THU StRVI(;t: ()l'WARi\f It.tAt{ls

rrrerrpl()\'mcnt an(l inf lati()n, lbnt ulas lirr investirrgvorrr rcliremcDt f uncls, and pr

fcnerated fionl oil. li0rrl coal, tlr fi-oltr the stttli'V[ill factories be ntrt by .rcoplc or r obots?

o lior uhont:rre qoods rrotlttcctl? \\/lto gcts lo catthe fruit of econonric activitv? ls tltc tlistl ilrrrtirno[ inconre and lvealth fiir:rrrtl cttritablc? Howis the national product diriderolirlc rninirual ( ()nsrIt)pti()tl to th(: P()()r, ot'ntU\l l)(1)l)lc rlok if the\. ill('l(, ('ittr

MARKET, COMMAND, AND MIXEDECONOMIESWlrat ar t' tlrc

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Alternative Production PossibltesButter Gurs

Possibilities (rnilliqns6fpsrrds) (thousands)ABCDEF

0I2J

4

l514t2I50

TABLE l- l. Limitation of Scarce Resourccs Inplies theGuns-Butter TradeoffScarce inpuLs and technology- imply that the productiottol guns and butter is limitect. As rve go from A to B . . .to F, rvc arc transfclring labor, rnachires. and lrnd f-drrction nrirs fronr Table l-1.

combinations of guns and butter, we lrave thc con-tinuntrs greerr cun'e shorvn 's Lh.: lrodudionlossibilityftanlin: or PPl, irr Figurc l-2

Thc productiorpossibility frontier (or PPf ) shossthe rnuximrrn quurtity of goods that c:rrr be cfficicnthproduccd bv arr ccn

THE PRODUCTION-POSS BII,ITY FRONTI ER

The Productlon-Posslblllty FrontlerG

tl

FIGURE l-2. A Smooth Curve C.onnecfs the Plotted Poinaof the NumcricI Production PocsibilitiesThis frontier shorvs the schedule along which society can cho

t2 CHAPTER I THE (]EiTRAL C]ON(:EPTS OF E(:O\IONIICS

(a) Frontier Society (b) Urban Society

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 gocxlslike clean air or public health. (b) A modern rtrbanized ec

II It. t'R( )t)t ( i ( )N-t'( )sstBlt.t l-\'lfR()\'l:R

()ut tlre II'I'. The figure also illrstr:rtes that poorc()untries must dev()te rnosI of their resrrrrces tofbocl orodtrcrion rvhilc rich corr'rtlit:s can affordrrrrt: luxrrries :rs prodrrctivt' potential i rrcr-t';rscs.

Figrrr-e l-4 depicts tlre choice l-x'trr,ecn plivatcgoods (horrght:rt a prcc) and public goods (pairl ftrr'bv taxes). Pror conrtries call afIord littlc of prrblicgoods like puhlic healtlr arrd prirnan' cdrrcation. thrtrvifh

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Lct's scc wlrv productivt't'f ficicncy leqrtires beingon tllc PP1'l Start in thc situation shown by point /)in Figtrrc l-2. Sav thc rnar-kct calls for another rnil-lit.rn 1-roun

SUMMARY

l5

A.l.

B.

4.

Why Study Economics?Wh:rt is economics? [,c

t CHAPTER I I t,. (:l.tN IR{t (,()N(.F.PTS OF F_CO\O! cS

FURTHER READING AND INTERNET WEBSITESFurther ReadingRobert Heilbroner, -fh.e lVnltll I>hilotolr:r. Ttlr trl.(Toucl.tstone Books, 1999). provides u lilclv bioglarlrv olthe great economism along with thcir irlcas artd intract.'.l he arrthoritative work on tlre lristotl ol ccttrr>rnic lurlvsisis.frrst:rlr Sclrrrnrpeter, Histul ol h otont. ,'lnuh.l.s (lr{c(iraw-Hill, Neu'York, l9li4).Websites()rrr.- ol the greatest books ol rll econorrtics is -\drmSrnith. 7'l ll'culth ol .\llrr (larl >rrlrlishtls. l77li).Everv ccorronrics sttrdent sllorrld r-ead a li'w ragt's toget the fla\'()r of his rvritinr. 'l.hr ll''tllh o/,\nlicrns catt bt'

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QUESTIONS FOR DTSCUSSTON

studies inefnciendy by listening to loud music andchatting with friends, where will Diligent's grade'output" be relative to the PPF? What will happen tothe grade PPF if Diligent increases study inputs froml0 hours to l5 hours?

9. Consider the PPf'for clean air and automobile travel.a. Explain why unregulated air pollution in autom(>

biles would push a country inside its PP,i{ lllustrte

t7

your discussion wi a carefully drwn PPI'forthese two goo(Ls.Next explain how putting a price on harmful automobile emissions would increase both goods andmove the counEy to its PPIT Illusrrc by showinghow correcting the 'market failure" would changethe final outcome.

' EtBu0Ttct l|uffi |

b.

ApHOW TO READ GRAPHS

il ltictwe is uorth a tltousrnd uords.Chinese Proverb

Before you can master economics, you must have aworking knowledge of graphs. They are a-s indispens-able 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-itwill be time wel'l spent.

What is a grcQh? lt is a cliagram showin how twnomic concepls and examine historical trends.

Yorr will encounter many differen t kinds of graphsin this book. Some graphs show how variables chang

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20 APPENDIX I HOW TO READ GRAPHS

(a) Inverse Relatlon (b) Dlrect Relatlon

FIGURE lA-3. Calculaon of Slope for Straight LincsIt. is easy to calculate slort:s firr straiht lincs as "risc over nrn.'Thus in both (a) and (b), thenumerical 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

(b)(a) FIGURE lA-4. Steepne*s Is Not theSame as SlopeNotc that cvc,n though (a) looks steeperthan (b), thcy displa,v the same relation-ship. Both have a slope of r, but rhe Xaxis has been stretched our in (b).

the sf ope of 8D is LD/BC. (For those who have stud-ied calculus, question 7 at the end of this appendixrelates slopcs to derivatives. )

Thc key points to understand about slopes arethc Ibllowing:l. The slope can be expressed as a number. It mea-

sures the change in Y per unit change in X, or"tlrc rise over the run."

2. I[ thc line is straight, its slope is constanreveryrvhere.

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

Dircrl relnt.iorcltips occrrl wher variables movein the same clircction (that is, thev increase ordecrease togcthcr); iruerse rlationsdps occurwhcn thc valiables rnove in opposite directions(that is, orre irrcreascs as the other decreases).Thus a ncgative slope indicates the X-Y relation

is invclsc, as it is in Figure lA-3(a). \{'hy? Because anincreasc in X calls fbl a decrease in X

Peoplc sornctirnes c

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

portra)' cxac tl)' thc saDrc rclationship. Rut in (D), thehorizontal scalc has bccn strctchcrl ortt corlparedrvith (). lf 1'ou calctrlate carcfirlly, you rvill scc thatthe slopes are exactlv tlte satrtc (aIrtl arc cctral to 7:r).

Slope of o Cuved Line,{ crrrled or nonlinear line is otte rvltosc slopech:rnges. Sornetimes ue \yrn t to know the slope at agnten lninl, srrch as point B in Figure lA-5. 1{'c see thatthe slope at point /i is positive, but it is not obviottsexactlv holr to calculate the slope.

To ncl the slope of a smooth curved line rt apoint. wc calculate the slope of the straight line thatjust tor.lchcs, brrt cloes r.rot cross, tlre curved line rtthc point irr question. Srrch a straight line is called atungnt ro the cun'ed line. Prt differentll', the slopeof-a cru-vcd line at:r point is given by'the slope of thestraight lirrc that is langent to the cun'e rt the givenpoint. Oncc wc clra* the tangent line, we find theslopc ol thc tal)gcrrt linc r+'ith the rrsrtzrl right-artglernc:rstrliug tcclruiqtrc disctrssed eal'lit'r.

'lb firrrl tht- slopc at point B irr Figrrre I A-l'r. rcesinrply corrstrtrct straight line /'7l as :r tangent to thectrlvcrl lirrc at point /j. \'!t'then calcttlate tht: skrpe oftlre tangcrrt as.\'//,&lN. Similar-11', th('t2rtgerrt line (jllgivcs thc slopc of tllc ctrlc 2. \4'lrat is its sLrpc lirr.X 2':

F

22

Slope os the MorginolYolueOlre of the rnost irnpol tar)l corccl;ts irr ccononrit s isnarginal, rvhich alwavs mcans "addititnal" or'"cxtra."l'or cxamplc, wc talk abort "rnarginal cost," rvhiclrtneans the extra cost tlrat is incrrr|cd wlrcrr a lirrrrproduces an extra trnit ol'output. Sirnilarly, iD fiscaleconomics, rre discuss thc "rnarginal tax latc," lvlriclrdenotes the additional taxcs that arc paid whcrr arrindil'iclual earns an additional dollar of incornc.

Wc can calctrlatc tlie rnargirral value in a I ela-tionsl-r\r from thc slopc. Figrrle lA-3 shows thenrarginal values for tu'o straight lines. Look first atFigur-e lA-3(). Perhaps thc l valiablc is taxcs arrdthe Xvariable is income. Thcn thc slopc s lr-prcscrrLsthe nrarginal tax mte. For- cve n'rrnit ol .l taxes go upb-v s units. For many taxpavct's, thc rnargiual tax ratelvould be between 0.20 and 0.40.

Next exarine Figurc lA-3(a). Hclc, thc rrrar-ginalraltre is negatir.e. This might rcplcsctrt what happcrrswhen a particular area is over-llshccl, whtrc tl)c Xvari-able is nrrnrber ofboats and thc )'raliallc is tr;tal Iisllcatch. Because of overfislrirrg, the rnarginal catch tt r'boat is acttulh' negatiye becarrse tlre stock of lish isbeing depleted.

\l'e can also applv this concept ro

SUMMARY TO APPENDIX

The lcft-hand graph shows a tnle series, sirce theAmerican Rc'volution, ol' a significant nlacroeco-nomic lariable, thc I atio of' thc f cclclal govct tllnentdebt to total gross tlolltestic product-this rati() s thedbt-CDP lio. Tin'rc-scries graphs ltavc titnc ott thehorizontal axis and v:rriatles ol ilttcrcst (in tl.ris casc,the debt-GDP ratio) on the vertical axis. '['[ris graphshows that the debt-GDP ratio has riscn sharplv clut-ing every major war.

Scotter Diogroms Sometinres individual data poinLswill be rlotted, as in Figure lA-1. Often, combinr-tions of variables for different years will be plotted.An important cxarnplt' of a scatter diagr:rnr fronrmacr

z4 APPENDIX I H0W To RF,AD GR{I'I IS

CONCEPTS FOR REVIEW

Elements of Graphsllor irrtal, f sleep, yotr have | (i h 0 and X > 0.a. 1'- 100-5Xb. /'j- 100

- 20X+ lX:

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

-

0 and when .Y = l. F