Contemporary
Economics
The eighth edition of Contemporary Economics continues to offer a clear, concise presentation of basic microand macroeconomic theory. Emphasizing how the discipline of economics connects to the world, the book
takes a friendly and accessible tone, illustrating theory with applications.
This new edition comes with updated applications and data to reflect the changing world events since the
previous edition was published. This handbook uses real-world, globally relevant case studies that make the
subject easy to understand. New and updated topics include:
•
Energy and oil
•
Economic sanctions on Russia and Iran
•
The Eurozone Crisis
•
The Trans-Pacific Partnership
•
China and the world currency market
Including a Companion Website complete with instructor’s manual, lecture slides and test bank, as well as
an online study guide and multiple-choice questions for students, Contemporary Economics is suitable for both
economics students and non-majors studying economics and economic issues at the introductory level.
Robert Carbaugh is Professor of Economics at Central Washington University, USA.
2
Contemporary
Economics
An Applications Approach
Eighth Edition
Robert Carbaugh
3
Eighth edition published 2017
by Routledge
711 Third Avenue, New York, NY 10017
and by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
Routledge is an imprint of the Taylor & Francis Group, an informa business
© 2017 Robert Carbaugh
The right of Robert Carbaugh to be identified as author of this work has been asserted by him in accordance with sections 77 and 78 of
the Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other
means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system,
without permission in writing from the publishers.
Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and
explanation without intent to infringe.
First edition published by South-Western 2000
Seventh edition published by Routledge 2015
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging in Publication Data
Names: Carbaugh, Robert J., 1946- author.
Title: Contemporary economics : an applications approach / Robert Carbaugh.
Description: 8th edition. | Abingdon, Oxon ; New York, NY : Routledge, [2016]
Identifiers: LCCN 2016005286| ISBN 9781138652170 (hardback) | ISBN 9781138652194 (pbk.) | ISBN 9781315624433 (ebook)
Subjects: LCSH: Economics. | United States—Economic conditions.
Classification: LCC HB171 .C277 2016 | DDC 330—dc23
LC record available at http://lccn.loc.gov/2016005286
ISBN: 978-1-138-65217-0 (hbk)
ISBN: 978-1-138-65219-4 (pbk)
ISBN: 978-1-315-62443-3 (ebk)
Typeset in Bembo Std
by Swales & Willis Ltd, Exeter, Devon, UK
4
Contents
List of Figures
List of Tables
Preface
Acknowledgments
PART
1 Introduction
CHAPTER 1
Scarcity and Choice
What is Economics?
Microeconomics
Macroeconomics
The Economic Way of Thinking
Every Choice Has a Cost
People Make Better Choices by Thinking at the Margin
Rational Self-Interest
Economic Models
Positive versus Normative Economics
Scarcity
Scarcity and Opportunity Cost
The Opportunity Cost of Attending College
Opportunity Costs and Choices
The Production Possibilities Curve and Opportunity Cost
Economic Inefficiency
The Law of Increasing Opportunity Cost
Economic Growth
Economic Decline
Innovation, Economic Growth, and the American Economy
Economic Growth: Trade-Offs between Current and Future Consumption
Production Possibilities Applications
Opportunity Cost of National Security
Economic Sanctions against Iran
5
Russian Aggression against Ukraine Brings Sanctions
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
Exploring Further 1.1: A Primer on Tables and Graphs
Movements along the Study Time–Grade Line
Slope of the Study Time–Grade Line
Shifts in the Study Time–Grade Line
PART
2 The Microeconomy
CHAPTER 2
Market Transactions: Demand and Supply Analysis
Markets
Demand
The Demand Curve and the Law of Demand
What Explains the Law of Demand?
Changes in Demand: Demand Shifters
Demand Theory Applications
GM Offers Deep Discounts to Bolster Volt Sales
Yankees Slash Prices of Top Tickets to Fill Seats at New Park
Supply
The Supply Curve and the Law of Supply
Changes in Supply: Supply Shifters
Hydraulic Fracturing Squeezes More Oil and Natural Gas from the Ground
Demand, Supply, and Equilibrium
Shifts in Demand and Supply
Contemporary Applications of Demand and Supply
Bike Competition Puts the Brakes on Schwinn
What Drives Gasoline Prices?
Rising Health Care Costs Harm Households
Reducing America’s Dependence on Oil
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
CHAPTER 3
6
Demand and Supply Applications
Price Elasticity of Demand
Determinants of Price Elasticity of Demand
Availability of Substitutes
Proportion of Income
Time
Price Elasticity of Demand and Total Revenue
Cigarette Tax Raised to Increase Government Revenue
Colleges Hike Tuition Used to Offset Cutbacks in State Aid to Higher Education
Pittsburgh Pirates Underestimate Fan Reaction: Ticket Price Hike Was Wrong
U.S. Postal Service Boosts Rates to Increase Revenue
Price Ceilings and Price Floors
Rent Controls Make Housing More Affordable
Should Federal Interest-Rate Ceilings Be Imposed on MasterCard and Visa?
U.S. Farmers Reap Subsidies from the Government
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
CHAPTER 4
Production and the Costs of Production
The Short Run and the Long Run
The Production Function
Short-Run Production
Improvements in Technology and Work Rules Shift Product Curves Upward
Short-Run Production Costs
Total Fixed, Total Variable, and Total Costs
Average Costs
Marginal Cost
Long-Run Production Costs
Economies of Scale
Diseconomies of Scale
Shifts in Cost Curves
Apple’s Global Production Network
Dell Downsizes to Slash Costs
Costs and Profit
7
Explicit Costs and Implicit Costs
Accounting Profit and Economic Profit
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
CHAPTER 5
Competition and Monopoly: Virtues and Vices
Perfect Competition
The Perfectly Competitive Firm as a Price Taker
Perfect Competition: Profit Maximization in the Short Run
Marginal Revenue Equals Marginal Cost Rule
Profit Maximization
Perfect Competition: Long-Run Adjustments and Economic Efficiency
Will iTunes Store Start Singing the Blues?
Monopoly
Barriers to Entry
Legal Barriers
Control over Essential Inputs
Economies of Scale
Cable Television: Why Rates Are So High
De Beers: The “Gift of Love”
Profit Maximization for a Monopoly
Price and Marginal Revenue
Maximizing Profits
Continuing Monopoly Profits
The Case Against Monopoly
Universal Service and the Postal Monopoly
Reducing Monopoly Power: Generic Drugs Compete Against Brand-Name Drugs
Is Google a Monopoly? Should It Be Broken Up?
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
Exploring Further 5.1: Loss Minimization and the Shut-Down Rule
CHAPTER 6
Imperfect Competition
8
Concentration Ratios
Monopolistic Competition
Profit Maximization in the Short Run
The Long Run: Normal Profit and Excess Capacity
Despite Competition from Starbucks, Many Independent Coffeehouses Survive
Advertising
Price Discrimination
Oligopoly
Oligopolistic Rivalry
Rivalry in the Soft Drink Industry
Rivalry in the Photographic Equipment Industry
Game Theory and Oligopoly Behavior
Competitive Oligopoly and Low Prices
Cooperative Behavior and Cheating
Airbus and Boeing Compete for Supremacy in the Jetliner Industry
Collusion and Cartels
Mergers and Oligopoly
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
CHAPTER 7
Labor Markets
Labor Market Equilibrium
Do Minimum Wage Laws Help Workers?
Are Workers Better Off with Labor Unions?
Increasing Union Wages
What Gives a Union Strength?
Indiana and Michigan Adopt Right-to-Work Laws
Caterpillar Bulldozes Canadian Locomotive Workers
Did Restrictive Work Rules Cream Twinkies and Ding Dongs?
Outsourcing: Threat or Opportunity for U.S. Workers?
What Prevents U.S. Jobs from Being Outsourced Abroad?
Effects of Outsourcing
Will Jobs Move Back to the United States?
Immigration Laws and American Workers
9
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
Exploring Further 7.1: A Firm’s Hiring Decision
CHAPTER 8
Government and Markets
Market Failure
Monopoly Power
Antitrust Policy
Is Microsoft a Monopoly?
Economic Regulation and Deregulation
Public Utility Regulation
Peak-Load Pricing: Buying Power by the Hour
Spillover Effects
Spillover Costs
Cap and Trade: Trading Emission Certificates
Spillover Benefits
Should the United States Shift More Energy Subsidies to Renewable Power?
Should Government Subsidize Professional Sports?
Social Regulation
Do Corporate Fuel Economy Standards Promote Fuel Conservation?
Public Goods
Inadequate Information
Economic Inequality
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
PART
3 The Macroeconomy
CHAPTER 9
The Mixed Economy of the United States
Households as Income Receivers: Income Inequality
Sources of Income Inequality
Trends in Income Inequality
Households as Spenders
10
The Business Sector
Government in the Mixed Economy
Social Insurance: Social Security, Medicare, and Unemployment Compensation
Should Social Security Be Privatized?
Government Finance
Taxation Principles: Benefits Received versus Ability to Pay
Progressive, Regressive, and Proportional Taxes
The U.S. Tax Structure
Federal Personal Income Tax
Federal Corporate Income Tax
Social Security Tax
Sales, Excise, and Property Taxes
Overall U.S. Tax System
Is the U.S. Tax System Fair?
Should the U.S. Tax System Be Reformed?
Flat-Rate Income Tax
Value-Added Tax
National Sales Tax
Corporate Income Tax
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
C H A P T E R 10
Gross Domestic Product and Economic Growth
Measuring an Economy’s Output
Gross Domestic Product
GDP Is the Market Value
Of All Final Goods and Services
Produced
Within a Country
In a Given Year
The Components of GDP
A Formula for GDP
What GDP Does Not Measure
Real GDP versus Nominal GDP
11
Long-Run Economic Growth
The Rate of Economic Growth
What Determines Economic Growth
Natural Resources
Physical Capital
Human Capital
Productivity
The Significance of Technological Innovation
The Role of Government
Theories of Economic Growth
Is Growth Desirable?
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
C H A P T E R 11
The Business Cycle, Unemployment, and Inflation
The Business Cycle
Phases of the Business Cycle
Theories of the Business Cycle
The Great Recession: 2007–2009
Bursting of Housing Bubble Triggers Recession
Unemployment
Measuring Unemployment
Three Kinds of Unemployment
Mitigating the Costs of Unemployment
What Is Full Employment?
Inflexible Labor Markets Cost Jobs
Productivity, Real Wages, and Jobs
Inflation
Measuring Inflation: The Consumer Price Index
Who Benefits from and Who is Hurt By Inflation?
Inflation and the Purchasing Power of Income
Redistribution of Wealth from Lenders to Borrowers
Inflation and Real Interest Rates
Inflation and Taxpayers
12
Effects of Severe Inflation
Causes of Inflation
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
C H A P T E R 12
Macroeconomic Instability: Aggregate Demand and Aggregate Supply
The Stability of the Macroeconomy
The Classical View
The Great Depression
The Keynesian View
Aggregate Demand and Aggregate Supply
Aggregate Demand
Movements along the Aggregate Demand Curve
Shifts in the Aggregate Demand Curve
The Multiplier Effect
Aggregate Supply
Movements along the Aggregate Supply Curve
Shifts in the Aggregate Supply Curve
The Origins of Recession
Decreases in Aggregate Demand
Decreases in Aggregate Supply
The Origins of Inflation Revisited
Demand-Pull Inflation
Cost-Push Inflation
Productivity Growth Dampens Inflation
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
Exploring Further 12.1: The Nature and Operation of the Multiplier Effect
Calculating the Value of the Multiplier
Graphical Illustration of the Multiplier Effect
C H A P T E R 13
Fiscal Policy and the Federal Budget
Fiscal Policy
13
Fiscal Policy and Aggregate Demand: Short-Run Effects
Combating Recession
Combating Inflation
Automatic Stabilizers
Effects of Fiscal Policy in the Long Run
Fiscal Policy in Action
Problems of Fiscal Policy
Timing Lags
Crowding-Out Effect
Offsetting State and Local Fiscal Policies
When Is Fiscal Policy Useful?
The Federal Deficit and Federal Debt
Sales and Ownership of Federal Debt
U.S. Fiscal Policy: Does the Federal Debt Cheat Future Generations?
Should the Federal Budget Be Balanced At All Times?
Annually Balanced Budget
Cyclically Balanced Budget
Functional Finance
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
Exploring Further 13.1: Fiscal Policy and the Multiplier
C H A P T E R 14
Money and the Banking System
The Meaning of Money
Medium of Exchange
Unit of Account
Store of Value
Are Credit Cards Money?
Shopping for a Credit Card: Why Are Rates So High?
The U.S. Money Supply
Coins
Paper Money
Checking Accounts
Special Types of Checks
14
Check Processing and Collection
Holds on Checking Accounts
What Backs the Money Supply?
Measuring the Money Supply: The M1 Money Supply
How Your Money Grows Over Time: Compound Interest
The Business of Banking
A Bank’s Balance Sheet
The Reserve Requirement
The Process of Money Creation
The Federal Deposit Insurance Corporation
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
C H A P T E R 15
The Federal Reserve and Monetary Policy
The Federal Reserve System
Structure of the Federal Reserve System
The Independence of the Fed
The Functions of the Federal Reserve System
Monetary Policy
Open Market Operations
The Discount Rate
The Reserve Requirement
Term Auction Facility
Shifting Aggregate Demand
Expansionary Policy
Restrictive Policy
The Federal Reserve and Economic Stabilization
The Great Recession of 2007–2009
2001 Attack on America
Monetary Policy: Advantages and Disadvantages
Advantages of Monetary Policy
Disadvantages of Monetary Policy
Discretion or Rules: Fixed Money Rule or Inflation Targeting
Should Congress Reduce the Independence of the Federal Reserve?
15
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
PART
4 The International Economy
C H A P T E R 16
International Trade and the Global Economy
The United States as an Open Economy
The Advantages of Specialization and Trade
Comparative Advantage and International Trade
Production and Consumption without Specialization and Trade
Production and Consumption with Specialization and Trade
Comparative Advantage
Why is Free Trade Controversial?
Limiting Foreign Competition: Tariffs
The Regressive Nature of U.S. Tariffs
Arguments for Trade Restrictions
Job Protection
Protection against Cheap Foreign Labor
Fairness in Trade: A Level Playing Field
Infant Industry
National Security Argument
Pursuing Trade Liberalization
World Trade Organization
North American Free Trade Agreement
The Trans-Pacific Partnership
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
C H A P T E R 17
International Finance
The Balance of Payments
The Current Account
The Capital and Financial Account
What Does a Current Account Deficit (Surplus) Mean?
16
The U.S. Balance of Payments
Are U.S. Current Account Deficits Bad?
Foreign Exchange Market
Exchange Rate Determination
Long-Run Determinants of Exchange Rates
Short-Run Determinants of Exchange Rates
Exchange Rate Systems
Floating Exchange Rates
Fixed Exchange Rates
Monetary Integration in Europe: The Euro
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
C H A P T E R 18
Economic Systems and Developing Countries
Economic Systems and the Fundamental Economic Questions
Market Economy
Command Economy
Mixed Economy
Transition Economies
Eastern European Countries
China
India
The Economics of Developing Countries
Obstacles to Economic Development
The Ladder of Economic Development and Trade Conflicts
Fair Trade and Coffee Growers
Strategies for Economic Growth
Assisting the Developing Countries
World Bank
International Monetary Fund
Generalized System of Preferences
Chapter Summary
Key Terms and Concepts
Study Questions and Problems
17
Glossary
Index
18
Brief Contents
List of Figures
List of Tables
Preface
Acknowledgments
PART
1 Introduction
1
PART
PART
2 The Microeconomy
2
Market Transactions: Demand and Supply Analysis
3
Demand and Supply Applications
4
Production and the Costs of Production
5
Competition and Monopoly: Virtues and Vices
6
Imperfect Competition
7
Labor Markets
8
Government and Markets
3 The Macroeconomy
9
PART
Scarcity and Choice
The Mixed Economy of the United States
10
Gross Domestic Product and Economic Growth
11
The Business Cycle, Unemployment, and Inflation
12
Macroeconomic Instability: Aggregate Demand and Aggregate Supply
13
Fiscal Policy and the Federal Budget
14
Money and the Banking System
15
The Federal Reserve and Monetary Policy
4 The International Economy
16
International Trade and the Global Economy
17
International Finance
19
18
Economic Systems and Developing Countries
Glossary
Index
20
Figures
1.1
Opportunity Cost and Choice
1.2
Production Possibilities Curve
1.3
The Law of Increasing Opportunity Cost
1.4
The Effect of Economic Growth on the Production Possibilities Curve
1.5
Economic Growth in the United States and Japan
1.6
The Opportunity Cost of National Security
1.7
Effects of Economic Sanctions
1.8
Study Time–Grade Relationship in an Economics Issues Class
2.1
The Demand Schedule and Demand Curve for CDs
2.2
An Increase in Demand
2.3
The Supply Schedule and Supply Curve of CDs
2.4
An Increase in Supply
2.5
Equilibrium in the CD Market
2.6
Changes in Demand and Supply: Effects on Price and Quantity
2.7
The Market for Schwinn Bikes
2.8
Increasing Cost of Health Care
3.1
Raising Tuition and Total Tuition Revenue
3.2
Rent Ceilings and Housing Shortages
3.3
Effect of Price Supports for Wheat
4.1
Short-Run Production Function of Denver Block Co.
4.2
Hypothetical Short-Run Cost Schedules for Hewlett-Packard
4.3
Hypothetical Long-Run Average Total Cost Curve for Hewlett-Packard
5.1
Demand and Marginal Revenue of a Perfectly Competitive Firm
5.2
Profit Maximization for a Perfectly Competitive Firm
5.3
Long-Run Adjustments for a Perfectly Competitive Firm
5.4
Economies of Scale and Natural Monopoly
5.5
Profit Maximization for a Monopolist
5.6
Short-Run Cost Conditions Faced by a Perfectly Competitive Firm
5.7
Demand and Cost Conditions Faced by a Monopolist
5.8
Loss Minimization for a Perfectly Competitive Firm
21
6.1
Market Outcomes Under Monopolistic Competition
6.2
The Effect of Advertising on Demand and Average Total Costs
6.3
Game Theory and Oligopoly Behavior
6.4
Short-Run Position of a Monopolistically Competitive Firm
7.1
Market for Apple Pickers
7.2
Effects of a Minimum Wage
7.3
Union Methods of Increasing Wages
7.4
Mt. Pleasant Apple Company’s Demand Schedule for Labor
8.1
Public Utility Regulation of Natural Monopoly
8.2
Correcting for Market Failure: Spillover Costs
8.3
Correcting for Market Failure: Spillover Benefits
9.1
Preparation of the Federal Government’s Annual Budget
9.2
Replacing the Progressive Income Tax with a Flat-Rate Tax
11.1
Historical Business Fluctuations in the United States
11.2
The Business Cycle
11.3
Rigid Wages Can Result in Involuntary Unemployment
12.1
Macroeconomic Equilibrium
12.2
Aggregate Supply Curve
12.3
The Origins of Recession
12.4
The Origins of Inflation
12.5
Productivity Growth Moderates Inflation
12.6
The Multiplier in Action
13.1
Expansionary Fiscal Policy
13.2
Contractionary Fiscal Policy
13.3
Deficits and Surpluses of the U.S. Government under Various Presidents, 1981–2011
13.4
Fiscal Policy and the Multiplier Effect
14.1
The Dollar Bill
14.2
Electronic Codes on a Check
14.3
How the Payments System Works
14.4
The Future Value of $10,000 Compounded Annually at an Interest Rate of 5 Percent
14.5
The Process of Money Creation
15.1
The Twelve Federal Reserve Districts
15.2
Fed Open Market Purchases of Securities Directly from a Commercial Bank
15.3
Effects of Monetary Policy on the Economy
22
15.4
The Fed and the Recession of 2007–2009
15.5
Combined Balance Sheet of All Commercial Banks
15.6
Wisconsin National Bank’s Balance Sheet
16.1
Comparative Advantage and International Trade
16.2
Economic Effects of a Tariff
17.1
Exchange Rate Determination
23
Tables
1.1
Estimated Average Cost of a Year of College, 2014–2015
1.2
Capacity Utilization Rates for Major U.S. Industries, 1972–2014 Average
1.3
Production Possibilities
1.4
Studying Pays Off in an Economics Issues Class
2.1
Impacts of Changes in Both Demand and Supply
2.2
Supply and Demand Schedules of Computers
3.1
Estimated Price Elasticities of Demand
3.2
Dynamic Ticket Pricing of the San Francisco Giants, AT&T Park, September 8, 2015
3.3
Price Elasticity of Demand for Mail Services of the U.S. Postal Service
3.4
Market for Apartments
3.5
Market for Milk
4.1
A Production Function for Chocolate Chip Cookies
4.2
Hypothetical Cost Schedules for HP Printers in the Short Run
4.3
The Cost of Driving in 2015
4.4
Average Total Cost of a Prescription Drug
4.5
Cost of Producing the iPhone
4.6
Productivity Data
4.7
Producing Textbooks
4.8
Hanson Electric Company’s Cost of Production
4.9
Cost Data for the Production of Microscopes
5.1
Demand and Revenue Schedules for De Beers as a Monopolist
5.2
Revenue and Cost Conditions of Johnson Electronics Inc.
5.3
Revenue and Cost Data of Charette Technologies Co.
5.4
Cost Data for a Perfectly Competitive Firm
6.1
Top-Four Concentration Ratios for Selected U.S. Manufacturing Industries, 2012
6.2
U.S. Automobile Market: Market Shares
6.3
Hypothetical Profit-Payoff Matrix for Nike and Reebok
7.1
Selected State Minimum Wage Rates
7.2
Union Membership, 1985–2010
7.3
Labor Data for Youngquist Strawberry Co.
24
7.4
Market for Less-Skilled Labor
8.1
Federal Subsidies for Electric Power by Source
8.2
Hypothetical Demand and Cost Data for New England Power and Light Co.
9.1
Distribution of Income in the United States, 1980–2012
9.2
Disposition of Household Personal Income, 2004–2014
9.3
Government Receipts and Expenditures, Percent of Total
9.4
Total Tax Receipts as a Percent of Gross Domestic Output
9.5
Progressive, Proportional, and Regressive Taxes
9.6
Federal Income Tax Rates for a Single Taxpayer, 2015
9.7
Share of Federal Personal Income Tax Paid by Various Income Groups
9.8
Corporate Income Tax Rates around the World, 2014
9.9
Hypothetical Tax Data
9.10
Hypothetical Sales Tax Data
10.1
Gross Domestic Product, 2014
10.2
Comparisons of Living Standards Throughout the World
10.3
Nominal GDP, Real GDP, and GDP Deflator, 2009–2014
10.4
Annual Rates of Growth in U.S. Labor Productivity and Real Compensation per Hour in the
Business Sector, 1960–2014
10.5
Gross Domestic Product Data
10.6
Calculation of Real Gross Domestic Product
11.1
Post-World War II Recessions for the United States
11.2
The Burdens of Unemployment: Unemployment Rates
11.3
Unemployment Rate Adjusted for Part-Time Workers and Discouraged Workers
11.4
The Impact of Inflation on the Real Value of $10,000, 2000–2010
11.5
Consumer Price Index and Rate of Inflation for Selected Years
11.6
The Price of a Big Mac, July 2015
11.7
Nominal and Real Interest Rates, 2000–2014
11.8
Inflation and Real Wages
11.9
Nominal and Real Interest Rates
12.1
Aggregate Demand and Aggregate Supply Data
12.2
The Multiplier Process
13.1
Examples of U.S. Fiscal Policies
13.2
Discretionary Fiscal Policies
13.3
Automatic Stabilizers during the Great Recession of 2007–2009
25
13.4
Federal Debt Held by the Public
13.5
Hypothetical Tax Data for the United States
14.1
How Bank Credit Cards Compare, 2015
14.2
Interest Rates on Household Loans
14.3
The M1 Measure of U.S. Money Supply, 2015
14.4
Consolidated Balance Sheet for All U.S. Commercial Banks, August 2015 (billions of dollars)
14.5
Hypothetical Money Supply Data
14.6
Balance Sheet of the Bank of Ohio
15.1
Required Reserve Ratios of the Fed, 2015
15.2
Using Monetary Policy to Combat a Recession or Inflation
16.1
The Fruits of Global Trade
16.2
Hewlett-Packard Outsources Production of the HP Pavilion
16.3
Comparative Advantages in the Global Economy
16.4
Hourly Compensation Costs for All Employees in Manufacturing, 2013
16.5
Production Possibilities Schedules of Japan and South Korea
16.6
Australia’s Computer Market
17.1
U.S. Balance of Payments: 1980–2014
17.2
Foreign Exchange Quotations
17.3
International Transactions of the United States
17.4
Supply of and Demand for British Pounds
17.5
Dollar/Franc Exchange Values
18.1
Basic Economic and Social Indicators for Selected Nations, 2013
18.2
Average Tariff Rates of Selected Developing Countries and Advanced Countries
26
Preface
As a university instructor, I have enthusiastically taught a one-term survey of economics course for more than
30 years to undergraduate students majoring in business, economics, and other disciplines. Most of the
students who take my course are still in their teens and have only a modest awareness of economics. They are
interested in learning, but they want to know how economics relates to their daily lives. Learning economic
theory, by itself, means little to most students. I sometimes hear students ask “What good is theory if it
doesn’t help me get a job or increase my income?”
To make my survey of economics course come alive for these students, I combine a clear and concise
presentation of microeconomic and macroeconomic theory with an abundance of contemporary applications.
To illustrate each economic principle, I relate real-world examples taken from current newspapers, magazines,
government reports, and economic journals. Also, I show videos to my students that deal with issues such as
Social Security reform, subsidies to renewable energies, and the European Monetary Union. To help my
students become informed consumers, I discuss topics such as obtaining mortgages with fixed or variable
interest rates and assessing the cost of driving an automobile.
Indeed, combining real-world applications with an exciting and sometimes humorous presentation of
economic theory is the main focus of my course. The positive feedback that I have received indicates that I
have developed an approach to teaching that makes economics come alive for students.
This pedagogical approach is integrated into my textbook Contemporary Economics: An Applications
Approach, 8th edition. The encouragement that I have received during the first seven editions of this text has
convinced me that my approach is meeting the needs of a considerable number of students and faculty. It is
with pleasure that I have prepared an eighth edition of this textbook.
MEETING STUDENTS’ NEEDS
A challenge faced by instructors on economics survey courses is that many of their students will go on to take
courses in the principles of microeconomics and the principles of macroeconomics. To be meaningful for
these students, the survey of economics course must provide an introduction to microeconomics and
macroeconomics without duplicating the principles courses.
A strength of Contemporary Economics is that it addresses such a need. By combining a relatively small
number of theoretical tools with an abundance of contemporary applications, my textbook is not an
abbreviation of a principles textbook. Rather, it is a distinct survey of economics for economics majors who
wish to take an introductory course before moving on to more rigorous courses in the principles of
microeconomics and macroeconomics and for non-majors who wish to take only one course in this field.
Contemporary Economics is written mainly for students at 4-year colleges and universities as well as for
students at community colleges. However, this textbook will also be highly attractive to high schools offering
27
an introductory course in economics.
DISTINGUISHING FEATURES
The distinguishing features of my textbook include clear and concise presentation of economic theory, global
coverage in every chapter, integration of contemporary issues throughout theoretical presentations, and the
inclusion of consumer economics topics.
Presentation of Theory
Presenting economic theory in a clear and easy-to-understand manner is the foundation of this textbook.
Students can easily relate to the economic theories because they are presented in terms of realistic examples
chosen to appeal to students of all backgrounds and abilities. For example, demand and supply analysis is
presented in terms of the market for compact discs, the costs of production in terms of computer printers,
perfect competition in terms of the Puget Sound Fishing Co., monopoly in terms of De Beers (the diamond
monopoly), and oligopoly in terms of Boeing and Airbus. These contemporary examples are reinforced by
additional real-world examples that come from publications such as The Wall Street Journal, Business Week, and
The New York Times.
For example, Chapter 5 discusses why cable television rates are so high. The discussion combines
theoretical topics such as barriers to entry, natural monopoly, and potential competition in the pricing of cable
television. Because they are familiar with cable television, students can easily identify with its pricing
implications.
Students who have read my textbook have commented not only that the presentation is clear and easy to
understand, but also that they could remember the specific examples illustrating the theories throughout the
textbook. Moreover, all diagrams throughout my textbook use numbers (for example, 10 CDs at a price of
$10) on their axes to make the examples familiar and obvious to the student. Many other textbooks use letters
on their axes (for example, OA units of product X at a price of OY), which students tend to find remote from
their daily lives. Finally, my textbook emphasizes only the economic models that are essential to an
introductory understanding of economics: production possibilities analysis, demand and supply for particular
markets, production and the costs of production, perfect competition and monopoly, and aggregate demand
and supply.
Global Content
No survey of economics textbooks can ignore discussion of the global economy. Contemporary Economics
addresses this issue using a two-pronged approach. First, I globalize each chapter so that students will not
think of the U.S. economy in isolated terms as they read this textbook.
For example, Chapter 7 discusses whether the outsourcing of jobs by U.S. companies is a threat or an
opportunity for American workers. This topic has been publicized in the news media and is familiar to
students. Here, they will learn how the U.S. labor market is linked to labor markets in other countries such as
28
India and China.
I also introduce a global component by including separate chapters on international trade, finance, and
development. Chapter 16, International Trade and the Global Economy, discusses the principle of comparative
advantage and the effects of free trade and protectionism. Chapter 17, International Finance, provides an
introduction to the U.S. balance of payments, the foreign exchange market, and the factors that cause
fluctuations in the dollar’s exchange value. Chapter 18, Economic Systems and Developing Countries, discusses
alternative economic systems and the role of developing countries in the global economy.
Real-World Applications
Contemporary Economics: An Applications Approach lives up to its name by emphasizing applications and policy
questions as often as possible. I have written this textbook for the student who is taking economics for the first
time, and I stress the material that students should and do find interesting about the study of our economy.
Therefore, I have devoted much attention to applications and policy questions that students hear about in the
news and bring from their own lives.
For example, Chapter 9 discusses the future of the U.S. social security system. Students learn how its payas-you-go system of social security can be threatened when the number of workers paying taxes into the
system falls relative to the number of beneficiaries. Of particular interest is whether Americans should be
allowed to place a portion of their payroll taxes in personal retirement accounts.
Not only are my applications current, but also they show a concern for the diversity among students. As
often as possible, I have used examples that are familiar to students: iPod, Google, Microsoft, Delta Airlines,
and the like. In particular, here are a few of the many real-world applications that are included in the 8th
edition:
•
Economic Sanctions, Iran, and Russia, Chapter 1
•
Hydraulic Fracturing Fosters Oil Production, Chapter 2
•
What Drives Gasoline Prices? Chapter 2
•
Dynamic Baseball Ticket Pricing, Chapter 3
•
U.S. Postal Service Boosts Rates to Increase Revenue, Chapter 3
•
Colleges Hike Tuition to Offset Cutbacks to Higher Education, Chapter 3
•
Apple’s Global Production Network, Chapter 4
•
Higher Wages in China Hamper Competitiveness, Chapter 4
•
Do Patents Encourage Innovation? Chapter 5
•
Google as a Monopoly, Chapter 5
•
Vaughan-Bassett Furniture Survives in a Global Economy, Chapter 6
•
Indiana and Michigan Adopt Right-to-Work Laws, Chapter 7
29
•
Cap and Trade: Trading Emissions Certificates, Chapter 8
•
Renewable Energy and Subsidies, Chapter 8
•
Has Income Inequality Gone Too Far? Chapter 9
•
Is the U.S. Tax System Fair? Chapter 9
•
Does the Penny Make Sense? Chapter 14
•
Do Policymakers Have Enough Ammo for the Next Recession? Chapter 15
•
Quantitative Easing and the Federal Reserve, Chapter 15
•
Should We Give Shoe Tariffs the Boot? Chapter 16
•
Mexico Stews Over Tariff Dispute, Chapter 16
•
The Trans-Pacific Partnership, Chapter 16
•
Is China’s Currency Manipulation the Problem? Chapter 17
•
Monetary Integration in Europe: The Euro, Chapter 17
•
Market Capitalism Versus State Capitalism: Which Works Better? Chapter 18
Consumer Economics Applications
To help students become informed consumers, Contemporary Economics includes applications in consumer
economics. Examples include calculating compound interest, identifying electronic codes on a personal check,
shopping for a credit card, and holds placed on checking accounts. I have incorporated these topics into my
survey of economics class, and my students find them interesting and beneficial to their lives.
For example, Chapter 4 discusses the costs of driving an automobile. Students learn about the fixed costs
and variable costs of driving and how to calculate the cost of driving on a per-mile basis. These concepts
provide a nice transition to the costs of production which are discussed later in the chapter.
SUPPLEMENTARY MATERIALS
To help students master the tools of economic analysis, Koushik Ghosh of Central Washington University
has prepared an excellent online Study Guide. Each chapter provides a summary of important points and
learning objectives, matching review questions, multiple-choice questions, true-false questions, and
application exercises.
To assist instructors in the teaching of this textbook, Margaret Brooks of Bridgewater State University and
I have written an online Instructor’s Manual with test bank. Part I contains learning objectives, lecture hints
and ideas, discussion starters, and brief answers to end-of-chapter study questions and problems. Part II
contains a comprehensive test bank with multiple-choice, true-false, and essay questions.
30
31
Acknowledgments
This textbook could not have been written and published without the assistance of many individuals. I am
pleased to acknowledge those who provided helpful suggestions and often detailed reviews:
John Olienyk, Colorado State University
John Adams, Texas A&M International University
Bruce Pietrykowski, University of Michigan–Dearborn
Tesa Stegner, Idaho State University
Clifford Hawley, West Virginia University
Rolando Santos, Lakeland Community College
Karin Steffens, Northern Michigan University
Pam Whalley, Western Washington University
Margaret Landman, Bridgewater State University
Barry Kotlove, Edmonds Community College
R. Edward Chatterton, Lock Haven University
Dea Ochs, Jesuit College Prep, Dallas, Texas
Z. Edward O’Relley, North Dakota State University
Laurence Malone, Hartwick College
Vicki Rostedt, University of Akron
Kishore Kulkami, Metropolitan State College
David Hammes, University of Hawaii at Hilo
Gary Galles, Pepperdine University
Bruce Billings, University of Arizona
Barry Goodwin, North Carolina State University
Wike Walden, North Carolina State University
Joseph Samprone, Georgia College and State University
Robert Grafstein, University of Georgia
Mark Healy, William Rainey Harper College
Vani Kotcherlakota, University of Nebraska
32
Donald A. Coffin, Indiana University, Northwest
Naga Pulikonda, Indiana University, Kokomo
F. P. Biggs, Principia College
Ken Harrison, The Richard Stockton College of New Jersey
Donald Bumpass, Sam Houston State College
Sandra Peart, Baldwin-Wallace College
Michael Rosen, Milwaukee Area Technical College
Nicholas Karatjas, Indiana University of Pennsylvania
Ernest Diedrich, St. John’s University
Arthur Janssen, Emporia State University
Ralph Gray, De Pauw University
Maria V. Gamba-Riedel, The University of Findlay
Anthony Patrick O’Brien, Lehigh University
Charles W. Smith, Lincoln Land Community College
Paul Comoli, University of Kansas
Walton Padelford, Union University
David Gillette, Truman State University
Laurence J. Malone, Hartwick College
Chris Phillips, Somerset Community College
I would also like to thank my colleagues at Central Washington University—Shirley Hood, Koushik Ghosh,
Peter Gray, David Hedrick, Peter Saunders, Toni Sipic, and Chad Wassell—for their advice and help while I
was preparing the manuscript.
It has been a pleasure to work with the staff at Routledge: Taylor & Francis Group who orchestrated the
production of this book—Emily Kindleysides, Elanor Best, Alaina Christensen, and Mary Dalton. Finally, I
am grateful to my students, who commented on the manuscript.
I would appreciate any comments, corrections, or suggestions that faculty or students wish to make, so that
I can continue to improve this textbook in the years ahead. Please contact me! Thank you for permitting this
text to evolve to the eighth edition.
Bob Carbaugh
Department of Economics
Central Washington University
33
400 East University Way
Ellensburg, Washington 98926
34
PART
1
Introduction
35
CHAPTER
1
Scarcity and Choice
Chapter objectives
After reading this chapter, you should be able to:
1. Discuss the nature of economics and the economic way of thinking.
2. Explain how the concept of scarcity relates to the concept of opportunity cost.
3. Identify the causes of economic growth and decline.
4. Identify the opportunity cost of national security.
5. Describe the purpose and effects of economic sanctions.
economics
I
IN CONTEXT
n the years following World War II, the United States sacrificed in order to equip itself with a national
defense that could meet the threat posed by the Soviet Union. Trillions of dollars were spent to
produce jet aircraft, tanks, missiles, submarines, and other defense goods. Indeed, the resources of the
United States were scarce. The production of more defense goods meant that fewer resources were
available for libraries, schools, golf courses, and other civilian goods. Put simply, the United States
sacrificed civilian goods to produce more military goods.
Each time the United States developed a new military system, the former Soviet Union would develop a
more costly system of its own. Were it not for scarce resources, the Soviets could have produced more
civilian goods and more military goods. Because of scarcity, however, the Soviets had to produce fewer
civilian goods to fulfill the everyday needs of the people. Moreover, the Soviet Union was less efficient at
producing goods than the United States and other countries. Civilian goods were thus in short supply and
of poor quality in the Soviet Union, which led to bitter complaints among the people. In 1992, the Soviet
Union collapsed under the pressure of its disenchanted citizens. Suddenly, the world appeared to be a
calmer and more secure place to live.
That tranquility, however, ended dramatically when terrorists attacked the United States on September
11, 2001, prompting the U.S. military to invade Afghanistan and Iraq. To improve national security, the
United States once again increased its expenditures on military goods. However, the production of more
military goods meant that fewer resources would be available for the production of civilian goods, such as
36
police and fire protection, hospitals, and highways.
The question of how an economy should use its scarce resources is a main focus of public debate for all
societies. In this chapter, we will examine the economic choices that must be made in every society
because of scarcity.
WHAT IS ECONOMICS?
Economics means different things to different people. To some it means making money in stocks, bonds, and
real estate. To others it means understanding how to own and operate a business. To the president of the
United States, it may mean developing a new federal budget or formulating plans to reform the welfare
system. Although all of these matters are part of economics, the subject has broader dimensions. Economics is
first and foremost the study of choice under conditions of scarcity. Both individually and as a society, we
attempt to choose wisely. We are forced to do so because human and property resources are limited, and it
takes resources to produce cell phones, computers, automobiles, CD players, and other goods and services that
we desire.
Obtaining the greatest value from resources is the goal of economic choice. At a personal level, we have
limited income to spend on the many items we want. For example, we might forgo purchasing a Toyota
RAV4 in order to have funds to pay tuition at University of Wisconsin. Businesses also face alternatives.
Should a company use its scarce funds to replace its photocopiers instead of buying new computers?
Moreover, the government has to make choices. Should tax dollars be used to purchase additional tanks and
missiles, or should these dollars be used to finance the construction of a new highway system?
The field of economics is quite broad. Its reach extends from personal concerns—why does a pound of
butter cost more than a pound of margarine?—to issues of national and global importance—will an economic
slump in Asia cause the U.S. economy to decline? The field of economics is generally divided into two
categories—microeconomics and macroeconomics.
Microeconomics
Microeconomics is the branch of economics that focuses on the choices made by households and firms and
the effects those choices have on particular markets. We can use microeconomics to understand how markets
work, to make personal or managerial decisions, and to analyze the impact of government policies. Consider
these microeconomic questions:
•
How would a higher tax on cigarettes affect consumption by teenagers?
•
Why do convenience stores often close after several years?
•
How would a ban on immigrant workers from Mexico affect U.S. apple growers?
•
Should I put my savings in a bank account or invest them in the stock market?
•
Will an increase in the federal minimum wage help the working poor?
37
Macroeconomics
The other branch of economics is macroeconomics. Macroeconomics is concerned with the overall
performance of the economy. Macroeconomics does not focus on the activities of individual households,
firms, or markets; instead, it focuses on the behavior of the economy itself. It deals especially with the
determination of total output, the level of employment, and the price level.
We study macroeconomics to learn how the overall economy works and to understand the controversies
concerning economic policies. Among the macroeconomic topics that we will examine are the following:
•
Why do some economies grow more rapidly than others?
•
What causes unemployment and inflation?
•
Should the government adopt policies to increase savings and investment?
•
Should the government limit the outsourcing of American jobs to foreign nations?
•
How does a decrease in interest rates affect the economy?
These two branches—microeconomics and macroeconomics—converge to form the field of modern
economics.
THE ECONOMIC WAY OF THINKING
The practice of economics often calls for an analysis of complex problems. Although economists may differ in
their ideological views, they have developed an “economic way of thinking.” This methodology is based on
several principles.
Every Choice Has a Cost
Because human and property resources are scarce, individuals and societies must choose how best to use them.
Making prudent choices requires trading off one thing for another. At the core of economics is the notion
that “there is no such thing as a free lunch.” A friend may buy your lunch, making it “free” to you, but there
still is a cost to someone and, ultimately, to society. This notion expresses the fundamental principle of
economics: Every choice involves a cost.
The cost of any choice is the value of the best opportunity that is forgone in making it. For example, you
can choose to remain in college or quit college. If you quit, you may find a job at Burger King and earn
enough money to buy some Levi’s jeans, rent some videos, go golfing and skiing, and hang out with your
friends. If you remain in college, you will not currently be able to afford all of these things now. However,
your education will enable you to find a better job later, and then you will be able to afford these and many
other items.
People Make Better Choices by Thinking at the Margin
Economists maintain that people make better choices by thinking “at the margin.” Making a choice at the
38
margin means deciding to do a little more or a little less of an activity. As a student, you can allocate the next
hour to sleeping or studying. In making this decision, you compare the benefit of extra study time to the cost
of forgone sleep.
As an example of thinking at the margin, consider how United Airlines decides how much to charge
passengers who fly standby. Assume that flying a 300-seat jetliner from Seattle to New York costs the airline
$90,000. Therefore, the average cost (per seat) is $300 ($90,000 / 300 = $300). You might conclude that
United Airlines should always charge at least $300 per ticket. However, the airline can increase its profits by
thinking at the margin. Suppose that a jetliner is going to take off with one empty seat. A standby passenger is
waiting at the gate and he is willing to pay $200 to fly from Seattle to New York. Should United Airlines sell
him a ticket at this price? Yes, because the cost of flying one more passenger is negligible. Although the
average cost of flying a passenger is $300, the marginal (extra) cost is only the cost of a can of Sprite, a bag of
pretzels, and a chicken sandwich. As long as United Airlines earns revenues that are more than the marginal
cost, the addition an extra passenger is profitable.
Rational Self-Interest
Economics is founded on the assumption of rational self-interest. This means that people act as if they are
motivated by self-interest and respond predictably to opportunities for gain. In other words, people try to
make the best of any situation. Often, making the best of a situation involves maximizing the value of some
quantity. As a student, getting high grades may be an incentive to study hard because they may help you
obtain a job interview with a particular employer or get accepted into a prestigious graduate school.
Throughout this text, we will assume that economic incentives underlie the rational decisions that people
make. We will assume that a firm’s owners want to maximize profit in order to improve their well-being.
Also, we will assume that households seek to maximize their satisfaction from consuming goods and services.
Because income is limited and goods have prices, we cannot buy all the things we would like to have.
Therefore, we should choose an attainable combination of goods that will maximize our satisfaction. Of
course, self-interest does not always imply increasing one’s wealth as measured in dollars and cents or one’s
satisfaction from goods consumed. In addition to economic motivations, people also have goals pertaining to
friendship, love, altruism, creativity, and the like.
Economic Models
Like other sciences, economics uses models. In chemistry, you may have seen a model of an atom—a device
with blue, green, and red balls that represent neutrons, electrons, and protons. Architects construct cardboard
models of skyscrapers before they are built. Economic models are not built with plastic or cardboard, but
rather with words, diagrams, and mathematical equations.
Economic models, or theories, are simplified representations of the real world that we use to help us
understand, explain, and predict economic phenomena in the real world. Economic models explain inflation,
unemployment, wage rates, exchange rates, and more. For example, an economic model might tell us how the
quantity of compact discs (CDs) that consumers purchase will change if the sellers raise the price. Other
39
models explain how changes in interest rates in the economy affect investment spending by business.
Throughout this textbook, we will use economic models to help us understand contemporary economic issues.
Positive versus Normative Economics
It is important to realize that economics is not always free of value judgments. In thinking about economic
questions, we must distinguish questions of fact from questions of fairness.
Positive economics describes the facts of the economy—it deals with the way in which the economy works.
Positive economics considers such questions as, why do computer scientists earn more than janitors? What is
the economic effect of reducing taxes? Does free trade result in job losses for less-skilled workers? Although
these questions are difficult to answer, they can be addressed by economic analysis and empirical evidence.
Normative economics involves value judgments that cannot be tested empirically. Ethical standards and
norms of fairness underlie normative economics. For example, should the United States penalize India for
violating U.S. patent and copyright laws? Should welfare payments be reduced in order to encourage the
unemployed to find income-producing jobs? Should all Americans have equal access to health care? Because
these questions involve value judgments instead of facts, there are no right or wrong answers. Both positive
and normative economics are important and will be considered throughout this textbook.
Why do economists often appear to give conflicting advice to policymakers? Because economists do not
fully understand how the economy operates, they often disagree about actual cause-and-effect relationships.
Moreover, economists may have different value judgments, and thus different normative views, about the
goals that economic policies should attempt to accomplish.
The first part of this chapter has given us an overview of economics and the economic way of thinking. We
will now examine the economic problem of scarcity.
SCARCITY
Whether you are taking just one economics course or majoring in economics, the most important topic you
will learn about is scarcity. Scarcity means that there are not enough, nor can there ever be enough, goods and
services to satisfy the wants and needs of everyone. Consider your own situation. Can you afford the school
that you would most prefer to attend or the car that you would most like to own? Do you have sufficient
financial resources for all the clothes, computers, concerts, and sporting events that you want? Societies also
face a scarcity problem. Money devoted to national defense, for example, is not available for education or food
stamps.
The source of the scarcity problem is that people have limited resources to satisfy their unlimited material
wants. Resources, or factors of production, are inputs used in the production of goods and services that we
want, such as CD players and textbooks. The total quantity of resources that an economy has at any one time
determines how much output the economy can produce. The factors of production are classified as follows:
1. Land. Land refers to all natural resources—such as raw materials, land, minerals, forests, water, and
40
climate—used in the productive process.
2. Labor. This resource includes all physical and mental efforts that people make available for production.
The services of professional baseball players, accountants, teachers, and autoworkers all fall under the
heading of labor.
3. Capital. Capital, or investment goods, refers to goods that are used to produce other goods and services.
This includes such things as machinery, tools, computers, computer software, buildings, and roads. Notice
that economists do not consider money to be capital because it is not directly used in production.
4. Entrepreneurship. This factor of production is a special type of labor. An entrepreneur is a person who
organizes, manages, and assembles the other factors of production to produce goods and services.
Entrepreneurs seek profit by undertaking risky activities such as starting a new business, creating a new
product, or inventing a new way of accomplishing something. Bill Gates (founder of Microsoft Corp.),
Levi Strauss (founder of Levi Strauss Co.), and Henry Ford (founder of Ford Motor Co.) are examples of
highly successful entrepreneurs.
These factors of production have a common characteristic: They are in limited supply. Quantities of
mineral deposits, capital equipment, arable land, and labor (time) are available only in finite amounts. Because
of the scarcity of resources and the limitation this scarcity imposes on productive activity, output will be
limited.
Limited resources conflict with unlimited wants. Human wants are said to be unlimited because no matter
how much people have, they always want more of something. Because not all wants can be fulfilled,
individuals must choose which ones to fulfill with limited available resources. In a world of scarcity, every
want that is fulfilled results in one or more other wants remaining unfulfilled.
SCARCITY AND OPPORTUNITY COST
The reality of scarcity forces us to make choices that involve giving up one opportunity in order to do or use
something else. For example, the cost of going to a Chicago Bulls’ basketball game includes the value of what
is sacrificed to attend. Economists use the term opportunity cost to denote the value of the best alternative
that is sacrificed. Part of the cost of attending a Bulls’ game is the price of the ticket. This price represents the
other goods and services you could have purchased with that money instead. In addition, there is the most
valuable alternative use of the time devoted to watching the game. Perhaps you could have used this time to
study for an upcoming economics exam. Thus, the opportunity cost of attending the game equals the ticket
price plus the difference in your test score that the additional study time would have yielded. Let us consider
several applications of opportunity cost.
economics
IN ACTION
Frederick Smith: Entrepreneur
41
Frederick Smith, founder of FedEx, is one of America’s most successful entrepreneurs. He comes from a
family tradition based on transportation. His grandfather was a steamboat captain, and his father
established a regional bus company that turned into a cornerstone of the Greyhound Bus system.
Learning to fly as a teenager, Smith worked weekends as a charter pilot while pursuing an economics
degree at Yale University in the 1960s.
While flying faculty and other passengers around, Smith had an idea that resulted in a radical change in
the transportation business. He realized that besides flying people, he often delivered spare parts for firms
that could not wait for United Airlines and others to ship essential components to customers. In 1965,
Smith formalized his notion of an express delivery service in a term paper written in an economics course.
Although lore has it that Smith received a modest grade of “C” for his efforts, he recalls doing better.
After serving a tour of duty with the Marines in Vietnam, Smith began to pursue his ambition. With $4
million in backing from his family and $80 million from other investors, he built the Federal Express
Corporation (FedEx) from scratch in 1971. Its vow: guaranteed one-day delivery of packages between any
two points in the United States.
However, FedEx was no overnight success. The firm drummed up only seven packages for its first run.
Therefore, Smith hired additional sales staff to boost sales. Yet deficient volume wasn’t the only problem.
Until the late 1970s, the U.S. Postal Service was able to use its monopoly power to prevent FedEx from
delivering documents. Also, strict airline regulations initially limited FedEx to flying small aircraft instead
of larger, more efficient ones. Smith was in such dire need of funds that he traveled to Las Vegas to play
the blackjack tables. He sent the $27,000 he won back to FedEx.
Smith’s perseverance yielded success. By 1980, Americans had come to rely on FedEx’s promise to deliver
packages by the next day. Although FedEx’s success has led to many competitors, it is still the dominant
firm of the express delivery market. And all because a college economics major could visualize an
opportunity that others could not.
Sources: “Frederick Smith: Father of Overnight Delivery Service,” Academy of Achievement, Washington, D.C., February 2005. See also
Dean Foust, “No Overnight Success,” Business Week, September 20, 2004, p. 18, and the home page of Federal Express, available at
www.fedex.com.
The Opportunity Cost of Attending College
Another example is the opportunity cost of attending college. It is not simply the dollar amount listed in your
college catalog. The money you spend on tuition, fees, textbooks, and supplies is only part of the opportunity
cost; the income that you could have earned during the years that you are spending in classes is also part of the
opportunity cost.
Table 1.1 shows the total estimated, out-of-pocket costs of a year of college for the average student in
2014–2015. For example, the second column of the table shows the cost for an average instate resident at a
42
four-year state college to be $23,410. Of this amount, the student pays $9,139 in tuition and fees, $1,225 in
books and supplies, $9,804 for room and board, and $3,242 for personal expenses and transportation.
Is the student’s opportunity cost for a year of college $23,410? No. Some of this cost must be incurred
regardless of whether the student attends college. For example, you would still have to assume room and
board expenses—say, by living in an apartment—even if you did not attend college. This cost would not be
eliminated even if you lived at home because your family could be renting your room to someone else. The
same reasoning applies to transportation and other expenses, at least the portion that you would have assumed
if you were not in college. Suppose that these expenses are the same regardless of whether you attend college.
The opportunity cost of attending college thus consists of tuition and fees ($9,139) and books and supplies
($1,225), which total $10,364.
In addition, the opportunity cost of a year of college includes the amount of forgone income. Assuming that
you earn $15 an hour and reduce your work hours by 30 hours a week during the 32 weeks a year that you are
in college, the forgone earnings represent a cost of $14,400 ($15 × 30 hours × 32 weeks) a year. It should be
noted that most students will use their education to generate future earnings that will more than offset this
sum. Nevertheless, the $14,400 also represents an opportunity cost of attending college.
The opportunity cost of a year of college thus includes the payments for tuition and fees ($9,139), payments
for books and supplies ($1,225), plus the $14,400 of forgone income. This sum totals $24,764. Notice that
this amount is greater than the estimated $23,410 of out-of-pocket costs shown in Table 1.1.
Some students find the opportunity cost of attending college to be even higher. Suppose that you are a
talented baseball player or tennis player who could play professionally after graduating from high school. The
opportunity cost of a year at college could easily exceed $100,000. Tiger Woods, a professional golfer, faced
this dilemma after attending Stanford University for two years. Upon winning his third straight U.S. Amateur
golf title, he chose to turn pro rather than continue his studies at Stanford. He immediately became a
multimillionaire, with contracts worth more than $40 million, from Nike and Titleist in hand. It is no wonder
that talented athletes often consider the opportunity cost of their college education to be too high and thus
drop out of school to pursue professional sports.
Opportunity Costs and Choices
Suppose that your student club conducts a fund-raiser, and each club member agrees to spend 8 hours
working at a Saturday car wash. A local service station donates its parking area and water, and your club
supplies the washcloths and detergent. Club members wave their signs at passing motorists in an attempt to
lure business.
After washing several vehicles, the members determine that they can wash 10 compact cars or 5 minivans in
an hour’s time. In an 8-hour day, then, the club could wash 80 compacts (8 × 10 = 80) or 40 minivans (8 × 5 =
40).
Figure 1.1 illustrates the combinations of compacts and minivans that could be washed in an 8-hour day.
Devoting the entire day to washing compacts results in 80 washed cars, shown by point A in the figure.
43
Conversely, devoting the entire day to washing minivans results in 40 washed minivans, shown by point E.
Let us connect these two combinations with line AE. Other combinations (B, C, D) are attainable on this line.
Line AE thus shows all the possible combinations of compacts and minivans that could be washed in a day.
Table 1.1
Estimated Average Cost of a Year of College, 2014–2015
Source: Data from Trends in College Pricing: 2014–2015, The College Board, available at www.collegeboard.com. Based on the College Board’s
Annual Survey of Colleges.
Figure 1.1
Opportunity Cost and Choice
In an 8-hour day, a student club can wash many combinations of minivans and compacts. Line AE illustrates these combinations given the
assumption that the entire day is devoted to washing the two types of vehicles. The line is downward-sloping, suggesting that there is a tradeoff between the number of compacts and the number of minivans that can be washed. Along line AE, the opportunity cost of each additional
washed minivan is 2 compacts that are not washed.
Sliding down line AE, we see that there is an opportunity cost for washing minivans. For every 10 minivans
that the club washes, it must sacrifice the washing of 20 compacts. This implies that the opportunity cost for
each additional washed minivan equals 2 compacts (20 ÷ 10 = 2) that are not washed. Why does this trade-off
occur? Given an 8-hour day, as more hours are devoted to the washing of minivans, fewer hours can be
devoted to washing compacts. The 8-hour limitation of our Saturday car wash thus forces the club to make
choices concerning how much effort should be devoted to washing compacts or minivans. Tabular and
graphical relationships are further discussed in “Exploring Further 1.1” at the end of this chapter.
CHECK POINT
44
1. What is economics?
2. Differentiate between microeconomics and macroeconomics.
3. Identify the major principles of the economic way of thinking.
4. How does scarcity force an individual to incur opportunity costs?
5. What opportunity cost do you face in attending college?
THE PRODUCTION POSSIBILITIES CURVE AND OPPORTUNITY COST
Just as scarcity affects the car-wash choices of a student club, it also influences the production choices of a
nation. The relationship between the ideas of scarcity and choice that an entire nation faces can be illustrated
by a production possibilities curve. A production possibilities curve illustrates graphically the maximum
combinations of two goods that an economy can produce, given its available resources and technology. Several
assumptions underlie an economy’s production possibilities curve:
1. Fixed resources. The quantities of all resources, or factors of production, are held constant. This means
that there are no changes in the economy’s labor, machinery, and the like. Existing resources can only be
transferred from the production of one good to the production of another good.
2. Fully employed resources. Everyone who wants a job has one, and all other resources are being used. All
resources are producing the maximum output possible.
3. Technology unchanged. The existing technology is held fixed with no new innovations or inventions
taking place.
The assumptions of fixed resources and fixed technology imply that we are looking at an economy at a
specific point in time or over a very short period. Over a relatively long period, it is possible for resources to
change and technological advances to occur.
Figure 1.2 illustrates a hypothetical economy that has the capacity to produce many combinations of DVD
players and computers. If all resources are devoted to computer production, 6 million computers per year can
be produced, denoted by point A in the figure. If all resources are devoted to the production of DVD players,
3 million DVD players per year can be produced, denoted by point D. Between the extremes of points A and
D are other possible combinations of the two goods, denoted by points B point C. By connecting these points,
we can see the economy’s production possibilities curve.
The production possibilities curve in Figure 1.2 (a) is downward-sloping because of the problem of scarcity.
Resources of land, labor, capital, and entrepreneurship are limited to particular amounts at any one point in
time. In a fully employed economy, if more resources are going into the production of DVD players, fewer
resources will be left for the production of computers. To produce more DVD players, the cost will be a lower
output of computers. The figure thus illustrates a basic truth of economics: All choices have opportunity costs.
45
Economic Inefficiency
Because all points along a production possibilities curve depict maximum output with given resources and
technology, an economy realizes economic efficiency when it is operating along the curve. What if an
economy does not employ all of its resources at their maximum capacity? For example, during economic
downturns some workers probably cannot find work, and some plants and equipment may become
underutilized. In this situation, the economy fails to realize the output potential of its production possibilities
curve, and economic inefficiency occurs.
In Figure 1.2 (b), point E shows an inefficient output combination for an economy that realizes
unemployed labor or other underutilized resources; only 1 million DVD players and 1 million computers are
produced. With full employment, the economy can produce a larger output combination—say, 2 million
DVD players and 3 million computers, shown by point C in the figure. Comparing these two points, we see
that unemployment results in forgone output equal to 2 million computers and 1 million DVD players.
Generalizing, the effect of unemployment is illustrated graphically by a point beneath the production
possibilities curve. This point is attainable, but not necessarily desirable.
Figure 1.2
Production Possibilities Curve
A production possibilities curve graphically depicts the various combinations of two goods that an economy can produce with full employment,
fixed resources, and fixed technology. Points inside the production possibilities curve are economically inefficient, while points outside the curve
are unattainable given an economy’s existing resources and technology.
Even if an economy can fully employ all of its resources at their maximum capacity, certain output
combinations cannot be realized. In Figure 1.2 (b), any point outside the economy’s production possibilities
curve, say, point F, is unattainable because it lies beyond the economy’s current production capabilities. The
economy cannot achieve this output combination with its existing resources and technology. Scarcity restricts
an economy to operating at points along or beneath its production possibilities curve.
Do economies actually operate along their production possibilities curves? Strictly speaking, no. Economies
always experience some degree of unemployment and underproduction which causes them to operate beneath
46
their production possibilities curves. A production possibilities curve can thus be viewed as a yardstick against
which an economy’s production performance can be measured.
To what extent has the United States been able to utilize its industrial capacity? A measure of such
utilization is the capacity utilization rate, which is the ratio of an industry’s production to its capacity.
According to this measure, an industry that is operating at full capacity has a 100-percent capacity utilization
rate; a rate less than 100 percent implies that at least some plants and equipment are idle.
Table 1.2 illustrates capacity utilization rates for major U.S. industries. We see that from 1972 to 2014 all
U.S. industries combined operated at an average capacity utilization rate of 80.1 percent. The average capacity
utilization rates for the economy’s manufacturing, mining, and utilities sectors during this period equaled 78.5
percent, 87.5 percent, and 85.9 percent, respectively. The table also shows capacity utilization rates for
particular U.S. manufacturing industries.
Table 1.2
Capacity Utilization Rates for Major U.S. Industries, 1972–2014 Average
Source: Federal Reserve Statistical Release G-17, Industrial Production and Capacity Utilization, available at www.federalreserve.gov.
The Law of Increasing Opportunity Cost
Figure 1.3 illustrates the production possibilities curve of our hypothetical economy as previously discussed.
Notice that the production possibilities curve is bowed outward, or concave. This is because the opportunity
cost of DVD players increases as more DVD players are produced. Moving from point A to point B along the
curve, the opportunity cost of 1 DVD player is 1 computer; between points B and C, the opportunity cost is 2
computers; and between points C and D, the opportunity cost is 3 computers. These opportunity costs
represent what occurs in the real world for most goods: Opportunity costs increase as we produce more of a
good. This relationship is known as the law of increasing opportunity cost.
But why do opportunity costs generally increase as we produce more of a good? The answer is that resources
are not completely adaptable to alternative uses. For example, some workers have skills that are more useful for
producing DVD players than other workers have. When a company first starts producing DVD players, it
employs workers who are most skilled at the production of DVD players. The most skilled workers are those
who can produce DVD players at a lower opportunity cost than others. Yet as the company produces more
DVD players, it finds that it has already employed the most skilled workers; thus, going forward, it must
employ workers who are less skilled in the production of DVD players. These workers produce DVD players
at a high opportunity cost. Whereas two skilled workers could produce a DVD player in a day, as many as five
47
unskilled workers may be required to produce one DVD player in the same amount of time. Thus, as more
DVD players are produced, the opportunity cost of producing DVD players increases.
ECONOMIC GROWTH
At any particular point in time, an economy cannot operate outside its production possibilities curve. Over
time, however, it is possible for an economy to expand its output potential. This occurs through economic
growth, which refers to the increased productive capabilities of an economy that are made possible by either
an increasing resource base or technological advancement.
Figure 1.3
The Law of Increasing Opportunity Cost
In the real world, most production possibilities curves are bowed outward. This means that, for most goods, the opportunity cost increases as we
produce more of them. Increasing opportunity costs occur when resources are not completely adaptable to alternative uses.
Economic growth entails an outward shift in an economy’s production possibilities curve so that more of all
goods can be produced. Figure 1.4 illustrates the significance of an outward shift in a production possibilities
curve. Before the occurrence of economic growth, suppose that an economy can produce 2 million DVD
players and 3 million computers, shown by point C along curve PPC0. As a result of growth in the economy’s
resource base or technological advancement, the production possibilities curve shifts outward to a higher level,
PPC1. Economic growth permits the economy to produce more computers (a movement to point E), more
DVD players (a movement to point G), or more of both goods (a movement to point F). Many other
previously unattainable combinations also become attainable with economic growth. In short, economic
growth allows the economy to produce more of everything! However, growth does not guarantee that the
economy will operate at a point along the higher production possibilities curve. The economy might fail to
fulfill its expanded possibilities.
One way to increase an economy’s production capacity is to gain additional resources. More (or better
trained) workers or more (or improved) plants and equipment can increase a nation’s output potential. Worker
productivity is also facilitated by investment in infrastructure such as roads, bridges, airports, and utilities.
Another way to achieve economic growth is through research and development of new technologies.
48
Technological development allows more output to be produced with the same quantity of resources. A faster
photocopier, a more smoothly operating assembly line, or a new-generation computer system are examples of
technological advances.
Throughout America’s history, agriculture has been a highly productive sector of the economy. In 1870,
about 75 percent of Americans were farmers; in 2013, there were about 2 million farmers and agricultural
workers, constituting less than 1 percent of the U.S. population. During this period, total farm output
expanded greatly. How could a declining number of farmers produce greater output? The answer is improved
technology. Whereas farmers once farmed with negligible capital equipment, today they use modern tractors,
computers, pesticides, cellular phones, and the like. As a result, more food can be produced by fewer farmers.
As farmers left farms, they entered manufacturing and service industries such as computers, automobiles,
aircraft, accounting services, and engineering. Technological advances in farming thus made it possible to
produce additional goods in other sectors of the economy. The result was an outward shift in the U.S.
production possibilities curve.
Figure 1.4
The Effect of Economic Growth on the Production Possibilities Curve
Economic growth shifts a production possibilities curve outward and makes it possible to produce more of all goods. Prior to growth in
production capacity, point C was on PPC0 and points E, F, and G were unattainable. After growth, shown by PPC1, points E, F, and G (and
many other previously unattainable combinations) are attainable.
ECONOMIC DECLINE
Just as an expanding resource base causes an economy’s production possibilities to increase, decreasing
resources can likewise reduce an economy’s output potential. During World War II, for example, the
production possibilities of Europe and Japan decreased. The war disrupted people’s lives, and many people did
not survive the war. Entire factories, roads, bridges, railway networks, electrical utilities, and other types of
capital goods were reduced to rubble. The destructive effects of the war caused the production possibilities
curves of Europe and Japan to shift inward.
The physical devastation of Europe and Japan caused by World War II yielded some paradoxical effects for
49
these war-devastated economies. Because a large share of their stock of capital goods was destroyed by the
war, these nations had to rebuild their industries from scratch. They did so with the most up-to-date factories
and equipment. The result was a substantial increase in labor productivity, which allowed these economies to
realize production possibilities exceeding those that had existed before the war. Conversely, nations that had
been spared the devastation of the war had their prewar technologies in place and grew slower than those
whose stock of capital goods was destroyed and replaced with more modern technology.
For example, the United States was the most powerful steel-producing nation in the world immediately
following World War II. The U.S. steel industry came out of the war intact, accounting for nearly half of the
world’s steel output. Moreover, U.S. firms produced more steel than all of Europe combined and almost 20
times as much as Japan! During the 1950s and 1960s, however, the absence of foreign competition caused
U.S. steel companies to become complacent. Instead of investing in new plants, they manufactured steel in
outmoded plants using obsolete technologies and paid wages almost twice the average of all other U.S.
manufacturing sectors. In contrast, Japan and Europe replaced the steel factories that had been devastated by
the war with modern plants which used the most efficient equipment. By the 1970s, the productivity of
Japanese and European steel companies was increasing relative to the productivity of U.S. companies and the
competitiveness of U.S. companies dwindled. The threat of foreign competition forced U.S. steel companies
to shut down many obsolete factories in the 1980s and replace them with modern plants and equipment.
Natural disasters can also reduce an economy’s output potential. For example, in 2005 the states of
Alabama, Louisiana, and Mississippi were struck by two major hurricanes (Katrina and Rita) which damaged
the productive capacity of the U.S. economy. These hurricanes passed through offshore areas where oil and
natural gas platforms are concentrated and then struck onshore areas where petroleum is refined and natural
gas is processed. In addition to the tragic loss of life and massive destruction of personal property that they
caused, the hurricanes damaged energy equipment and structures; about 28 percent of total U.S. production
was shut down. Most of this output loss was the result of the destruction of oil and natural gas operations.1
Innovation, Economic Growth, and the American Economy
As we have seen, the ability of an economy to grow rests on its resource base and technological advancement.
Innovation is crucial for improving technologies that result in economic growth. Is the United States
maintaining its innovation edge?
The next time that you are at an electronics store, take a close look at an iPhone. You will find that it was
designed by Apple Inc. in California and assembled in China. Similar to Apple, the United States has often
seen other industries locating abroad in the past, such as wind turbines and smart phones, which were born in
the United States. Moreover, when abandoning an industry, the United States may also lose technologies that
can promote the development of future industries.
Consider the Amazon Kindle. In 2007, Amazon introduced the Kindle electronic reader, a device that
allows users to download and read textbooks, magazines, and other digital media on a portable computer
screen. Amazon first released the Kindle in November 2007, for $399 and it was sold out in five and one half
hours. By 2013, the Kindle sold for less than $130 as competition from other producers intensified.
50
To produce the electronic ink for the Kindle, Amazon initially partnered with E-Ink Co., an American
producer. However, it turned out that E-Ink could not produce the screens due to unforeseen problems and
Amazon had to find another partner. Although Amazon’s search initially began in the United States, it was
unsuccessful because American firms did not have the capability to produce the Kindle screen. Eventually,
Amazon linked with Prime View, a Chinese company, to produce the screen. Within a short period of time,
Prime View acquired E-Ink and moved ink production from the United States to China. Even though the
Kindle’s key innovation was initially invented in the United States, most of the Kindle production took place
in China.
economics
IN ACTION
Adam Smith: Father of Modern Economics
Adam Smith (1723–1790) was a Scottish philosopher and is widely cited as the father of modern
economics. He is the author of The Wealth of Nations, which is considered the first modern work of
economics.
Born in a small fishing village near Edinburgh, Scotland, Smith was the only child of the village’s customs
officer. He studied philosophy at the University of Glasgow and Oxford University. After graduating,
Smith became a professor at the University of Glasgow. He was lured away from his professorship by a
wealthy Scottish duke who gave him a pension of £300 per year (ten times the average income of his day)
to devote to the writing of The Wealth of Nations. This book was published in 1776 at the height of the
Industrial Revolution when new technologies were applied to the manufacturing of iron, textiles, and
agriculture. In his later life, Smith took a tutoring position allowing him to travel throughout Europe
where he met other intellectual leaders of the day.
The Wealth of Nations considers why some nations are wealthy and others are poor. Smith’s answer to this
question emphasized the importance of free markets and the division of labor. He believed that the free
market is guided to produce the right amount and variety of goods by an “invisible hand.” According to
Smith, in a free market each participant will try to maximize self-interest. The interaction of market
participants, leading to the exchange of goods and services, provides for each participant better than when
simply producing for themselves. He further said that in a free market, no government regulation of any
type would be needed to ensure that the mutually beneficial exchange of goods and services took place,
since this “invisible hand” would guide market participants to trade in the most mutually beneficial
manner.
Smith also maintained that the division of labor and specialization would result in a large increase in labor
productivity. An example he used was the making of pins. He noted that one worker using hand tools
might make only 20 pins per day. However, if 10 workers divided up the 18 steps required to make a pin,
they could together make 48,000 pins in one day: One worker draws out the wire, another straightens it, a
51
third cuts it, and so on. However, a large market is needed to support the division of labor. A factory
employing 10 workers would need to sell more than 15 million pins a year to remain in operation.
The Wealth of Nations was a precursor to the modern study of economics. It provided a strong intellectual
rationale for free trade and capitalism, greatly influencing the writings of later economists.
Sources: James Buchan, The Authentic Adam Smith: His Life and Ideas (New York, NY: W.W. Norton and Company, 2006); and Mark
Skousen, The Making of Modern Economics (Armonk, NY: M.E. Sharpe, 2001).
Some analysts note that as firms exit the United States, the country loses its innovation edge. They
emphasize how manufacturing is a vital driver of research and development that fosters inventions which
promote economic growth. The United States cannot sustain the level of economic growth it needs without a
strong manufacturing sector. To promote stronger manufacturing, the United States needs investmentfriendly government policies, according to these analysts.
However, others disagree. They maintain that from the perspective of America’s competitiveness, all of the
essential technological activities still take place in America. They also note that international trade promotes
evolution in a country’s industries over time. For example, the production of televisions initially began in the
United States. But as technologies became standardized, television production shifted to other countries, such
as Japan, with lower wages. This resulted in manufacturing costs and prices tumbling, to the benefit of
consumers. Yet the question remains: how about the livelihood of Americans that formerly produced
televisions? Indeed, the world economy is dynamic and producers who have prospered have been the ones who
can modify their business models to match or surpass their competitors.
ECONOMIC GROWTH: TRADE-OFFS BETWEEN CURRENT AND FUTURE
CONSUMPTION
The production possibilities curve and economic growth can be used to investigate the trade-off between
current and future consumption. This trade-off can be illustrated for nations producing consumer goods and
capital goods.
Consumer goods are goods such as food, electricity, and clothing that are available for immediate use by
households. They do not contribute to future production in the economy. Capital goods, such as factories and
machines, are used to produce other goods and services in the future. Instead of being consumed today, capital
goods are a source of an economy’s economic growth potential.
A nation that sacrifices current consumption in order to invest in capital goods is forward-looking. Rather
than getting instant satisfaction from the production of capital goods, the nation increases its capacity to
produce consumer goods in the future. This is similar to students attending college. Students devote time to
study that could have been spent working, earning income, and therefore engaging in a higher level of
consumption. Most students decide to postpone consumption because they expect education to increase their
productivity and income, allowing greater consumption in the future.
52
Figure 1.5 illustrates the production possibilities curves for the United States and Japan. The two axes of
each production possibilities curve are designated as consumer goods (current goods) and capital goods (goods
for the future). Assume that the two nations are identical in every respect except that the U.S. choice along its
production possibilities curve strongly favors consumer goods as opposed to capital goods; let this be
designated by point A in Figure 1.5(a). Conversely, Japan’s choice along its production possibilities curve
strongly favors capital goods and is denoted by point A in Figure 1.5(b).
The relatively large accumulation of capital goods allows the Japanese economy to grow faster than the U.S.
economy. In Figure 1.5, this is illustrated by Japan’s production possibilities curve, which shifts farther out to
the right than the U.S. curve. Over time, Japan’s faster growth rate allows it to produce more consumer goods
than the United States. This increase in production, however, requires Japanese households to sacrifice current
consumption in exchange for future consumption.
PRODUCTION POSSIBILITIES APPLICATIONS
The production possibilities concept can be applied to issues pertaining to national security. Let us consider
the application of the production possibilities concept to the terrorist attacks of September 11, 2001, and to
the economic sanctions levied by the United States against Iran.
Figure 1.5
Economic Growth in the United States and Japan
The current choice favoring consumer goods, made by the United States in (a), will cause a modest outward shift in the U.S. production
possibilities curve. A current choice favoring capital goods, as made by Japan in (b), will lead to a greater outward shift in the Japanese
production possibilities curve. The extra goods, made possible by economic growth, thus result in a greater improvement in the standards of
living in Japan.
Opportunity Cost of National Security
The September 11 terrorist attacks resulted in a tragic loss of life for thousands of innocent people. It also
jolted America’s golden age of prosperity and the promise it held for global growth, which had existed
53
throughout the 1990s. Because of the threat of terrorism, Americans became increasingly concerned about
their safety.
Immediately following the terrorist attacks, businesses and governments made greater efforts to improve
their security. For example, Quality Carriers Inc., the country’s biggest chemical trucker, rehired the $5,000a-month night-shift security guard it had previously let go at its tanker-truck terminal in Newark, New Jersey.
The company also paid two drivers a total of $1,200 to re-park any vehicles loaded with chemicals in plain
view and under security lights. For Quality Carriers, achieving extra security required the firm to use more of
its resources to protect the company from terrorists, leaving fewer resources available to transport chemicals
for its customers. In like manner, security procedures were beefed up at power plants, communication
companies, airports, and government buildings following the September 11 attacks.
Simply put, providing for national security entails an opportunity cost. When we employ labor, capital, and
land for security, we sacrifice other things that we could have produced with them. To demonstrate this point,
consider Figure 1.6, which depicts hypothetical production possibilities curves for the United States. The
vertical axis denotes the annual production of security goods (for example, metal detectors and X-ray
monitors) and the horizontal axis denotes the annual production of goods other than security (for example,
televisions and autos) that contribute directly to our standard of living. Because of technological progress and
the growth in the nation’s stock of plants and equipment, the nation’s production possibilities curve shifts
outward, as shown by the movement from curve PPC0 to curve PPC1.
Figure 1.6
The Opportunity Cost of National Security
Providing for national security entails an opportunity cost. When we use land, labor, and capital to produce security goods, we sacrifice other
things we could have produced with them.
Assume that prior to September 11, the United States was located at point E along curve PPC0. Also
assume that in a typical year, economic growth would shift the United States from point E on curve PPC0 to
point F on curve PPC1. This means that the nation would realize a modest increase in production of security
goods, but most of our growth would have been used to produce additional quantities of autos, televisions, and
other things we enjoy. Because of the September 11 terrorist attacks, however, we move from point E to point
54
G. Notice that although we produce additional quantities of nonsecurity goods, we do not produce as much of
those goods as we would have if the attacks had not occurred. This limits our economic well-being as
measured by the quantity of nonsecurity goods available for our consumption. Therefore, providing for
national security results in an opportunity cost in terms of other goods that we enjoy.
Economic Sanctions against Iran
Nations often disagree with each other’s policies regarding military adventures, arms proliferation, support of
terrorism and drug trafficking, human rights abuses, and so on. Besides military action, are there other ways to
convince a foreign government to modify its policies regarding these issues?
One alternative is economic sanctions, which are government-imposed limitations, or complete bans,
placed on customary trade or financial relations between nations. The nation initiating the sanctions, the
imposing nation, hopes to impair the economic capabilities of the recipient target nation. The goal of economic
sanctions is to inspire the people of the target nation to force their government to alter its policies. Let us
consider the sanctions imposed by the United States and other countries on Iran.
Since 1987, the United States has implemented numerous sanctions against Iran, such as export boycotts,
import boycotts, and financial sanctions. These sanctions have been in response to the United States’ viewing
Iran as a state sponsor of international terrorism. An objective of the sanctions has been to force Iran to
verifiably confine its nuclear program to purely peaceful uses rather than for the development of nuclear
weapons that could be used against nations such as Israel. Since 2011, a broad coalition has joined the United
States in applying progressively strict sanctions against Iran. Included in the coalition have been the European
Union, Australia, Canada, India, Japan, South Korea, and others.
Figure 1.7 can be used to illustrate the goal of the U.N. sanctions levied against Iran. The figure shows the
hypothetical production possibilities curve of Iran for machines and oil. Prior to the imposition of sanctions,
suppose that Iran is able to operate at maximum efficiency, as shown by point A along production possibilities
curve PPC0. Under the sanctions program, the imposing nations’ refusal to purchase Iranian oil leads to idle
wells, refineries, and workers in Iran. The unused production capacity thus forces Iran to move inside PPC0. If
the imposing nations also target productive inputs, thus curtailing equipment sales to Iran, the output
potential of Iran would decrease. This is shown by an inward shift of Iran’s production possibilities curve to
PPC1. Economic inefficiencies and reduced production possibilities, both of which are caused by economic
sanctions, are thus intended to inflict hardship on the people and government of Iran.
International sanctions had sizable adverse effects on Iran. The value of Iran’s currency, the rial, has
decreased more than 50 percent from 2011 to 2015. Also, Iran has virtually been cut off from the international
banking system and was increasingly forced to trade through barter arrangements rather than hard currency
exchange. Inflation soared in Iran, many foreign firms have left Iran’s markets, and Iranian firms have laid off
workers. Also, the sanctions have reduced Iranian oil exports, which provide most of Iranian government
revenues.
Figure 1.7
Effects of Economic Sanctions
55
Trade and financial bans placed against a target nation have the effect of forcing the nation to operate inside its production possibilities curve.
Economic sanctions can also result in a leftward (inward) shift in the target nation’s production possibilities curve.
With the intensity of the sanctions increasing, Iran saw that it was in a vulnerable position. In 2015 Iran
negotiators reached an agreement with the United States and its allies. Iran agreed to restrain its enrichment
of uranium (the fuel for a bomb), and to reduce its stockpile of low- and medium enriched uranium (from
which the weapons-grade material is produced), for a period of 10–15 years. Iran also agreed to United
Nations’ inspectors monitoring of all its nuclear facilities. When the agreement was enacted, most of the
sanctions would be removed. At the writing of this textbook, it remains to be seen if this agreement will be
approved by the governments involved.
Russian Aggression against Ukraine Brings Sanctions
In response to political unrest stirred up by pro-Russian supporters in Ukraine, in 2014 President Vladimir
Putin sent Russian troops into the country. Russian military forces rapidly gained control of the Crimea
region in Ukraine. Russian arms and technical assistance were also provided for pro-Russian rebels living in
Ukraine. The Ukrainian government immediately protested and declared that Russia’s aggression was illegal
and must stop.
To show support for the Ukrainian government, the United States, European Union, and other major
nations soon enacted a coordinated set of economic sanctions against Russia. The sanctions were intended to
convince Putin that his military activities would result in a high cost to Russia, and that they must cease.
The sanctions included prohibitions on travel to the United States, Canada, and the European Union by
key Russian officials and politicians, the freezing of financial assets of wealthy Russians having holdings in the
United States, and restrictions imposed against Russian state-owned banks. Also, bans were placed on the
export of technologies needed by Russia’s oil and defense industries. Analysts widely agreed that the West’s
sanctions were not sufficiently strong to bring about a collapse in the Russian economy. But they could inflict
considerable damage on an already ailing economy which was plagued by a collapse in its currency, the ruble.
Hit by the sanctions and falling oil prices, the Russian economy slid into recession in 2015, for the first time
56
since 2009.
Most observers felt that Putin underestimated the West’s resolve in levying economic pressure against
Russia for its aggression against Ukraine. Although Putin appeared to count on the West’s inability to enact a
significant arsenal of sanctions, the sanctions did occur, and the costs were higher than Putin estimated.
In February 2015, Russia and Ukraine agreed to a tentative cease-fire accord. It was hoped that this would
lead to the government of Ukraine agreeing to more autonomy for the eastern regions of its country; for
Russia, it would mean withdrawing forces from Ukraine and returning control to Kiev of the Ukrainian side of
the border. At the writing of this text, it was unclear how Russian–Ukrainian relations would unfold.
In this chapter, we have examined the economic choices that must be made in every society because of
scarcity. The next chapter will consider the role of demand and supply in analyzing market transactions.
CHECK POINT
1. How can we use a production possibilities curve to illustrate opportunity cost for a nation?
2. Concerning economic growth, does it make any difference whether an economy devotes more
resources to the production of capital goods as opposed to the production of consumer goods?
3. Identify the opportunity cost of nat...
Purchase answer to see full
attachment