Micro V2 Chapter 1

A Primer on
Microeconomics, Volume I
A Primer on
Microeconomics, Volume I
Fundamentals of Exchange
Second Edition
Thomas M. Beveridge
A Primer on Microeconomics, Volume I: Fundamentals of Exchange
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Abstract
Economics, far from being the “dismal science,” offers us valuable lessons
that can be applied to our everyday experiences. At its heart, economics
is the science of choice and a study of economic principles that allows us
to achieve a more informed understanding of how we make our choices,
regardless of whether these choices occur in our everyday life, in our work
environment, or at the national or international level.
The present two-volume text represents a commonsense approach
to basic microeconomic principles. It is directed toward all students,
but particularly toward those within business school settings, including
students beginning an advanced business degree course of study. It will
deliver clear statements of essential economic principles, supported by
easy-to-understand examples, and uncluttered by extraneous material, the
goal being to provide a concise readable primer that covers the substance
of microeconomic theory.
Over the course of the two volumes, the text will look at the effi-
cient operation of competitive markets and what may cause those markets
to fail, the benefits derived from trade, profit maximization, the conse-
quences of choice, and the implications of imperfect competition.
Keywords
comparative advantage, consumer surplus, demand and supply, economic
efficiency, elasticity, equilibrium, imperfect competition, marginal ben-
efit, market failures, , monopoly, opportunity cost, perfect competition,
producer surplus, profit maximization
Contents
Preface...................................................................................................ix
Acknowledgments....................................................................................xi
Chapter 1 Scarcity and Choice...........................................................1
Chapter 2 Demand and Supply........................................................37
Chapter 3 More on Markets.............................................................67
Chapter 4 Elasticity........................................................................105
About the Author.................................................................................129

Index..................................................................................................131
Preface
This two-volume Primer on Microeconomics has been long in the writ-
ing. It has been shaped by after-class discussions with students over many
years while we tried to break down economics into understandable con-
cepts and examples. A former student, Dr. Jeff Edwards, now Chairman
of the Economics Department at North Carolina A&T State University,
requested that I write an introductory text, and advised, “Make it like
your lectures.”
No book, at least no book that I’m capable of writing, can capture
the immediacy and intimacy of a classroom environment, but equally, no
classroom environment permits the opportunity to dwell on detail quite
as effectively as the pages of a book. As with everything in economics,
there are trade-offs.
I’ve devised this Primer to help you to master the concepts in what
may to be your first, and perhaps only, economics course. I’ve given you
opportunities to apply these concepts in real-world situations. Most econ-
omists stress the need for competence in three major areas—the applica-
tion of economic concepts to real-world situations, the interpretation of
graphs, and the analysis of numerical problems.
Throughout the text, I’ve attempted to maintain the sense of a
dialogue—there are frequent “THINK IT THROUGH” pauses, with
which you can review and check your grasp of the topic under discussion
and relate it to real-world applications.
I hope that this book will ignite in you a passion for economics that
will blaze for a lifetime. Economics surrounds us—it fills the airwaves, our
daily lives, our hopes and dreams. Learning how to apply economic con-
cepts to our world creates a better and more durable understanding, and
a reasonable goal for a noneconomics major is to have sufficient insight
to evaluate the economic content of articles in The Wall Street Journal or
The Economist or the views expressed by commentators on CNN or Fox.
x PREFACE
This Primer has been written with the hope that long after you have
turned the final page, you will retain a deeper understanding of the eco-
nomic issues that confront us and the tools to analyze the exciting and
challenging concerns that we all must address in our contemporary world.
My best wishes to you in your study of economics. You will find it
a rewarding and worthwhile experience, and I trust that this Primer will
stimulate you in your endeavors.
Acknowledgments
Through the years, many students have asked me questions, and by doing
so, have given me deeper insights into the difficulties that arise when
economics is first approached. I am grateful to all of them. Much of the
material included in this book springs from such “after-class” discussions.
The efforts of reviewers Phil Romero and Jeff Edwards have added
greatly to the quality of the final product. A former student, Jonas Feit,
now thriving in Washington, DC, critiqued early drafts of the first edition.
Scott Isenberg and Charlene Kronstedt of Business Expert Press provided
stalwart support. Rene Caroline Balan of S4Carlisle Publishing Services
deserves great credit for keeping things moving smoothly by encourag-
ing and cajoling effectively. Denver Harris was reliable in converting a
misshapen, poorly written first-edition manuscript into an orderly text.
Needless to say, any remaining lapsi calami are my responsibility.
This Primer is dedicated, with love, to the memory of my parents, to
my wife, Pamela, (a software instructor with Microsoft Certification), to
our son, Andrew (whose surprises are no longer shocks but delights), and
to the dogs and cats, and especially for Jake, for whom all lunches are free.
Thomas M. Beveridge
Hillsborough, North Carolina
CHAPTER 1
Scarcity and Choice
Chapter Preview: In this introductory chapter, we look at the fundamental

concerns of economics and why these concerns arise. Also, we will develop
the concept of opportunity cost that is embodied in the popular phrase
“There’s no such thing as a free lunch.” Finally, we will consider a diagram
(the production possibility frontier) that will permit us to use opportu-
nity cost to explore the benefits flowing from trade.
By the end of this chapter, you will be able to:

• Identify the three fundamental economic questions.
• Explain why a production possibility frontier has a
negative slope and why that slope depicts the concept of
opportunity cost.
• Interpret what is depicted by a production possibility frontier.
• Explain why increasing opportunity costs occur in the real world
and how this relates to the production possibility frontier diagram.
• Use the production possibility frontier to identify how
economic growth might occur.
• Distinguish between productive efficiency and allocative
efficiency.
• Distinguish between absolute advantage and comparative
advantage.
• Use comparative advantage to explain the theory that
individuals or countries can gain from specialization and
exchange.
• Evaluate the assumption of self-interested rationality in
economic models.
2 A PRIMER ON MICROECONOMICS, VOLUME I
What is “economics” all about?

Sometimes, as an icebreaker at the beginning of the semester, I ask my
new students what they think economics is “about.” I’ve grown accus-
tomed to a wide range of answers, some tautological (“It’s about the econ-
omy.”), some focused on finance, with references to businesses, money,
Wall Street, and profits, and some technical (“It’s about demand and sup-
ply.”) While a knowledge of economic principles may help us address of
these topics, the subject matter is more fundamental than any of them.
Boiled down, economics is about choice.
Economics: The Scientiﬁc Study of Rational Choice

Imagine you’re in a restaurant and the server has just handed you the
menu. You are preparing to make a choice. You have entered the realm
of economics. At its most fundamental, economics is about choice. We
may define economics as the scientific study of rational choice. Although
that assumption of rationality has recently come under some attack, and
we’ll look at some evidence on this issue later in this chapter, it remains a
good working assumption. We make choices as we each strive to achieve
the best outcomes possible in our own self-interest. Individually and as
a society, we must make choices because there is a basic imbalance in
our world—we have unlimited wants, but we have only limited (scarce)
resources to meet those wants.
Unlimited wants, by themselves, are not a problem. Wishing for more
than we currently have (a bigger house, a newer car, fashionable clothes)
can be seen as a symptom of ambition, of seeking better things. However,
because our resources are “scarce,” we cannot hope to satisfy all of those de-
sires, and therefore, we are obliged to choose the items we desire the most.
Scarcity
In economics, an item is considered “scarce” if, when its price is zero,

there is not enough of the item available to satisfy our requirements. If a
good has a positive price tag, then it’s scarce. Can you think of any “free”
(nonscarce) goods? Is clean air a free good or is it scarce? How about clean
water? What about sunlight?
Scarcity and Choice 3
Resources
Economists define four types of scarce resources.

Natural resources (sometimes conveniently but misleadingly termed
“land” by the early economists) include any usable naturally occurring
resources. Farmland, a navigable river, or lobsters off the coast of Maine
are examples of natural resources.
Capital resources are reusable tools—goods that are produced to
make other goods. Private capital includes a carpenter’s chisel, a sales rep’s
car, or a warehouse, whereas social capital includes the nation’s roads,
bridges, and docks. We should note, in passing, the money is not capital
in the sense used here. Robinson Crusoe alone on his island would be
dismayed to find a trunk full of money that had been washed up on the
beach—the contents can’t help him to produce shelter, food, or cloth-
ing—but a box of tools would be a welcome addition to his stock of
resources. Money may allow us to buy capital, but in itself, it is not a
productive resource.
Human resources (“labor”) include all of the mental and physical
attributes of the labor force, such as the shooting ability of LeBron James,
the physical stamina of a fruit picker, or the specialized skills and knowl-
edge of a brain surgeon. As an aside, if a worker trains and acquires new
skills, this acquisition is termed “human capital.” Education of any kind
that increases our abilities is an investment in human capital.
Finally, enterprise (“entrepreneurial ability”) is the risk-taking tal-
ent needed to recognize unfulfilled market opportunities and organize
production to meet those needs. The entrepreneur must decide what is
to be produced, rent or purchase premises, advertise for, interview, hire,
and train employees, hire or buy capital equipment, and devote time and
energy to the new endeavor—and all before a single customer has been
attracted to the business. This represents a significant outlay of effort, and
therefore, a significant risk of failure and financial loss.
The rewards for the use of these four classes of resources are rent,
interest, wages and salaries, and profit, respectively. The farmer who lets a
neighbor use his tractor during harvest would receive an interest payment
but if he lets him use some unneeded acreage, then the payment is rent.
The farm laborer receives a wage or salary. The farmer (the owner of an
enterprise) hopes to earn a profit for himself.
Comment: In economics, unlike in accounting, profit (more properly,

a “normal” profit, which is a reasonable rate of return for the entrepre-
neur) is treated the same as wages and salaries, rent, and interest. Just as
those other payments represent costs of doing business, so does profit. We
will return to this point later in the chapter.
Caution: Terms used in economics may not mean the same as they
do in regular speech. “Rent” is a good example. Apartment-dwellers pay
“rent” to their “landlord,” but most of that payment is not for the use of a
natural resource (the space the apartment occupies); it’s for the structure
itself, and for the wiring and plumbing and other man-made (capital)
features being used. “Investment” (the addition to the stock of capital) is
another term with a very specific meaning in economics.
THINK IT THROUGH: Every productive activity involves some

combination of those four categories of scarce resource. Think of your
own work environment and identify examples of each of the four types
of resources. It is almost impossible to specify a productive activity
that does not involve human resources, natural resources, capital, and
enterprise. Try it!
The Economic Challenge and the Three Fundamental

Questions of Economics
The economic challenge, then, is to find the way to best satisfy our unlim-
ited wants with our limited resources. The three fundamental questions
that must be answered by any economy are: “What to Produce?”, “How
to Produce?”, and “To Whom Do We Distribute Production?” Every
economy must display enterprise to transform its scarce natural, capital,
and human resources into usable production through the application of
enterprise. In a complex society, the opportunity to cooperate and spe-
cialize offers great scope for increased production—but decisions must be
made regarding the extent of cooperation, who specializes in what, and
how goods are distributed. Even Robinson Crusoe and Friday on their
island must come up with answers to these questions. Wants are limitless,
but resources are scarce. We are compelled to make choices.
As a restaurant owner, because you cannot offer everything, you must

decide which items will be on your menu (answering the “What to pro-
duce?” question). In answering this question, you are also deciding what
you will not produce. You must also determine how your service will be
produced (cordon-bleu chef or a microwave; self-service or servers; and so
on). Finally, you must come up with a method of allocating your produc-
tion among your potential customers (first-come, first-serve, or reserva-
tions; all you can eat or à la carte).
The trick is to choose the most effective technique in order to ensure
that we do produce “the right stuff” in the best way and market it
correctly to the right people. If the entrepreneur answers the questions
correctly, then she earns a profit; if not, she incurs a loss.
A Personal Example
A friend (“Emily”) once opened a shop selling imported specialties from

Europe, but mainly from Britain. Emily stocked candies, soft drinks,
clothing, jewelry, books, and music. From the beginning, the store was a
moderate success, but the rent charged for the premises was quite high.
The proprietress decided to give up the bricks-and-mortar shop and move
her operations online as she had compiled a long email list of interested
customers. The result was a disaster! Emily had failed to give adequate
consideration to the “How to Produce?” and the “To Whom?” questions.
Established customers liked to visit the store, examine the merchandise,
and socialize—an online catalog was no substitute. In addition, a fair pro-
portion of customers were walk-ins, buying on impulse. Emily’s decision
to go online lost both groups. The business never recovered, and Emily
finally disposed of her unsold stock at community yard sales before even-
tually abandoning the business.
In our economy, although there is a role for the public provision of
certain goods and services such as national defense or our justice system,
we mainly use private markets to answer the three fundamental questions.
Typically, we produce items that can earn a profit as cheaply as possible
(in order to make the most profit), and then, provide them to those who
are able to pay the price. If there aren’t enough goods to go round, then
we raise the price until some potential buyers move away.
THINK IT THROUGH: When the Titanic sank in 1912, there were

limited spaces available in the lifeboats. The collision with the iceberg
posed an immediate “distribution” question—who gets the lifeboat
seats? The traditional solution of “Women and children first!” was
largely adhered to (most babies and children and a high proportion of
women survived) although upper-class males seem to have been given
priority over steerage passengers. If “Women and children first” were
not used to allocate lifeboat seats, what other methods would have
been effective in such a crisis situation?
THINK IT THROUGH: Can you think of other “rules” that our

society has developed to apportion our limited goods and services?
Opportunity Cost
Choice is at the heart of economics. Any time we make a choice, there
is a cost involved. Economists use the term “opportunity cost.” Oppor-
tunity cost is the value of the next most preferred alternative given up
when you make a choice. This idea of opportunity cost is both simple and
profound—there’s no such thing as a free lunch, as the saying goes. In the
restaurant, if you order shrimp lo mein, then, unless you are very hungry,
you must give up the opportunity to have other items on the menu. If the
shrimp had not been available, the value you place on the item you would
have chosen instead is the opportunity cost of the shrimp, as this item is
the next-best alternative that you gave up in order to enjoy the shrimp.
Remember: Whenever you make a choice, you are choosing to accept

one option (A), but you are also choosing to give up all the other options
(B, C, and so on). Opportunity cost is the value you place on the second-
best option. The value of the option selected should exceed its oppor-
tunity cost; otherwise, you’ve not made a rational choice. It would be
irrational to choose something less attractive and forgo a more desirable
option. Note that our opportunity cost definition doesn’t refer explicitly
to a financial cost. Even if a friend is paying the tab, it’s still not a free
lunch for you because you are making choices. Choosing the New York
strip means that you can’t choose your next-favorite option.
THINK IT THROUGH: Consider your actions in the restaurant.

You wish to make the “best” choice when you read the menu, but do
you always choose the offering that is most appealing to you? Perhaps
not. The relative prices of dishes may also have an effect. Sweet and
sour chicken may not be as popular with you as shrimp lo mein, but
if the chicken is on “special” or the shrimp is exorbitantly priced, then
your selection may change.
The Production Possibility Frontier

The production possibility frontier (PPF) diagram can be used to depict
choice and opportunity cost. A PPF diagram shows precisely what its
name suggests—the frontier (or boundary) between what it is possible for
us to produce and what it is not possible for us to produce, given the most
effective use of our resources and our technology. We know already what
our resources consist of (human resources, natural resources, capital, and
enterprise), but what is “technology?” Technology is our method of com-
bining our resources. If we develop a method of combining our resources
that increases output, then this is a technological advance. A better crop
rotation system or irrigation techniques in farming, or a more productive
floor plan in a factory would be examples. Can you think of others?
In a world where two goods are produced (say, guns and butter) and
where all resources are fully employed, if we allocate more of our resources
to produce guns, then fewer resources are available to produce butter and
less butter will be produced—there is a trade-off, one good for the other,
along the PPF. The opportunity cost of choosing to produce more guns is
the quantity of butter we can no longer produce.
Following from this conclusion, it is clear that the PPF must have a
negative slope. More guns mean less butter.
Suppose we have a small firm that produces two goods—wooden
chairs and tables. We have workers and other resources. Each hour, using
the best available production methods (technology), there can be only a
finite maximum quantity of chairs we can produce. Let’s say six chairs. We
can plot this option (6 chairs, 0 tables) on the vertical axis of Figure 1.1
at point A. Similarly, there are only so many tables we can produce each
hour—perhaps three tables. We can plot this option (0 chairs, 3 tables)
on the horizontal axis at point D. If we’re currently producing six chairs,
A Maximum chair production

6
zero table production
Chairs 5
4
3
2 Maximum table production
1 zero chair production
D
0 1 2 3
Tables
Figure 1.1 Constructing a production
possibility frontier
then if we increase the production of tables, we will have to pull resources

away from chair production. Chair production will decrease as table pro-
duction increases—there is a negative relationship between them.
So far, we have the two endpoints of the PPF and we know that it must
have a negative slope. The frontier’s slope represents the rate at which one
good is given up as more of the other good is produced. This rate of trade off,
known formally as the marginal rate of transformation, describes opportu-
nity cost. For example, if we produce one more table, then the o pportunity
cost is the number of chairs we will no longer be able to produce.
The Law of Increasing Cost

In the real world, this rate of trade-off, one good for the other, is unlikely to
remain constant. As we increase the production of chairs, the opportunity
cost of each additional chair produced is likely to increase. Why? Because
resources are not equally well suited to different activities. Think back to high
school and the choosing of teams for basketball. Just as some players were
more talented and with superior physical attributes than others at basketball
(taller, faster, and with superior passing or shooting abilities) and would be
chosen first, some resources are likely to be more productive in chair produc-
tion than others and will be preferred. It is because our resources have differ-
ing qualities and abilities that we should expect to encounter increasing costs.
Suppose we have three workers with differing skills—Abe, Bill, and
Calvin—whose hourly outputs are listed as follows.
Production alternatives Opportunity cost of one

Tables per hour Chairs per hour Table Chair
Abe 1 Or 1 1 chair 1 table
Bill 1 Or 2 2 chairs 1/2 table
Calvin 1 Or 3 3 chairs 1/3 table
Suppose that, currently, you are only producing chairs. Abe, Bill, and
Calvin are producing a total of six chairs. Who would you choose first to
switch over to table production? And who would be your next choice?
Does it matter?
It does matter! You should choose Abe first to produce tables, then
Bill, and finally, Calvin because, relative to the others, Abe can produce
tables at the lowest (opportunity) cost. With Abe, the table he produces
“costs” one chair that will no longer be produced, but if Calvin is selected
to produce the table, then we must give up the three chairs he could other-
wise have produced. Looked at differently, we should keep Calvin produc-
ing chairs as long as possible because he is so skilled at chair production.
Note that as we expand the production of tables, the opportunity cost of
tables increases. The first table (Abe’s) costs one chair; Bill’s costs two chairs;
and Calvin’s costs three chairs. The production alternatives are listed as follows.
Production
alternatives Tables Chairs
A 0 6
B 1 5
C 2 3
D 3 0
At alternative A, all three workers are producing chairs. At alternative

B, one table is being produced (by Abe). Although any of the three workers
could produce the table (all are capable), if we wish to maximize the overall
THINK IT THROUGH: Verify that if one table is being produced,

then the maximum possible number of chairs that can be produced at
the same time is five chairs. If, however, either Bill or Calvin is chosen
to produce the first table, then total chair production will be less than
five chairs.
production of tables and chairs, then Abe should be switched first. Why?
Because the opportunity cost, in terms of chairs lost, is least with Abe.
At alternative C, two tables are being produced. Who should be
moved from producing chairs and asked to produce the second table?
Bill, because relative to Calvin, the opportunity cost of the table, in terms
of chairs given up, is less—only two chairs lost, instead of three.
At alternative D, we finally switch over Calvin to table production.
We have saved him until last because this is a relatively expensive deci-
sion, in the sense that the three chairs that Calvin could have produced
are being sacrificed to increase table production by one.
The “big idea” revealed in this example is that as we begin table pro-
duction, we should choose the least-cost resource (Abe), and as table
production expands, we are forced to switch over resources that involve
progressively higher opportunity costs.
We can plot these alternatives. Graphically, as shown in Figure 1.2,
the PPF bends outwards. The “bowed-outward” slope of the PPF depicts
the increasing opportunity cost we have discussed.
A
6
5 B
Chairs
4
3 C
2
1
D
0 1 2 3
Tables
Figure 1.2 Production possibility frontier
Comment on Reciprocals: Note that, for Calvin, the opportunity cost of

producing one table is three chairs and the opportunity cost of one chair is a
third of a table. The opportunity costs of the two goods are reciprocals of each
other at each step. If Calvin is the least costly at producing chairs, then he
necessarily must be the most costly at producing tables. This is a general result
and we’ll use it later in this chapter when we look at comparative advantage.
THINK IT THROUGH: Verify that if the workers are all producing

tables, and we switch them over, one by one, to producing chairs, we
should switch Calvin first, then Bill, and finally, Abe. Opportunity
cost again increases as we expand the production of chairs. Movements
along a bowed-out PPF in either direction reveal increasing costs.
Marginal Cost
Let’s press this example a little further. Economists, as we shall see later,
are deeply concerned with “marginal” analysis. “Marginal” is just a fancy
term economists use, meaning “extra” or “additional.” Marginal cost is
the additional cost incurred when an extra unit of a good is produced.
(Similarly, marginal benefit is the additional benefit that is received
when an extra unit of a good is consumed.) Superficially, we may think of
“the additional cost incurred when an extra unit of a good is produced”
in terms of dollars and cents, but more profoundly, it is the opportunity
cost. Alone on his island, Robinson Crusoe has no money, but because he
makes choices, he still incurs costs.
In our example, choosing to produce more chairs results in increasing
costs. The extra opportunity cost of the first table was one chair, but the
second table cost two chairs, and the third table’s cost was higher still—at
three chairs. Typically, because of the law of increasing cost, we’d predict
that the marginal cost would increase as more tables are produced. If he
chooses to pick berries today, then the cost is not financial, it is the value
of the next most preferred alternative he gives up.
THINK IT THROUGH: If the cost of producing additional tables

increases, what must happen to the price of tables in order to encour-
age the producer to boost output? The price received by the producer
would have to increase. We shall pick up on this point in Chapter 2.
Constant Costs
An outward-bending PPF depicts increasing cost. However, if the PPF is
a straight downward-sloping line, then the opportunity cost is constant.
A straight line shows that the rate of trade-off, one good for the other, is
unchanging. This would happen if resources were identical in abilities,

endowments, and talents.
In contrast, if the PPF were to bend inward, then this would mean
that opportunity cost is decreasing—in real-world terms, improbable.
The slope of the PPF reveals whether we are experiencing increasing
costs (the PPF bows outward), constant costs (the PPF is a straight line—
the slope of a straight line is constant), or decreasing costs (the PPF bends
inward). In short, the slope of the PPF (the rate of trade-off between
goods) is opportunity cost.
Any PPF diagram has three regions—the frontier itself, the area inside
the frontier, and the area beyond the frontier. Consider Figure 1.3. Any
point on the frontier (such as point K) represents a point of maximum
production; any point inside the frontier (such as point L) indicates
underproduction (because we could be producing more guns, more but-
ter, or more of both); and any point beyond the frontier (such as point
M) is an option that is not attainable, given our current resources and
technology.
M currently unattainable
Guns
K a maximum combination
L Underproduction
0
Butter
Figure 1.3 The components of a production possibility
frontier
Although increasing costs are typical in the real world, as we have

seen, from now on, we will assume that producers face constant oppor-
tunity costs because this will allow us to draw simpler straight-line PPFs.
Note: If we have constant costs, then the marginal cost is constant,

rather than increasing as output increases.
Relaxing the Diagram’s Assumptions

As we have established, the PPF is drawn on the basis of a given set of
resources and a given best way of combining those resources (technol-
ogy). If we get more or better resources, or an improved way of combin-
ing our given quantity of resources, then there will be a general increase in
what it is possible to produce. In such a case, the PPF will shift outward
from PPF1 to PPF2, as shown in Figure 1.4. A decrease in the quantity or
quality of resources or a deterioration in technology, will shift the whole
curve inward as what is possible to produce is diminished. Usually, this
sort of change is depicted as a parallel shift in the frontier, indicating that
the opportunity cost of producing each good (as represented by the slope
of the frontier) has not changed.
Soybeans
90
PPF1 PPF2
0 30
Corn
Figure 1.4 A general increase in the production
possibility frontier
Comment: It may be hard to imagine a situation where one would

willingly adopt a less productive technology. However, choosing to ban
fracking because of environmental concerns might be an example. Other
examples of not-so-good technological “improvements” might include
using lead for water pipes and asbestos for insulation in houses.
A change in resources or technology could be specific to only one
good. In farming, for example, a strain of corn with a higher yield might
be developed. In this case, although the maximum production of soybeans
would be unaltered, the maximum production of corn would increase,
causing the PPF to pivot from PPF1 to PPF2, as shown in Figure 1.5.
Observe that in this case, the slope of the PPF has changed. Because the
slope of the frontier depicts opportunity cost, the opportunity cost of
corn (and thus, soybeans) must have changed.
90
Soybeans
PPF1 PPF2
0 30 45
Corn
Figure 1.5 A good-speciﬁc increase in the
production possibility frontier
We can demonstrate this conclusion quite simply. Although increas-

ing costs are the real-world norm, from now on, we will assume that pro-
ducers face constant opportunity costs, because this will allow us to draw
simpler straight-line PPFs.
Note: If we have constant costs, then marginal cost is constant, rather

than increasing as output increases.
Consider the slope of PPF1 and its endpoints. If we choose to produce
only corn, then we can produce 30 units of corn, but we must give up
the 90 units of soybeans that otherwise could have been produced. Each
unit of corn “costs” three units of soybeans. Now consider the slope of
PPF2. If we choose to produce only corn, then we can produce 45 units
of corn, but we must give up the 90 units of soybeans. Each unit of corn
now “costs” only two units of soybeans. The opportunity cost of corn
has decreased. Verify that the opportunity cost of a unit of soybeans has
increased from one-third of a unit of corn to one-half of a unit of corn.
Recall that the opportunity cost of each good is the reciprocal of the
opportunity cost of the other good.
THINK IT THROUGH: What happened to medieval Europe’s PPF

during the Black Death? What was the effect on American production
of the introduction of the Internet in the 1990s? Finally, in 1945, the
Manhattan Project developed the atomic bomb. In terms of “guns”
(military capability) and “butter,” (consumer goods) how did the
Allies’ PPF change? Show each of these cases with a PPF diagram.
Using the PPF Diagram

We have now developed an understanding of the general meaning of the
PPF and the assumptions behind it. But how can it be used? The analy-
sis can be used in several ways—for instance, when thinking about the
consequences of choice, different concepts of efficiency, the distinction
between microeconomics and macroeconomics, and the basis for trade.
The PPF diagram illustrates choice. Along the frontier, where we have
full employment of resources, if we choose to produce more guns, the con-
sequence is that we must settle for less butter. The slope of the frontier shows
the rate of trade-off and reminds us that “there’s no such thing as a free lunch.”
Comment: Note, though, that if we have unemployed resources, we

may be able to produce more guns without giving up any butter. There
need be no opportunity cost in this situation.
Efficiency: The diagram can also be used to distinguish between two

differing concepts of efficiency. Consider Figure 1.6.
B
Meat
C
E
D
0 Vegetables
Figure 1.6 Productive efficiency and
allocative efficiency
Any point on the frontier is a point of maximum productive effi-

ciency. In this sense of producing at maximum capacity, points A, B,
C, and D are all equally “efficient.” Point E is inefficient because some
of our scarce resources are being squandered—we could be producing
more meat, more vegetables, or more of both.
However, there’s more to life than simply producing lots of stuff. Our
economy ought to produce the mix of goods and services most desired by
society—the “right stuff ” to best satisfy the wants of its citizens. Consider
the figure once more. Are points A, B, C, and D equal in terms of satisfy-
ing our wants?
Clearly not! If we are a society of vegans, then point A (all meat, no
vegetables) is certainly a less desirable option than point D. Not all points
on the frontier are equivalent in terms of allocative efficiency (producing
the mixture of goods that society prefers the most). In fact, points inside
the frontier may be superior to some of the points on the frontier. For
example, the vegan society would feel that point A is certainly less desir-
able than point E (where we get at least some vegetables).
The two “efficiency” concepts are distinct. In terms of productive effi-
ciency, any point on the PPF is certainly superior to any point inside the
frontier. However, in terms of allocative efficiency, a given point inside
the frontier may be preferred to some points on the frontier. (As a gen-
eral rule though, there must be at least one point on the frontier that is
superior to any point inside. Point C, for example, is preferred to point E
because society gets more vegetables without losing any meat.)
Given our resources and technology, maximum allocative efficiency
must occur at some point on the PPF—productive efficiency is a neces-
sary, but not a sufficient, condition for allocative efficiency. Maximum
allocative efficiency occurs when the economy is producing the mix of
goods and services to which it is impossible to make any change to satisfy
one individual’s wants more fully without causing the wants of another
individual to be satisfied less fully.
Comment : Intuitively, productive efficiency may be thought of as

“activity” while allocative efficiency may be thought of as “achievement.”
Microeconomics versus Macroeconomics: Microeconomics generally

starts from the assumption that society is already at a given point on its PPF
and can be thought of as examining how we might move the production mix
to a point of greater allocative efficiency along the line. Macroeconomics,
which considers the consequences of unemployment or lackluster growth,
may be thought of as exploring how we might either move toward the
frontier, or indeed, shift the frontier itself.
Comparative Advantage and the Basis for Trade

The PPF diagram and the concept of opportunity cost can be used to
examine the basis for specialization and trade. The roots of this analysis
reach back to the early nineteenth century and the British economist,
David Ricardo, who developed the Law of Comparative Advantage.
Briefly, let us assume two participants (Jack and Jill), two goods (bread
and wine), and constant costs (straight-line PPFs) for each individual. If
Jack and Jill’s opportunity costs differ, then it must be the case that each
individual must have PPFs with differing slopes. Given this, each indi-
vidual must have a “comparative advantage” in the production of one, but
only one, of the two goods. The one exception to this conclusion would be
if the slopes of the PPFs (and therefore, the opportunity costs) were identi-
cal. We can make this analysis a little easier if we realize that the compara-
tive advantage referred to is an advantage in terms of opportunity cost. If,
relatively, Jack can produce wine at a lower opportunity cost than Jill (that
is, Jack has a comparative cost advantage in wine production), then Jill
must be able to produce bread at a lower opportunity cost than Jack (that
is, she must have a comparative cost advantage in bread production).
This may seem a curious conclusion. An obvious objection to raise
would be “But what if Jack can produce both goods more cheaply than
Jill?” Such a situation is impossible. Recall the tables and chairs example
where we concluded that each worker’s opportunity cost of producing a
chair is the reciprocal of his opportunity cost of producing a table. Rela-
tively, the greater the cost advantage a worker has in the production of
one good, the greater the cost disadvantage he must have in the produc-
tion of the other good.
Consider Figure 1.7. Jack, specializing only in bread production, can
bake 8 loaves each day, while Jill, similarly devoted to bread production,
can bake 12 loaves each day. Jill can produce more loaves perhaps because
of superior skill, better ingredients, or a more reliable oven. Fully devoted to

wine production, Jack can produce four bottles each day, but Jill (less skilled
perhaps, or with less good grapes) can produce only three. Recall that the
slope of the PPF depicts opportunity cost, so the straight lines indicate that
the opportunity costs are constant for each individual. The differing slopes
indicate that the opportunity costs between individuals are different.
Ja ck 12 Jill
8
Bread
Bread
0 4 0 3
Wine Wine
Figure 1.7 The graphical basis for trade
The law of comparative (cost) advantage states that Jack and Jill
are each able to benefit from specialization and trade if their opportunity
costs (and the slopes of the frontiers) differ.
We must determine who should produce which good by compar-
ing opportunity costs. For Jack, the opportunity cost of producing eight
loaves is the four bottles of wine he is no longer able to produce—one loaf
costs him half a bottle of wine. Using the reciprocal trick, one bottle of
wine must “cost” him two loaves. For Jill, the opportunity cost of produc-
ing 12 loaves is the 3 bottles of wine she can no longer produce—1 loaf
costs her a fourth of a bottle of wine. Using the reciprocal trick, one bottle
of wine “costs” her four loaves.
One bottle of wine costs Jack two loaves, whereas for Jill, one bottle of
wine costs a four loaves. One loaf costs Jack half a bottle of wine, whereas
for Jill, one loaf costs a fourth of a bottle of wine.
Jack can produce wine cheaper (he has a comparative advantage in
wine) while Jill can produce bread cheaper (she has a comparative advan-
tage in bread). As long as the slopes of the PPFs differ, then it must be true
that one producer has the comparative advantage in one good and the
other producer has the comparative advantage in the other good. Again,
because of reciprocity, no individual can have a comparative advantage in

both goods (or neither good).
Caution: “But,” you say, “This result is obvious. Jack is better at wine
production because he can produce more wine than Jill, and Jill is better
at bread production because she can produce more loaves than Jack!” This
is false logic. You have fallen into the trap of absolute advantage. In abso-
lute terms, while it is true that Jack is superior to Jill in wine production
and Jill trumps Jack in bread production, this fact has no bearing on how
the two parties should specialize.
The fallacy is easy to show. Suppose that Jack can produce more wine
and more bread than Jill. Does this mean that Jack should produce every-
thing and that Jill should produce nothing? Clearly not. In the real world,
there are large countries with many resources and small countries with
few, but the small countries can still gain from trade and still can contrib-
ute to general prosperity despite an absolute disadvantage in all goods.
We can summarize the results thus far.
Opportunity Comparative
cost of: Jack Jill advantage
One loaf of bread 1/2 bottle 1/4 bottle Jill
One bottle of wine 2 loaves 4 loaves Jack
Jack and Jill decide to specialize according to comparative advantage

and trade with each other. Is mutually beneficial trade possible? Let’s as-
sume that Jack and Jill barter their trade goods—wine and bread, respec-
tively. If the “price” of a bottle of wine (the technical term for the “price”
or the barter rate of exchange such as when one bottle of wine trades for
three loaves is the “terms of trade”) is two loaves, then Jack will not gain
from trade (as his cost of production of a bottle of wine is also two loaves),
but Jill will gain from trade. (Can you verify this?) If the “price” of a bottle
of wine rises to four loaves, then Jack gains from trade, but Jill will not
gain because if the price of wine is four loaves, then the price of bread is
a quarter of a bottle of wine, which equals Jill’s cost of production—her
cost and the price at which she is trading are equal.
Between these two prices for a bottle of wine (two loaves and four
loaves), which are known as the “limits to the terms of trade,” there lies a
range of prices that will benefit both traders. Consider the situation where
one bottle of wine is traded for three loaves. Jack, producing wine at a
cost of two loaves, will gain because the price he is charging exceeds his
cost of production. Similarly, but less obviously, Jill, producing bread at
a cost of a quarter of a bottle of wine per loaf, will also gain because the
price of a loaf (one-third of a bottle of wine) is also higher than her cost.
Both benefit.
There is no requirement that both must benefit equally—that depends
on relative negotiating abilities, for example. As long as the price lies
between the limits where one party or the other does not gain (one wine
sells for two loaves and one wine sells for four loaves), trade will be mutu-
ally beneficial. If the price of a bottle of wine moves outside the limits to
the terms of trade—trading for one loaf or five loaves, for example—then
trade between the two parties will collapse. For example, if the price that
wine commands is five loaves, then Jack will produce wine, but so will
Jill! Jill’s opportunity cost for a bottle of wine is four loaves. If she can
exchange her wine and receive five loaves, then that is what she should do.
THINK IT THROUGH: Can you verify that Jill would make a loss
if she continued to produce loaves if the terms of trade are one wine
for five loaves?
If the “price” of one wine is five loaves, then the “price” of one loaf is
one-fifth of a bottle of wine. It costs Jill a quarter of a bottle of wine to
produce the loaf. If she did, then the cost of production would exceed the
benefit she would receive.
Caution: We have concluded that the Law of Comparative Advantage
persuades us that trade can be beneficial and that parties should specialize
in producing the good in which they have the comparative (cost) advan-
tage. Before moving on, it’s worth noting that the analysis depends on
the assumption that each person (or economy) is fully employed that
is, on the production possibility frontier. If that is not the case, then the
basis for trade (being on one’s PPF, and from there, being able to com-
pare opportunity costs) evaporates. Our opportunity cost calculations are
valid only along the frontier itself. A nation struggling through a recession
might still find it to be in its own best interests to restrict imports and
boost domestic employment.
Trade when Preferences Differ

and Endowments Do Not
In the example with Jack and Jill producing bread and wine and jointly de-
termining whether or not there is a basis for trade, we assumed that the two
parties had identical preferences and differing endowments of resources. It
is the difference in endowments—resources and technology, if you will—
that makes Jack’s PPF differ from Jill’s. If their resources and technology
were identical, then the PPFs and opportunity costs would also be identi-
cal. However, this is not the only possible case—individuals do not always
have identical preferences. Is there still a basis for mutually advantageous
trade if, for example, preferences differ but endowments are identical?
Let us suppose that there is a refugee camp somewhere in Latin
America and two of the inmates are Juan and Carlos. They have differing
preferences—Juan is a lifelong smoker with a severe nicotine addiction
whereas, although he does smoke on occasion, Carlos’s passion is candy.
Carlos is known in the camp as having a sweet tooth.
Every so often, a Red Cross truck arrives at the refugee camp and
delivers a parcel to each inmate—each parcel contains 10 cigarettes and
20 pieces of chocolate candy. At the start of the analysis, Juan and Carlos
have differing preferences by the same initial endowment. Can beneficial
trade occur?
We ask Juan to determine how much satisfaction he will derive from
his parcel of 10 cigarettes and 20 pieces of candy—economists call sat-
isfaction “utility”—and, after a little thought, Juan comes up with an
answer. His answer (how much satisfaction or utility he will derive from
the 10 cigarettes and 20 pieces of candy) depends on how much he likes
cigarettes and how much he likes candy.
Thought Experiment: We now ask Juan to participate in a thought

experiment. We ask him to tell us what will happen to his level of
satisfaction if we were to give him two more cigarettes. His satisfaction
will increase by some amount because he has the same amount of candy
as before, but more cigarettes. How much his satisfaction will increase
will depend on how much he enjoys the two extra cigarettes. Finally, we
say that we will remove some of his candy, piece by piece, causing his
satisfaction to decline, and we ask him to tell us when so much candy has
been removed that his satisfaction level has been restored to its original
(10 cigarettes and 20 pieces of candy) level. Let’s say he stops us when
we have taken away 10 pieces of candy. We have established that the two
“bundles” of goods—10 cigarettes and 20 pieces of candy (bundle A) and
12 cigarettes and 10 pieces of candy (bundle B)—are equivalent for Juan.
An economist would say he is “indifferent” between the two bundles. The
results are given in Table 1.1.
Table 1.1 Thought experiments for Juan and Carlos

Juan Carlos
Bundle Cigarettes Candy Cigarettes Candy
A Red Cross parcel 10 20 10 20
B=A Thought experiment 12 10 8 22
With Carlos, we repeat the process, but with a slight difference—

first, we ask him to decide how much satisfaction he derives from his
Red Cross parcel of 10 cigarettes and 20 pieces of candy. We then ask
what will h appen to his level of satisfaction if we were to remove 2 of his
10 cigarettes. Clearly, his satisfaction will decrease by some amount—
how much will depend on how much he likes cigarettes. We tell him that
we will compensate him for the loss of his cigarettes by “paying” him with
candy and we ask him to say when he has been paid enough candy to
compensate him fully for his loss of cigarettes and to restore his original
(10 cigarettes and 20 pieces of candy) level of satisfaction. He stops us
when we have given him two extra pieces of candy.
Our thought experiment has established that Carlos is “indifferent”
between bundle A (10 cigarettes and 20 pieces of candy) and bundle B
(8 cigarettes and 22 pieces of candy). The results are given in Table 1.1.
To recap, currently, Juan and Carlos both have bundle A, the Red Cross
parcel; the thought experiment was just that—a thought experiment.
Let us now introduce a trader—Pedro. Pedro approaches Juan and
offers to give him 2 cigarettes in exchange for 9 pieces of candy, leaving
Juan with 12 cigarettes for 11 pieces of candy. Juan should accept because
this bundle (bundle C) is superior to bundle B (more candy), and bundle
B is equivalent to him to bundle A. (Juan should haggle, but let us ignore
that.) By trading, Juan achieves a better outcome and improves his overall
level of satisfaction.
Similarly, Pedro approaches Carlos and offers to give him 3 pieces of
candy for 2 cigarettes, leaving Carlos with 8 cigarettes and 23 pieces of
candy (bundle C). Like Juan, Carlos should accept the trade because bun-
dle C is superior to bundle B (more candy), and bundle B is equivalent to
him to bundle A; therefore, bundle C is superior to bundle A. See Table 1.2.
Table 1.2 Trades with Pedro and Pancho

Juan Carlos
Bundle Cigarettes Candy Cigarettes Candy
A Red Cross parcel 10 20 10 20
B (= A) Thought 12 10 8 22
experiment
C (> A) Pedro trades 12 11 8 23
D (> C) Pancho trades 12 12 8 24
Pedro’s payment from trading is the 6 pieces of candy he receives.

(There were 40 pieces—Juan has 11, Carlos has 23, and Pedro has 6.) This
is Pedro’s payment for acting as a middleman. He is providing a distribu-
tion service and improving the outcomes for Juan and Carlos. It is pos-
sible for Juan and Carlos to get together themselves and trade cigarettes
and candy, dividing all of the goods between themselves and excluding
Pedro, but this may be inconvenient to them.
THINK IT THROUGH: If you wish to borrow money to buy a car,

you could approach friends, relatives, work colleagues, and strangers,
and ask each of them to lend you a few dollars, haggle over the terms of
the loans, and sign a number of loan contracts. This, though, is incon-
venient and a waste of your time—it’s far easier and more efficient to
visit the loan officer at your bank. The bank, by collecting the unused
funds of depositors and redirecting those funds to borrowers who need
financial capital, is acting as an intermediary and charges a price for
this service—the interest rate paid by the borrower. Likewise, Pedro is
providing a service and deserves to be paid for his trouble.
THINK IT THROUGH: There is an opportunity cost incurred by

Pedro in trading with Juan and Carlos. Let us suppose that Pedro (or
any other trader) values his next-best alternative; say, sitting under a
shade tree relaxing with his friends, at two pieces of candy. If Pedro
receives six pieces of candy in payment for his efforts, then in some
sense, his profit is four pieces of candy. As we shall see, economists
term this profit that is over-and-above opportunity cost the economic
profit and the profit that is necessary to cover the opportunity cost—
the normal profit.
The next time the Red Cross parcels arrive at the camp, another
entrepreneur—Pancho—appears on the scene. Pancho has observed the
economic profit—four pieces of candy—that Pedro has been earning on
his trades and wishes to get in on the action. He approaches Juan, and
in order to encourage Juan to trade with him, offers him a better deal
than Pedro’s—2 cigarettes in exchange for only 8 pieces of candy, leav-
ing Juan with 12 cigarettes for 12 pieces of candy. This bundle of goods
(bundle D) is superior to bundle C (Pedro’s offer) and Juan will benefit
by accepting it.
Pancho then approaches Carlos and offers to give him 4 pieces of
candy in return for 2 cigarettes, leaving Carlos with 8 cigarettes and
24 pieces of candy (bundle D). Bundle D is superior to bundle C (Pedro’s
offer) and Carlos will gain by accepting it. Pancho’s payment from trading
is the 4 pieces of candy he receives. (Initially, there were 40 pieces—Juan
has 12, Carlos has 24, and Pancho has 4.) If Pancho values his next-best
alternative to negotiating in the hot sun, sitting under a shade tree, at two
pieces of candy, then his economic profit is two pieces of candy.
THINK IT THROUGH: Note that all the trading parties have

gained. Pedro did not gain, but he was not a participant in this round
of trading.
When Pedro was the only trader, the payment he received was six
pieces of candy. With Pancho in competition, the payment was cut to
four pieces of candy, as each trader tried to attract customers to him. If an
additional trader (Pablo) were now to enter the market and compete for
customers with both Pedro and Pancho, then we can see that the traders’
reward would be driven even lower.
How low will the payment go? Not to zero—for no one would be
willing to accept the risk and inconvenience of trading for no payment
at all. The answer is determined by opportunity cost. A trader will par-
ticipate if the reward he receives is “worth it,” that is, if it covers his op-
portunity cost. If the opportunity cost of trading is the value placed on
socializing with friends under a shade tree and if that value is two pieces
of candy, then the lowest payment that will encourage traders to par-
ticipate in the market is two pieces of candy. This payment, equal to and
determined by opportunity cost, is a reasonable payment for their time
and trouble, and economists call it a normal profit. In economics, unlike
in accounting, normal profit (a reasonable rate of return for the entrepre-
neur) is treated the same as wages and salaries, rent, and interest. Just as
those other payments represent costs of doing business, so does normal
profit. Any payment received above the amount that covers opportunity
cost is considered economic profit.
THINK IT THROUGH: This is an important point that we shall

revisit in Chapter 5 in Volume II, and unfortunately, it is quite subtle
and elusive. Accountants—and, with them, the general public—are
used to adding up business costs, subtracting the total from revenues and
designating the difference “profit.” According to this view, profit, then, is
what remains after costs have been subtracted. Economists, on the other
hand, consider some portion of profit—normal profit—to be part of the
cost of doing business. In economics, “profit” has two components—
normal profit (based on opportunity cost) and economic profit.
Lessons: We can learn some important lessons from this example.
Lesson 1: If participants have the same endowments but different pref-
erences, then trade can be mutually beneficial. This is true
whether Juan and Carlos prefer to trade with each other or to
use intermediaries.
Lesson 2: It is self-interest and the desire to earn a profit that prompts
Pedro and the other entrepreneurs to provide goods, or, as in
this case, services. Entrepreneurs, seeing profit opportunities,
will enter the market.
Lesson 3: C
ompetition among traders can be expected to drive down
profit margins until only a normal profit is earned. At that
point, there is no incentive for additional entrepreneurs to
enter the market and the market will stabilize. It is opportunity
cost that determines the level of normal profit.
Lesson 4: (following from Lesson 3). Competition is beneficial for cus-
tomers such as Juan and Carlos. Because competition drives
down the profit received by entrepreneurs, as competition
increases and profit margins decline, Juan and Carlos retain
more of their candy, and therefore, gain more.
Lesson 5: There is an incentive for entrepreneurs to collude to reduce
competition. Although competition benefits customers,
it hurts entrepreneurs because it reduces their profits—
ultimately to the point at which only a normal profit is being
earned. Entrepreneurs have an incentive to collude to fix
prices or to impose barriers to the entry of more entrepreneurs
in order to reduce competition and keep profits high.
Lesson 6: (following from Lesson 5). Such collusive or restrictive action
hurts consumers and reduces market efficiency.
Rationality and Self-Interest—How Far Do They Go?

The Assumption of Rationality
In our example with Juan and Carlos, we assumed that each refugee
would trade, perhaps using middlemen, perhaps not, but that each would
trade if such a trade were in his own self-interest. In such circumstances,
it would be rational to do so and irrational to hold on to inferior bundles
of goods and not to trade. But is this how we actually behave in the real
world? The new field of behavioral economics, which extends the tradi-
tional view of rationality by incorporating insights from psychology and
real-world behavior, suggests strongly that it is not!
The concepts of rationality and self-interest are deeply rooted in eco-

nomics. At its strictest, full rationality would insist that we weigh up all
the available information about a choice and select the option that best
suits our personal self-interested objectives—the behavior of “economic
man.” Many times, though, we operate in situations where there is lim-
ited information. Here, we may have to rely on rules of thumb or tradi-
tion. Psychologist Daniel Kahneman suggests that we have two modes
of thinking. System 1 makes rapid, automatic decisions but is frequently
biased or inconsistent, whereas System 2 is a more deliberate mode,
employing reason and logic to assemble evidence and to plan optimal
strategies that will achieve considered objectives.
Economics assumes we use System 2 thinking, but often, when we
are hurried, tired, distracted, or faced with a bewildering array of choices,
we resort to System 1’s rule-of-thumb approach because it is less taxing
cognitively.
Even when we strive to be rational, frequently we can be led astray.
The concept of “framing” suggests that the way options are presented can
influence preferences. Offered three alternatives by a salesperson, we are
likely to opt for the middle one.
Further, language and context are important in shaping our choices.
For instance, two equivalent statements (“This new drug will benefit
70 percent of recipients” and “This new drug will show no benefit for
30 percent of recipients”) may not generate the same responses. In a
school lunchroom or in a supermarket, a change in the placement and
presentation of items can change which items are chosen.
“Anchoring” has a similar impact, leading to irrational behavior. Eco-
nomic theory suggests that consumer choice is affected by the respective
prices of goods and by income. If so, information regarding the previous
price of a good ought to be irrelevant, but in fact, if a good is publicized
as being offered at a “specially reduced price,” then we become more likely
to buy it. The regular price acts as an anchor for our decision. The higher
the “regular price” is said to be, the more eagerly we buy at the “cheap”
price we encounter.
Parker’s marketing strategy was effective. Attendance soared, and of
course, so did the Colonel’s revenue. Because the “anchor” price had been
THINK IT THROUGH: Jerry Hopkins, Elvis Presley’s biographer, tells

a story that is perhaps apocryphal, about Presley’s manager, “Colonel”
Tom Parker. Before he met Elvis, Parker managed a run-of-the-mill
country and western show that appeared at carnivals and fairs, and for
which he charged admission of 50 cents. Attendance, however, was lack-
luster. Economists would have recommended that he lower his price to
attract more customers, but Parker did a rethink and raised the price of
admission to $1.00, while stating that any dissatisfied customer would
receive a fifty-cent refund on his ticket. Can you predict what happened?
raised, the public was more willing to attend, and then, reclaim their
fifty-cent “refund.”
We ought to react equally to losses and gains but, for most of us,
because we exhibit loss aversion, the happiness we feel at receiving a one-
time $100 bonus is less than the displeasure we feel at experiencing a one-
time $100 deduction in this month’s paycheck. The tendency to respond
more vigorously to losses than to gains is known as loss aversion.
The endowment effect seems to be related to loss aversion. We place
more value on things we own (and that we might lose) than on equivalent
items that we don’t own (that we might gain). In one experiment, partici-
pants were asked to give a value for an item that they were shown (a coffee
mug). Following this, they were given the mug and then asked what price
they would a ccept if they were to sell or trade the mug. Having estab-
lished ownership of the mug, participants tended to value it significantly
more highly than before they owned it. Clearly, we dislike loss more than
we like gain.
We also dislike excessive choice. Certainly, we regard choice as benefi-
cial, and may express discontent when presented with a severely limited
choice set. However, some research has shown that at the other extreme,
when confronted by a great many options, decision-makers can become
confused and overloaded, sometimes to the point that “no choice” is
seen as the preferred action. In one study, shoppers were offered a free
sample from a range of available soft drinks that they might then go on
and purchase if they wished. In one condition, the choice was from a
range of 6 soft drinks; in the other, 24 varieties were available. Two results
emerged. First, subjects tended to prefer the smaller range of items—they
disliked too much choice. Second, when the shoppers had taken their
sample, those who had been exposed the larger range of alternatives were
significantly more likely to leave without buying any of them than those
subjects who were offered the smaller choice set. After some point, more
numerous alternatives became demotivating.
This behavior may be due, in part, to the cognitive burden required to
assess each option, and then, to weigh it against the others. In the cereal
aisle of the grocery store, for instance, with differing prices, ingredients,
and package sizes, it may not seem worthwhile to incur such a burden,
and be preferable simply to buy what was bought last time or what is on
sale today. Further, the larger the choice set, the greater the number of
alternatives that must be evaluated but rejected, and therefore, the greater
may be the feeling of regret at opportunities not pursued. If we suffer
regret that we may have made a suboptimal choice, then we may prefer to
avoid having to make the choice at all!
Comment : Might there be a link between the image of a discontented

cable viewer, channel-surfing through dozens, if not hundreds of channels
and the contented TV viewer of old who had only three channels to consider?
Allied to the concept of rationality is that of maximization. In
Chapter 3, the investigation of maximization will encourage us to assume
that consumers strive to maximize “total net consumer benefit” whereas
producers strive to maximize “total net producer benefit.” Put more sim-
ply, we assume that as consumers, we seek to get the best deals for the
money we spend at the grocery store. When we buy a new car, we shop
around. In business, given our resources, we wish to maximize profit,
pruning away inefficiencies and unneeded expenses, and searching for
innovative procedures and technologies that will permit us to produce
with fewer resources, and ultimately, to earn the greatest profit possible.
Again, we must ask, “Is this how the real world behaves?” and again,
the answer must be “No!” To be sure, there are those who will obsessively
fight to wring the last ounce of benefit from any particular situation, but
such “maximizers” are not the norm. It is far more likely to encounter
“satisficers,” that is, those who are content with a sufficient level of gain.
In our trading example with Juan and Carlos, if we assume that each
middleman is a maximizer, then, as a result of competition, each interme-
diary would see his profits driven down to the level of a “normal” profit
that would barely cover the opportunity cost of trading. Consequently,
Juan and Carlos would benefit from competition between “maximizing”
middlemen. But what if the middlemen had been content with less profit?
In that case, the drive to undercut the competing traders would have been
absent, collusion would have been more plausible, and paradoxically, eco-
nomic profits would have been preserved!
With respect to choice, whereas a maximizer will devote time and
energy to assessing all the options available to her (as suggested by
Kahneman’s System 2 thinking), a satisficer will find an option that
achieves her acceptable level of value, and then, move on. For the business
owner, profit, rather than holding center stage, instead may be only one
of a number of variables that the entrepreneur is trying to reach. Having
reached a sufficient level of profit, the accomplishment of other goals,
such as a less-stressed life, may become more prominent.
Perhaps because of their relentless quest for optimality, maximizers
are an unhappy lot, research indicates, with significantly lower levels of
satisfaction, self-esteem, and happiness than their more optimistic sat-
isficing counterparts, and with measurably higher levels of remorse and
self-doubt. In the light of this evidence, we may conclude that it is irra-
tional to be rational.
The Assumption of Self-Interest
As well as assuming that individuals will be rational maximizers, we

assume that each person acts in his own best self-interest, as he sees it.
If I think it’s better for me to drive through at a stop sign on a quiet
country road at two in the morning instead of stopping, then I will. (I’ll
weigh up the likely benefits and costs of my action before I do so.) If,
after having considered the pros and cons, I feel it’s in my self-interest
to exceed the speed limit on the freeway on my way to work, then I
will speed (along with everyone else). My actions may or may not be
beneficial or detrimental to others, but my self-interest trumps other
considerations.
I am sure we can recognize others (and ourselves) in this description of

self-interested behavior. However, in our world, we also encounter acts that
seem to defy self-interest—selfless sacrifice on the battlefield, for instance.
Whereas self-interest might make us run away from a fire or drive past a car
accident, people often wish to help and reach out the assist those in hazard.
It is certain, then, that our self-regarding preferences exist alongside
what might be referred to as other-regarding preferences such as fairness
and a concern for the well-being of others.
THINK IT THROUGH: Why do we leave a tip at a restaurant? If

it is a restaurant that we visit often, tipping may buy us better service
in future visits, and so, we could argue, is a rational action. But what
about a restaurant that will only ever be visited once, perhaps dur-
ing a road trip? In this case, there is no possible future benefit to the
customer who leaves a tip—she will never return. However, even in
such a situation, it is quite likely that a gratuity will be given. In this
circumstance, unless we count the benefit we may derive from feeling
generous, tipping offers no direct benefit to the tipper, so doing it must
be due to some other-regarding preference—if we were in the server’s
role, then we would expect the tip.
The Ultimatum Experiment: Behavioral economists have suggested

that these other-regarding preferences may be quite strong and predict-
able and have devised experiments to test rationality and self-interest.
One such game is the Ultimatum Experiment.
This game involves two participants. One player, Henry, receives a
sum of money, perhaps $20, and must choose some portion of his wind-
fall to give to the second participant, Minnie. Minnie’s role is limited
to either accepting the offer or to rejecting it, without negotiation. If
she accepts, then she keeps the money offered, and Henry pockets the
remainder. If she rejects the offer, then the $20 is returned to the experi-
menter and Henry and Minnie receive nothing.
If each player is rational and self-interested, then Minnie should
accept any nonzero amount that Henry offers. After all, 50 cents is bet-
ter than nothing, which is what she will receive if she rejects an offer of
50 cents. Also, Henry, knowing that Minnie is better off accepting any
nonzero amount, should offer her only a small fraction of the $20 so that
his gain is increased.
In practice, however, it does not turn out the way that rational
self-interest would dictate. The first player typically offers the second player
a substantial fraction of the $20—perhaps between 40 to 50 percent.
In addition, if the second player feels that the amount offers is too low
(usually something less than 20 percent), then the offer will be rejected.
Although the percentages may vary from trial to trial, the conclusion is
robust—neither the Henrys nor the Minnies of our world are driven solely
by rational self-interest.
Even if we admit that Henry may feel it necessary to make an offer
big enough to mollify Minnie, that still doesn’t explain Minnie’s behavior.
If offered $3, why should she refuse? Is it some desire to exact revenge on
parsimonious Henry, even if it means losing the $3, or perhaps to teach
him a lesson that will guide him to better choices in future transactions?
The related Dictator Game (devised by Kahneman and his associates)
provides some answers. In this game, Henry (the “dictator”) gets to keep
his fraction of the money, even if Minnie rejects his offer. Any amount he
offers her, therefore, cannot be because of a fear of rejection and monetary
loss. Even in this case, however, researchers have found that offers remain
significantly higher than zero, indicating some other-regarding altruistic
motive. In the real world, we share our bounty.
One final aspect of this topic is worth touching on—fairness. Some
years ago, Coca-Cola introduced a vending machine that adjusted the prices
of sodas as the temperature changed—higher temperature, higher price.
This seemed like good economics. On a hot day at the beach, the enjoy-
ment derived from a cold soda is greater than would be derived on a chilly
overcast day, and accordingly, consumers ought to be willing to pay more.
The marketing strategy was a disaster! When they saw the higher
prices, consumers felt as if they were being exploited, and refused to buy.
The Coke machines were soon withdrawn.
To Be or Not to Be—Rational?
“What does all this mean?” you might ask. If economics is based on
an assumption—rational self-interest—that has proven itself not to be
universal, then should we therefore reject the findings of generations of

economists? Put differently, why do economists persist in using models
based on rationality, if individuals are manifestly not completely ratio-
nal? Simply, because the models still provide robust insights into how
we behave in most markets and most circumstances. If the price of cof-
fee increases, then consumers will tend to buy less coffee. If the mini-
mum wage is increased, then employers will try to hire fewer unskilled
workers.
Further, market forces can motivate participants to behave more
rationally over time. A highly optimist entrepreneur, touting a product
that, in fact, is not particularly attractive to consumers will be forced
out of business eventually, unless he or she admits the error and adjusts
to comply with market discipline. Incentives and penalties reduce
irrationality.
Finally, despite the taint of implausibility, adopting the assumption
of rationality makes economic modeling far more simple than would
otherwise be the case. Any model, by its very nature, is a generalization
and involves trade-offs: if incorporating irrational behavior is likely to
muddy the water more than it is worth, then should we do it? In addition,
although we frequently may be irrational, our irrationality is predict-
able—we are, when all is said and done, creatures of habit and fall into
patterns of behavior that can be predicted.
Big Ideas
Economics is an intriguing field of study, and we can distill some durable

lessons. Some years ago, the economists at the Federal Reserve Bank of
Minneapolis drew up a short list of the main ideas that an economically
literate citizen should understand. We might add to or subtract from this
list—it’s neither definitive nor exhaustive and I offer you my own adapta-
tion of the “big ideas” of economics.
First, Adam Smith mostly had it right. Remarkably, many of Smith’s
views have come down to us largely intact and untarnished. To be sure,
his emphasis was on “supply side” and “long run,” but nevertheless, his
faith in the benevolence of the “invisible hand” and in the productive
power of lightly regulated markets resonates today.
Big Idea #1: “Choice involves cost, or, there’s no such thing as a free lunch.”
Choices matter and trade-offs exist because of scarcity. When we choose an
option, we give up all the other competing options—there is an opportunity
cost and that is the value placed on the next most preferred alternative given
up. In a world of limited resources, our actions have consequences, and no
lunches are free.
Big Idea #2: “Trade is beneficial in that it increases value for the traders.”
More precisely, free trade voluntarily entered into can be mutually
beneficial. Smith’s The Wealth of Nations was a reaction against the
restrictive mercantilist and monopolistic trade policies of the time and
his argument was that exchange benefits both partners. A generation
later, David Ricardo provided the theoretical confirmation with his Law
of Comparative Advantage. Is trade always beneficial? No, certainly not
for every individual. In the past, textile workers in North Carolina and
car workers in Michigan have suffered from trade liberalization as jobs
have moved overseas. In times of high unemployment, for instance,
the temptation to “save jobs” through protectionist policies may be
compelling, but in general, freer trade generates gains that restricted trade
denies.
Big Idea #3: “Individuals and firms respond to incentives and markets
efficiently coordinate production, distribution, and consumption.” Self-
interest and incentives drive the participants in competitive markets to
produce the mix of goods and services that is most preferred by society. A
government’s function is to act as a referee, facilitating transactions and
standing by to levy sanctions when the market’s rules are broken.
THINK IT THROUGH: It should not be surprising to you to learn

that the overwhelming majority of economists support the legalization
of marijuana. This is not because economists believe that marijuana
smoking is a desirable activity (although they may!), but because, gen-
erally, prohibitions or restrictions on markets are felt to be undesirable,
inefficient, and costly.
Big Idea #4: “Sometimes markets fail.” As discussed in Chapter 9 (Volume

II), there are cases where third parties are affected, positively or negatively,
by market transactions. Markets are blind to such external effects, and
therefore, government intervention is required. There is also scope for
government intervention in situations where one party is capable of
yielding undue power, or where free riders (that is, those who can receive
the benefits of a good or service without having to pay) exist.
Review: In this chapter, we have discovered that “there is no such

thing as a free lunch,” in the sense that, any time a choice is made, an
alternative is chosen, but other alternatives are given up. The value placed
on the next-best alternative that is given up when a choice is made is its
opportunity cost—perhaps the single most important idea in economics.
When we look at “cost” in future chapters, keep in mind that at its most
profound level, it is opportunity cost that is involved.
Index
Absolute value, 107–109 A Beautiful Mind (movie), 251
Abusive monopoly, 205 Beer. See under Oligopoly
Achievement, 16 Behavior of Marginal Product, 145
Adam’s marginal benefit curve for Black Death, 15
apples, 78–79 Brain Teaser Solution, 73–74
Adam’s Ribs, 240 Brat tax, 272
Adverse selection, 194 Bundling, 231
Advertising elasticity of demand, 106 Burger King, 38
After-tax income, 48 Burgers. See under Oligopoly
After-tax revenues, 54 Butter mountains and milk lakes,
Agricultural price support, 97 96–98
unintended effects of guaranteed, gift-giving and inefficiency, 98
97–98 public choice, rent-seeking
Agricultural Revolution, 278 behavior, and government
Agriculture Bill, 55, 273 failure, 102–103
Airbags, 195 scalping, 98
Akerlof, George, 196 tariffs and inefficiency, 99–100
Alcoholic beverage control (ABC), 225 tariffs and inefficiency redux,
Allocative efficiency, 16, 191–192, 222, 100–102
243, 260 taxes and inefficiency, 98–99
Anchoring, 27 Buyers
Anti-lemon laws, 197 number/composition of, 52–53
Antitrust actions, 224 remorse, 78
Antitrust Division of the Department of
Justice, 224, 256 Cabal Cable, 231
Artificial barrier to entry, 205–206 Cable TV, as natural monopoly,
Artificial monopoly, 206, 250 230–231
Asymmetrical information, 193 Cap and trade permits, 271–272
Atmospheric pollution, 262 Capital resources, 3
Average Fixed Cost (AFC), 154–155 Cartels, 244, 246–247
Average-marginal rule, 147, 210 Caveat emptor (Buyer beware), 87
Average Product (AP), 143–144 Ceteris paribus assumption,
Average revenue (AR), 158–160, 209 41–42, 53
Average Total Cost (ATC), 155–157, Change in demand, 47–48, 60
176–178, 212 Change in quantity demanded, 41,
Average Variable Cost (AVC), 153–154 60–61
Averch–Johnson effect, 229 Change in quantity supplied, 45
“Child-free” areas, 272
Baby boomers, 201 “Child-free” nights, 272
Bacardi, 117 Choice, 6. See also Economics
Banking. See under Oligopoly involves cost, 34
Barriers to entry, 205 Cigarette tax, 98–99
artificial, 205–206 Clayton Act of 1914, 256
natural, 206–207 Club good, 276
132 INDEX
Coase, Ronald, 268 and total revenue, 110

Coase Theorem, 268–270 utility theory, 69–74
Coca-Cola, 32, 50, 69, 74, 108, 110, Demand and supply analysis. See also
117 Demand; Supply
Collusion, 253–254 examples of using informally, 38
explicit, 246–247 multiple-shift cases, 64–65
tacit, 247 single-shift cases, 57–64
Common Agricultural Policy (CAP), Deregulation, 232–233
96, 97 Determinants of price elasticity of
Common Market, 96 demand, 113–114
Common resource, 276 Dictator Game, 32
Commons, tragedy of, 277–278 Diminishing marginal productivity. See
Community meeting, 279 Law of diminishing marginal
Comparative Advantage, 17–20 productivity
Competition, 26, 30, 103 Diminishing marginal utility
Complements, 50 and demand, 74
in production, 55, 56–57 law of, 74
relationship between, 51 Diseconomies of scale, 176, 179–182
Conduct, 236 causes of, 181–182
Congestion effect, 145–148, 180, 238 Division of labor, 145
Constant costs, 11–12 Dodos, 277–278
Constructive engagement, 200 Dominant strategy, 252
Consumer surplus, 79–81 “Drop-in-the bucket” problem, 280
Consumption Duopoly, 245
negative externalities in, 264
positive externalities in, 267 Earnest money, 87
Contestable markets, 250 East Carolina, 124–125
Cross-price elasticity of demand, 106, Economic cost, 148–149
116–118 Economic efficiency. See Efficiency
Crowe, Russell, 251 “Economic man” behavior, 27
Customer loyalty plans, 251 Economic model, constructing and
testing, 42
Deadweight loss, 85 Economic profit, 25, 161–163
Decrease in demand, 61, 64 allocative role of, 188–189
Decrease in supply, 63 Economic rent, 102
Demand, 260–261. See also Demand Economic theory, 27
and supply analysis Economics
consumer surplus, 79–81 challenge and three fundamental
defined, 38 questions of, 4–6
increase in, 47 defined, 2
law of, 39–42 ideas, 33–35
marginal benefit, explanation of slope resources, 3–4
of demand curve, 77–79 scarcity, 2
negative relationship between price Economies
and quantity demanded, of scale, 176, 179–182
explanations for, 68 causes of, 181
new way to look at, 78–79 and structure of industry, 182
schedule, 39, 40 Efficiency, 15–16
substitution effect and the allocative, 191–192
income effect normal profit, 189–190
demand behavior, 74–76 productive, 190–191
labor supply behavior, 76–77 Elastic demand, 108–112
INDEX
133
Elasticity Fairness, 32
applications Federal Trade Commission, 224
elasticity and tax revenues, 126 Ferrari sports, 38
gas price volatility, responsible Fine Fruit-Filled Pies, 158–159
for, 127 “First come, first served” rationing
incidence of taxes, 124–126 method, 91
minimum wage legislation, Fish market, 122
elasticity and effectiveness of, Ford, Henry, 189, 193
127–128 “Framing,” concept of, 27
cross-price elasticity of demand, Freda, 142–152
116–118 Free rider problem, 279
income elasticity of demand,
115–116 Game theory, 251–256
measure of responsiveness, 106 Gas price volatility, responsible
price elasticity of demand, 106–107 for, 127
absolute value, 107–109 Gasoline, 90–92
determinants of, 113–114 Gates, Bill, 243
midpoint formula, 111–113 Gentlemen’s agreements, 247
total revenue test, 109–111 Giffen goods, 76
price elasticity of supply, 118–120 Gift-giving and inefficiency, 98
determinants of, 120–124 Global warming, 262
Elasticity value (“coefficient”), 107 Government failure, 102–103
Electricity generation and deregulation, Great auk, 277–278
232–233 Great Recession, 48
Employment, tax revenues and, 126
Emus, 200–201 Herfindahl-Hirschman Index (HHI), 256
Endowment effect, 21–26, 28 Honey subsidy, 273
Enforcement costs, 87 Hopkins, Jerry, 28
Enterprise, 3 Human capital, 3
Entrepreneurial ability, 3 Human resources (“labor”), 3
Envelope curve, 179–180 Hurricane, 275
Equilibrium, 46 Hydrogen fuel cells, 189
adjustment to, 45–46 Immediate (market) period, 122
great about, 47 Incentives, 34
market price, 91 Income
price, 90 after-tax, 48–49
Ethanol, 188 effect. See Substitution effect and
Eve’s marginal cost curve for apples, income effect
81–82 elasticity of demand, 106, 115–116
Excludability, 199, 274 expectations about, 49
Explicit collusion, 246–247 Increase in demand, 47, 59, 60
External economies and diseconomies of Increase in supply, 62
scale, 188 Increasing cost, law of, 8
Externalities, 88, 192, 198, Inelastic demand, 108–113
260–261 Inferior goods, 49, 75–76, 115
negative, 261–264 Initial equilibrium diagram, 58
internalizing negative, 267–272 Internal economies and diseconomies of
positive, 264–267 scale, 187–188
internalizing positive, 273 Internalizing negative externalities,
267–272
Facebook, 226 Internalizing positive externalities, 273
Fair return output level, 228–229 Interstate Commerce Commission, 230
134 INDEX
“Invisible hand” of individual pursuit Manhattan Project, 15

of self-interest, 103 Marginal benefit, explanation of slope
of demand curve, 77–79
Jagger, Mick, 71 Marginal cost (MC), 11, 81–82,
James, LeBron, 3 152–153, 162–163, 212
Jobs, Steve, 243 Marginal external benefits (MEB),
Justin Beiber T-shirt, 98 265–266
Marginal external costs (MEC),
Kahneman, Daniel, 27 262–263
Kinked demand curve model, 247–250, Marginal private benefits (MPB),
254–255 265–266
Marginal private costs (MPC), 262–263
Labor supply behavior, 76–77 Marginal product (MP), 144, 148
Law of Comparative (cost) Advantage, Marginal rate of transformation, 8
17–20 Marginal revenue (MR), 158–160,
Law of Demand, 39–42, 68, 107 162–163, 209
Law of diminishing marginal Marginal social benefit (MSB),
productivity 265, 266
production concepts, 142–148 Marginal social cost (MSC), 262, 263
short run and long run, review of, 141 Marginal utility, 69–72
Law of diminishing marginal Marijuana legalization, 201
utility, 69 Market
Law of increasing cost, 8–11 after-tax income or wealth, 48–49
Legal recourse, 270 after-tax revenues, 54
Lindbeck, Assar, 94 and efficiency, 83
Lipitor, 204 equilibrium, 47
Long run, 122–123 expectations about price, income,
adjustment, 184–189 or wealth, 49
defined, 141 and inefficient situation, 84
equilibrium, 185–187 intervention
long-run adjustment, 184–189 price ceiling, 89–92
oligopoly in. See under Oligopoly price floor, 92–94
short-run adjustment, 182–184 modeling, 45–47
monopolistic competition in, number/composition of buyers,
239–241 52–53
monopoly in price of inputs, 53
long-run equilibrium with positive prices of related products, 50–52
economic profits, 221–225 in production, 55–57
long-run equilibrium with zero productivity, 54
economic profits, 220–221 as rationing devices, 86–88
perfect competition in. See Perfect tastes and preferences, 48
competition, in long run technology, 53–54
Long-run average cost (LRAC), Market failures, 35, 88–89, 192–194
176–179 adverse selection, 194
Long-run industry supply (LRIS) moral hazard, 194–197
curve, 187 principal-agent problem, 197
Long-run marginal cost (LRMC), 179 and solutions
Luxury, defined, 114 externalities. See Externalities
parting thoughts, 280–281
Macroeconomics, microeconomics public goods. See Public goods
vs., 16–17 Market structure, 236
INDEX
135
Marriage market, 88 Movie theater, cross-price elasticity

Marshall, Alfred, 121–122 value of, 118
Maximum allocative efficiency, Mutual interdependence, 245
103, 192 MySpace, 226
McDonald, 38
Medical care, 201 Nash (or noncooperative) equilibrium,
Microeconomics vs. Macroeconomics, 252
16–17 National defense, 274
Midpoint formula, 111–113 National Public Radio (NPR), 280
Minimum wage, 93 Natural barrier to entry, 206–207
legislation, 127–128 Natural monopoly, 88, 206,
Monopolist 226–228
performance, 220–222 Natural resources, 3
profit-maximizing for, 218 Necessity, defined, 114
revenue picture, 208–211 Negative economic profit
short-run cost picture, 211–212 continuing to produce, 167–168,
short-run supply curve, 218–219 216–217
Monopolistic competition shut-down case, 217–219
characteristics of, 237–238 shutdown case, 168–170
in long run, 239–241 Negative externalities, 261
monopolistic competitor and in consumption, 264
performance criteria, 241–243 in production, 262–263
review of, 243–244 resource misallocation with, 263
in short run, 238–239 Negative price elasticity of supply, 123
Monopolistic competitor, 241–243 “Negative” tax, 54
Monopoly Neil Diamond, 267
applications in NFL and apparel logos, 231–232
cable TV, 230–231 9/11 event, 227
electricity generation and 19th amendment, 201
deregulation, 232–233 Normal goods, 48, 74–75, 115
NFL and apparel logos, 231–232 Normal profit, 25, 149, 189–190
barriers to entry
artificial, 205–206 OkraCoke, 252–254
natural, 206–207 Oleg, 254–255
characteristics of, 204–205 Olga, 248–249, 254–255
economies of scale creating, 206–207 Oligopoly
in long run, 219–225 characteristics of, 244–245
natural, 88, 226–228 policy response to, 256–257
fair return output level, 228–229 short-run cases and long-run
problems with regulation, 229–230 equilibrium, 245–246
socially optimal output level, 228 contestable markets, 250
perfect competition and, 222 explicit collusion, 246–247
price discrimination, 225–226 game theory, 251–256
in short run, 208 kinked demand curve model,
monopolist’s revenue picture, 247–250
208–211 tacit collusion, 247
monopolist’s short-run cost picture, Omertà, 252
211–212 Opportunity cost, 6–7, 156–157,
profit maximization, 212–219 183–184, 261
Moral hazard, 194–197 Organization of Petroleum Exporting
Mosquito control, 275 Countries (OPEC), 246
136 INDEX
Ostriches, 200–201 Price

Overshoots, 240 ceiling, 89–91
unintended effects of, 91–92
Pareto efficiency, 191 change, length of time to adjust to,
Pareto, Vilfredo, 191 114, 120
Parker, Tom, 28 elasticity of demand, 106–107
Parker’s marketing strategy, 27–28 absolute value, 107–109
Passive smoking, 198 determinants of, 113–114
PensaCola, 252–254 midpoint formula, 111–113
Pepsi, 50, 74–75, 117 total revenue test, 109–111
“Per gallon” tax, 124–125 elasticity of supply, 106, 118–120
Perfect competition, 237–244. See determinants of, 120–124
also under Monopolistic expectations about, 49
competition floor, 92–94
imperfect results from, 192 in labor market, 93
adverse selection, 194 of inputs, 53
externalities, 198 of related products, 50–52,
moral hazard, 194–197 55–57
principal-agent problem, 197 Price discrimination, 205, 225–226
public goods, 198–199 Price leadership, 247
in long run, 176–179, 182–189 Price maker, 205
applications, 199–201 Price stickiness, 254–255
economies and diseconomies of Price taker, 205
scale, 176, 179–182 Principal-agent problem, 197
efficiency, 189–192 Prisoners’ dilemma, 251–252
market failures, 192–199 Private goods, 276
and monopoly, 222 Private negotiation, 268–270
Perfect price discrimination, 225–226 Problems with regulation, 229–230
Perfectly competitive industry Producer surplus, 82–83
characteristics of, 158 Product differentiation, 237
revenue picture for, 158–161 Production
short-run supply curve, 170–173 efficiency, 190–191, 242–243
Performance, 236 function, 142–143
criteria, 220, 241–243 shape of, 147
monopolist, 220–222 negative externalities in, 262–263
Pfizer, 204 positive externalities in, 265–267
Policing cost, 88 Production possibility frontier (PPF)
Policy response to oligopoly, 256–257 diagram, 7–8
Pollution control, 270 components of, 12
Pollution rights market, 271 general increase in, 13
Positive economic profit, 164–166, good-specific increase in, 14
213–215 relaxing assumptions, 13–15
long-run equilibrium with, 221–225 using, 15
Positive externalities efficiency, 15–16
in consumption, 267 microeconomics vs.
in production, 265–267 macroeconomics, 16–17
resource misallocation with, 266 Productive efficiency, 15–16
Preferences Productivity, 54
tastes and, 48 Profit, 25
trade and, 21–26 Profit-earning attraction, 206
INDEX
137
Profit maximization, 29, 212–213, 260 Ricardo, David, 17, 102

negative economic profit Rivalry, 274–275
continuing to produce, 216–217 Rule-of-thumb approach, 27
shut-down case, 217–219
positive economic profit, 213–215 Sam, Salty, 279–280
short-run, 170 Scalping, 98
zero economic profit, 215 Scarcity, 2
Profit-maximizing monopolist, 222 Seat belts, 195
Profit-maximizing rule, 162–163 Self-interest, assumption of, 30–32
Public choice, 102–103 Self-interested behavior, 253–254
Public goods, 88, 198–199, 273 Sellers, number of, 57
commons, tragedy of, 277–278 Shale and silver, 189
excludability, 274 Sherman Act of 1890, 225
problem with private provision of, Short run, 122–123
278–280 adjustment, 182–184
provision by society, 279–280 costs in. See Short-run cost picture
rivalry, 274–276 defined, 141
Public Television, 280 monopolistic competition in, 238–239
Public transport, income elasticity of monopoly in, 208
demand of, 116 monopolist’s revenue picture,
Pure monopoly, 204 208–211
Pure private goods, 273 monopolist’s short-run cost picture,
Pure public goods, 273 211–212
profit maximization, 212–219
Quadricycle, 189 oligopoly in. See under Oligopoly
“Quantity demanded,” 39–40 profit maximization, 170
“Quantity supplied,” 42–44 economic profit, 161–163
general procedure for, 170
Rationality, assumption of, 26–30 short-run cases, 163–170
Rationing devices, markets as, 86–88 Short-run cost picture, 156–157,
Reagan Administration, 200 211–212, 238–239
Red Cross parcel, 21–26 average variable cost, average fixed
Refuse to pay, 279 cost, and average total cost,
Regulation 153–157
internalizing negative externalities, 270 economic cost, 148–149
internalizing positive externalities, 273 total variable cost, total fixed cost, and
of monopoly, 226–230 total cost, 149–153
problems with, 229–230 Short-run supply curve, 170–173
Regulatory capture, 229 Shortage, 46
Rent controls, 94–96 “Sin” taxes, 55
Rent-seeking behavior, 102–103 Smith, Adam, 33, 68, 70, 78, 89
Resources, 3–4. See also specific Snapple, 50
resources Social media, 226
Restaurants, cross-price elasticity Socially optimal output level, 228
value of, 118 Society, provision of public goods by,
Revenue maximization, 255 279–280
Revenue picture, 210, 238, 240 Soda wars, 253–254
monopolist’s, 208–211 Sparx, 227, 228–229
for perfectly competitive industry, Specialization effect, 145, 180, 238
158–161 Speed dating, 88, 147
138 INDEX
Speed networking, 147 Thought experiment, 21–26

Spillover costs and benefits, 260–273 Threat of competition, 250
Spontaneous order, 86 Time, 244
Sports Illustrated, 244 Tip at restaurant, 31
Springsteen concert ticket, 275 Tit-for-tat strategy, 256
Sprite, 69, 117 Titanic, 6
Stellio’s pizzeria Total average, 148
short run monopoly Total cost (TC), 151–152, 211
profit maximization, 212–219 Total economic profit, 161–162, 164–166
revenue picture for, 208–211 Total Fixed Cost (TFC), 150–151, 211
short-run cost information for, Total joint economic surplus, 83–86
211–212 Total net benefit, 84
Storage, cost of, 121 Total net consumer benefit, 29
Subsidies, 273 Total net producer benefit, 29
Substantial transaction costs, 88 Total Product (TP), 142, 144
Substitutes, 50 Total revenue (TR), 159, 208
availability of, 113 defined, 109
in production, 55–56 demand and, 110
relationship between, 51 test, 109–111
Substitution effect and income effect Total Revenue Test, 233
demand behavior, 74–76 Total spending, defined, 109
labor supply behavior, 76–77 Total utility, 69–71
Sunk costs, 151 Total Variable Cost (TVC),
Supply, 260. See also Demand and 149–150, 211
supply analysis Trade, 34
change in, 52–53 basis for, 17–20
defined, 42 graphical basis for, 18
increase in, 53 limits to terms of, 19–20
law of, 42–45 preferences differ and endowments,
marginal cost, 81–82 21–26
producer surplus, 82–83 Tragedy of the commons, 277–278
schedule, 43 Transaction costs, 87
total joint economic surplus, Transportation Security Administration,
maximizing, 83–86 227
Surplus, 45 Turgot, Jacques, 146
Sweezy, Paul, 249
Ultimatum Experiment, 31–32
Tacit collusion, 247 Utility-Maximizing Rule, 68, 72–73
Tariffs Utility Theory, 68
effect on efficiency of, 100
and inefficiency, 99–100 Vlasic Pickles, 181
and inefficiency redux, 100–102
prohibitive, 101 Walmart’s dominance, 181
Taxes, 271 Wealth, 48
cigarette, 98–99 expectations, 49
incidence of, 124–126 Wealth of Nations, 34, 68, 145
and inefficiency, 98–99 West Carolina, 124–125
and preferences, 48 Windows operating system, 205
revenues, elasticity and, 126
Technological improvement, 54 Zero economic profit, 166–167, 215
Technology, 7 long-run equilibrium with, 220–221
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by Marcus Goncalves and Erika Cornelius Smith
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• Economics of Sustainable Development by Runa Sarkar and Anup Sinha
• New Macroeconomics by Apek Mulay
• Hedge Fund Secrets: An Introduction to Quantitative Portfolio Management
by Philip J. Romero and Tucker Balch
• Econometrics for Daily Lives, Volume II by Tam Bang Vu
• The Basics of Foreign Exchange Markets: A Monetary Systems Approach, Second Edition
by William D. Gerdes
• Universal Basic Income and the Threat to Democracy as We Know It by Peter Nelson
• Negotiation Madness by Peter Nelson
• A Primer on Macroeconomics, Volume I, Second Edition: Elements and Principles
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A Primer on

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First published in 2018 by

ISBN-13: 978-1-63157-727-7 (paperback)

Business Expert Press Economics and Public Policy Collection

Collection ISSN: 2163-761X (print)

Cover and interior design by S4Carlisle Publishing Services Private Ltd.,

First edition: 2013

Printed in the United States of America.

About the Author.................................................................................129

Scarcity and Choice

Chapter Preview: In this introductory chapter, we look at the ­fundamental

By the end of this chapter, you will be able to:

What is “economics” all about?

Economics: The Scientiﬁc Study of Rational Choice

In economics, an item is considered “scarce” if, when its price is zero,

Economists define four types of scarce resources.

Comment: In economics, unlike in accounting, profit (more properly,

THINK IT THROUGH: Every productive activity involves some

The Economic Challenge and the Three Fundamental

As a restaurant owner, because you cannot offer everything, you must

A friend (“Emily”) once opened a shop selling imported specialties from

THINK IT THROUGH: When the Titanic sank in 1912, there were

THINK IT THROUGH: Can you think of other “rules” that our

Remember: Whenever you make a choice, you are choosing to accept

THINK IT THROUGH: Consider your actions in the restaurant.

The Production Possibility Frontier

A Maximum chair production

then if we increase the production of tables, we will have to pull resources

The Law of Increasing Cost

Production alternatives Opportunity cost of one

At alternative A, all three workers are producing chairs. At alternative

THINK IT THROUGH: Verify that if one table is being produced,

Comment on Reciprocals: Note that, for Calvin, the opportunity cost of

THINK IT THROUGH: Verify that if the workers are all producing

THINK IT THROUGH: If the cost of producing additional tables

unchanging. This would happen if resources were identical in abilities,

Although increasing costs are typical in the real world, as we have

Note: If we have constant costs, then the marginal cost is constant,

Relaxing the Diagram’s Assumptions

Comment: It may be hard to imagine a situation where one would

We can demonstrate this conclusion quite simply. Although increas-

Note: If we have constant costs, then marginal cost is constant, rather

THINK IT THROUGH: What happened to medieval Europe’s PPF

Using the PPF Diagram

Comment: Note, though, that if we have unemployed resources, we

Efficiency: The diagram can also be used to distinguish between two

Any point on the frontier is a point of maximum productive effi-

Comment : Intuitively, productive efficiency may be thought of as

Microeconomics versus Macroeconomics: Microeconomics generally

Comparative Advantage and the Basis for Trade

of superior skill, better ingredients, or a more reliable oven. Fully devoted to

Figure 1.7 The graphical basis for trade

because of reciprocity, no individual can have a comparative advantage in

Jack and Jill decide to specialize according to comparative advantage

Trade when Preferences Differ

Thought Experiment: We now ask Juan to participate in a thought

Table 1.1 Thought experiments for Juan and Carlos

With Carlos, we repeat the process, but with a slight difference—

Table 1.2 Trades with Pedro and Pancho

D (> C) Pancho trades 12 12 8 24

Pedro’s payment from trading is the 6 pieces of candy he receives.

THINK IT THROUGH: If you wish to borrow money to buy a car,

THINK IT THROUGH: There is an opportunity cost incurred by

Chapter Preview: In this introductory chapter, we look at the fundamental