886607 800091 5

One novel feature of this course reader is that, as all the
content is licensed under creative commons copyright,
it will continuously evolve. The current edition is the
1st, published February 17, 2013.
Students wishing to contribute rewritten Case in Point
boxes may send them to matthew.holian@sjsu.edu.
Cases that demonstrate economic models and that
provide new statistics may be included in future editions
of this reader.
This is a course reader assembled by Professor Matthew J. Holian. It contains
sections on Microeconomics and Macroeconomics, from Libby Rittenberg and
Timothy Tregarthen’s Principles of Economics, and Statistics, from Barbara
Illowsky and Susan Dean’s Collaborative Statistics. Both of these were
published under creative commons copyright licenses.
By carefully reading the selections, and by diligently working through the
exercises, a motivated student can use this reader to develop a firm
understanding of economic principles, and to gain an understanding of how
economists use statistical techniques to test hypotheses and generate new
knowledge.
The reader is divided into three sections. Section I contains chapters from
economics and statistics; Chapter 2 from Principles of Economics introduces
two key models: a theoretical model illustrating comparative advantage, and
an empirical model estimated using ordinary least squares (OLS) regression.
Thus Section I contains examples of the types of models—theoretical and
empirical—that economists use. Following this introduction to economics, we
cover chapters 1-2 and 12 of Collaborative Statistics, in order to give students
the minimum statistical skills they will need to apply their knowledge.
Section II of reader covers core microeconomic concepts and theory,
including demand and supply, elasticity, welfare measures, the neoclassical
theory of the firm, and the following market structures: perfect competition,
monopoly and oligopoly.
Section III of the reader covers core macroeconomic concepts and theory,
including interest rates, measures of economic activity, financial institutions,
the aggregate demand / aggregate supply model, money, growth, and bond
and currency markets.
Assembled by Prof. Matthew J. Holian
An Introduction to Economics with
Statistics: A Course Reader
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An Introduction to Economics with Statistics
Course Reader
February 17, 2013

This is a course reader assembled by Professor Matthew J. Holian. It contains sections on
Microeconomics and Macroeconomics, from Rittenberg and Tregarthen’s Principles of Economics,
and Statistics, from Illowsky and Dean’s Collaborative Statistics.
By carefully reading these sections, and by diligently working through the exercises given below, a
motivated student can develop a firm understanding of economic principles, and also gain a good sense
of how economists use statistical techniques to test hypotheses and generate new knowledge.
The course starts off in Section I with the first two chapters of Principles of Economics. Chapter 2
introduces two key models: a theoretical model illustrating comparative advantage, and an empirical
model estimated using ordinary least squares (OLS) regression. Thus already in Chapter 2 we are given
examples of the types of models—theoretical and empirical—that economists use. Following this
introduction to economics, we cover chapters 1-2 and 12 of Collaborative Statistics, in order to give
students the minimum statistical skills they will need to write an economics research paper.
Section II of the course covers core microeconomic concepts and theory, including demand and supply,
elasticity, welfare measures, the neoclassical theory of the firm, and the following market structures:
perfect competition, monopoly and oligopoly.
1

Section III of the course covers core macroeconomic concepts and theory, including interest rates,
measures of economic activity, financial institutions, the aggregate demand / aggregate supply model,
money, growth, and bond and currency markets.
2

To apply their knowledge after completing the readings and exercises, a student might write a short
paper. Ideally the student would use the Internet to find a data source related to a topic covered in this
reader. Then the student would carry out a short study using one or more economic models and the
data they found to help answer a specific question. Such a study might be similar to the Case in Point
boxes below, but as stressed in this course, would clearly use models and new statistics.
References:
Rittenberg, Libby & Timothy Tregarthen, 2009. Principles of Economics. 1st edition. Flat World
Knowledge (www.flatworldknowledge.com). These chapters were published under a Creative Commons
BY-NC-SA 3.0 license.
Illowsky, Barbara & Susan Dean, 2012. Collaborative Statistics. http://cnx.org/content/col10522/latest/.
The Creative Commons attribution license (http://creativecommons.org/licenses/by/2.0/) applies.

1
To economize on space and time, this reader does not include a chapter on the theory of consumer choice. An
interested reader could consult Chapter 7 of Rittenberg and Tregarthen’s Principles of Economics, available at
http://www.sjsu.edu/faculty/matthew.holian/RT/Master.html.
2
This reader does not emphasize comparing different macroeconomic theories; an interested reader could consult
Chapter 32 of Rittenberg and Tregarthen (2009).



Table of Contents (Brief)

Part I: Introduction to Economics and Statistics (Rittenberg and Tregarthen & Illowsky and Dean)
Chapter 1: Economics: The Study of Choice (Rittenberg and Tregarthen)
Chapter 2: Confronting Scarcity: Choices in Production (Rittenberg and Tregarthen)
Chapter 1: Sampling and Data (Illowsky and Dean)
Chapter 2: Descriptive Statistics (Illowsky and Dean)
Chapter 12: Linear Regression and Correlation (Illowsky and Dean)

Part II: Microeconomics (From Rittenberg and Tregarthen)
Chapter 3: Demand and Supply
Chapter 4: Applications of Demand and Supply
Chapter 5: Elasticity: A Measure of Response
Chapter 6: Markets, Maximizers, and Efficiency
Chapter 8: Production and Cost
Chapter 9: Competitive Markets for Goods and Services
Chapter 10: Monopoly
Chapter 11: The World of Imperfect Competition (Oligopoly)

Part III: Macroeconomics (From Rittenberg and Tregarthen)
Chapter 13: Interest Rates and the Markets for Capital and Natural Resources
Chapter 20: Macroeconomics: The Big Picture
Chapter 21: Measuring Total Output and Income
Chapter 22: Aggregate Demand and Aggregate Supply
Chapter 23: Economic Growth
Chapter 24: The Nature and Creation of Money
Chapter 25: Financial Markets and the Economy (Bond and Currency Markets)








Table of Contents (Detailed)

Part I: Introduction to Economics and Statistics


Chapter 1: Economics: The Study of Choice (Rittenberg and Tregarthen)

Section 1: Defining Economics
Section 2: The Field of Economics
Section 3: The Economists’ Tool Kit
Section 4: Review and Practice

Chapter 2: Confronting Scarcity: Choices in Production (Rittenberg and Tregarthen)

Section 1: Factors of Production
Section 2: The Production Possibilities Curve
Section 3: Applications of the Production Possibilities Model
Section 4: Review and Practice

Chapter 1: Sampling and Data (Illowsky and Dean)

Sections 1.1-1.5: Sampling, Statistics, Probability and Data
Sections 1.6-1.9: Sampling, Variation, Answers and Rounding Off
Sections 1.10-1.14: Summary, Practice, Homework, Lab 1 and Lab 2
Solutions

Chapter 2: Descriptive Statistics (Illowsky and Dean)

Sections 2.1-2.5: Describing Data, Displaying Data (Stemplots, Line & Bar Graphs, Histograms, Box Plot)
Sections 2.6 -2.7: Measures of the Location and Center of the Data
Sections 2.8-2.9: Skewness, Mean, Median, Mode and Measures of the Spread of the Data
Sections 2.10-2.14: Summary of Formulas, Practice 1, Practice 2, Homework, Lab
Solutions

Chapter 12: Linear Regression and Correlation (Illowsky and Dean)

Sections 12.1 -12.3: Linear Regression and Correlation, Linear Equations, Slope and Y-Intercept
Sections 12.4-12.6: Scatter Plots, Regression Equation, Correlation Coefficient, r
2

Sections 12.7-12.9: Testing the Significance of the Correlation Coefficient , Outliers
Sections 12.10: Critical Values of the Sample Correlation Coefficient 95% Table
Sections 12.11-12.14: Summary, Practice, Lab 1, Lab 2, Lab 3
Solutions






Part II: Microeconomics

Chapter 3: Demand and Supply

Section 1: Demand
Section 2: Supply
Section 3: Demand, Supply, and Equilibrium
Section 4: Review and Practice

Chapter 4: Applications of Demand and Supply

Section 1: Putting Demand and Supply to Work
Section 2: Government Intervention in Market Prices: Price Floors and Price Ceilings
Section 3: The Market for Health-Care Services
Section 4: Review and Practice

Chapter 5: Elasticity: A Measure of Response

Section 1: The Price Elasticity of Demand
Section 2: Responsiveness of Demand to Other Factors
Section 3: Price Elasticity of Supply
Section 4: Review and Practice

Chapter 6: Markets, Maximizers, and Efficiency

Section 1: The Logic of Maximizing Behavior
Section 2: Maximizing in the Marketplace
Section 3: Market Failure
Section 4: Review And Practice

Chapter 8: Production and Cost

Section 1: Production Choices and Costs: The Short Run
Section 2: Production Choices and Costs: The Long Run
Section 3: Review and Practice

Chapter 9: Competitive Markets for Goods and Services

Section 1: Perfect Competition: A Model
Section 2: Output Determination in the Short Run
Section 3: Perfect Competition in the Long Run
Section 4: Review and Practice

Chapter 10: Monopoly

Section 1: The Nature of Monopoly
Section 2: The Monopoly Model
Section 3: Assessing Monopoly
Section 4: Review and Practice

Chapter 11: The World of Imperfect Competition

Section 2: Oligopoly: Competition Among the Few
Section 3: Extensions of Imperfect Competition: Advertising and Price Discrimination
Section 4: Review and Practice

Part III: Macroeconomics

Chapter 13: Interest Rates and the Markets for Capital and Natural Resources

Section 1: Time and Interest Rates
Section 2: Interest Rates and Capital
Section 4: Review and Practice

Chapter 20: Macroeconomics: The Big Picture

Section 1: Growth of Real GDP and Business Cycles
Section 2: Price-Level Changes
Section 3: Unemployment
Section 4: Review and Practice

Chapter 21: Measuring Total Output and Income

Section 1: Measuring Total Output
Section 2: Measuring Total Income
Section 3: GDP and Economic Well-Being
Section 4: Review and Practice

Chapter 22: Aggregate Demand and Aggregate Supply

Section 1: Aggregate Demand
Section 2: Aggregate Demand and Aggregate Supply: the Long Run and the Short Run
Section 3: Recessionary and Inflationary Gaps and Long-run Macroeconomic Equilibrium
Section 4: Review and Practice

Chapter 23: Economic Growth

Section 1: The Significance of Economic Growth
Section 2: Growth and the Long-Run Aggregate Supply Curve
Section 3: Determinants of Economic Growth
Section 4: Review and Practice

Chapter 24: The Nature and Creation of Money

Section 1: What Is Money?
Section 2: The Banking System and Money Creation
Section 3: The Federal Reserve System
Section 4: Review and Practice

Chapter 25: Financial Markets and the Economy

Section 1: The Bond and Foreign Exchange Markets
Section 2: Demand, Supply, and Equilibrium in the Money Market
Section 3: Review and Practice
´ | A | ¯ | | 1
Economics: The Study of
Choice
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1. DEFINING ECONOMICS
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1. Deñne economics.
2. £xpIain the concepts of scarcity and opportunity cost and how they reIate to the deñnition of
economics.
3. Understand the three fundamentaI economic questions: What shouId be produced1 How
shouId goods and services be produced1 Ior whom shouId goods and services be produced1
Economics is a social science that examines how people choose among the alteinatives available to
them. It is social because it involves people and theii behavioi. It is a science because it uses, as much as
possible, a scientifc appioach in its investigation of choices.
1.1 Scaicity, Choice, and Cost
All choices mean that one alteinative is selected ovei anothei. Selecting among alteinatives involves
thiee ideas cential to economics: scaicity, choice, and oppoitunity cost.
Scarcity
Oui iesouices aie limited. At any one time, we have only so much land, so many factoiies, so much oil,
so many people. But oui wants, oui desiies foi the things that we can pioduce with those iesouices, aie
unlimited. We would always like moie and bettei housing, moie and bettei education-moie and bet-
tei of piactically eveiything.
If oui iesouices weie also unlimited, we could say yes to each of oui wants-and theie would be
no economics. Because oui iesouices aie limited, we cannot say yes to eveiything. To say yes to one
thing iequiies that we say no to anothei. Whethei we like it oi not, we must make choices.
Oui unlimited wants aie continually colliding with the limits of oui iesouices, foicing us to pick
some activities and to ieject otheis. Scarcity is the condition of having to choose among alteinatives. A
scarce good is one foi which the choice of one alteinative iequiies that anothei be given up.
Considei a paicel of land. The paicel piesents us with seveial alteinative uses. We could build a
house on it. We could put a gas station on it. We could cieate a small paik on it. We could leave the
land undeveloped in oidei to be able to make a decision latei as to how it should be used.
Suppose we have decided the land should be used foi housing. Should it be a laige and expensive
house oi seveial modest ones: Suppose it is to be a laige and expensive house. Who should live in the
house: If the Lees live in it, the Nguyens cannot. Theie aie alteinative uses of the land both in the sense
of the type of use and also in the sense of who gets to use it. The fact that land is scaice means that soci-
ety must make choices conceining its use.
Viitually eveiything is scaice. Considei the aii we bieathe, which is available in huge quantity at
no chaige to us. Could it possibly be scaice:
The test of whethei aii is scaice is whethei it has alteinative uses. What uses can we make of the
aii: We bieathe it. We pollute it when we diive oui cais, heat oui houses, oi opeiate oui factoiies. In
efect, one use of the aii is as a gaibage dump. We ceitainly need the aii to bieathe. But just as ceitainly,
we choose to dump gaibage in it. Those two uses aie cleaily alteinatives to each othei. The moie
gaibage we dump in the aii, the less desiiable-and healthy-it will be to bieathe. If we decide we want
to bieathe cleanei aii, we must limit the activities that geneiate pollution. Aii is a scaice good because
it has alteinative uses.
Not all goods, howevei, confiont us with such choices. A free good is one foi which the choice of
one use does not iequiie that we give up anothei. One example of a fiee good is giavity. The fact that
giavity is holding you to the eaith does not mean that youi neighboi is foiced to diift up into space!
One peison's use of giavity is not an alteinative to anothei peison's use.
Theie aie not many fiee goods. Outei space, foi example, was a fiee good when the only use we
made of it was to gaze at it. But now, oui use of space has ieached the point wheie one use can be an al-
teinative to anothei. Conficts have alieady aiisen ovei the allocation of oibital slots foi communica-
tions satellites. Thus, even paits of outei space aie scaice. Space will suiely become moie scaice as we
fnd new ways to use it. Scaicity chaiacteiizes viitually eveiything. Consequently, the scope of econom-
ics is wide indeed.
8 PRINCIPL£S OI £CONOMICS
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Scarcity and the IundamentaI £conomic Questions
The choices we confiont as a iesult of scaicity iaise thiee sets of issues. Eveiy economy must answei
the following questions:
1. What should be produced: Using the economy's scaice iesouices to pioduce one thing iequiies
giving up anothei. Pioducing bettei education, foi example, may iequiie cutting back on othei
seivices, such as health caie. A decision to pieseive a wildeiness aiea iequiies giving up othei
uses of the land. Eveiy society must decide what it will pioduce with its scaice iesouices.
2. How should goods and services be produced: Theie aie all soits of choices to be made in
deteimining how goods and seivices should be pioduced. Should a fim employ a few skilled oi a
lot of unskilled woikeis: Should it pioduce in its own countiy oi should it use foieign plants:
Should manufactuiing fims use new oi iecycled iaw mateiials to make theii pioducts:
3. For whom should goods and services be produced: If a good oi seivice is pioduced, a decision
must be made about who will get it. A decision to have one peison oi gioup ieceive a good oi
seivice usually means it will not be available to someone else. Foi example, iepiesentatives of the
pooiest nations on eaith often complain that eneigy consumption pei peison in the United States
is 17 times gieatei than eneigy consumption pei peison in the woild's 62 pooiest countiies.
Ciitics aigue that the woild's eneigy should be moie evenly allocated. Should it: That is a ¨foi
whom" question.
Eveiy economy must deteimine what should be pioduced, how it should be pioduced, and foi whom it
should be pioduced. We shall ietuin to these questions again and again.
Opportunity Cost
It is within the context of scaicity that economists defne what is peihaps the most impoitant concept
in all of economics, the concept of oppoitunity cost. Opportunity cost is the value of the best altein-
ative foigone in making any choice.
The oppoitunity cost to you of ieading the iemaindei of this chaptei will be the value of the best
othei use to which you could have put youi time. If you choose to spend $20 on a potted plant, you
have simultaneously chosen to give up the benefts of spending the $20 on pizzas oi a papeiback book
oi a night at the movies. If the book is the most valuable of those alteinatives, then the oppoitunity cost
of the plant is the value of the enjoyment you otheiwise expected to ieceive fiom the book.
The concept of oppoitunity cost must not be confused with the puichase piice of an item. Con-
sidei the cost of a college oi univeisity education. That includes the value of the best alteinative use of
money spent foi tuition, fees, and books. But the most impoitant cost of a college education is the value
of the foigone alteinative uses of time spent studying and attending class instead of using the time in
some othei endeavoi. Students saciifce that time in hopes of even gieatei eainings in the futuie oi be-
cause they place a value on the oppoitunity to leain. Oi considei the cost of going to the doctoi. Pait of
that cost is the value of the best alteinative use of the money iequiied to see the doctoi. But, the cost
also includes the value of the best alteinative use of the time iequiied to see the doctoi. The essential
thing to see in the concept of oppoitunity cost is found in the name of the concept. Oppoitunity cost is
the value of the best oppoitunity foigone in a paiticulai choice. It is not simply the amount spent on
that choice.
The concepts of scaicity, choice, and oppoitunity cost aie at the heait of economics. A good is
scaice if the choice of one alteinative iequiies that anothei be given up. The existence of alteinative
uses foices us to make choices. The oppoitunity cost of any choice is the value of the best alteinative
foigone in making it.
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10 PRINCIPL£S OI £CONOMICS
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CHAP7£R 1 £CONOMICS: 7H£ S7UDY OI CHOIC£ 11
2. THE FIELD OF ECONOMICS
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. £xpIain the distinguishing characteristics of the economic way of thinking.
2. Distinguish between microeconomics and macroeconomics.
We have examined the basic concepts of scaicity, choice, and oppoitunity cost in economics. In this
section, we will look at economics as a feld of study. We begin with the chaiacteiistics that distinguish
economics fiom othei social sciences.
2.1 The Economic Way of Thinking
Economists study choices that scaicity iequiies us to make. This fact is not what distinguishes econom-
ics fiom othei social sciences; all social scientists aie inteiested in choices. An anthiopologist might
study the choices of ancient peoples; a political scientist might study the choices of legislatuies; a psy-
chologist might study how people choose a mate; a sociologist might study the factois that have led to a
iise in single-paient households. Economists study such questions as well. What is it about the study of
choices by economists that makes economics difeient fiom these othei social sciences:
Thiee featuies distinguish the economic appioach to choice fiom the appioaches taken in othei
social sciences:
1. Economists give special emphasis to the iole of oppoitunity costs in theii analysis of choices.
2. Economists assume that individuals make choices that seek to maximize the value of some
objective, and that they defne theii objectives in teims of theii own self-inteiest.
3. Individuals maximize by deciding whethei to do a little moie oi a little less of something.
Economists aigue that individuals pay attention to the consequences of small changes in the
levels of the activities they puisue.
The emphasis economists place on oppoitunity cost, the idea that people make choices that maximize
the value of objectives that seive theii self-inteiest, and a focus on the efects of small changes aie ideas
of gieat powei. They constitute the coie of economic thinking. The next thiee sections examine these
ideas in gieatei detail.
Opportunity Costs Are Important
If doing one thing iequiies giving up anothei, then the expected benefts of the alteinatives we face will
afect the ones we choose. Economists aigue that an undeistanding of oppoitunity cost is ciucial to the
examination of choices.
As the set of available alteinatives changes, we expect that the choices individuals make will
change. A iainy day could change the oppoitunity cost of ieading a good book; we might expect moie
ieading to get done in bad than in good weathei. A high income can make it veiy costly to take a day
of; we might expect highly paid individuals to woik moie houis than those who aie not paid as well. If
individuals aie maximizing theii level of satisfaction and fims aie maximizing piofts, then a change in
the set of alteinatives they face may afect theii choices in a piedictable way.
The emphasis on oppoitunity costs is an emphasis on the examination of alteinatives. One beneft
of the economic way of thinking is that it pushes us to think about the value of alteinatives in each
pioblem involving choice.
IndividuaIs Maximize in Pursuing SeIf-Interest
What motivates people as they make choices: Peihaps moie than anything else, it is the economist's
answei to this question that distinguishes economics fiom othei felds.
Economists assume that individuals make choices that they expect will cieate the maximum value
of some objective, given the constiaints they face. Fuitheimoie, economists assume that people's ob-
jectives will be those that seive theii own self-inteiest.
Economists assume, foi example, that the owneis of business fims seek to maximize pioft. Given
the assumed goal of pioft maximization, economists can piedict how fims in an industiy will iespond
to changes in the maikets in which they opeiate. As laboi costs in the United States iise, foi example,
economists aie not suipiised to see fims moving some of theii manufactuiing opeiations oveiseas.
12 PRINCIPL£S OI £CONOMICS
margin
¯|e cu..ert |eve| c| .r
.ct|v|ty.
choice at the margin
A Jec|s|cr tc Jc . ||tt|e nc.e
c. . ||tt|e |ess c| scnet||rg.
microeconomics
¯|e b..rc| c| eccrcn|cs
t|.t |ccuses cr t|e c|c|ces
n.Je by ccrsune.s .rJ
|.ns .rJ t|e |np.cts t|cse
c|c|ces |.ve cr |rJ|v|Ju.|
n..kets.
macroeconomics
¯|e b..rc| c| eccrcn|cs
t|.t |ccuses cr t|e |np.ct c|
c|c|ces cr t|e tct.|, c.
.gg.eg.te, |eve| c| eccrcn|c
.ct|v|ty.
Similaily, economists assume that maximizing behavioi is at woik when they examine the behavi-
oi of consumeis. In studying consumeis, economists assume that individual consumeis make choices
aimed at maximizing theii level of satisfaction. In the next chaptei, we will look at the iesults of the
shift fiom skiing to snowboaiding; that is a shift that iefects the puisuit of self-inteiest by consumeis
and by manufactuieis.
In assuming that people puisue theii self-inteiest, economists aie not assuming people aie selfsh.
People cleaily gain satisfaction by helping otheis, as suggested by the laige chaiitable contiibutions
people make. Puisuing one's own self-inteiest means puisuing the things that give one satisfaction. It
need not imply gieed oi selfshness.
Choices Are Made at the Margin
Economists aigue that most choices aie made ¨at the maigin." The margin is the cuiient level of an
activity. Think of it as the edge fiom which a choice is to be made. A choice at the margin is a de-
cision to do a little moie oi a little less of something.
Assessing choices at the maigin can lead to extiemely useful insights. Considei, foi example, the
pioblem of cuitailing watei consumption when the amount of watei available falls shoit of the amount
people now use. Economists aigue that one way to induce people to conseive watei is to iaise its piice.
A common iesponse to this iecommendation is that a highei piice would have no efect on watei con-
sumption, because watei is a necessity. Many people asseit that piices do not afect watei consumption
because people ¨need" watei.
But choices in watei consumption, like viitually all choices, aie made at the maigin. Individuals do
not make choices about whethei they should oi should not consume watei. Rathei, they decide wheth-
ei to consume a little moie oi a little less watei. Household watei consumption in the United States
totals about 103 gallons pei peison pei day. Think of that staiting point as the edge fiom which a
choice at the maigin in watei consumption is made. Could a highei piice cause you to use less watei
biushing youi teeth, take shoitei showeis, oi watei youi lawn less: Could a highei piice cause people
to ieduce theii use, say, to 104 gallons pei peison pei day: To 103: When we examine the choice to
consume watei at the maigin, the notion that a highei piice would ieduce consumption seems much
moie plausible. Piices afect oui consumption of watei because choices in watei consumption, like oth-
ei choices, aie made at the maigin.
The elements of oppoitunity cost, maximization, and choices at the maigin can be found in each
of two bioad aieas of economic analysis: micioeconomics and macioeconomics. Youi economics
couise, foi example, may be designated as a ¨micio" oi as a ¨macio" couise. We will look at these two
aieas of economic thought in the next section.
2.2 Micioeconomics and Macioeconomics
The feld of economics is typically divided into two bioad iealms: micioeconomics and macioeconom-
ics. It is impoitant to see the distinctions between these bioad aieas of study.
Microeconomics is the bianch of economics that focuses on the choices made by individual
decision-making units in the economy-typically consumeis and fims-and the impacts those choices
have on individual maikets. Macroeconomics is the bianch of economics that focuses on the impact
of choices on the total, oi aggiegate, level of economic activity.
Why do tickets to the best conceits cost so much: How does the thieat of global waiming afect
ieal estate piices in coastal aieas: Why do women end up doing most of the housewoik: Why do seni-
oi citizens get discounts on public tiansit systems: These questions aie geneially iegaided as micioeco-
nomic because they focus on individual units oi maikets in the economy.
Is the total level of economic activity iising oi falling: Is the iate of infation incieasing oi decieas-
ing: What is happening to the unemployment iate: These aie questions that deal with aggiegates, oi
totals, in the economy; they aie pioblems of macioeconomics. The question about the level of econom-
ic activity, foi example, iefeis to the total value of all goods and seivices pioduced in the economy.
Infation is a measuie of the iate of change in the aveiage piice level foi the entiie economy; it is a mac-
ioeconomic pioblem. The total levels of employment and unemployment in the economy iepiesent the
aggiegate of all laboi maikets; unemployment is also a topic of macioeconomics.
Both micioeconomics and macioeconomics give attention to individual maikets. But in micioeco-
nomics that attention is an end in itself; in macioeconomics it is aimed at explaining the movement of
majoi economic aggiegates-the level of total output, the level of employment, and the piice level.
We have now examined the chaiacteiistics that defne the economic way of thinking and the two
bianches of this way of thinking: micioeconomics and macioeconomics. In the next section, we will
have a look at what one can do with tiaining in economics.
CHAP7£R 1 £CONOMICS: 7H£ S7UDY OI CHOIC£ 13
2.3 Putting Economics to Woik
Economics is one way of looking at the woild. Because the economic way of thinking has pioven quite
useful, tiaining in economics can be put to woik in a wide iange of felds. One, of couise, is in woik as
an economist. Undeigiaduate woik in economics can be applied to othei caieeis as well.
Careers in £conomics
Economists woik in thiee types of oiganizations. About 38° of economists woik foi goveinment agen-
cies.
[1]
The iemaindei woik foi business fims oi in colleges and univeisities.
Economists woiking foi business fims and goveinment agencies sometimes foiecast economic
activity to assist theii employeis in planning. They also apply economic analysis to the activities of the
fims oi agencies foi which they woik oi consult. Economists employed at colleges and univeisities
teach and conduct ieseaich.
Peiuse the website of youi college oi univeisity's economics depaitment. Chances aie the depait-
ment will discuss the wide vaiiety of occupations that theii economics majois entei. Unlike engineei-
ing and accounting majois, economics and othei social science majois tend to be distiibuted ovei a
bioad iange of occupations.
AppIying £conomics to Other IieIds
Suppose that you aie consideiing something othei than a caieei in economics. Would choosing to
study economics help you:
The evidence suggests it may. Suppose, foi example, that you aie consideiing law school. The
study of law iequiies keen analytical skills; studying economics shaipens such skills. Economists have
tiaditionally aigued that undeigiaduate woik in economics seives as excellent piepaiation foi law
school. Economist Michael Nieswiadomy of the Univeisity of Noith Texas collected data on Law
School Admittance Test (LSAT) scoies foi undeigiaduate majois listed by 2,200 oi moie students tak-
ing the test in 2003. Table 1.1 gives the scoies, as well as the ianking foi each of these majois, in 2003
and in two pievious yeais in which the iankings weie compiled. In iankings foi all thiee yeais, eco-
nomics majois iecoided the highest scoies.
7A8L£ 1. 1 LSA7 Scores and Undergraduate Ma|ors
|e.e ..e t|e .ve..ge |SA¯ scc.es .rJ ..rk|rgs |c. t|e 12 urJe.g..Ju.te n.¦c.s .|t| nc.e t|.r 2200 stuJerts
t.k|rg t|e test tc erte. |.. sc|cc| |r t|e 20032004 .c.Jen|c ye...
Ma|or ñeId LSA7 average 2003-2004 2003-2004 Rank 1994-1995 Rank 1991-1992 Rank
|ccrcn|cs 156.6 1 1 1
|rg|ree.|rg 155.4 2 4 2
||stc.y 155.0 3 2 3
|rg||s| 154.3 4 3 4
||r.rce 152.6 5 6 5
|c||t|c.| sc|erce 152.1 6 9 9
|syc|c|cgy 152.1 8
Acccurt|rg 151.1 8 8 6
´cnnur|c.t|crs 150.5 9 10 10
Scc|c|cgy 150.2 10 12 13
bus. AJn|r|st..t|cr 149.6 11 13 12
´.|n|r.| 'ust|ce 144. 12 14 14
Source· Michael ^ieswiadomy, ¨LSAT Scores of Economics Majors· 2003-2004 Class Update,¨ journal of Economic Education, 37(2) (Spring 200õ)·
244-247 and Michael ^ieswiadomy, ¨LSAT Scores of Economics Majors¨ journal of Economic Education, 29(4) (Fall 1998)· 377-379.
Did the stiong peifoimance by economics, engineeiing, and histoiy majois mean that tiaining in those
felds shaipens analytical skills tested in the LSAT, oi that students with good analytical skills aie moie
likely to majoi in them: Both factois weie piobably at woik. Economics cleaily attiacts students with
good analytical skills-and studying economics helps develop those skills.
Economics majois shine in othei aieas as well. Accoiding to the Buieau of Laboi Statistics Occupa-
tional Outlook Handbook, a stiong backgiound in economic theoiy, mathematics, and statistics
piovides the basis foi competing foi the best job oppoitunities, paiticulaily ieseaich assistant positions,
in a bioad iange of felds. Many giaduates with bacheloi's degiees will fnd good jobs in industiy and
14 PRINCIPL£S OI £CONOMICS
business as management oi sales tiainees oi as administiative assistants. Because economists aie con-
ceined with undeistanding and inteipieting fnancial matteis, among othei subjects, they will also be
attiacted to and qualifed foi jobs as fnancial manageis, fnancial analysts, undeiwiiteis, actuaiies, se-
cuiities and fnancial seivices sales woikeis, ciedit analysts, loan and budget omceis, and uiban and ie-
gional planneis.
Table 1.2 shows aveiage yeaily salaiy ofeis foi bacheloi degiee candidates foi May 2006 and the
outlook foi ielated occupations to 2014.
7A8L£ 1. 2 Average YearIy SaIary Offers, May 2006 and OccupationaI OutIook 2004-2014, SeIected
Ma|ors/Occupations
Undergraduate ma|or Average $ Oñer
May, 2006
Pro|ected % Change in 7otaI £mpIoyment
in Occupation 2004-2014
´cnpute. |rg|ree.|rg ´54,200 10.1
||ect.|c.|/||ect.cr|c |rg|ree.|rg 54,053 11.8
´cnpute. Sc|erce 50,892 25.6
Acccurt|rg 46,188 22.4
|ccrcn|cs .rJ ||r.rce 45,058 12.4
V.r.genert |r|c.n.t|cr Systens 44,55 25.9
|cg|st|cs .rJ V.te.|.|s V.r.genert 43,426 13.2
bus|ress AJn|r|st..t|cr 40,96 1.0
|rv|.crnert.| Sc|erces (|rc|uJ|rg |c.est.y
.rJ ccrse.v.t|cr sc|erce)
39,50 6.3
Ot|e. bus|ress V.¦c.s (e.g., V..ket|rg) 3,446 20.8
|un.r |escu.ces (|rc|. |.bc. |e|.t|crs) 36,256 15.9
Cec|cgy .rJ Cec|cg|c.| Sc|erces 35,034 8.3
Scc|c|cgy 33,52 4.
|c||t|c.| Sc|erce/Ccve.rnert 33,151 .3
||be..| A.ts ° Sc|erces (gere..| stuJ|es) 32,62 r.
|ub||c |e|.t|crs 32,623 21.
Spec|.| |Juc.t|cr 31,81 23.3
||enert..y |Juc.t|cr 31,8 18.2
|c.e|gr |.rgu.ges 31,364 r.
|ette.s (|rc|. |rg||s|) 31,204 20.4
Ot|e. Scc|.| Sc|erces (|rc|uJ|rg ´.|n|r.|
'ust|ce .rJ ||stc.y)
30,88 12.3
|syc|c|cgy 30,308 9.9
|.ee|enert..y |Juc.t|cr 2,550 22.4
Scc|.| \c.k 25,865 19.6
\|su.| .rJ |e.|c.n|rg A.ts 21,26 15.2
Sources· ^ational Association of Colleges and Employers, Salary Survey, Spring 200õ http·//naceweb.org, Bureau of Labor Statistics, 200õ-2007 edition
of the Occupational Outlook Handbook, Occupational Employment, Training, and Earnings· Educational Level Report (May, 200õ) URL·
http·//data.bls.gov/oep/noeted/empoptd.jsp (note· na = not reported, that is, no specifc occupation was reported in BLS report, Other business majors,
Other social sciences, Social work (including Sociology), and Environmental Sciences are weighted averages of various disciplines, calculated by
authors.)
One's choice of a majoi, oi minoi, is not likely to be based solely on consideiations of potential eain-
ings oi the piospect of landing a spot in law school. You will also considei youi inteiests and abilities in
making a decision about whethei to puisue fuithei study in economics. And, of couise, you will con-
sidei the expected benefts of alteinative couises of study. What is your oppoitunity cost of puisuing
study of economics: Does studying moie economics seive youi inteiests and will doing so maximize
youi satisfaction level: These consideiations may be on youi mind as you begin to study economics at
the college level and obviously students will make many difeient choices. But, should you decide to
puisue a majoi oi minoi in economics, you should know that a backgiound in this feld is likely to
seive you well in a wide iange of caieeis.
CHAP7£R 1 £CONOMICS: 7H£ S7UDY OI CHOIC£ 15
k £ Y 7 A k £ A W A Y S
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stuJerts .|c erte. t|e ¦cb n..ket .|t| . n.¦c. |r eccrcn|cs terJ tc e..r nc.e t|.r Jc stuJerts |r ncst
ct|e. n.¦c.s. |u.t|e., eccrcn|cs n.¦c.s Jc p..t|cu|..|y .e|| cr t|e |SA¯.
7 R Y I 7 !
¯|e |ep..tnert c| Ag.|cu|tu.e est|n.teJ t|.t t|e experJ|tu.es . n|JJ|e|rccne, |usb.rJ.||e |.n||y c|
t|.ee .cu|J |rcu. tc ..|se cre .JJ|t|cr.| c|||J |.cn b|.t| |r 2005 tc .ge 1 .cu|J be ´250,530. |r .|.t ..y
Jces t||s est|n.te |||ust..te t|e eccrcn|c ..y c| t||rk|rg` \cu|J t|e |ep..tnerts est|n.te be .r ex.np|e
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Case in Point: 7he IinanciaI Payoff to Studying £conomics
÷ 2010 jupiterimages Corporation
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.cccurt|rg n.¦c.s. ¯|e eccrcn|cs n.¦c.s |r t|e|. su.vey, ||ke t|cse .|c n.¦c.eJ |r ct|e. scc|.| sc|erces .rJ
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16 PRINCIPL£S OI £CONOMICS
variabIe
Scnet||rg .|cse v.|ue c.r
c|.rge.
constant
Scnet||rg .|cse v.|ue Jces
rct c|.rge.
b.seJ cr t|e su.vey t|ey useJ, cve. 40 c| eccrcn|cs n.¦c.s .ert cr tc e..r g..Ju.te Jeg.ees, n.ry |r |..
.rJ bus|ress. |ccrcn|cs n.¦c.s ..rkeJ |.st |r te.ns c| ..ges, .s ccnp..eJ tc ct|e. |.. sc|cc| g..Ju.tes
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3. THE ECONOMISTS' TOOL KIT
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. £xpIain how economists test hypotheses, deveIop economic theories, and use modeIs in their
anaIyses.
2. £xpIain how the aII-other-things unchanged (ceteris paribus) probIem and the faIIacy of faIse
cause añect the testing of economic hypotheses and how economists try to overcome these
probIems.
3. Distinguish between normative and positive statements.
Economics difeis fiom othei social sciences because of its emphasis on oppoitunity cost, the assump-
tion of maximization in teims of one's own self-inteiest, and the analysis of choices at the maigin. But
ceitainly much of the basic methodology of economics and many of its dimculties aie common to
eveiy social science-indeed, to eveiy science. This section exploies the application of the scientifc
method to economics.
Reseaicheis often examine ielationships between vaiiables. A variable is something whose value
can change. By contiast, a constant is something whose value does not change. The speed at which a
cai is tiaveling is an example of a vaiiable. The numbei of minutes in an houi is an example of a
constant.
CHAP7£R 1 £CONOMICS: 7H£ S7UDY OI CHOIC£ 17
scientiñc method
A systen.t|c set c|
p.cceJu.es t|.cug| .||c|
krc.|eJge |s c.e.teJ.
hypothesis
Ar .sse.t|cr c| . .e|.t|crs||p
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v..|.b|es t|.t ccu|J be
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v|.tu.||y ur|ve.s.| .ccept.rce.
modeI
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.ssunpt|crs .bcut scne
.spect c| t|e .e.| .c.|J.
ceteris paribus
A |.t|r p|..se t|.t ne.rs,
´.|| ct|e. t||rgs urc|.rgeJ.´
Reseaich is geneially conducted within a fiamewoik called the scientinc method, a systematic
set of pioceduies thiough which knowledge is cieated. In the scientifc method, hypotheses aie sugges-
ted and then tested. A hypothesis is an asseition of a ielationship between two oi moie vaiiables that
could be pioven to be false. A statement is not a hypothesis if no conceivable test could show it to be
false. The statement ¨Plants like sunshine" is not a hypothesis; theie is no way to test whethei plants
like sunshine oi not, so it is impossible to piove the statement false. The statement ¨Incieased solai ia-
diation incieases the iate of plant giowth" is a hypothesis; expeiiments could be done to show the iela-
tionship between solai iadiation and plant giowth. If solai iadiation weie shown to be unielated to
plant giowth oi to ietaid plant giowth, then the hypothesis would be demonstiated to be false.
If a test ieveals that a paiticulai hypothesis is false, then the hypothesis is iejected oi modifed. In
the case of the hypothesis about solai iadiation and plant giowth, we would piobably fnd that moie
sunlight incieases plant giowth ovei some iange but that too much can actually ietaid plant giowth.
Such iesults would lead us to modify oui hypothesis about the ielationship between solai iadiation and
plant giowth.
If the tests of a hypothesis yield iesults consistent with it, then fuithei tests aie conducted. A hypo-
thesis that has not been iejected aftei widespiead testing and that wins geneial acceptance is commonly
called a theory. A theoiy that has been subjected to even moie testing and that has won viitually uni-
veisal acceptance becomes a law. We will examine two economic laws in the next two chapteis.
Even a hypothesis that has achieved the status of a law cannot be pioven tiue. Theie is always a
possibility that someone may fnd a case that invalidates the hypothesis. That possibility means that
nothing in economics, oi in any othei social science, oi in any science, can evei be proven tiue. We can
have gieat confdence in a paiticulai pioposition, but it is always a mistake to asseit that it is ¨pioven."
3.1 Models in Economics
All scientifc thought involves simplifcations of ieality. The ieal woild is fai too complex foi the hu-
man mind-oi the most poweiful computei-to considei. Scientists use models instead. A model is a
set of simplifying assumptions about some aspect of the ieal woild. Models aie always based on as-
sumed conditions that aie simplei than those of the ieal woild, assumptions that aie necessaiily false.
A model of the ieal woild cannot be the ieal woild.
We will encountei oui fist economic model in Chaptei 33. Foi that model, we will assume that an
economy can pioduce only two goods. Then we will exploie the model of demand and supply. One of
the assumptions we will make theie is that all the goods pioduced by fims in a paiticulai maiket aie
identical. Of couise, ieal economies and ieal maikets aie not that simple. Reality is nevei as simple as a
model; one point of a model is to simplify the woild to impiove oui undeistanding of it.
Economists often use giaphs to iepiesent economic models. The appendix to this chaptei piovides
a quick, iefieshei couise, if you think you need one, on undeistanding, building, and using giaphs.
Models in economics also help us to geneiate hypotheses about the ieal woild. In the next section,
we will examine some of the pioblems we encountei in testing those hypotheses.
3.2 Testing Hypotheses in Economics
Heie is a hypothesis suggested by the model of demand and supply: an inciease in the piice of gasoline
will ieduce the quantity of gasoline consumeis demand. How might we test such a hypothesis:
Economists tiy to test hypotheses such as this one by obseiving actual behavioi and using empiiic-
al (that is, ieal-woild) data. The aveiage ietail piice of gasoline in the United States iose fiom an avei-
age of $2.12 pei gallon on May 22, 2003 to $2.88 pei gallon on May 22, 2006. The numbei of gallons of
gasoline consumed by U.S. motoiists iose 0.3° duiing that peiiod.
The small inciease in the quantity of gasoline consumed by motoiists as its piice iose is inconsist-
ent with the hypothesis that an incieased piice will lead to an ieduction in the quantity demanded.
Does that mean that we should dismiss the oiiginal hypothesis: On the contiaiy, we must be cautious
in assessing this evidence. Seveial pioblems exist in inteipieting any set of economic data. One piob-
lem is that seveial things may be changing at once; anothei is that the initial event may be unielated to
the event that follows. The next two sections examine these pioblems in detail.
7he AII-Other-7hings-Unchanged ProbIem
The hypothesis that an inciease in the piice of gasoline pioduces a ieduction in the quantity demanded
by consumeis caiiies with it the assumption that theie aie no othei changes that might also afect con-
sumei demand. A bettei statement of the hypothesis would be: An inciease in the piice of gasoline will
ieduce the quantity consumeis demand, ceteiis paiibus. Ceteris paribus is a Latin phiase that means
¨all othei things unchanged."
18 PRINCIPL£S OI £CONOMICS
dependent variabIe
A v..|.b|e t|.t .espcrJs tc
c|.rge.
independent variabIe
A v..|.b|e t|.t |rJuces .
c|.rge.
faIIacy of faIse cause
¯|e |rcc..ect .ssunpt|cr
t|.t cre evert c.uses
.rct|e. bec.use t|e t.c
everts terJ tc cccu.
tcget|e..
positive statement
A st.tenert c| |.ct c. .
|ypct|es|s.
normative statement
A st.tenert t|.t n.kes .
v.|ue ¦uJgnert.
But things changed between May 2003 and May 2006. Economic activity and incomes iose both in
the United States and in many othei countiies, paiticulaily China, and people with highei incomes aie
likely to buy moie gasoline. Employment iose as well, and people with jobs use moie gasoline as they
diive to woik. Population in the United States giew duiing the peiiod. In shoit, many things happened
duiing the peiiod, all of which tended to inciease the quantity of gasoline people puichased.
Oui obseivation of the gasoline maiket between May 2003 and May 2006 did not ofei a conclus-
ive test of the hypothesis that an inciease in the piice of gasoline would lead to a ieduction in the
quantity demanded by consumeis. Othei things changed and afected gasoline consumption. Such
pioblems aie likely to afect any analysis of economic events. We cannot ask the woild to stand still
while we conduct expeiiments in economic phenomena. Economists employ a vaiiety of statistical
methods to allow them to isolate the impact of single events such as piice changes, but they can nevei
be ceitain that they have accuiately isolated the impact of a single event in a woild in which viitually
eveiything is changing all the time.
In laboiatoiy sciences such as chemistiy and biology, it is ielatively easy to conduct expeiiments in
which only selected things change and all othei factois aie held constant. The economists' laboiatoiy is
the ieal woild; thus, economists do not geneially have the luxuiy of conducting contiolled
expeiiments.
7he IaIIacy of IaIse Cause
Hypotheses in economics typically specify a ielationship in which a change in one vaiiable causes an-
othei to change. We call the vaiiable that iesponds to the change the dependent variable; the vaiiable
that induces a change is called the independent variable. Sometimes the fact that two vaiiables move
togethei can suggest the false conclusion that one of the vaiiables has acted as an independent vaiiable
that has caused the change we obseive in the dependent vaiiable.
Considei the following hypothesis: People weaiing shoits cause waim weathei. Ceitainly, we ob-
seive that moie people weai shoits when the weathei is waim. Piesumably, though, it is the waim
weathei that causes people to weai shoits iathei than the weaiing of shoits that causes waim weathei;
it would be incoiiect to infei fiom this that people cause waim weathei by weaiing shoits.
Reaching the incoiiect conclusion that one event causes anothei because the two events tend to
occui togethei is called the fallacy of false cause. The accompanying essay on baldness and heait dis-
ease suggests an example of this fallacy.
Because of the dangei of the fallacy of false cause, economists use special statistical tests that aie
designed to deteimine whethei changes in one thing actually do cause changes obseived in anothei.
Given the inability to peifoim contiolled expeiiments, howevei, these tests do not always ofei convin-
cing evidence that peisuades all economists that one thing does, in fact, cause changes in anothei.
In the case of gasoline piices and consumption between May 2003 and May 2006, theie is good
theoietical ieason to believe the piice inciease should lead to a ieduction in the quantity consumeis de-
mand. And economists have tested the hypothesis about piice and the quantity demanded quite ex-
tensively. They have developed elaboiate statistical tests aimed at iuling out pioblems of the fallacy of
false cause. While we cannot piove that an inciease in piice will, ceteiis paiibus, lead to a ieduction in
the quantity consumeis demand, we can have consideiable confdence in the pioposition.
Normative and Positive Statements
Two kinds of asseitions in economics can be subjected to testing. We have alieady examined one, the
hypothesis. Anothei testable asseition is a statement of fact, such as ¨It is iaining outside" oi
¨Miciosoft is the laigest pioducei of opeiating systems foi peisonal computeis in the woild." Like hy-
potheses, such asseitions can be demonstiated to be false. Unlike hypotheses, they can also be shown to
be coiiect. A statement of fact oi a hypothesis is a positive statement.
Although people often disagiee about positive statements, such disagieements can ultimately be
iesolved thiough investigation. Theie is anothei categoiy of asseitions, howevei, foi which investiga-
tion can nevei iesolve difeiences. A normative statement is one that makes a value judgment. Such
a judgment is the opinion of the speakei; no one can ¨piove" that the statement is oi is not coiiect.
Heie aie some examples of noimative statements in economics: ¨We ought to do moie to help the
pooi." ¨People in the United States should save moie." ¨Coipoiate piofts aie too high." The state-
ments aie based on the values of the peison who makes them. They cannot be pioven false.
Because people have difeient values, noimative statements often piovoke disagieement. An eco-
nomist whose values lead him oi hei to conclude that we should piovide moie help foi the pooi will
disagiee with one whose values lead to a conclusion that we should not. Because no test exists foi these
values, these two economists will continue to disagiee, unless one peisuades the othei to adopt a difei-
ent set of values. Many of the disagieements among economists aie based on such difeiences in values
and theiefoie aie unlikely to be iesolved.
CHAP7£R 1 £CONOMICS: 7H£ S7UDY OI CHOIC£ 19
k £ Y 7 A k £ A W A Y S
< |ccrcn|sts t.y tc enp|cy t|e sc|ert||c net|cJ |r t|e|. .ese..c|.
< Sc|ert|sts c.rrct p.cve . |ypct|es|s tc be t.ue, t|ey c.r cr|y |.|| tc p.cve |t |.|se.
< |ccrcn|sts, ||ke ct|e. scc|.| sc|ert|sts .rJ sc|ert|sts, use ncJe|s tc .ss|st t|en |r t|e|. .r.|yses.
< ¯.c p.cb|ens |r|e.ert |r tests c| |ypct|eses |r eccrcn|cs ..e t|e .||ct|e.t||rgsurc|.rgeJ p.cb|en
.rJ t|e |.||.cy c| |.|se c.use.
< |cs|t|ve st.tenerts ..e |.ctu.| .rJ c.r be testeJ. |c.n.t|ve st.tenerts ..e v.|ue ¦uJgnerts t|.t c.rrct
be testeJ. V.ry c| t|e J|s.g.eenerts .ncrg eccrcn|sts sten |.cn J||e.erces |r v.|ues.
7 R Y I 7 !
|cck .g.|r .t t|e J.t. |r ¯.b|e 1.1. |c. ccrs|Je. t|e |ypct|es|s. ´V.¦c.|rg |r eccrcn|cs .||| .esu|t |r . ||g|e.
|SA¯ scc.e.´ A.e t|e J.t. g|ver ccrs|stert .|t| t||s |ypct|es|s` |c t|e J.t. p.cve t|.t t||s |ypct|es|s |s cc.
.ect` \|.t |.||.cy n|g|t be |rvc|veJ |r .ccept|rg t|e |ypct|es|s`
Case in Point: Does 8aIdness Cause Heart Disease1
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20 PRINCIPL£S OI £CONOMICS
\|.t J|J |.. V..g..et .rs.e.` Vcst |npc.t.rt|y, s|e J|J rct .eccnnerJ t|.t t|e ,uest|cre. t.ke J.ugs
tc t.e.t ||s b.|Jress, bec.use Jcctc.s Jc rct t||rk t|.t t|e b.|Jress c.uses t|e |e..t J|se.se. A nc.e ||ke|y
exp|.r.t|cr |c. t|e .sscc|.t|cr bet.eer b.|Jress .rJ |e..t J|se.se |s t|.t bct| ccrJ|t|crs ..e .|ecteJ by .r
urJe.|y|rg |.ctc.. \|||e rct|rg t|.t nc.e .ese..c| reeJs tc be Jcre, cre |ypct|es|s t|.t |.. V..g..et c|e.s
|s t|.t ||g|e. testcste.cre |eve|s n|g|t be t.|gge.|rg bct| t|e |.|. |css .rJ t|e |e..t J|se.se. ¯|e gccJ re.s
|c. pecp|e .|t| e..|y b.|J|rg (.||c| |s .e.||y .|e.e t|e .sscc|.t|cr .|t| |rc.e.seJ .|sk c| |e..t J|se.se |.s
beer cbse.veJ) |s t|.t t|ey |.ve . s|gr.| t|.t n|g|t |e.J t|en tc be c|eckeJ e..|y cr |c. |e..t J|se.se.
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¯|e J.t. ..e ccrs|stert .|t| t|e |ypct|es|s, but |t |s reve. pcss|b|e tc p.cve t|.t . |ypct|es|s |s cc..ect. Ac
cept|rg t|e |ypct|es|s ccu|J |rvc|ve t|e |.||.cy c| |.|se c.use, stuJerts .|c n.¦c. |r eccrcn|cs n.y .|.e.Jy
|.ve t|e .r.|yt|c.| sk|||s reeJeJ tc Jc .e|| cr t|e ex.n.
4. REVIEW AND PRACTICE
Summary
´|c|ces ..e |c.ceJ cr us by sc..c|ty, eccrcn|sts stuJy t|e c|c|ces t|.t pecp|e n.ke. Sc..ce gccJs ..e t|cse
|c. .||c| t|e c|c|ce c| cre .|te.r.t|ve .e,u|.es g|v|rg up .rct|e.. ¯|e cppc.tur|ty ccst c| .ry c|c|ce |s t|e
v.|ue c| t|e best .|te.r.t|ve |c.gcre |r n.k|rg t|.t c|c|ce.
Scne key c|c|ces .ssesseJ by eccrcn|sts |rc|uJe .|.t tc p.cJuce, |c. tc p.cJuce |t, .rJ |c. .|cn |t
s|cu|J be p.cJuceJ. |ccrcn|cs |s J|st|rgu|s|eJ |.cn ct|e. .c.Jen|c J|sc|p||res t|.t .|sc stuJy c|c|ces by .r
enp|.s|s cr t|e cert..| |npc.t.rce c| cppc.tur|ty ccsts |r ev.|u.t|rg c|c|ces, t|e .ssunpt|cr c| n.x|n|.|rg
be|.v|c. t|.t se.ves t|e |rte.ests c| |rJ|v|Ju.| Jec|s|cr n.ke.s, .rJ . |ccus cr ev.|u.t|rg c|c|ces .t t|e
n..g|r.
|ccrcn|c .r.|yses n.y be .|neJ .t exp|.|r|rg |rJ|v|Ju.| c|c|ce c. c|c|ces |r .r |rJ|v|Ju.| n..ket, suc| |r
vest|g.t|crs ..e |..ge|y t|e |ccus c| n|c.ceccrcn|cs. ¯|e .r.|ys|s c| t|e |np.ct c| t|cse |rJ|v|Ju.| c|c|ces cr
suc| .gg.eg.tes .s tct.| cutput, t|e |eve| c| enp|cynert, .rJ t|e p.|ce |eve| |s t|e ccrce.r c|
n.c.ceccrcn|cs.
\c.k|rg .|t||r t|e |..ne.c.k c| t|e sc|ert||c net|cJ, eccrcn|sts |c.nu|.te |ypct|eses .rJ t|er test t|en.
¯|ese tests c.r cr|y .e|ute . |ypct|es|s, |ypct|eses |r sc|erce c.rrct be p.cveJ. A |ypct|es|s t|.t |.s beer
.|Je|y testeJ c|ter ccnes tc be .eg..JeJ .s . t|ec.y, cre t|.t |.s .cr v|.tu.||y ur|ve.s.| .ccept.rce |s . |...
bec.use c| t|e ccnp|ex|ty c| t|e .e.| .c.|J, eccrcn|sts .e|y cr ncJe|s t|.t .est cr . se.|es c| s|np|||y|rg .s
sunpt|crs. ¯|e ncJe|s ..e useJ tc gere..te |ypct|eses .bcut t|e eccrcny t|.t c.r be testeJ us|rg .e.|
.c.|J J.t..
St.tenerts c| |.ct .rJ |ypct|eses ..e pcs|t|ve st.tenerts. |c.n.t|ve st.tenerts, ur||ke pcs|t|ve st.tenerts,
c.rrct be testeJ .rJ p.cv|Je . scu.ce |c. pctert|.| J|s.g.eenert.
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P R O 8 L £ M S
1. \|y Jces t|e |.ct t|.t scnet||rg |s sc..ce .e,u|.e t|.t .e n.ke c|c|ces`
2. |ces t|e |.ct t|.t scnet||rg |s .burJ.rt ne.r |t |s rct sc..ce |r t|e eccrcn|c serse` \|y c. .|y rct`
3. |r scne ccurt.|es, suc| .s ´ub. .rJ |c.t| |c.e., t|e gcve.rnert n.kes ncst c| t|e Jec|s|crs .bcut
.|.t .||| be p.cJuceJ, |c. |t .||| be p.cJuceJ, .rJ |c. .|cn. |ces t|e |.ct t|.t t|ese c|c|ces ..e n.Je
by t|e gcve.rnert e||n|r.te sc..c|ty |r t|ese ccurt.|es` \|y c. .|y rct`
4. |xp|.|r .|.t |s ne.rt by t|e cppc.tur|ty ccst c| . c|c|ce.
5. \|.t |s t|e .pp.cx|n.te Jc||.. ccst c| t|e tu|t|cr .rJ ct|e. |ees .sscc|.teJ .|t| t|e eccrcn|cs ccu.se
ycu ..e t.k|rg` |ces t||s Jc||.. ccst |u||y .e|ect t|e cppc.tur|ty ccst tc ycu c| t.k|rg t|e ccu.se`
6. |r t|e ´.se |r |c|rt ess.y ´¯|e ||s|rg ´cst c| |re.gy,´ .|.t .cu|J be scne c| t|e t||rgs t|.t .cu|J be
|rc|uJeJ |r .r est|n.te c| t|e cppc.tur|ty ccst c| p.ese.v|rg p..t c| rc.t|e.r A|be.t. ´.r.J. by
p.c||b|t|rg |e.vy c.uJe c|| ext..ct|cr` |c ycu t||rk t|.t t|e |rc.e.seJ ext..ct|cr .ep.eserts t|e best use
c| t|e |.rJ` \|y c. .|y rct`
. |rJ|c.te .|et|e. e.c| c| t|e |c||c.|rg |s . tcp|c c| n|c.ceccrcn|cs c. n.c.ceccrcn|cs.
.. ¯|e |np.ct c| ||g|e. c|| p.|ces cr t|e p.cJuct|cr c| stee|
b. ¯|e |rc.e.seJ Jen.rJ |r t|e |.st 15 ye..s |c. exct|c J|et..y supp|enerts
c. ¯|e su.ge |r .gg.eg.te eccrcn|c .ct|v|ty t|.t ||t nuc| c| As|. |.te |r t|e e..|y 2000s
J. ¯|e s|..p |rc.e.ses |r |.S. enp|cynert .rJ tct.| cutput t|.t cccu..eJ bet.eer 2003 .rJ 200
e. ¯|e |np.ct c| p.ese.v.t|cr c| .||Je.ress ..e.s cr t|e |cgg|rg |rJust.y .rJ cr t|e p.|ce c|
|unbe.
8. |ete.n|re .|et|e. e.c| c| t|e |c||c.|rg ..|ses . ´.|.t,´ ´|c.,´ c. ´|c. .|cn´ |ssue. A.e t|e st.tenerts
rc.n.t|ve c. pcs|t|ve`
.. A .e,u|.enert t|.t .|un|run useJ |r c..s be n.Je |.cn .ecyc|eJ n.te.|.|s .||| ..|se t|e p.|ce c|
.utcncb||es.
b. ¯|e |eJe..| gcve.rnert Jces rct sperJ ercug| |c. c|||J.er.
c. Ar |rc.e.se |r pc||ce .escu.ces p.cv|JeJ tc t|e |rre. c|ty .||| |c.e. t|e c.|ne ..te.
J. Autcn.t|cr Jest.cys ¦cbs.
e. ||c.ts tc |np.cve t|e erv|.crnert terJ tc .eJuce p.cJuct|cr .rJ enp|cynert.
|. '.p.rese |.ns s|cu|J be nc.e .||||rg tc ||.e .JJ|t|cr.| .c.ke.s .|er p.cJuct|cr .|ses .rJ tc
|.y c| .c.ke.s .|er p.cJuct|cr |.||s.
g. Access tc |e.|t| c..e s|cu|J rct be ||n|teJ by |rccne.
9. +cu. t|ne |s . sc..ce .escu.ce. \|.t || t|e ,u.rt|ty c| t|ne .e.e |rc.e.seJ, s.y tc 48 |cu.s pe. J.y, .rJ
eve.ycre st||| ||veJ .s n.ry J.ys .s be|c.e. \cu|J t|ne st||| be sc..ce`
10. Vcst cc||ege stuJerts ..e urJe. .ge 25. C|ve t.c exp|.r.t|crs |c. t||scre b.seJ cr t|e bere|ts
pecp|e c| J||e.ert .ges ..e ||ke|y tc .ece|ve |.cn ||g|e. eJuc.t|cr .rJ cre b.seJ cr t|e cppc.tur|ty
ccsts c| . cc||ege eJuc.t|cr tc stuJerts c| J||e.ert .ges.
11. Scne nur|c|p.| ..te. ccnp.r|es c|..ge custcne.s . |.t |ee e.c| ncrt|, .eg..J|ess c| t|e .ncurt c|
..te. t|ey ccrsune. Ot|e.s nete. ..te. use .rJ c|..ge .ccc.J|rg tc t|e ,u.rt|ty c| ..te. custcne.s
use. ´cnp..e t|e ..y t|e t.c systens .|ect t|e ccst c| ..te. use .t t|e n..g|r.
12. |c. n|g|t ycu test e.c| c| t|e |c||c.|rg |ypct|eses` Suggest scne p.cb|ens t|.t n|g|t ..|se |r e.c|
test Jue tc t|e cete.|s p..|bus (.||ct|e.t||rgsurc|.rgeJ) p.cb|en .rJ t|e |.||.cy c| |.|se c.use.
.. |eJuc|rg t|e ,u.rt|ty c| |e.c|r .v.||.b|e .||| |rc.e.se tct.| sperJ|rg cr |e.c|r .rJ |rc.e.se t|e
c.|ne ..te.
b. ||g|e. |rccnes n.ke pecp|e |.pp|e..
c. ||g|e. |rccnes n.ke pecp|e ||ve |crge..
13. V.ry ncJe|s |r p|ys|cs .rJ |r c|en|st.y .ssune t|e ex|sterce c| . pe.|ect v.cuun (t|.t |s, . sp.ce
ert|.e|y enpty c| n.tte.). +et .e krc. t|.t . pe.|ect v.cuun c.rrct ex|st. A.e suc| ncJe|s v.||J` \|y
..e ncJe|s b.seJ cr .ssunpt|crs t|.t ..e essert|.||y |rcc..ect`
14. Suppcse ycu .e.e .skeJ tc test t|e p.cpcs|t|cr t|.t pub||s||rg stuJerts te.c|e. ev.|u.t|crs c.uses
g..Je |r|.t|cr. \|.t ev|Jerce n|g|t ycu ..rt tc ccrs|Je.` |c. .cu|J t|e |r.b|||ty tc c...y cut
ccrt.c||eJ expe.|nerts n.ke ycu. .r.|ys|s nc.e J||cu|t`
15. |e|e..|rg tc t|e ´.se |r |c|rt ´b.|Jress .rJ |e..t ||se.se,´ exp|.|r t|e pcss|b|e |.||.cy c| |.|se c.use |r
ccrc|uJ|rg t|.t b.|Jress n.kes . pe.scr nc.e ||ke|y tc |.ve |e..t J|se.se.
16. |r 2005 t|e |ccJ .rJ |.ug AJn|r|st..t|cr c.Je.eJ t|.t \|cxx .rJ ct|e. pcpu|.. J.ugs |c. t.e.t|rg t|e
p.|r c| ..t|.|t|s be .|t|J...r |.cn t|e n..ket. ¯|e c.Je. .esu|teJ |.cn . |rJ|rg t|.t pecp|e t.k|rg t|e
J.ugs |.J .r |rc.e.seJ .|sk c| c..J|cv.scu|.. p.cb|ens. Scne .ese..c|e.s c.|t|c|.eJ t|e gcve.rnerts
.ct|cr, ..gu|rg t|.t ccrc|uJ|rg t|.t t|e J.ugs c.useJ t|e c..J|cv.scu|.. p.cb|ens .ep.eserteJ .r
ex.np|e c| t|e |.||.cy c| |.|se c.use. ´.r ycu t||rk c| .ry .e.scr .|y t||s n|g|t be t|e c.se`
22 PRINCIPL£S OI £CONOMICS
1.
ENDNOTES
bu.e.u c| |.bc. St.t|st|cs ´cco¡o||o·o| ´o||oo| .t |ttp.//....b|s.gcv/ccc/.
CHAP7£R 1 £CONOMICS: 7H£ S7UDY OI CHOIC£ 23
24 PRINCIPL£S OI £CONOMICS
production possibiIities
modeI
VcJe| t|.t s|c.s t|e gccJs
.rJ se.v|ces t|.t .r eccrcny
|s c.p.b|e c| p.cJuc|rg|ts
pcss|b|||t|esg|ver t|e
|.ctc.s c| p.cJuct|cr .rJ t|e
tec|rc|cgy |t |.s .v.||.b|e.
economic system
¯|e set c| .u|es t|.t Je|re
|c. .r eccrcnys .escu.ces
..e tc be c.reJ .rJ |c.
Jec|s|crs .bcut t|e|. use ..e
tc be n.Je.
´ | A | ¯ | | 2
Confronting Scarcity:
Choices in Production
S7AR7 UP: 7IGH7£NING S£CURI7Y A7 7H£ WORLD'S
AIRPOR7S
|c ycu ..rt s.|e. .|. t..ve| c. rct` \|||e t|.t ,uest|cr |s se|Jcn .skeJ sc b|urt|y, .ry pe.scr .|c t..ve|s by .|.
c.r te|| ycu t|.t cu. cc||ect|ve .rs.e. |.s beer ´yes,´ .rJ |t |.s beer .cccnp.r|eJ by |rc.e.ses |r secu.|ty .rJ |ts
.sscc|.teJ ccsts .t .|.pc.ts .|| cve. t|e .c.|J. \|y` |r s|c.t, ´9/11.´ ¯e..c.|sts |¡.ckeJ |cu. |.S. ccnne.c|.| .|.||re.s
cr Septenbe. 11, 2001, .rJ t|e t..g|c .esu|ts t|.t |c||c.eJ |eJ tc . s|..p t|g|ter|rg |r .|.pc.t secu.|ty.
|r .r e|c.t tc p.evert s|n||.. J|s.ste.s, .|.pc.t secu.|ty c|c|.|s sc.ut|r|.e |ugg.ge .rJ p.sserge.s nc.e c..e
|u||y t|.r eve. be|c.e. |r t|e ncrt|s |c||c.|rg 9/11, Je|.ys c| .s nuc| .s t|.ee |cu.s .e.e ccnncr .s .gerts
t.|eJ tc .ssu.e t|.t rc .e.pcrs c. bcnbs ccu|J be snugg|eJ crtc .rct|e. p|.re.
´\|.t tc p.cJuce`´ |s . |urJ.nert.| eccrcn|c ,uest|cr. |ve.y eccrcny nust .rs.e. t||s ,uest|cr. S|cu|J |t
p.cJuce nc.e eJuc.t|cr, bette. |e.|t| c..e, |np.cveJ t..rspc.t.t|cr, . c|e.re. erv|.crnert` ¯|e.e ..e ||n|ts tc
.|.t . r.t|cr c.r p.cJuce, Jec|J|rg tc p.cJuce nc.e c| cre t||rg |rev|t.b|y ne.rs p.cJuc|rg |ess c| scnet||rg
e|se. |rJ|v|Ju.|s |r nuc| c| t|e .c.|J, .|te. t|e t..geJy c| 9/11, c|e..|y .e.e .||||rg tc g|ve up t|ne, .rJ . |.|.
.ncurt c| |rJ|v|Ju.| p.|v.cy, |r .r e|c.t tc cbt.|r g.e.te. secu.|ty. |.t|crs .rJ |rJ|v|Ju.| c|t|es .|sc JevcteJ .JJ|
t|cr.| .escu.ces tc pc||ce .rJ ct|e. |c.ns c| p.ctect|cr |r .r e|c.t tc p.evert t..geJ|es suc| .s 9/11. |ecp|e .||
cve. t|e .c.|J c|cse tc p.cJuce |ess c| ct|e. gccJs |r c.Je. tc Jevcte nc.e .escu.ces tc t|e p.cJuct|cr c| g.e.t
e. secu.|ty. ArJ, .s c| e..|y 2009, t|e c|c|ce tc Jevcte nc.e .escu.ces tc secu.|ty |.J p.|J c|, t|e.e |.J beer rc
s|n||.. |¡.ck|rgs |r t|e |r|teJ St.tes.
|r t||s c|.pte. .e use cu. |.st ncJe|, t|e p.cJuct|cr pcss|b|||t|es ncJe|, tc ex.n|re t|e r.tu.e c| c|c|ces tc
p.cJuce nc.e c| scne gccJs .rJ |ess c| ct|e.s. As |ts r.ne suggests, t|e production possibiIities modeI
s|c.s t|e gccJs .rJ se.v|ces t|.t .r eccrcny |s c.p.b|e c| p.cJuc|rg|ts pcss|b|||t|esg|ver t|e |.ctc.s c| p.c
Juct|cr .rJ t|e tec|rc|cgy |t |.s .v.||.b|e. ¯|e ncJe| spec||es .|.t |t ne.rs tc use .escu.ces |u||y .rJ e|c|ert|y
.rJ suggests scne |npc.t.rt |np||c.t|crs |c. |rte.r.t|cr.| t..Je. \e c.r .|sc use t|e ncJe| tc |||ust..te eccrcn|c
g.c.t|, . p.ccess t|.t exp.rJs t|e set c| p.cJuct|cr pcss|b|||t|es .v.||.b|e tc .r eccrcny.
\e t|er tu.r tc .r ex.n|r.t|cr c| t|e type c| eccrcn|c systen |r .||c| c|c|ces ..e n.Je. Ar economic
system|s t|e set c| .u|es t|.t Je|re |c. .r eccrcnys .escu.ces ..e tc be c.reJ .rJ |c. Jec|s|crs .bcut t|e|.
use ..e tc be n.Je. \e .||| see t|.t eccrcn|c systens J||e. |r te.ns c| |c. t|ey .rs.e. t|e |urJ.nert.| ecc
rcn|c ,uest|crs. V.ry c| t|e .c.|Js eccrcn|c systens, |rc|uJ|rg t|e systens t|.t p.ev.|| |r |c.t| Ane.|c.,
|u.cpe, .rJ nuc| c| As|. .rJ ´ert..| .rJ Scut| Ane.|c., .e|y cr |rJ|v|Ju.|s cpe..t|rg |r . n..ket eccrcny tc
n.ke t|cse c|c|ces. Ot|e. eccrcn|c systens, |rc|uJ|rg t|cse c| ´ub. .rJ |c.t| |c.e. tcJ.y .rJ ||stc.|c.||y
factors of production
¯|e .escu.ces .v.||.b|e tc t|e
eccrcny |c. t|e p.cJuct|cr
c| gccJs .rJ se.v|ces.
utiIity
¯|e v.|ue, c. s.t|s|.ct|cr, t|.t
pecp|e Je.|ve |.cn t|e
gccJs .rJ se.v|ces t|ey
ccrsune .rJ t|e .ct|v|t|es
t|ey pu.sue.
Iabor
¯|e |un.r e|c.t t|.t c.r be
.pp||eJ tc t|e p.cJuct|cr c|
gccJs .rJ se.v|ces.
capitaI
A |.ctc. c| p.cJuct|cr t|.t
|.s beer p.cJuceJ |c. use |r
t|e p.cJuct|cr c| ct|e.
gccJs .rJ se.v|ces.
naturaI resources
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c.r be useJ |c. t|e
p.cJuct|cr c| gccJs .rJ
se.v|ces.
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.esu|t c| eJuc.t|cr, t..|r|rg,
c. expe.|erce t|.t c.r be
useJ |r p.cJuct|cr.
t|cse c| t|e |c.ne. Scv|et |r|cr, Scv|et b|cc ccurt.|es, .rJ ´||r., .e|yc. .e||eJcr gcve.rnert tc n.ke t|ese
c|c|ces. |||e.ert eccrcn|c systens .esu|t |r J||e.ert sets c| c|c|ces .rJ t|us J||e.ert cutccnes, t|e |.ct t|.t
n..ket eccrcn|es gere..||y cutpe.|c.n t|e ct|e.s .|er |t ccnes tc p.cv|J|rg nc.e c| t|e t||rgs t|.t pecp|e
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t|e .c|e c| gcve.rnert |r .r eccrcny t|.t .e||es c||e|y cr n..kets tc .||cc.te gccJs .rJ se.v|ces.
1. FACTORS OF PRODUCTION
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. Deñne the three factors of production÷Iabor, capitaI, and naturaI resources.
2. £xpIain the roIe of technoIogy and entrepreneurs in the utiIization of the economy's factors of
production.
Choices conceining what goods and seivices to pioduce aie choices about an economy's use of its
factors of production, the iesouices available to it foi the pioduction of goods and seivices. The
value, oi satisfaction, that people deiive fiom the goods and seivices they consume and the activities
they puisue is called utility. Ultimately, then, an economy's factois of pioduction cieate utility; they
seive the inteiests of people.
The factois of pioduction in an economy aie its laboi, capital, and natuial iesouices. Iabor is the
human efoit that can be applied to the pioduction of goods and seivices. People who aie employed oi
would like to be aie consideied pait of the laboi available to the economy. Capital is a factoi of pio-
duction that has been pioduced foi use in the pioduction of othei goods and seivices. Omce buildings,
machineiy, and tools aie examples of capital. Natural resources aie the iesouices of natuie that can
be used foi the pioduction of goods and seivices.
In the next thiee sections, we will take a closei look at the factois of pioduction we use to pioduce
the goods and seivices we consume. The thiee basic building blocks of laboi, capital, and natuial ie-
souices may be used in difeient ways to pioduce difeient goods and seivices, but they still lie at the
coie of pioduction. We will then look at the ioles played by technology and entiepieneuis in putting
these factois of pioduction to woik. As economists began to giapple with the pioblems of scaicity,
choice, and oppoitunity cost two centuiies ago, they focused on these concepts, just as they aie likely to
do two centuiies hence.
1.1 Laboi
Laboi is human efoit that can be applied to pioduction. People who woik to iepaii tiies, pilot aii-
planes, teach childien, oi enfoice laws aie all pait of the economy's laboi. People who would like to
woik but have not found employment-who aie unemployed-aie also consideied pait of the laboi
available to the economy.
In some contexts, it is useful to distinguish two foims of laboi. The fist is the human equivalent of
a natuial iesouice. It is the natuial ability an untiained, uneducated peison biings to a paiticulai pio-
duction piocess. But most woikeis biing fai moie. The skills a woikei has as a iesult of education,
tiaining, oi expeiience that can be used in pioduction aie called human capital. Students who aie at-
tending a college oi univeisity aie acquiiing human capital. Woikeis who aie gaining skills thiough ex-
peiience oi thiough tiaining aie acquiiing human capital. Childien who aie leaining to iead aie ac-
quiiing human capital.
The amount of laboi available to an economy can be incieased in two ways. One is to inciease the
total quantity of laboi, eithei by incieasing the numbei of people available to woik oi by incieasing the
aveiage numbei of houis of woik pei week. The othei is to inciease the amount of human capital pos-
sessed by woikeis.
26 PRINCIPL£S OI £CONOMICS
ñnanciaI capitaI
|rc|uJes ncrey .rJ ct|e.
´p.pe.´ .ssets (suc| .s stccks
.rJ bcrJs) t|.t .ep.esert
c|.|ns cr |utu.e p.ynerts.
1.2 Capital
Long ago, when the fist human beings walked the eaith, they pioduced food by picking leaves oi fiuit
of a plant oi by catching an animal and eating it. We know that veiy eaily on, howevei, they began
shaping stones into tools, appaiently foi use in butcheiing animals. Those tools weie the fist capital
because they weie pioduced foi use in pioducing othei goods-food and clothing.
Modein veisions of the fist stone tools include saws, meat cleaveis, hooks, and giindeis; all aie
used in butcheiing animals. Tools such as hammeis, sciewdiiveis, and wienches aie also capital.
Tianspoitation equipment, such as cais and tiucks, is capital. Facilities such as ioads, biidges, poits,
and aiipoits aie capital. Buildings, too, aie capital; they help us to pioduce goods and seivices.
Capital does not consist solely of physical objects. The scoie foi a new symphony is capital because
it will be used to pioduce conceits. Computei softwaie used by business fims oi goveinment agencies
to pioduce goods and seivices is capital. Capital may thus include physical goods and intellectual dis-
coveiies. Any iesouice is capital if it satisfes two ciiteiia:
1. The iesouice must have been pioduced.
2. The iesouice can be used to pioduce othei goods and seivices.
One thing that is not consideied capital is money. A fim cannot use money diiectly to pioduce othei
goods, so money does not satisfy the second ciiteiion foi capital. Fiims can, howevei, use money to ac-
quiie capital. Money is a foim of fnancial capital. Financial capital includes money and othei
¨papei" assets (such as stocks and bonds) that iepiesent claims on futuie payments. These fnancial as-
sets aie not capital, but they can be used diiectly oi indiiectly to puichase factois of pioduction oi
goods and seivices.
1.3 Natuial Resouices
Theie aie two essential chaiacteiistics of natuial iesouices. The fist is that they aie found in
natuie-that no human efoit has been used to make oi altei them. The second is that they can be used
foi the pioduction of goods and seivices. That iequiies knowledge; we must know how to use the
things we fnd in natuie befoie they become iesouices.
Considei oil. Oil in the giound is a natuial iesouice because it is found (not manufactuied) and
can be used to pioduce goods and seivices. Howevei, 230 yeais ago oil was a nuisance, not a natuial ie-
souice. Pennsylvania faimeis in the eighteenth centuiy who found oil oozing up thiough theii soil
weie dismayed, not delighted. No one knew what could be done with the oil. It was not until the mid-
nineteenth centuiy that a method was found foi iefning oil into keiosene that could be used to genei-
ate eneigy, tiansfoiming oil into a natuial iesouice. Oil is now used to make all soits of things, includ-
ing clothing, diugs, gasoline, and plastic. It became a natuial iesouice because people discoveied and
implemented a way to use it.
Defning something as a natuial iesouice only if it can be used to pioduce goods and seivices does
not mean that a tiee has value only foi its wood oi that a mountain has value only foi its mineials. If
people gain utility fiom the existence of a beautiful wildeiness aiea, then that wildeiness piovides a sei-
vice. The wildeiness is thus a natuial iesouice.
The natuial iesouices available to us can be expanded in thiee ways. One is the discoveiy of new
natuial iesouices, such as the discoveiy of a deposit of oie containing titanium. The second is the dis-
coveiy of new uses foi iesouices, as happened when new techniques allowed oil to be put to pioductive
use oi sand to be used in manufactuiing computei chips. The thiid is the discoveiy of new ways to ex-
tiact natuial iesouices in oidei to use them. New methods of discoveiing and mapping oil deposits
have incieased the woild's supply of this impoitant natuial iesouice.
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 27
technoIogy
¯|e krc.|eJge t|.t c.r be
.pp||eJ tc t|e p.cJuct|cr c|
gccJs .rJ se.v|ces.
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A pe.scr .|c, cpe..t|rg
.|t||r t|e ccrtext c| .
n..ket eccrcny, seeks tc
e..r p.c|ts by |rJ|rg re.
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1.4 Technology and the Entiepieneui
Goods and seivices aie pioduced using the factois of pioduction available to the economy. Two things
play a ciucial iole in putting these factois of pioduction to woik. The fist is technology, the know-
ledge that can be applied to the pioduction of goods and seivices. The second is an individual who
plays a key iole in a maiket economy: the entiepieneui. An entrepreneur is a peison who, opeiating
within the context of a maiket economy, seeks to eain piofts by fnding new ways to oiganize factois
of pioduction. In non-maiket economies the iole of the entiepieneui is played by buieauciats and oth-
ei decision makeis who iespond to incentives othei than pioft to guide theii choices about iesouice
allocation decisions.
The inteiplay of entiepieneuis and technology afects all oui lives. Entiepieneuis put new techno-
logies to woik eveiy day, changing the way factois of pioduction aie used. Faimeis and factoiy woik-
eis, engineeis and electiicians, technicians and teacheis all woik difeiently than they did just a few
yeais ago, using new technologies intioduced by entiepieneuis. The music you enjoy, the books you
iead, the athletic equipment with which you play aie pioduced difeiently than they weie fve yeais
ago. The book you aie ieading was wiitten and manufactuied using technologies that did not exist ten
yeais ago. We can dispute whethei all the changes have made oui lives bettei. What we cannot dispute
is that they have made oui lives difeient.
k £ Y 7 A k £ A W A Y S
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7 R Y I 7 !
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1. Ar urenp|cyeJ |.ctc.y .c.ke.
2. A cc||ege p.c|essc.
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28 PRINCIPL£S OI £CONOMICS
Case in Point: 7echnoIogy Cuts Costs, 8oosts Productivity and Profits
÷ 2010 jupiterimages Corporation
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CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 29
production possibiIities
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g.s |s c.p|t.|.
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2. THE PRODUCTION POSSIBILITIES CURVE
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. £xpIain the concept of the production possibiIities curve and understand the impIications of its
downward sIope and bowed-out shape.
2. Use the production possibiIities modeI to distinguish between fuII empIoyment and situations
of idIe factors of production and between emcient and inemcient production.
3. Understand speciaIization and its reIationship to the production possibiIities modeI and com-
parative advantage.
An economy's factois of pioduction aie scaice; they cannot pioduce an unlimited quantity of goods
and seivices. A production possibilities curve is a giaphical iepiesentation of the alteinative com-
binations of goods and seivices an economy can pioduce. It illustiates the pioduction possibilities
model. In diawing the pioduction possibilities cuive, we shall assume that the economy can pioduce
only two goods and that the quantities of factois of pioduction and the technology available to the eco-
nomy aie fxed.
2.1 Constiucting a Pioduction Possibilities Cuive
To constiuct a pioduction possibilities cuive, we will begin with the case of a hypothetical fim, Alpine
Spoits, Inc., a specialized spoits equipment manufactuiei. Chiistie Rydei began the business 13 yeais
ago with a single ski pioduction facility neai Killington ski iesoit in cential Veimont. Ski sales giew,
and she also saw demand foi snowboaids iising-paiticulaily aftei snowboaid competition events
weie included in the 2002 Wintei Olympics in Salt Lake City. She added a second plant in a neaiby
town. The second plant, while smallei than the fist, was designed to pioduce snowboaids as well as
skis. She also modifed the fist plant so that it could pioduce both snowboaids and skis. Two yeais
latei she added a thiid plant in anothei town. While even smallei than the second plant, the thiid was
piimaiily designed foi snowboaid pioduction but could also pioduce skis.
30 PRINCIPL£S OI £CONOMICS
We can think of each of Ms. Rydei's thiee plants as a miniatuie economy and analyze them using
the pioduction possibilities model. We assume that the factois of pioduction and technology available
to each of the plants opeiated by Alpine Spoits aie unchanged.
Suppose the fist plant, Plant 1, can pioduce 200 paiis of skis pei month when it pioduces only
skis. When devoted solely to snowboaids, it pioduces 100 snowboaids pei month. It can pioduce skis
and snowboaids simultaneously as well.
The table in Figuie 2.2 gives thiee combinations of skis and snowboaids that Plant 1 can pioduce
each month. Combination A involves devoting the plant entiiely to ski pioduction; combination C
means shifting all of the plant's iesouices to snowboaid pioduction; combination B involves the pio-
duction of both goods. These values aie plotted in a pioduction possibilities cuive foi Plant 1. The
cuive is a downwaid-sloping stiaight line, indicating that theie is a lineai, negative ielationship
between the pioduction of the two goods.
Neithei skis noi snowboaids is an independent oi a dependent vaiiable in the pioduction possibil-
ities model; we can assign eithei one to the veitical oi to the hoiizontal axis. Heie, we have placed the
numbei of paiis of skis pioduced pei month on the veitical axis and the numbei of snowboaids pio-
duced pei month on the hoiizontal axis.
The negative slope of the pioduction possibilities cuive iefects the scaicity of the plant's capital
and laboi. Pioducing moie snowboaids iequiies shifting iesouices out of ski pioduction and thus pio-
ducing fewei skis. Pioducing moie skis iequiies shifting iesouices out of snowboaid pioduction and
thus pioducing fewei snowboaids.
The slope of Plant 1's pioduction possibilities cuive measuies the iate at which Alpine Spoits must
give up ski pioduction to pioduce additional snowboaids. Because the pioduction possibilities cuive
foi Plant 1 is lineai, we can compute the slope between any two points on the cuive and get the same
iesult. Between points A and B, foi example, the slope equals ÷2 paiis of skis/snowboaid (equals ÷100
paiis of skis/30 snowboaids). (Many students aie helped when told to iead this iesult as ¨÷2 paiis of
skis per snowboaid.") We get the same value between points B and C, and between points A and C.
II GUR£ 2. 2 A Production PossibiIities Curve
¯|e t.b|e s|c.s t|e ccnb|r.t|crs c| p.|.s c| sk|s .rJ src.bc..Js t|.t ||.rt 1 |s c.p.b|e c| p.cJuc|rg e.c| ncrt|.
¯|ese ..e .|sc |||ust..teJ .|t| . p.cJuct|cr pcss|b|||t|es cu.ve. |ct|ce t|.t t||s cu.ve |s ||re...
To see this ielationship moie cleaily, examine Figuie 2.3. Suppose Plant 1 is pioducing 100 paiis of skis
and 30 snowboaids pei month at point B. Now considei what would happen if Ms. Rydei decided to
pioduce 1 moie snowboaid pei month. The segment of the cuive aiound point B is magnifed in Fig-
uie 2.3. The slope between points B and B is ÷2 paiis of skis/snowboaid. Pioducing 1 additional snow-
boaid at point B iequiies giving up 2 paiis of skis. We can think of this as the oppoitunity cost of pio-
ducing an additional snowboaid at Plant 1. This oppoitunity cost equals the absolute value of the slope
of the pioduction possibilities cuive.
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 31
II GUR£ 2. 3 7he SIope of a Production PossibiIities Curve
¯|e s|cpe c| t|e ||re.. p.cJuct|cr pcss|b|||t|es cu.ve |r ||gu.e 2.2 |s ccrst.rt, |t |s 2 p.|.s c| sk|s/src.bc..J. |r t|e
sect|cr c| t|e cu.ve s|c.r |e.e, t|e s|cpe c.r be c.|cu|.teJ bet.eer pc|rts b .rJ b. |xp.rJ|rg src.bc..J
p.cJuct|cr tc 51 src.bc..Js pe. ncrt| |.cn 50 src.bc..Js pe. ncrt| .e,u|.es . .eJuct|cr |r sk| p.cJuct|cr tc
98 p.|.s c| sk|s pe. ncrt| |.cn 100 p.|.s. ¯|e s|cpe e,u.|s 2 p.|.s c| sk|s/src.bc..J (t|.t |s, |t nust g|ve up t.c
p.|.s c| sk|s tc |.ee up t|e .escu.ces recess..y tc p.cJuce cre .JJ|t|cr.| src.bc..J). ¯c s|||t |.cn b tc b, A|p|re
Spc.ts nust g|ve up t.c nc.e p.|.s c| sk|s pe. src.bc..J. ¯|e .bsc|ute v.|ue c| t|e s|cpe c| . p.cJuct|cr
pcss|b|||t|es cu.ve ne.su.es t|e cppc.tur|ty ccst c| .r .JJ|t|cr.| ur|t c| t|e gccJ cr t|e |c.|.crt.| .x|s ne.su.eJ
|r te.ns c| t|e ,u.rt|ty c| t|e gccJ cr t|e ve.t|c.| .x|s t|.t nust be |c.gcre.
The absolute value of the slope of any pioduction possibilities cuive equals the oppoitunity cost of an
additional unit of the good on the hoiizontal axis. It is the amount of the good on the veitical axis that
must be given up in oidei to fiee up the iesouices iequiied to pioduce one moie unit of the good on
the hoiizontal axis. We will make use of this impoitant fact as we continue oui investigation of the pio-
duction possibilities cuive.
Figuie 2.4 shows pioduction possibilities cuives foi each of the fim's thiee plants. Each of the
plants, if devoted entiiely to snowboaids, could pioduce 100 snowboaids. Plants 2 and 3, if devoted ex-
clusively to ski pioduction, can pioduce 100 and 30 paiis of skis pei month, iespectively. The exhibit
gives the slopes of the pioduction possibilities cuives foi each plant. The oppoitunity cost of an addi-
tional snowboaid at each plant equals the absolute values of these slopes (that is, the numbei of paiis of
skis that must be given up pei snowboaid).
32 PRINCIPL£S OI £CONOMICS
comparative advantage
|r p.cJuc|rg . gccJ c.
se.v|ce, t|e s|tu.t|cr t|.t
cccu.s || t|e cppc.tur|ty ccst
c| p.cJuc|rg t|.t gccJ c.
se.v|ce |s |c.e. |c. t|.t
eccrcny t|.r |c. .ry ct|e..
II GUR£ 2. 4 Production PossibiIities at 7hree PIants
¯|e s|cpes c| t|e p.cJuct|cr pcss|b|||t|es cu.ves |c. e.c| p|.rt J||e.. ¯|e steepe. t|e cu.ve, t|e g.e.te. t|e
cppc.tur|ty ccst c| .r .JJ|t|cr.| src.bc..J. |e.e, t|e cppc.tur|ty ccst |s |c.est .t ||.rt 3 .rJ g.e.test .t ||.rt 1.
The exhibit gives the slopes of the pioduction possibilities cuives foi each of the fim's thiee plants.
The oppoitunity cost of an additional snowboaid at each plant equals the absolute values of these
slopes. Moie geneially, the absolute value of the slope of any pioduction possibilities cuive at any point
gives the oppoitunity cost of an additional unit of the good on the hoiizontal axis, measuied in teims
of the numbei of units of the good on the veitical axis that must be foigone.
The gieatei the absolute value of the slope of the pioduction possibilities cuive, the gieatei the op-
poitunity cost will be. The plant foi which the oppoitunity cost of an additional snowboaid is gieatest
is the plant with the steepest pioduction possibilities cuive; the plant foi which the oppoitunity cost is
lowest is the plant with the fattest pioduction possibilities cuive. The plant with the lowest oppoitun-
ity cost of pioducing snowboaids is Plant 3; its slope of ÷0.3 means that Ms. Rydei must give up half a
paii of skis in that plant to pioduce an additional snowboaid. In Plant 2, she must give up one paii of
skis to gain one moie snowboaid. We have alieady seen that an additional snowboaid iequiies giving
up two paiis of skis in Plant 1.
2.2 Compaiative Advantage and the Pioduction Possibilities Cuive
To constiuct a combined pioduction possibilities cuive foi all thiee plants, we can begin by asking how
many paiis of skis Alpine Spoits could pioduce if it weie pioducing only skis. To fnd this quantity, we
add up the values at the veitical inteicepts of each of the pioduction possibilities cuives in Figuie 2.4.
These inteicepts tell us the maximum numbei of paiis of skis each plant can pioduce. Plant 1 can pio-
duce 200 paiis of skis pei month, Plant 2 can pioduce 100 paiis of skis at pei month, and Plant 3 can
pioduce 30 paiis. Alpine Spoits can thus pioduce 330 paiis of skis pei month if it devotes its iesouices
exclusively to ski pioduction. In that case, it pioduces no snowboaids.
Now suppose the fim decides to pioduce 100 snowboaids. That will iequiie shifting one of its
plants out of ski pioduction. Which one will it choose to shift: The sensible thing foi it to do is to
choose the plant in which snowboaids have the lowest oppoitunity cost-Plant 3. It has an advantage
not because it can pioduce moie snowboaids than the othei plants (all the plants in this example aie
capable of pioducing up to 100 snowboaids pei month) but because it is the least pioductive plant foi
making skis. Pioducing a snowboaid in Plant 3 iequiies giving up just half a paii of skis.
Economists say that an economy has a comparative advantage in pioducing a good oi seivice if
the oppoitunity cost of pioducing that good oi seivice is lowei foi that economy than foi any othei.
Plant 3 has a compaiative advantage in snowboaid pioduction because it is the plant foi which the op-
poitunity cost of additional snowboaids is lowest. To put this in teims of the pioduction possibilities
cuive, Plant 3 has a compaiative advantage in snowboaid pioduction (the good on the hoiizontal axis)
because its pioduction possibilities cuive is the fattest of the thiee cuives.
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 33
Iaw of increasing
opportunity cost
As .r eccrcny ncves .|crg
|ts p.cJuct|cr pcss|b|||t|es
cu.ve |r t|e J|.ect|cr c|
p.cJuc|rg nc.e c| .
p..t|cu|.. gccJ, t|e
cppc.tur|ty ccst c| .JJ|t|cr.|
ur|ts c| t|.t gccJ .|||
|rc.e.se.
II GUR£ 2. 5 7he Combined Production PossibiIities Curve for AIpine Sports
¯|e cu.ve s|c.r ccnb|res t|e p.cJuct|cr pcss|b|||t|es cu.ves |c. e.c| p|.rt. At pc|rt A, A|p|re Spc.ts p.cJuces
350 p.|.s c| sk|s pe. ncrt| .rJ rc src.bc..Js. || t|e |.n .|s|es tc |rc.e.se src.bc..J p.cJuct|cr, |t .||| |.st use
||.rt 3, .||c| |.s . ccnp...t|ve .Jv.rt.ge |r src.bc..Js.
Plant 3's compaiative advantage in snowboaid pioduction makes a ciucial point about the natuie of
compaiative advantage. It need not imply that a paiticulai plant is especially good at an activity. In oui
example, all thiee plants aie equally good at snowboaid pioduction. Plant 3, though, is the least em-
cient of the thiee in ski pioduction. Alpine thus gives up fewei skis when it pioduces snowboaids in
Plant 3. Compaiative advantage thus can stem fiom a lack of emciency in the pioduction of an altein-
ative good iathei than a special piofciency in the pioduction of the fist good.
The combined pioduction possibilities cuive foi the fim's thiee plants is shown in Figuie 2.3. We
begin at point A, with all thiee plants pioducing only skis. Pioduction totals 330 paiis of skis pei
month and zeio snowboaids. If the fim weie to pioduce 100 snowboaids at Plant 3, ski pioduction
would fall by 30 paiis pei month (iecall that the oppoitunity cost pei snowboaid at Plant 3 is half a paii
of skis). That would biing ski pioduction to 300 paiis, at point B. If Alpine Spoits weie to pioduce still
moie snowboaids in a single month, it would shift pioduction to Plant 2, the facility with the next-low-
est oppoitunity cost. Pioducing 100 snowboaids at Plant 2 would leave Alpine Spoits pioducing 200
snowboaids and 200 paiis of skis pei month, at point C. If the fim weie to switch entiiely to snow-
boaid pioduction, Plant 1 would be the last to switch because the cost of each snowboaid theie is 2
paiis of skis. With all thiee plants pioducing only snowboaids, the fim is at point D on the combined
pioduction possibilities cuive, pioducing 300 snowboaids pei month and no skis.
Notice that this pioduction possibilities cuive, which is made up of lineai segments fiom each as-
sembly plant, has a bowed-out shape; the absolute value of its slope incieases as Alpine Spoits pioduces
moie and moie snowboaids. This is a iesult of tiansfeiiing iesouices fiom the pioduction of one good
to anothei accoiding to compaiative advantage. We shall examine the signifcance of the bowed-out
shape of the cuive in the next section.
2.3 The Law of Incieasing Oppoitunity Cost
We see in Figuie 2.3 that, beginning at point A and pioducing only skis, Alpine Spoits expeiiences
highei and highei oppoitunity costs as it pioduces moie snowboaids. The fact that the oppoitunity
cost of additional snowboaids incieases as the fim pioduces moie of them is a iefection of an impoit-
ant economic law. The law of increasing opportunity cost holds that as an economy moves along
its pioduction possibilities cuive in the diiection of pioducing moie of a paiticulai good, the oppoi-
tunity cost of additional units of that good will inciease.
We have seen the law of incieasing oppoitunity cost at woik tiaveling fiom point A towaid point
D on the pioduction possibilities cuive in Figuie 2.3. The oppoitunity cost of each of the fist 100
snowboaids equals half a paii of skis; each of the next 100 snowboaids has an oppoitunity cost of 1 paii
of skis, and each of the last 100 snowboaids has an oppoitunity cost of 2 paiis of skis. The law also ap-
plies as the fim shifts fiom snowboaids to skis. Suppose it begins at point D, pioducing 300 snow-
boaids pei month and no skis. It can shift to ski pioduction at a ielatively low cost at fist. The
34 PRINCIPL£S OI £CONOMICS
oppoitunity cost of the fist 200 paiis of skis is just 100 snowboaids at Plant 1, a movement fiom point
D to point C, oi 0.3 snowboaids pei paii of skis. We would say that Plant 1 has a compaiative advant-
age in ski pioduction. The next 100 paiis of skis would be pioduced at Plant 2, wheie snowboaid pio-
duction would fall by 100 snowboaids pei month. The oppoitunity cost of skis at Plant 2 is 1 snow-
boaid pei paii of skis. Plant 3 would be the last plant conveited to ski pioduction. Theie, 30 paiis of
skis could be pioduced pei month at a cost of 100 snowboaids, oi an oppoitunity cost of 2 snowboaids
pei paii of skis.
The bowed-out pioduction possibilities cuive foi Alpine Spoits illustiates the law of incieasing op-
poitunity cost. Scaicity implies that a pioduction possibilities cuive is downwaid sloping; the law of in-
cieasing oppoitunity cost implies that it will be bowed out, oi concave, in shape.
The bowed-out cuive of Figuie 2.3 becomes smoothei as we include moie pioduction facilities.
Suppose Alpine Spoits expands to 10 plants, each with a lineai pioduction possibilities cuive. Panel (a)
of Figuie 2.6 shows the combined cuive foi the expanded fim, constiucted as we did in Figuie 2.3.
This pioduction possibilities cuive includes 10 lineai segments and is almost a smooth cuive. As we in-
clude moie and moie pioduction units, the cuive will become smoothei and smoothei. In an actual
economy, with a tiemendous numbei of fims and woikeis, it is easy to see that the pioduction possib-
ilities cuive will be smooth. We will geneially diaw pioduction possibilities cuives foi the economy as
smooth, bowed-out cuives, like the one in Panel (b). This pioduction possibilities cuive shows an eco-
nomy that pioduces only skis and snowboaids. Notice the cuive still has a bowed-out shape; it still has
a negative slope. Notice also that this cuive has no numbeis. Economists often use models such as the
pioduction possibilities model with giaphs that show the geneial shapes of cuives but that do not in-
clude specifc numbeis.
II GUR£ 2. 6 Production PossibiIities for the £conomy
As .e ccnb|re t|e p.cJuct|cr pcss|b|||t|es cu.ves |c. nc.e .rJ nc.e ur|ts, t|e cu.ve beccnes sncct|e.. |t .et.|rs
|ts reg.t|ve s|cpe .rJ bc.eJcut s|.pe. |r |.re| (.) .e |.ve . ccnb|reJ p.cJuct|cr pcss|b|||t|es cu.ve |c. A|p|re
Spc.ts, .ssun|rg t|.t |t rc. |.s 10 p|.rts p.cJuc|rg sk|s .rJ src.bc..Js. |ver t|cug| e.c| c| t|e p|.rts |.s .
||re.. cu.ve, ccnb|r|rg t|en .ccc.J|rg tc ccnp...t|ve .Jv.rt.ge, .s .e J|J .|t| 3 p|.rts |r ||gu.e 2.5, p.cJuces
.|.t .ppe..s tc be . sncct|, rcr||re.. cu.ve, ever t|cug| |t |s n.Je up c| ||re.. segnerts. |r J...|rg
p.cJuct|cr pcss|b|||t|es cu.ves |c. t|e eccrcny, .e s|.|| gere..||y .ssune t|ey ..e sncct| .rJ ´bc.eJ cut,´ .s |r
|.re| (b). ¯||s cu.ve Jep|cts .r ert|.e eccrcny t|.t p.cJuces cr|y sk|s .rJ src.bc..Js.
2.4 Movements Along the Pioduction Possibilities Cuive
We can use the pioduction possibilities model to examine choices in the pioduction of goods and sei-
vices. In applying the model, we assume that the economy can pioduce two goods, and we assume that
technology and the factois of pioduction available to the economy iemain unchanged. In this section,
we shall assume that the economy opeiates on its pioduction possibilities cuive so that an inciease in
the pioduction of one good in the model implies a ieduction in the pioduction of the othei.
We shall considei two goods and seivices: national secuiity and a categoiy we shall call ¨all othei
goods and seivices." This second categoiy includes the entiie iange of goods and seivices the economy
can pioduce, aside fiom national defense and secuiity. Cleaily, the tiansfei of iesouices to the efoit to
enhance national secuiity ieduces the quantity of othei goods and seivices that can be pioduced. In the
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 35
II GUR£ 2. 7 Spending More for Security
|e.e, .r eccrcny t|.t c.r p.cJuce t.c
c.tegc.|es c| gccJs, secu.|ty .rJ ´.|| ct|e.
gccJs .rJ se.v|ces,´ beg|rs .t pc|rt A cr |ts
p.cJuct|cr pcss|b|||t|es cu.ve. ¯|e eccrcny
p.cJuces .
A
ur|ts c| secu.|ty .rJ ´
A
ur|ts c| .||
ct|e. gccJs .rJ se.v|ces pe. pe.|cJ. A
ncvenert |.cn A tc b .e,u|.es s|||t|rg
.escu.ces cut c| t|e p.cJuct|cr c| .|| ct|e.
gccJs .rJ se.v|ces .rJ |rtc sperJ|rg cr
secu.|ty. ¯|e |rc.e.se |r sperJ|rg cr secu.|ty,
tc .
A
ur|ts c| secu.|ty pe. pe.|cJ, |.s .r
cppc.tur|ty ccst c| .eJuceJ p.cJuct|cr c| .||
ct|e. gccJs .rJ se.v|ces. |.cJuct|cr c| .||
ct|e. gccJs .rJ se.v|ces |.||s by O
A
´
b
ur|ts
pe. pe.|cJ.
fuII empIoyment
S|tu.t|cr |r .||c| .|| t|e
|.ctc.s c| p.cJuct|cr t|.t ..e
.v.||.b|e |c. use urJe.
cu..ert n..ket ccrJ|t|crs ..e
be|rg ut|||.eJ.
wake of the 9/11 attacks in 2001, nations thioughout the woild incieased theii spending foi national
secuiity. This spending took a vaiiety of foims. One, of couise, was incieased defense spending. Local
and state goveinments also incieased spending in an efoit to pievent teiioiist attacks. Aiipoits aiound
the woild hiied additional agents to inspect luggage and passengeis.
The inciease in iesouices devoted to secuiity meant fewei ¨othei goods and seivices" could be
pioduced. In teims of the pioduction possibilities cuive in Figuie 2.7, the choice to pioduce moie se-
cuiity and less of othei goods and seivices means a movement fiom A to B. Of couise, an economy
cannot ieally produce secuiity; it can only attempt to piovide it. The attempt to piovide it iequiies ie-
souices; it is in that sense that we shall speak of the economy as ¨pioducing" secuiity.
At point A, the economy was pioducing S
A
units of secuiity on the veitical ax-
is-defense seivices and vaiious foims of police piotection-and O
A
units of othei
goods and seivices on the hoiizontal axis. The decision to devote moie iesouices to se-
cuiity and less to othei goods and seivices iepiesents the choice we discussed in the
chaptei intioduction. In this case we have categoiies of goods iathei than specifc
goods. Thus, the economy chose to inciease spending on secuiity in the efoit to defeat
teiioiism. Since we have assumed that the economy has a fxed quantity of available ie-
souices, the incieased use of iesouices foi secuiity and national defense necessaiily ie-
duces the numbei of iesouices available foi the pioduction of othei goods and seivices.
The law of incieasing oppoitunity cost tells us that, as the economy moves along
the pioduction possibilities cuive in the diiection of moie of one good, its oppoitunity
cost will inciease. We may conclude that, as the economy moved along this cuive in the
diiection of gieatei pioduction of secuiity, the oppoitunity cost of the additional secui-
ity began to inciease. That is because the iesouices tiansfeiied fiom the pioduction of
othei goods and seivices to the pioduction of secuiity had a gieatei and gieatei com-
paiative advantage in pioducing things othei than secuiity.
The pioduction possibilities model does not tell us wheie on the cuive a paiticulai
economy will opeiate. Instead, it lays out the possibilities facing the economy. Many
countiies, foi example, chose to move along theii iespective pioduction possibilities
cuives to pioduce moie secuiity and national defense and less of all othei goods in the
wake of 9/11. We will see in the chaptei on demand and supply how choices about
what to pioduce aie made in the maiketplace.
2.3 Pioducing on Veisus Pioducing Inside the Pioduction
Possibilities Cuive
An economy that is opeiating inside its pioduction possibilities cuive could, by moving
onto it, pioduce moie of all the goods and seivices that people value, such as food,
housing, education, medical caie, and music. Incieasing the availability of these goods
would impiove the standaid of living. Economists conclude that it is bettei to be on the
pioduction possibilities cuive than inside it.
Two things could leave an economy opeiating at a point inside its pioduction pos-
sibilities cuive. Fiist, the economy might fail to use fully the iesouices available to it.
Second, it might not allocate iesouices on the basis of compaiative advantage. In eithei
case, pioduction within the pioduction possibilities cuive implies the economy could
impiove its peifoimance.
IdIe Iactors of Production
Suppose an economy fails to put all its factois of pioduction to woik. Some woikeis aie without jobs,
some buildings aie without occupants, some felds aie without ciops. Because an economy's pioduc-
tion possibilities cuive assumes the full use of the factois of pioduction available to it, the failuie to use
some factois iesults in a level of pioduction that lies inside the pioduction possibilities cuive.
If all the factois of pioduction that aie available foi use undei cuiient maiket conditions aie being
utilized, the economy has achieved full employment. An economy cannot opeiate on its pioduction
possibilities cuive unless it has full employment.
36 PRINCIPL£S OI £CONOMICS
emcient production
\|er .r eccrcny |s
cpe..t|rg cr |ts p.cJuct|cr
pcss|b|||t|es cu.ve.
inemcient production
S|tu.t|cr |r .||c| t|e
eccrcny |s us|rg t|e s.ne
,u.rt|t|es c| |.ctc.s c|
p.cJuct|cr but |s cpe..t|rg
|rs|Je |ts p.cJuct|cr
pcss|b|||t|es cu.ve.
II GUR£ 2. 8 IdIe Iactors and Production
¯|e p.cJuct|cr pcss|b|||t|es cu.ve s|c.r suggests .r eccrcny t|.t c.r p.cJuce t.c gccJs, |ccJ .rJ c|ct||rg. As
. .esu|t c| . |.||u.e tc .c||eve |u|| enp|cynert, t|e eccrcny cpe..tes .t . pc|rt suc| .s b, p.cJuc|rg |
b
ur|ts c|
|ccJ .rJ ´
b
ur|ts c| c|ct||rg pe. pe.|cJ. |utt|rg |ts |.ctc.s c| p.cJuct|cr tc .c.k .||c.s . ncve tc t|e p.cJuct|cr
pcss|b|||t|es cu.ve, tc . pc|rt suc| .s A. ¯|e p.cJuct|cr c| bct| gccJs .|ses.
Figuie 2.8 shows an economy that can pioduce food and clothing. If it chooses to pioduce at point A,
foi example, it can pioduce F
A
units of food and C
A
units of clothing. Now suppose that a laige fiac-
tion of the economy's woikeis lose theii jobs, so the economy no longei makes full use of one factoi of
pioduction: laboi. In this example, pioduction moves to point B, wheie the economy pioduces less
food (F
B
) and less clothing (C
B
) than at point A. We often think of the loss of jobs in teims of the
woikeis; they have lost a chance to woik and to eain income. But the pioduction possibilities model
points to anothei loss: goods and seivices the economy could have pioduced that aie not being
pioduced.
Inefficient Production
Now suppose Alpine Spoits is fully employing its factois of pioduction. Could it still opeiate inside its
pioduction possibilities cuive: Could an economy that is using all its factois of pioduction still pio-
duce less than it could: The answei is ¨Yes," and the key lies in compaiative advantage. An economy
achieves a point on its pioduction possibilities cuive only if it allocates its factois of pioduction on the
basis of compaiative advantage. If it fails to do that, it will opeiate inside the cuive.
Suppose that, as befoie, Alpine Spoits has been pioducing only skis. With all thiee of its plants
pioducing skis, it can pioduce 330 paiis of skis pei month (and no snowboaids). The fim then staits
pioducing snowboaids. This time, howevei, imagine that Alpine Spoits switches plants fiom skis to
snowboaids in numeiical oidei: Plant 1 fist, Plant 2 second, and then Plant 3. Figuie 2.9 illustiates the
iesult. Instead of the bowed-out pioduction possibilities cuive ABCD, we get a bowed-in cuive,
ABCD. Suppose that Alpine Spoits is pioducing 100 snowboaids and 130 paiis of skis at point B. Had
the fim based its pioduction choices on compaiative advantage, it would have switched Plant 3 to
snowboaids and then Plant 2, so it could have opeiated at a point such as C. It would be pioducing
moie snowboaids and moie paiis of skis-and using the same quantities of factois of pioduction it was
using at B. Had the fim based its pioduction choices on compaiative advantage, it would have
switched Plant 3 to snowboaids and then Plant 2, so it would have opeiated at point C. It would be
pioducing moie snowboaids and moie paiis of skis-and using the same quantities of factois of pio-
duction it was using at B. When an economy is opeiating on its pioduction possibilities cuive, we say
that it is engaging in emcient production. If it is using the same quantities of factois of pioduction
but is opeiating inside its pioduction possibilities cuive, it is engaging in inemcient production.
Inemcient pioduction implies that the economy could be pioducing moie goods without using any ad-
ditional laboi, capital, oi natuial iesouices.
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 37
II GUR£ 2. 9 £fficient Versus Inefficient
Production
\|er |.ctc.s c| p.cJuct|cr ..e .||cc.teJ cr .
b.s|s ct|e. t|.r ccnp...t|ve .Jv.rt.ge, t|e
.esu|t |s |re|c|ert p.cJuct|cr. Suppcse A|p|re
Spc.ts cpe..tes t|e t|.ee p|.rts .e ex.n|reJ
|r ||gu.e 2.4. Suppcse |u.t|e. t|.t .|| t|.ee
p|.rts ..e JevcteJ exc|us|ve|y tc sk|
p.cJuct|cr, t|e |.n cpe..tes .t A. |c.
suppcse t|.t, tc |rc.e.se src.bc..J
p.cJuct|cr, |t t..rs|e.s p|.rts |r rune.|c.|
c.Je.. ||.rt 1 |.st, t|er ||.rt 2, .rJ |r.||y
||.rt 3. ¯|e .esu|t |s t|e bc.eJ|r cu.ve
Ab´|. |.cJuct|cr cr t|e p.cJuct|cr
pcss|b|||t|es cu.ve Ab´| .e,u|.es t|.t |.ctc.s c|
p.cJuct|cr be t..rs|e..eJ .ccc.J|rg tc
ccnp...t|ve .Jv.rt.ge.
speciaIization
S|tu.t|cr |r .||c| .r
eccrcny |s p.cJuc|rg t|e
gccJs .rJ se.v|ces |r .||c|
|t |.s . ccnp...t|ve
.Jv.rt.ge.
Points on the pioduction possibilities cuive thus satisfy two conditions: the eco-
nomy is making full use of its factois of pioduction, and it is making emcient use of its
factois of pioduction. If theie aie idle oi inemciently allocated factois of pioduction,
the economy will opeiate inside the pioduction possibilities cuive. Thus, the pioduc-
tion possibilities cuive not only shows what can be pioduced; it piovides insight into
how goods and seivices should be pioduced. It suggests that to obtain emciency in pio-
duction, factois of pioduction should be allocated on the basis of compaiative advant-
age. Fuithei, the economy must make full use of its factois of pioduction if it is to pio-
duce the goods and seivices it is capable of pioducing.
SpeciaIization
The pioduction possibilities model suggests that specialization will occui. Specializa-
tion implies that an economy is pioducing the goods and seivices in which it has a
compaiative advantage. If Alpine Spoits selects point C in Figuie 2.9, foi example, it
will assign Plant 1 exclusively to ski pioduction and Plants 2 and 3 exclusively to snow-
boaid pioduction.
Such specialization is typical in an economic system. Woikeis, foi example, spe-
cialize in paiticulai felds in which they have a compaiative advantage. People woik
and use the income they eain to buy-peihaps impoit-goods and seivices fiom
people who have a compaiative advantage in doing othei things. The iesult is a fai
gieatei quantity of goods and seivices than would be available without this
specialization.
Think about what life would be like without specialization. Imagine that you aie
suddenly completely cut of fiom the iest of the economy. You must pioduce
eveiything you consume; you obtain nothing fiom anyone else. Would you be able to
consume what you consume now: Cleaily not. It is haid to imagine that most of us
could even suivive in such a setting. The gains we achieve thiough specialization aie
enoimous.
Nations specialize as well. Much of the land in the United States has a compaiative
advantage in agiicultuial pioduction and is devoted to that activity. Hong Kong, with
its huge population and tiny endowment of land, allocates viitually none of its land to
agiicultuial use; that option would be too costly. Its land is devoted laigely to nonagii-
cultuial use.
k £ Y 7 A k £ A W A Y S
< A p.cJuct|cr pcss|b|||t|es cu.ve s|c.s t|e ccnb|r.t|crs c| t.c gccJs .r eccrcny |s c.p.b|e c|
p.cJuc|rg.
< ¯|e Jc.r...J s|cpe c| t|e p.cJuct|cr pcss|b|||t|es cu.ve |s .r |np||c.t|cr c| sc..c|ty.
< ¯|e bc.eJcut s|.pe c| t|e p.cJuct|cr pcss|b|||t|es cu.ve .esu|ts |.cn .||cc.t|rg .escu.ces b.seJ cr
ccnp...t|ve .Jv.rt.ge. Suc| .r .||cc.t|cr |np||es t|.t t|e |.. c| |rc.e.s|rg cppc.tur|ty ccst .||| |c|J.
< Ar eccrcny t|.t |.||s tc n.ke |u|| .rJ e|c|ert use c| |ts |.ctc.s c| p.cJuct|cr .||| cpe..te |rs|Je |ts
p.cJuct|cr pcss|b|||t|es cu.ve.
< Spec|.||..t|cr ne.rs t|.t .r eccrcny |s p.cJuc|rg t|e gccJs .rJ se.v|ces |r .||c| |t |.s . ccnp...t|ve
.Jv.rt.ge.
38 PRINCIPL£S OI £CONOMICS
7 R Y I 7 !
Suppcse . n.ru|.ctu.|rg |.n |s e,u|ppeJ tc p.cJuce ..J|cs c. c.|cu|.tc.s. |t |.s t.c p|.rts, ||.rt | .rJ
||.rt S, .t .||c| |t c.r p.cJuce t|ese gccJs. C|ver t|e |.bc. .rJ t|e c.p|t.| .v.||.b|e .t bct| p|.rts, |t c.r
p.cJuce t|e ccnb|r.t|crs c| t|e t.c gccJs .t t|e t.c p|.rts s|c.r.
Output per day, PIant R
Combination CaIcuIators Radios
A 100 0
b 50 25
´ 0 50
Output per day, PIant S
Combination CaIcuIators Radios
| 50 0
| 25 50
| 0 100
|ut c.|cu|.tc.s cr t|e ve.t|c.| .x|s .rJ ..J|cs cr t|e |c.|.crt.| .x|s. |... t|e p.cJuct|cr pcss|b|||t|es cu.ve |c.
||.rt |. Or . sep...te g..p|, J... t|e p.cJuct|cr pcss|b|||t|es cu.ve |c. ||.rt S. \||c| p|.rt |.s . ccnp...t
|ve .Jv.rt.ge |r c.|cu|.tc.s` |r ..J|cs` |c. J... t|e ccnb|reJ cu.ves |c. t|e t.c p|.rts. Suppcse t|e |.n
Jec|Jes tc p.cJuce 100 ..J|cs. \|e.e .||| |t p.cJuce t|en` |c. n.ry c.|cu|.tc.s .||| |t be .b|e tc p.cJuce`
\|e.e .||| |t p.cJuce t|e c.|cu|.tc.s`
Case in Point: 7he Cost of the Great Depression
÷ 2010 jupiterimages Corporation
¯|e |.S. eccrcny |cckeJ ve.y |e.|t|y |r t|e beg|rr|rg c| 1929. |t |.J er¦cyeJ sever ye..s c| J..n.t|c
g.c.t| .rJ urp.eceJerteJ p.cspe.|ty. |ts .escu.ces .e.e |u||y enp|cyeJ, |t ..s cpe..t|rg ,u|te c|cse tc |ts
p.cJuct|cr pcss|b|||t|es cu.ve.
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 39
|r t|e sunne. c| 1929, |c.eve., t||rgs st..teJ gc|rg ..crg. |.cJuct|cr .rJ enp|cynert |e||. ¯|ey ccrt|r
ueJ tc |.|| |c. seve..| ye..s. by 1933, nc.e t|.r 25 c| t|e r.t|crs .c.ke.s |.J |cst t|e|. ¦cbs. |.cJuct|cr |.J
p|unneteJ by .|ncst 30. ¯|e eccrcny |.J ncveJ .e|| .|t||r |ts p.cJuct|cr pcss|b|||t|es cu.ve.
Output beg.r tc g.c. .|te. 1933, but t|e eccrcny ccrt|rueJ tc |.ve v.st runbe.s c| |J|e .c.ke.s, |J|e
|.ctc.|es, .rJ |J|e |..ns. ¯|ese .escu.ces .e.e rct put b.ck tc .c.k |u||y urt|| 1942, .|te. t|e |.S. ert.y |rtc
\c.|J \.. || Jen.rJeJ ncb|||..t|cr c| t|e eccrcnys |.ctc.s c| p.cJuct|cr.
bet.eer 1929 .rJ 1942, t|e eccrcny p.cJuceJ 25 |e.e. gccJs .rJ se.v|ces t|.r |t .cu|J |.ve || |ts .e
scu.ces |.J beer |u||y enp|cyeJ. ¯|.t ..s . |css, ne.su.eJ |r tcJ.ys Jc||..s, c| .e|| cve. ´3 t.||||cr. |r n.te.|
.| te.ns, t|e |c.gcre cutput .ep.eserteJ . g.e.te. ccst t|.r t|e |r|teJ St.tes .cu|J u|t|n.te|y sperJ |r
\c.|J \.. ||. ¯|e C.e.t |ep.ess|cr ..s . ccst|y expe.|erce |rJeeJ.
A N S W £ R 7 O 7 R Y I 7 ! P R O 8 L £ M
¯|e p.cJuct|cr pcss|b|||t|es cu.ves |c. t|e t.c p|.rts ..e s|c.r, .|crg .|t| t|e ccnb|reJ cu.ve |c. bct|
p|.rts. ||.rt | |.s . ccnp...t|ve .Jv.rt.ge |r p.cJuc|rg c.|cu|.tc.s. ||.rt S |.s . ccnp...t|ve .Jv.rt.ge |r
p.cJuc|rg ..J|cs, sc, || t|e |.n gces |.cn p.cJuc|rg 150 c.|cu|.tc.s .rJ rc ..J|cs tc p.cJuc|rg 100 ..J|cs, |t
.||| p.cJuce t|en .t ||.rt S. |r t|e p.cJuct|cr pcss|b|||t|es cu.ve |c. bct| p|.rts, t|e |.n .cu|J be .t V, p.c
Juc|rg 100 c.|cu|.tc.s .t ||.rt |.
3. APPLICATIONS OF THE PRODUCTION POSSIBILITIES
MODEL
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. Understand the argument for unrestricted internationaI trade in terms of economic speciaIiza-
tion and comparative advantage.
2. Deñne economic growth in terms of the production possibiIities modeI and discuss factors that
make such growth possibIe.
3. £xpIain the cIassiñcation of economic systems, the roIe of government in diñerent economic
systems, and the strengths and weaknesses of diñerent systems.
The pioduction possibilities cuive gives us a model of an economy. The model piovides poweiful in-
sights about the ieal woild, insights that help us to answei some impoitant questions: How does tiade
between two countiies afect the quantities of goods available to people: What deteimines the iate at
which pioduction will inciease ovei time: What is the iole of economic fieedom in the economy: In
this section we exploie applications of the model to questions of inteinational tiade, economic giowth,
and the choice of an economic system.
40 PRINCIPL£S OI £CONOMICS
3.1 Compaiative Advantage and Inteinational Tiade
One of the most impoitant implications of the concepts of compaiative advantage and the pioduction
possibilities cuive ielates to inteinational tiade. We can think of difeient nations as being equivalent
to Chiistie Rydei's plants. Each will have a compaiative advantage in ceitain activities, and emcient
woild pioduction iequiies that each nation specialize in those activities in which it has a compaiative
advantage. A failuie to allocate iesouices in this way means that woild pioduction falls inside the pio-
duction possibilities cuive; moie of each good could be pioduced by ielying on compaiative advantage.
If nations specialize, then they must iely on each othei. They will sell the goods in which they spe-
cialize and puichase othei goods fiom othei nations. Suppose, foi example, that the woild consists of
two continents that can each pioduce two goods: South Ameiica and Euiope can pioduce food and
computeis. Suppose they can pioduce the two goods accoiding to the tables in Panels (a) and (b) of
Figuie 2.12. We have simplifed this example by assuming that each continent has a lineai pioduction
possibilities cuive; the cuives aie plotted below the tables in Panels (a) and (b). Each continent has a
sepaiate pioduction possibilities cuive; the two have been combined to illustiate a woild pioduction
possibilities cuive in Panel (c) of the exhibit.
II GUR£ 2. 12 Production PossibiIities Curves and 7rade
Suppcse t|e .c.|J ccrs|sts c| t.c ccrt|rerts. Scut| Ane.|c. .rJ |u.cpe. ¯|ey c.r e.c| p.cJuce t.c gccJs. |ccJ .rJ ccnpute.s. |r t||s ex.np|e,
.e .ssune t|.t e.c| ccrt|rert |.s . ||re.. p.cJuct|cr pcss|b|||t|es cu.ve, .s s|c.r |r |.re|s (.) .rJ (b). Scut| Ane.|c. |.s . ccnp...t|ve
.Jv.rt.ge |r |ccJ p.cJuct|cr .rJ |u.cpe |.s . ccnp...t|ve .Jv.rt.ge |r ccnpute. p.cJuct|cr. \|t| |.ee t..Je, t|e .c.|J c.r cpe..te cr t|e
bc.eJcut cu.ve C||, s|c.r |r |.re| (c). || t|e ccrt|rerts .e|use tc t..Je, t|e .c.|J .||| cpe..te |rs|Je |ts p.cJuct|cr pcss|b|||t|es cu.ve. ||, |c.
ex.np|e, e.c| ccrt|rert .e.e tc p.cJuce .t t|e n|Jpc|rt c| |ts p.cJuct|cr pcss|b|||t|es cu.ve, t|e .c.|J .cu|J p.cJuce 300 ccnpute.s .rJ 300
ur|ts c| |ccJ pe. pe.|cJ .t pc|rt ¸. || e.c| ccrt|rert .e.e tc spec|.||.e |r t|e gccJ |r .||c| |t |.s . ccnp...t|ve .Jv.rt.ge, .c.|J p.cJuct|cr
ccu|J ncve tc . pc|rt suc| .s |, .|t| nc.e c| bct| gccJs p.cJuceJ.
The woild pioduction possibilities cuive assumes that iesouices aie allocated between computei and
food pioduction based on compaiative advantage. Notice that, even with only two economies and the
assumption of lineai pioduction possibilities cuives foi each, the combined cuive still has a bowed-out
shape. At point H, foi example, South Ameiica specializes in food, while Euiope pioduces only com-
puteis. Woild pioduction equals 400 units of each good. In this situation, we would expect South
Ameiica to expoit food to Euiope while Euiope expoits computeis to South Ameiica.
But suppose the iegions iefuse to tiade; each insists on pioducing its own food and computeis.
Suppose fuithei that each chooses to pioduce at the midpoint of its own pioduction possibilities cuive.
South Ameiica pioduces 100 units of computeis and 200 units of food pei peiiod, while Euiope pio-
duces 200 units of computeis and 100 units of food pei peiiod. Woild pioduction thus totals 300 units
of each good pei peiiod; the woild opeiates at point Q in Figuie 2.12. If the two continents weie willing
to move fiom isolation to tiade, the woild could achieve an inciease in the pioduction of both goods.
Pioducing at point H iequiies no moie iesouices, no moie efoit than pioduction at Q. It does,
howevei, iequiie that the woild's iesouices be allocated on the basis of compaiative advantage.
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 41
economic growth
¯|e p.ccess t|.cug| .||c|
.r eccrcny .c||eves .r
cut...J s|||t |r |ts
p.cJuct|cr pcss|b|||t|es cu.ve.
The implications of oui model foi tiade aie poweiful indeed. Fiist, we see that tiade allows the
pioduction of moie of all goods and seivices. Restiictions on tiade thus ieduce pioduction of goods
and seivices. Second, we see a lesson often missed in discussions of tiade: a nation's tiade policy has
nothing to do with its level of employment of its factois of pioduction. In oui example, when South
Ameiica and Euiope do not engage in tiade and pioduce at the midpoints of each of theii iespective
pioduction possibilities cuives, they each have full employment. With tiade, the two nations still opei-
ate on theii iespective pioduction possibilities cuives: they each have full employment. Tiade ceitainly
iedistiibutes employment in the two continents. In South Ameiica, employment shifts fiom computei
pioduction to food pioduction. In Euiope, it shifts fiom food pioduction to computei pioduction.
Once the shift is made, though, theie is no efect on employment in eithei continent.
Of couise, this idealized example would have all of South Ameiica's computei expeits becoming
faimeis while all of Euiope's faimeis become computei geeks! That is a bit much to swallow, but it is
meiely the iesult of assuming lineai pioduction possibilities cuives and complete specialization. In the
ieal woild, pioduction possibilities cuives aie concave, and the ieallocation of iesouices iequiied by
tiade is not neaily as diamatic. Still, fiee tiade can iequiie shifts in iesouices fiom one activity to an-
othei. These shifts pioduce enoimous benefts, but they do not come without costs.
Neaily all economists agiee that laigely uniestiicted tiade between countiies is desiiable; iestiic-
tions on tiade geneially foice the woild to opeiate inside its pioduction possibilities cuive. In some
cases iestiictions on tiade could be desiiable, but in the main, fiee tiade piomotes gieatei pioduction
of goods and seivices foi the woild's people. The iole of inteinational tiade is exploied in gieatei detail
in subsequent chapteis of this book.
3.2 Economic Giowth
An inciease in the physical quantity oi in the quality of factois of pioduction available to an economy
oi a technological gain will allow the economy to pioduce moie goods and seivices; it will shift the eco-
nomy's pioduction possibilities cuive outwaid. The piocess thiough which an economy achieves an
outwaid shift in its pioduction possibilities cuive is called economic growth. An outwaid shift in a
pioduction possibilities cuive is illustiated in Figuie 2.13. In Panel (a), a point such as N is not attain-
able; it lies outside the pioduction possibilities cuive. Giowth shifts the cuive outwaid, as in Panel (b),
making pieviously unattainable levels of pioduction possible.
II GUR£ 2. 13 £conomic Growth and the Production PossibiIities Curve
Ar eccrcny c.p.b|e c| p.cJuc|rg t.c gccJs, A .rJ b, |s |r|t|.||y cpe..t|rg .t pc|rt V cr p.cJuct|cr pcss|b|||t|es
cu.ve OV| |r |.re| (.). C|ver t||s p.cJuct|cr pcss|b|||t|es cu.ve, t|e eccrcny ccu|J rct p.cJuce . ccnb|r.t|cr
suc| .s s|c.r by pc|rt |, .||c| ||es cuts|Je t|e cu.ve. Ar |rc.e.se |r t|e |.ctc.s c| p.cJuct|cr .v.||.b|e tc t|e
eccrcny .cu|J s|||t t|e cu.ve cut...J tc S|¯, .||c.|rg t|e c|c|ce c| . pc|rt suc| .s |, .t .||c| nc.e c| bct|
gccJs .||| be p.cJuceJ.
7he Sources of £conomic Growth
Economic giowth implies an outwaid shift in an economy's pioduction possibilities cuive. Recall that
when we diaw such a cuive, we assume that the quantity and quality of the economy's factois of
42 PRINCIPL£S OI £CONOMICS
pioduction and its technology aie unchanged. Changing these will shift the cuive. Anything that in-
cieases the quantity oi quality of the factois of pioduction available to the economy oi that impioves
the technology available to the economy contiibutes to economic giowth.
Considei, foi example, the diamatic gains in human capital that have occuiied in the United States
since the beginning of the past centuiy. In 1900, about 3.3° of U.S. woikeis had completed a high
school education. By 2006, that peicentage iose almost to 92. Fewei than 1° of the woikeis in 1900
had giaduated fiom college; as late as 1940 only 3.3° had giaduated fiom college. By 2006, neaily 32°
had giaduated fiom college. In addition to being bettei educated, today's woikeis have ieceived moie
and bettei tiaining on the job. They biing fai moie economically useful knowledge and skills to theii
woik than did woikeis a centuiy ago.
Moieovei, the technological changes that have occuiied within the past 100 yeais have gieatly ie-
duced the time and efoit iequiied to pioduce most goods and seivices. Automated pioduction has be-
come commonplace. Innovations in tianspoitation (automobiles, tiucks, and aiiplanes) have made the
movement of goods and people cheapei and fastei. A dizzying aiiay of new mateiials is available foi
manufactuiing. And the development of modein infoimation technology-including computeis, soft-
waie, and communications equipment-that seemed to pioceed at bieathtaking pace especially duiing
the fnal yeais of the last centuiy and continuing to the piesent has tiansfoimed the way we live and
woik.
Look again at the technological changes of the last few yeais desciibed in the Case in Point on ad-
vances in technology. Those examples of technological piogiess thiough applications of computei
technology-fiom new ways of mapping oil deposits to new methods of milking cows-helped piopel
the United States and othei economies to diamatic gains in the ability to pioduce goods and seivices.
They have helped shift the countiies' pioduction possibilities cuive outwaid. They have helped fuel
economic giowth.
Table 2.1 summaiizes the factois that have contiibuted to U.S. economic giowth in the past half
centuiy. When looking at the peiiod of 1948-2002 as a whole we see that about 60° of economic
giowth stems fiom incieases in the quantities of capital and laboi and 40° fiom incieases in the qualit-
ies of the factois of pioduction and impiovements in technology. In the most iecent peiiod,
1993-2002, howevei, these peicentages aie essentially ieveised, with a little less than 30° explained by
incieases in quantities of the factois of pioduction and a whopping 70° explained by impiovements in
factoi quality and technology.
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 43
7A8L£ 2. 1 Sources of U.S. £conomic Growth, 1948-2002
¯ct.| cutput Ju.|rg t|e pe.|cJ s|c.r |rc.e.seJ s|x|c|J. ¯|e c|..t s|c.s t|e pe.cert.ge c| t||s |rc.e.se .cccurteJ
|c. by |rc.e.ses |r t|e ,u.rt|ty c| |.bc. .rJ c| c.p|t.| .rJ by |rc.e.ses |r t|e ,u.||ty c| |.bc. .rJ c| c.p|t.| .rJ
|np.cvenerts |r tec|rc|cgy. |r t|e 19952002 pe.|cJ, t|e |rcc.pc..t|cr c| |r|c.n.t|cr tec|rc|cgy |eJ tc
|np.cvenerts |r t|e ,u.||ty c| c.p|t.| .rJ tec|rc|cgy t|.t g.e.t|y ccrt.|buteJ tc g.c.t|.
Year Percentage contribution to growth Period growth rate
Years 1948-2002 3.46%
|rc.e.se |r ,u.rt|ty c| |.bc. 21
|rc.e.se |r ,u.rt|ty c| c.p|t.| 41
|rc.e.se |r ,u.||ty c| |.bc. 10
|rc.e.se |r ,u.||ty c| c.p|t.| 20
|np.cveJ tec|rc|cgy 25
Years 1948-1973 3.99%
|rc.e.se |r ,u.rt|ty c| |.bc. 15
|rc.e.se |r ,u.rt|ty c| c.p|t.| 44
|rc.e.se |r ,u.||ty c| |.bc. 11
|rc.e.se |r ,u.||ty c| c.p|t.| 5
|np.cveJ tec|rc|cgy 25
Years 1973-1989 2.97%
|rc.e.se |r ,u.rt|ty c| |.bc. 31
|rc.e.se |r ,u.rt|ty c| c.p|t.| 39
|rc.e.se |r ,u.||ty c| |.bc.
|rc.e.se |r ,u.||ty c| c.p|t.| 12
|np.cveJ tec|rc|cgy 10
Years 1989-1995 2.43%
|rc.e.se |r ,u.rt|ty c| |.bc. 26
|rc.e.se |r ,u.rt|ty c| c.p|t.| 33
|rc.e.se |r ,u.||ty c| |.bc. 15
|rc.e.se |r ,u.||ty c| c.p|t.| 1
|np.cveJ tec|rc|cgy 11
Years 1995-2002 3.59%
|rc.e.se |r ,u.rt|ty c| |.bc. 19
|rc.e.se |r ,u.rt|ty c| c.p|t.| 8
|rc.e.se |r ,u.||ty c| |.bc. 5
|rc.e.se |r ,u.||ty c| c.p|t.| 4
|np.cveJ tec|rc|cgy 20
Source· Based on Dale V. jorgenson, ¨Accounting for Growth in the Information Age,¨ Handbook of Economic Growth, Phillipe Aghion and Steven
Durlauf, eds. Amsterdam· ^orth Holland, 2005.
Anothei way of looking at these data foi the most iecent peiiod is to notice that the inciease in the iate
of economic giowth between the 1989 to 1993 peiiod and the 1993 to 2002 peiiod of moie than one
peicentage point pei yeai is laigely explained by bettei-quality capital and bettei technology. The study
by economist Dale Joigenson on which the data shown in Table 2.1 aie deiived notes that these two
main contiibutois to highei economic giowth can be laigely attiibuted to the development of infoima-
tion technology and its incoipoiation in the woikplace.
Waiting for Growth
One key to giowth is, in efect, the willingness to wait, to postpone cuiient consumption in oidei to en-
hance futuie pioductive capability. When Stone Age people fashioned the fist tools, they weie spend-
ing time building capital iathei than engaging in consumption. They delayed cuiient consumption to
enhance theii futuie consumption; the tools they made would make them moie pioductive in the
futuie.
44 PRINCIPL£S OI £CONOMICS
market capitaIist economy
|ccrcny |r .||c| .escu.ces
..e gere..||y c.reJ by
p.|v.te |rJ|v|Ju.|s .|c |.ve
t|e pc.e. tc n.ke Jec|s|crs
.bcut t|e|. use.
command sociaIist
economy
|ccrcny |r .||c|
gcve.rnert |s t|e p.|n..y
c.re. c| c.p|t.| .rJ r.tu..|
.escu.ces .rJ |.s b.c.J
pc.e. tc .||cc.te t|e use c|
|.ctc.s c| p.cJuct|cr.
mixed economies
|ccrcny t|.t ccnb|re
e|enerts c| n..ket c.p|t.||st
.rJ c| ccnn.rJ scc|.||st
eccrcn|c systens.
Resouices society could have used to pioduce consumei goods aie being used to pioduce new cap-
ital goods and new knowledge foi pioduction instead-all to enhance futuie pioduction. An even moie
impoitant souice of giowth in many nations has been incieased human capital. Incieases in human
capital often iequiie the postponement of consumption. If you aie a college student, you aie engaged in
piecisely this efoit. You aie devoting time to study that could have been spent woiking, eaining in-
come, and thus engaging in a highei level of consumption. If you aie like most students, you aie mak-
ing this choice to postpone consumption because you expect it will allow you to eain moie income, and
thus enjoy gieatei consumption, in the futuie.
Think of an economy as being able to pioduce two goods, capital and consumei goods (those
destined foi immediate use by consumeis). By focusing on the pioduction of consumei goods, the
people in the economy will be able to enjoy a highei standaid of living today. If they ieduce theii con-
sumption-and theii standaid of living-today to enhance theii ability to pioduce goods and seivices
in the futuie, they will be able to shift theii pioduction possibilities cuive outwaid. That may allow
them to pioduce even moie consumei goods. A decision foi gieatei giowth typically involves the sac-
iifce of piesent consumption.
3.3 Aienas foi Choice: A Compaiison of Economic Systems
Undei what ciicumstances will a nation achieve emciency in the use of its factois of pioduction: The
discussion above suggested that Chiistie Rydei would have an incentive to allocate hei plants emciently
because by doing so she could achieve gieatei output of skis and snowboaids than would be possible
fiom inemcient pioduction. But why would she want to pioduce moie of these two goods-oi of any
goods: Why would decision makeis thioughout the economy want to achieve such emciency:
Economists assume that piivately owned fims seek to maximize theii piofts. The diive to maxim-
ize piofts will lead fims such as Alpine Spoits to allocate iesouices emciently to gain as much pioduc-
tion as possible fiom theii factois of pioduction. But whethei fims will seek to maximize piofts de-
pends on the natuie of the economic system within which they opeiate.
CIassifying £conomic Systems
Each of the woild's economies can be viewed as opeiating somewheie on a spectium between maiket
capitalism and command socialism. In a market capitalist economy, iesouices aie geneially owned
by piivate individuals who have the powei to make decisions about theii use. A maiket capitalist sys-
tem is often iefeiied to as a fiee enteipiise economic system. In a command socialist economy, the
goveinment is the piimaiy ownei of capital and natuial iesouices and has bioad powei to allocate the
use of factois of pioduction. Between these two categoiies lie mixed economies that combine ele-
ments of maiket capitalist and of command socialist economic systems.
No economy iepiesents a puie case of eithei maiket capitalism oi command socialism. To deteim-
ine wheie an economy lies between these two types of systems, we evaluate the extent of goveinment
owneiship of capital and natuial iesouices and the degiee to which goveinment is involved in de-
cisions about the use of factois of pioduction.
The diagiam below suggests the spectium of economic systems. Maiket capitalist economies lie to-
waid the left end of this spectium; command socialist economies appeai towaid the iight. Mixed eco-
nomies lie in between. The maiket capitalist end of the spectium includes countiies such as the United
States, the United Kingdom, and Chile. Hong Kong, though now pait of China, has a long histoiy as a
maiket capitalist economy and is geneially iegaided as opeiating at the maiket capitalist end of the
spectium. Countiies at the command socialist end of the spectium include Noith Koiea and Cuba.
II GUR£ 2. 14 £conomic Systems
Some Euiopean economies, such as Fiance, Geimany, and Sweden, have a sumciently high degiee of
iegulation that we considei them as opeiating moie towaid the centei of the spectium. Russia and Ch-
ina, which long opeiated at the command socialist end of the spectium, can now be consideied mixed
economies. Most economies in Latin Ameiica once opeiated towaid the iight end of the spectium.
While theii goveinments did not exeicise the extensive owneiship of capital and natuial iesouices that
aie one chaiacteiistic of command socialist systems, theii goveinments did impose extensive
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 45
iegulations. Many of these nations aie in the piocess of caiiying out economic iefoims that will move
them fuithei in the diiection of maiket capitalism.
The global shift towaid maiket capitalist economic systems that occuiied in the 1980s and 1990s
was in laige pait the iesult of thiee impoitant featuies of such economies. Fiist, the emphasis on indi-
vidual owneiship and decision-making powei has geneially yielded gieatei individual fieedom than
has been available undei command socialist oi some moie heavily iegulated mixed economic systems
that lie towaid the command socialist end of the spectium. People seeking political, ieligious, and eco-
nomic fieedom have thus giavitated towaid maiket capitalism. Second, maiket economies aie moie
likely than othei systems to allocate iesouices on the basis of compaiative advantage. They thus tend to
geneiate highei levels of pioduction and income than do othei economic systems. Thiid, maiket
capitalist-type systems appeai to be the most conducive to entiepieneuiial activity.
Suppose Chiistie Rydei had the same thiee plants we consideied eailiei in this chaptei but was op-
eiating in a mixed economic system with extensive goveinment iegulation. In such a system, she might
be piohibited fiom tiansfeiiing iesouices fiom one use to anothei to achieve the gains possible fiom
compaiative advantage. If she weie opeiating undei a command socialist system, she would not be the
ownei of the plants and thus would be unlikely to pioft fiom theii emcient use. If that weie the case,
theie is no ieason to believe she would make any efoit to assuie the emcient use of the thiee plants.
Geneially speaking, it is economies towaid the maiket capitalist end of the spectium that ofei the
gieatest inducement to allocate iesouices on the basis of compaiative advantage. They tend to be moie
pioductive and to delivei highei mateiial standaids of living than do economies that opeiate at oi neai
the command socialist end of the spectium.
Maiket capitalist economies iely on economic fieedom. Indeed, one way we can assess the degiee
to which a countiy can be consideied maiket capitalist is by the degiee of economic fieedom it peimits.
Seveial oiganizations have attempted to compaie economic fieedom in vaiious countiies. One of the
most extensive compaiisons is a joint annual efoit by the Heiitage Foundation and The Vall Street
journal. The 2008 iating was based on policies in efect in 162 nations eaily that yeai. The iepoit ianks
these nations on the basis of such things as the degiee of iegulation of fims, tax levels, and iestiictions
on inteinational tiade. Hong Kong ianked as the fieest economy in the woild. Noith Koiea ieceived
the dubious distinction of being the least fiee.
46 PRINCIPL£S OI £CONOMICS
II GUR£ 2. 15 £conomic Ireedom and Income
¯|e |c.|.crt.| .x|s s|c.s t|e Jeg.ee c| eccrcn|c |.eeJcn´|.ee,´ ´ncst|y |.ee,´ ´ncst|y ur|.ee,´ .rJ
´.ep.esseJ´.ccc.J|rg tc t|e ne.su.es useJ by t|e |e.|t.ge |curJ.t|cr .rJ ¯|e /o|| .|·ee| .oo··o|. ¯|e g..p|
s|c.s t|e .e|.t|crs||p bet.eer eccrcn|c |.eeJcn .rJ pe. c.p|t. |rccne. ´curt.|es .|t| ||g|e. Jeg.ees c|
eccrcn|c |.eeJcn terJeJ tc |.ve ||g|e. pe. c.p|t. |rccnes.
Source· Vorld Bank, Vorld Development Indicators Online, available by subscription at www.worldbank.org/data, Central Intelligence Agency, The
Vorld Factbook 2004, available at http·//www.cia.gov/cia/publications/factbook/index.html for the following countries· Bahamas, Burma, Cuba,
Cyprus, Equatorial Guinea, ^orth Korea, Libya, Qatar, Suriname, Taiwan, Zimbabwe, Marc A. Miles, Edwin j. Feulner, and Mary Anastasia
O´Grady, 2005 Index of Economic Freedom (Vashington, D.C.· The Heritage Foundation and Dow jones o Company, Inc., 2005), at
www.heritage.org/index.
It seems ieasonable to expect that the gieatei the degiee of economic fieedom a countiy peimits, the
gieatei the amount of income pei peison it will geneiate. This pioposition is illustiated in Figuie 2.13.
The gioup of countiies categoiized as ¨fiee" geneiated the highest incomes in the Heiitage Founda-
tion/Vall Street journal study; those iated as ¨iepiessed" had the lowest. The study also found that
countiies that ovei the last decade have done the most to impiove theii positions in the economic fiee-
dom iankings have also had the highest iates of giowth. We must be waiy of slipping into the fallacy of
false cause by concluding fiom this evidence that economic fieedom geneiates highei incomes. It could
be that highei incomes lead nations to opt foi gieatei economic fieedom. But in this case, it seems ieas-
onable to conclude that, in geneial, economic fieedom does lead to highei incomes.
3.4 Goveinment in a Maiket Economy
The pioduction possibilities model piovides a menu of choices among alteinative combinations of
goods and seivices. Given those choices, which combinations will be pioduced:
In a maiket economy, this question is answeied in laige pait thiough the inteiaction of individual
buyeis and selleis. As we have alieady seen, goveinment plays a iole as well. It may seek to encouiage
gieatei consumption of some goods and discouiage consumption of otheis. In the United States, foi
example, taxes imposed on cigaiettes discouiage smoking, while special tieatment of piopeity taxes
and moitgage inteiest in the fedeial income tax encouiages home owneiship. Goveinment may tiy to
stop the pioduction and consumption of some goods altogethei, as many goveinments do with diugs
such as heioin and cocaine. Goveinment may supplement the piivate consumption of some goods by
pioducing moie of them itself, as many U.S. cities do with golf couises and tennis couits. In othei
cases, theie may be no piivate maiket foi a good oi seivice at all. In the choice between secuiity and
defense veisus all othei goods and seivices outlined at the beginning of this chaptei, goveinment agen-
cies aie viitually the sole piovideis of secuiity and national defense.
All nations also iely on goveinment to piovide defense, enfoice laws, and iedistiibute income.
Even maiket economies iely on goveinment to iegulate the activities of piivate fims, to piotect the
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 47
enviionment, to piovide education, and to pioduce a wide iange of othei goods and seivices. Govein-
ment's iole may be limited in a maiket economy, but it iemains fundamentally impoitant.
k £ Y 7 A k £ A W A Y S
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||ke|y tc .eJuce p.cJuct|cr c| gccJs .rJ se.v|ces.
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.rJ c| .Jv.rces |r tec|rc|cgy.
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eccrcn|es.
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Case in Point: 7he £uropean Union and the Production PossibiIities Curve
÷ 2010 jupiterimages Corporation
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t|ne tc exp|c|t t|e t|ec.y c| ccnp...t|ve .Jv.rt.ge. ¯|e ¯.e.ty scug|t tc e||n|r.te .|| t..Je b...|e.s bet.eer
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48 PRINCIPL£S OI £CONOMICS
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.oo·ce· ´o··e· ||o /o·o. ¯|e |o|e o| ´o·¡o·o||.e ^J.o·|o¸e |· ¯·oJe /||||· |·Jo·|·|e· ^ |o·e| |o|o ^¡¡·ooc| |o· ||e |o·o¡eo· |·|o·.'
/e||.|·|·c|o||||c|e· ^·c||. ¹3S2 (2002:. 29¹3¹6
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 49
A N S W £ R 7 O 7 R Y I 7 ! P R O 8 L £ M
+cu. |.st p.cJuct|cr pcss|b|||t|es cu.ve s|cu|J .esenb|e t|e cre |r |.re| (.). St..t|rg .t pc|rt A, .r |rc.e.se |r
¦.cket p.cJuct|cr .e,u|.es . ncve Jc.r .rJ tc t|e .|g|t .|crg t|e cu.ve, .s s|c.r by t|e ...c., .rJ t|us .
.eJuct|cr |r t|e p.cJuct|cr c| ´| p|.ye.s. A|te.r.t|ve|y, || t|e.e |s eccrcn|c g.c.t|, |t s|||ts t|e p.cJuct|cr
pcss|b|||t|es cu.ve cut...J, .s |r |.re| (b). ¯||s s|||t .||c.s .r |rc.e.se |r p.cJuct|cr c| bct| gccJs, .s sug
gesteJ by t|e ...c..
4. REVIEW AND PRACTICE
Summary
|ccrcn|cs Je.|s .|t| c|c|ces. |r t||s c|.pte. .e |.ve ex.n|reJ nc.e c..e|u||y t|e ..rge c| c|c|ces |r p.c
Juct|cr t|.t nust be n.Je |r .ry eccrcny. |r p..t|cu|.., .e |cckeJ .t c|c|ces |rvc|v|rg t|e .||cc.t|cr c| .r
eccrcnys |.ctc.s c| p.cJuct|cr. |.bc., c.p|t.|, .rJ r.tu..| .escu.ces.
|r .JJ|t|cr, |r .ry eccrcny, t|e |eve| c| tec|rc|cgy p|.ys . key .c|e |r Jete.n|r|rg |c. p.cJuct|ve t|e
|.ctc.s c| p.cJuct|cr .||| be. |r . n..ket eccrcny, ert.ep.ereu.s c.g.r|.e |.ctc.s c| p.cJuct|cr .rJ .ct tc |r
t.cJuce tec|rc|cg|c.| c|.rge.
¯|e p.cJuct|cr pcss|b|||t|es ncJe| |s . Jev|ce t|.t .ss|sts us |r t||rk|rg .bcut n.ry c| t|e c|c|ces .bcut .e
scu.ce .||cc.t|cr |r .r eccrcny. ¯|e ncJe| .ssunes t|.t t|e eccrcny |.s |.ctc.s c| p.cJuct|cr t|.t ..e
|xeJ |r bct| ,u.rt|ty .rJ ,u.||ty. \|er |||ust..teJ g..p||c.||y, t|e p.cJuct|cr pcss|b|||t|es ncJe| typ|c.||y
||n|ts cu. .r.|ys|s tc t.c gccJs. C|ver t|e eccrcnys |.ctc.s c| p.cJuct|cr .rJ tec|rc|cgy, t|e eccrcny c.r
p.cJuce v..|cus ccnb|r.t|crs c| t|e t.c gccJs. || |t uses |ts |.ctc.s c| p.cJuct|cr e|c|ert|y .rJ |.s |u|| en
p|cynert, |t .||| be cpe..t|rg cr t|e p.cJuct|cr pcss|b|||t|es cu.ve.
¯.c c|...cte.|st|cs c| t|e p.cJuct|cr pcss|b|||t|es cu.ve ..e p..t|cu|..|y |npc.t.rt. ||.st, |t |s Jc.r...J s|cp
|rg. ¯||s .e|ects t|e sc..c|ty c| t|e |.ctc.s c| p.cJuct|cr .v.||.b|e tc t|e eccrcny, p.cJuc|rg nc.e c| cre
gccJ .e,u|.es g|v|rg up scne c| t|e ct|e.. SeccrJ, t|e cu.ve |s bc.eJ cut. Arct|e. ..y c| s.y|rg t||s |s tc
s.y t|.t t|e cu.ve gets steepe. .s .e ncve |.cn |e|t tc .|g|t, t|e .bsc|ute v.|ue c| |ts s|cpe |s |rc.e.s|rg. |.c
Juc|rg e.c| .JJ|t|cr.| ur|t c| t|e gccJ cr t|e |c.|.crt.| .x|s .e,u|.es . g.e.te. s.c.||ce c| t|e gccJ cr t|e
ve.t|c.| .x|s t|.r J|J t|e p.ev|cus ur|ts p.cJuceJ. ¯||s |.ct, c.||eJ t|e |.. c| |rc.e.s|rg cppc.tur|ty ccst, |s t|e
|rev|t.b|e .esu|t c| e|c|ert c|c|ces |r p.cJuct|crc|c|ces b.seJ cr ccnp...t|ve .Jv.rt.ge.
¯|e p.cJuct|cr pcss|b|||t|es ncJe| |.s |npc.t.rt |np||c.t|crs |c. |rte.r.t|cr.| t..Je. |t suggests t|.t |.ee
t..Je .||| .||c. ccurt.|es tc spec|.||.e |r t|e p.cJuct|cr c| gccJs .rJ se.v|ces |r .||c| t|ey |.ve . ccnp...t
|ve .Jv.rt.ge. ¯||s spec|.||..t|cr |rc.e.ses t|e p.cJuct|cr c| .|| gccJs .rJ se.v|ces.
|rc.e.s|rg t|e ,u.rt|ty c. ,u.||ty c| |.ctc.s c| p.cJuct|cr .rJ/c. |np.cv|rg tec|rc|cgy .||| s|||t t|e p.cJuc
t|cr pcss|b|||t|es cu.ve cut...J. ¯||s p.ccess |s c.||eJ eccrcn|c g.c.t|. |r t|e |.st 50 ye..s, eccrcn|c g.c.t|
|r t|e |r|teJ St.tes |.s .esu|teJ c||e|y |.cn |rc.e.ses |r |un.r c.p|t.| .rJ |.cn tec|rc|cg|c.| .Jv.rce.
50 PRINCIPL£S OI £CONOMICS
´|c|ces ccrce.r|rg t|e use c| sc..ce .escu.ces t.ke p|.ce .|t||r t|e ccrtext c| . set c| |rst|tut|cr.| ....rge
nerts t|.t Je|re .r eccrcn|c systen. ¯|e p.|rc|p.| J|st|rct|crs bet.eer systens ||e |r t|e Jeg.ee tc .||c|
c.re.s||p c| c.p|t.| .rJ r.tu..| .escu.ces .rJ Jec|s|cr n.k|rg .ut|c.|ty cve. sc..ce .escu.ces ..e |e|J by
gcve.rnert c. by p.|v.te |rJ|v|Ju.|s. |ccrcn|c systens |rc|uJe n..ket c.p|t.||st, n|xeJ, .rJ ccnn.rJ sc
c|.||st eccrcn|es. Ar |rc.e.s|rg bcJy c| ev|Jerce suggests t|.t n..ket c.p|t.||st eccrcn|es terJ tc be ncst
p.cJuct|ve, n.ry ccnn.rJ scc|.||st .rJ n|xeJ eccrcn|es ..e ncv|rg |r t|e J|.ect|cr c| n..ket c.p|t.||st
systens.
¯|e p.esunpt|cr |r |.vc. c| n..ketb.seJ systens Jces rct p.ec|uJe . .c|e |c. gcve.rnert. Ccve.rnert |s
recess..y tc p.cv|Je t|e systen c| |..s cr .||c| n..ket systens ..e |curJeJ. |t n.y .|sc be useJ tc p.cv|Je
ce.t.|r gccJs .rJ se.v|ces, tc |e|p |rJ|v|Ju.|s |r reeJ, .rJ tc .egu|.te t|e .ct|crs c| |rJ|v|Ju.|s .rJ |.ns.
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 51
C O N C £ P 7 P R O 8 L £ M S
1. |c. Jces . cc||ege eJuc.t|cr |rc.e.se cres |un.r c.p|t.|`
2. \|y Jces t|e Jc.r...Js|cp|rg p.cJuct|cr pcss|b|||t|es cu.ve |np|y t|.t |.ctc.s c| p.cJuct|cr ..e
sc..ce`
3. |r .|.t ..ys ..e t|e bc.eJcut s|.pe c| t|e p.cJuct|cr pcss|b|||t|es cu.ve .rJ t|e |.. c| |rc.e.s|rg
cppc.tur|ty ccst .e|.teJ`
4. \|.t |s t|e .e|.t|crs||p bet.eer t|e ccrcept c| ccnp...t|ve .Jv.rt.ge .rJ t|e |.. c| |rc.e.s|rg
cppc.tur|ty ccst`
5. Suppcse .r eccrcny c.r p.cJuce t.c gccJs, A .rJ b. |t |s rc. cpe..t|rg .t pc|rt | cr p.cJuct|cr
pcss|b|||t|es cu.ve |¯. Ar |np.cvenert |r t|e tec|rc|cgy .v.||.b|e tc p.cJuce gccJ A s|||ts t|e cu.ve tc
S¯, .rJ t|e eccrcny se|ects pc|rt |. |c. Jces t||s c|.rge .|ect t|e cppc.tur|ty ccst c| p.cJuc|rg .r
.JJ|t|cr.| ur|t c| gccJ b`
6. ´cu|J . r.t|crs p.cJuct|cr pcss|b|||t|es cu.ve eve. s|||t |r...J` |xp|.|r .|.t suc| . s|||t .cu|J ne.r,
.rJ J|scuss everts t|.t n|g|t c.use suc| . s|||t tc cccu..
. Suppcse b|ueeyeJ pecp|e .e.e b.rreJ |.cn .c.k|rg. |c. .cu|J t||s .|ect . r.t|crs p.cJuct|cr
pcss|b|||t|es cu.ve`
8. |v.|u.te t||s st.tenert. ´¯|e |.S. eccrcny ccu|J .c||eve g.e.te. g.c.t| by Jevct|rg |e.e. .escu.ces tc
ccrsunpt|cr .rJ nc.e tc |rvestnert, |t |c||c.s t|.t suc| . s|||t .cu|J be Jes|..b|e.´
9. ¯.c ccurt.|es, Spc.ts|.rJ .rJ |ccJ|.rJ, |.ve s|n||.. tct.| ,u.rt|t|es c| |.bc., c.p|t.|, .rJ r.tu..|
.escu.ces. bct| c.r p.cJuce t.c gccJs, |gs .rJ |cctb.||s. Spc.ts|.rJs .escu.ces ..e p..t|cu|..|y .e||
su|teJ tc t|e p.cJuct|cr c| |cctb.||s but ..e rct ve.y p.cJuct|ve |r p.cJuc|rg |gs. |ccJ|.rJs .escu.ces
..e ve.y p.cJuct|ve .|er useJ |c. |gs but ..e rct c.p.b|e c| p.cJuc|rg n.ry |cctb.||s. |r .||c| ccurt.y
|s t|e ccst c| .JJ|t|cr.| |cctb.||s gere..||y g.e.te.` |xp|.|r.
10. Suppcse . ccurt.y |s ccnn|tteJ tc us|rg |ts .escu.ces b.seJ cr t|e .eve.se c| ccnp...t|ve .Jv.rt.ge
Jcct.|re. |t |.st t..rs|e.s t|cse .escu.ces |c. .||c| t|e ccst |s g.e.test, rct |c.est. |esc.|be t||s ccurt.ys
p.cJuct|cr pcss|b|||t|es cu.ve.
11. ¯|e |.S. ´crst|tut|cr b.rs st.tes |.cn .est.|ct|rg |npc.ts c| gccJs .rJ se.v|ces |.cn ct|e. st.tes.
Suppcse t||s .est.|ct|cr J|J rct ex|st .rJ t|.t st.tes .e.e .||c.eJ tc ||n|t |npc.ts c| gccJs .rJ se.v|ces
p.cJuceJ |r ct|e. st.tes. |c. Jc ycu t||rk t||s .cu|J .|ect |.S. cutput` |xp|.|r.
12. by 1993, r.t|crs |r t|e |u.cpe.r |r|cr (||) |.J e||n|r.teJ .|| b...|e.s tc t|e |c. c| gccJs, se.v|ces,
|.bc., .rJ c.p|t.| .c.css t|e|. bc.Je.s. |ver suc| t||rgs .s ccrsune. p.ctect|cr |..s .rJ t|e types c|
p|ugs .e,u|.eJ tc p|ug |r .pp||.rces |.ve beer st.rJ..J|.eJ tc ersu.e t|.t t|e.e .||| be rc b...|e.s tc
t..Je. |c. Jc ycu t||rk t||s e||n|r.t|cr c| t..Je b...|e.s .|ecteJ || cutput`
13. |c. J|J t|e tec|rc|cg|c.| c|.rges Jesc.|beJ |r t|e ´.se |r |c|rt ´¯ec|rc|cgy ´uts ´csts, bccsts
|.cJuct|v|ty .rJ |.c|ts´ .|ect t|e p.cJuct|cr pcss|b|||t|es cu.ve |c. t|e |r|teJ St.tes`
52 PRINCIPL£S OI £CONOMICS
N U M £ R I C A L P R O 8 L £ M S
1. |.t|.r c.r nc. |cu. |..rs |r . J.y c. p|.rt 20 t.ees |r . J.y.
.. |... |.t|.rs p.cJuct|cr pcss|b|||t|es cu.ve |c. nc.|rg |..rs .rJ p|.rt|rg t.ees. Assune t|e
p.cJuct|cr pcss|b|||t|es cu.ve |s ||re.. .rJ put t|e ,u.rt|ty c| |..rs nc.eJ pe. J.y cr t|e
|c.|.crt.| .x|s .rJ t|e ,u.rt|ty c| t.ees p|.rteJ pe. J.y cr t|e ve.t|c.| .x|s.
b. \|.t |s |.t|.rs cppc.tur|ty ccst c| p|.rt|rg t.ees`
c. \|.t |s |.t|.rs cppc.tur|ty ccst c| nc.|rg |..rs`
2. |.v|J c.r nc. |cu. |..rs |r . J.y c. p|.rt |cu. t.ees |r . J.y.
.. |... |.v|Js p.cJuct|cr pcss|b|||t|es cu.ve |c. nc.|rg |..rs .rJ p|.rt|rg t.ees. Ag.|r, .ssune
. ||re.. p.cJuct|cr pcss|b|||t|es cu.ve .rJ put t|e ,u.rt|ty c| |..rs nc.eJ pe. J.y cr t|e
|c.|.crt.| .x|s.
b. \|.t |s |.v|Js cppc.tur|ty ccst c| p|.rt|rg t.ees`
c. \|.t |s |.v|Js cppc.tur|ty ccst c| nc.|rg |..rs`
3. C|ver t|e p.cJuct|cr |r|c.n.t|cr |r p.cb|ens 1 .rJ 2 .bcve, .|c |.s t|e ccnp...t|ve .Jv.rt.ge |r
p|.rt|rg t.ees` Vc.|rg |..rs`
4. ¯|e ex||b|ts be|c. Jesc.|be t|e p.cJuct|cr pcss|b|||t|es |c. Ce.n.ry .rJ ¯u.key.
.. \|.t |s t|e s|cpe c| Ce.n.rys p.cJuct|cr pcss|b|||t|es cu.ve`
b. \|.t |s t|e s|cpe c| ¯u.keys p.cJuct|cr pcss|b|||t|es cu.ve`
c. \|.t |s t|e cppc.tur|ty ccst c| p.cJuc|rg ¯s||.ts |r Ce.n.ry`
J. \|.t |s t|e cppc.tur|ty ccst c| p.cJuc|rg ¯s||.ts |r ¯u.key`
e. \|.t |s t|e cppc.tur|ty ccst c| p.cJuc|rg cpt|c.| |rst.unerts |r Ce.n.ry`
|. \|.t |s t|e cppc.tur|ty ccst c| p.cJuc|rg cpt|c.| |rst.unerts |r ¯u.key`
g. |r .||c| gccJ Jces Ce.n.ry |.ve . ccnp...t|ve .Jv.rt.ge`
|. |r .||c| gccJ Jces ¯u.key |.ve . ccnp...t|ve .Jv.rt.ge`
5. ¯|e r.t|cr c| |e|su.e|.rJ c.r p.cJuce t.c gccJs, b|cyc|es .rJ bc.||rg b.||s. ¯|e .este.r .eg|cr c|
|e|su.e|.rJ c.r, || |t Jevctes .|| |ts .escu.ces tc b|cyc|e p.cJuct|cr, p.cJuce 100 b|cyc|es pe. ncrt|.
A|te.r.t|ve|y, |t ccu|J Jevcte .|| |ts .escu.ces tc bc.||rg b.||s .rJ p.cJuce 400 pe. ncrt|c. |t ccu|J
p.cJuce .ry ccnb|r.t|cr c| b|cyc|es .rJ bc.||rg b.||s |y|rg cr . st..|g|t ||re bet.eer t|ese t.c
ext.enes.
.. |... . p.cJuct|cr pcss|b|||t|es cu.ve |c. .este.r |e|su.e|.rJ (.|t| b|cyc|es cr t|e ve.t|c.| .x|s).
b. \|.t |t |s t|e cppc.tur|ty ccst c| p.cJuc|rg .r .JJ|t|cr.| bc.||rg b.|| ne.su.eJ |r te.ns c|
|c.gcre b|cyc|es |r .este.r |e|su.e|.rJ`
c. Suppcse t|.t e.ste.r |e|su.e|.rJ c.r, || |t Jevctes .|| |ts .escu.ces tc t|e p.cJuct|cr c| b|cyc|es,
p.cJuce 400. || |t Jevctes .|| |ts .escu.ces tc bc.||rg b.|| p.cJuct|cr, t|cug|, |t c.r p.cJuce cr|y
100. |... t|e p.cJuct|cr pcss|b|||t|es cu.ve |c. e.ste.r |e|su.e|.rJ (.g.|r, .ssune |t |s ||re.. .rJ
put b|cyc|es cr t|e ve.t|c.| .x|s).
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 53
J. \|.t |s t|e cppc.tur|ty ccst c| p.cJuc|rg .r .JJ|t|cr.| bc.||rg b.|| ne.su.eJ |r te.ns c|
|c.gcre b|cyc|es |r e.ste.r |e|su.e|.rJ`
e. |xp|.|r t|e J||e.erce |r cppc.tur|ty ccst bet.eer .este.r .rJ e.ste.r |e|su.e|.rJ. \||c|
.eg|cr |.s . ccnp...t|ve .Jv.rt.ge |r p.cJuc|rg bc.||rg b.||s` b|cyc|es`
|. |... t|e p.cJuct|cr pcss|b|||t|es cu.ve |c. |e|su.e|.rJ, cre t|.t ccnb|res t|e cu.ves |c. .este.r
.rJ e.ste.r |e|su.e|.rJ.
g. Suppcse |t |s Jete.n|reJ t|.t 400 b|cyc|es nust be p.cJuceJ. |c. n.ry bc.||rg b.||s c.r be
p.cJuceJ`
|. \|e.e .||| t|ese gccJs be p.cJuceJ`
6. ¯|e t.b|e be|c. s|c.s t|e p.cJuct|cr pcss|b|||t|es sc|eJu|e |c. .r eccrcny.
Production AIternatives CapitaI goods per period Consumer goods per period
A 0 40
b 1 36
´ 2 28
| 3 16
| 4 0
.. |utt|rg c.p|t.| gccJs pe. pe.|cJ cr t|e |c.|.crt.| .x|s .rJ ccrsune. gccJs pe. pe.|cJ cr t|e
ve.t|c.| .x|s, g..p| t|e p.cJuct|cr pcss|b|||t|es cu.ve |c. t|e eccrcny.
b. || t|e eccrcny |s p.cJuc|rg .t .|te.r.t|ve b, .|.t |s t|e cppc.tur|ty ccst tc |t c| p.cJuc|rg .t
.|te.r.t|ve ´ |rste.J`
c. || t|e eccrcny |s p.cJuc|rg .t .|te.r.t|ve ´, .|.t |s t|e cppc.tur|ty ccst tc |t c| p.cJuc|rg .t
.|te.r.t|ve | |rste.J`
J. |s |t pcss|b|e |c. t||s eccrcny tc p.cJuce 30 ur|ts c| ccrsune. gccJs pe. pe.|cJ .|||e
p.cJuc|rg 1 ur|t c| c.p|t.| gccJs` \cu|J t||s ccnb|r.t|cr c| gccJs .ep.esert e|c|ert c.
|re|c|ert p.cJuct|cr` |xp|.|r.
e. \||c| pc|rt, b c. ´, .cu|J |e.J tc ||g|e. eccrcn|c g.c.t|` |xp|.|r ycu. .rs.e..
. ¯|e ex||b|t be|c. s|c.s t|e scu.ces c| g.c.t| |r t|e |r|teJ St.tes bet.eer 1909 .rJ 1929 .rJ bet.eer
1950 .rJ 199, .ccc.J|rg tc . stuJy by |J...J |er|scr.
¦1¦
(|cte. ¯|e scu.ces c| eccrcn|c g.c.t| ..e
cunu|.t|ve .rJ, t.ker cc||ect|ve|y, exp|.|r 100 c| tct.| g.c.t| cve. t|e pe.|cJ.)
.. App.cx|n.te|y .|.t pe.cert.ge c| |.S. g.c.t| bet.eer 1909 .rJ 1929 ..s Jue tc |rc.e.ses |r
,u.rt|t|es c| |.ctc.s c| p.cJuct|cr`
b. App.cx|n.te|y .|.t pe.cert.ge c| |.S. g.c.t| bet.eer 1909 .rJ 1929 ..s Jue tc |rc.e.ses |r
,u.||ty c| |.ctc.s c| p.cJuct|cr .rJ tec|rc|cg|c.| |np.cvenert`
54 PRINCIPL£S OI £CONOMICS
c. App.cx|n.te|y .|.t pe.cert.ge c| |.S. g.c.t| bet.eer 1950 .rJ 199 ..s Jue tc |rc.e.ses |r
,u.rt|t|es c| |.ctc.s c| p.cJuct|cr`
J. App.cx|n.te|y .|.t pe.cert.ge c| |.S. g.c.t| bet.eer 1950 .rJ 199 ..s Jue tc |rc.e.ses |r
,u.||ty c| |.ctc.s c| p.cJuct|cr .rJ tec|rc|cg|c.| |np.cvenert`
CHAP7£R 2 CONIRON7ING SCARCI7Y: CHOIC£S IN PRODUC7ION 55
1.
ENDNOTES
|J...J |er|scr, ¯|e .oo·ce· o| |co·o·|c O·o.|| |· ||e |·||eJ .|o|e· (|e. +c.k. ´cn
n|ttee |c. |ccrcn|c |eve|cpnert, 1962) .rJ |J...J |er|scr, ¯·e·J· |· ^·e·|co·
O·o.|| ¹929¹9S2 (\.s||rgtcr, |.´.. b.cck|rgs |rst|tut|crs, 1985).
56 PRINCIPL£S OI £CONOMICS
Chapter 1
Sampling and Data
1.1 Sampling and Data
1
1.1.1 Student Learning Outcomes
By the end of this chapter, the student should be able to:
• Recognize and differentiate between key terms.
• Apply various types of sampling methods to data collection.
• Create and interpret frequency tables.
1.1.2 Introduction
You are probably asking yourself the question, "When and where will I use statistics?". If you read any
newspaper or watch television, or use the Internet, you will see statistical information. There are statistics
about crime, sports, education, politics, and real estate. Typically, when you read a newspaper article or
watch a news program on television, you are given sample information. With this information, you may
make a decision about the correctness of a statement, claim, or "fact." Statistical methods can help you make
the "best educated guess."
Since you will undoubtedly be given statistical information at some point in your life, you need to know
some techniques to analyze the information thoughtfully. Think about buying a house or managing a
budget. Think about your chosen profession. The fields of economics, business, psychology, education,
biology, law, computer science, police science, and early childhood development require at least one course
in statistics.
Included in this chapter are the basic ideas and words of probability and statistics. You will soon under-
stand that statistics and probability work together. You will also learn how data are gathered and what
"good" data are.
1.2 Statistics
2
The science of statistics deals with the collection, analysis, interpretation, and presentation of data. We see
and use data in our everyday lives.
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14 CHAPTER 1. SAMPLING AND DATA
1.2.1 Optional Collaborative Classroom Exercise
In your classroom, try this exercise. Have class members write down the average time (in hours, to the
nearest half-hour) they sleep per night. Your instructor will record the data. Then create a simple graph
(called a dot plot) of the data. A dot plot consists of a number line and dots (or points) positioned above
the number line. For example, consider the following data:
5; 5.5; 6; 6; 6; 6.5; 6.5; 6.5; 6.5; 7; 7; 8; 8; 9
The dot plot for this data would be as follows:
Frequency of Average Time (in Hours) Spent Sleeping per Night
Figure 1.1
Does your dot plot look the same as or different from the example? Why? If you did the same example in
an English class with the same number of students, do you think the results would be the same? Why or
why not?
Where do your data appear to cluster? How could you interpret the clustering?
The questions above ask you to analyze and interpret your data. With this example, you have begun your
study of statistics.
In this course, you will learn how to organize and summarize data. Organizing and summarizing data is
called descriptive statistics. Two ways to summarize data are by graphing and by numbers (for example,
finding an average). After you have studied probability and probability distributions, you will use formal
methods for drawing conclusions from "good" data. The formal methods are called inferential statistics.
Statistical inference uses probability to determine how confident we can be that the conclusions are correct.
Effective interpretation of data (inference) is based on good procedures for producing data and thoughtful
examination of the data. You will encounter what will seem to be too many mathematical formulas for
interpreting data. The goal of statistics is not to perform numerous calculations using the formulas, but to
gain an understanding of your data. The calculations can be done using a calculator or a computer. The
understanding must come from you. If you can thoroughly grasp the basics of statistics, you can be more
confident in the decisions you make in life.
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1.3 Probability
3
Probability is a mathematical tool used to study randomness. It deals with the chance (the likelihood) of
an event occurring. For example, if you toss a fair coin 4 times, the outcomes may not be 2 heads and 2
tails. However, if you toss the same coin 4,000 times, the outcomes will be close to half heads and half tails.
The expected theoretical probability of heads in any one toss is
1
2
or 0.5. Even though the outcomes of a
few repetitions are uncertain, there is a regular pattern of outcomes when there are many repetitions. After
reading about the English statistician Karl Pearson who tossed a coin 24,000 times with a result of 12,012
heads, one of the authors tossed a coin 2,000 times. The results were 996 heads. The fraction
996
2000
is equal
to 0.498 which is very close to 0.5, the expected probability.
The theory of probability began with the study of games of chance such as poker. Predictions take the form
of probabilities. To predict the likelihood of an earthquake, of rain, or whether you will get an A in this
course, we use probabilities. Doctors use probability to determine the chance of a vaccination causing the
disease the vaccination is supposed to prevent. A stockbroker uses probability to determine the rate of
return on a client’s investments. You might use probability to decide to buy a lottery ticket or not. In your
study of statistics, you will use the power of mathematics through probability calculations to analyze and
interpret your data.
1.4 Key Terms
4
In statistics, we generally want to study a population. You can think of a population as an entire collection
of persons, things, or objects under study. To study the larger population, we select a sample. The idea of
sampling is to select a portion (or subset) of the larger population and study that portion (the sample) to
gain information about the population. Data are the result of sampling from a population.
Because it takes a lot of time and money to examine an entire population, sampling is a very practical
technique. If you wished to compute the overall grade point average at your school, it would make sense
to select a sample of students who attend the school. The data collected from the sample would be the
students’ grade point averages. In presidential elections, opinion poll samples of 1,000 to 2,000 people are
taken. The opinion poll is supposed to represent the views of the people in the entire country. Manu-
facturers of canned carbonated drinks take samples to determine if a 16 ounce can contains 16 ounces of
carbonated drink.
From the sample data, we can calculate a statistic. A statistic is a number that is a property of the sample.
For example, if we consider one math class to be a sample of the population of all math classes, then the
average number of points earned by students in that one math class at the end of the term is an example of
a statistic. The statistic is an estimate of a population parameter. A parameter is a number that is a property
of the population. Since we considered all math classes to be the population, then the average number of
points earned per student over all the math classes is an example of a parameter.
One of the main concerns in the field of statistics is how accurately a statistic estimates a parameter. The
accuracy really depends on how well the sample represents the population. The sample must contain the
characteristics of the population in order to be a representative sample. We are interested in both the
sample statistic and the population parameter in inferential statistics. In a later chapter, we will use the
sample statistic to test the validity of the established population parameter.
A variable, notated by capital letters like X and Y, is a characteristic of interest for each person or thing in
a population. Variables may be numerical or categorical. Numerical variables take on values with equal
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units such as weight in pounds and time in hours. Categorical variables place the person or thing into a
category. If we let X equal the number of points earned by one math student at the end of a term, then X
is a numerical variable. If we let Y be a person’s party affiliation, then examples of Y include Republican,
Democrat, and Independent. Y is a categorical variable. We could do some math with values of X (calculate
the average number of points earned, for example), but it makes no sense to do math with values of Y
(calculating an average party affiliation makes no sense).
Data are the actual values of the variable. They may be numbers or they may be words. Datum is a single
value.
Two words that come up often in statistics are mean and proportion. If you were to take three exams in
your math classes and obtained scores of 86, 75, and 92, you calculate your mean score by adding the three
exam scores and dividing by three (your mean score would be 84.3 to one decimal place). If, in your math
class, there are 40 students and 22 are men and 18 are women, then the proportion of men students is
22
40
and the proportion of women students is
18
40
. Mean and proportion are discussed in more detail in later
chapters.
NOTE: The words "mean" and "average" are often used interchangeably. The substitution of one
word for the other is common practice. The technical term is "arithmetic mean" and "average" is
technically a center location. However, in practice among non-statisticians, "average" is commonly
accepted for "arithmetic mean."
Example 1.1
Define the key terms from the following study: We want to know the average (mean) amount
of money first year college students spend at ABC College on school supplies that do not include
books. We randomly survey 100 first year students at the college. Three of those students spent
$150, $200, and $225, respectively.
Solution
The population is all first year students attending ABC College this term.
The sample could be all students enrolled in one section of a beginning statistics course at ABC
College (although this sample may not represent the entire population).
The parameter is the average (mean) amount of money spent (excluding books) by first year col-
lege students at ABC College this term.
The statistic is the average (mean) amount of money spent (excluding books) by first year college
students in the sample.
The variable could be the amount of money spent (excluding books) by one first year student.
Let X = the amount of money spent (excluding books) by one first year student attending ABC
College.
The data are the dollar amounts spent by the first year students. Examples of the data are $150,
$200, and $225.
1.4.1 Optional Collaborative Classroom Exercise
Do the following exercise collaboratively with up to four people per group. Find a population, a sample,
the parameter, the statistic, a variable, and data for the following study: You want to determine the average
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(mean) number of glasses of milk college students drink per day. Suppose yesterday, in your English class,
you asked five students how many glasses of milk they drank the day before. The answers were 1, 0, 1, 3,
and 4 glasses of milk.
1.5 Data
5
Data may come from a population or from a sample. Small letters like x or y generally are used to represent
data values. Most data can be put into the following categories:
• Qualitative
• Quantitative
Qualitative data are the result of categorizing or describing attributes of a population. Hair color, blood
type, ethnic group, the car a person drives, and the street a person lives on are examples of qualitative data.
Qualitative data are generally described by words or letters. For instance, hair color might be black, dark
brown, light brown, blonde, gray, or red. Blood type might be AB+, O-, or B+. Researchers often prefer to
use quantitative data over qualitative data because it lends itself more easily to mathematical analysis. For
example, it does not make sense to find an average hair color or blood type.
Quantitative data are always numbers. Quantitative data are the result of counting or measuring attributes
of a population. Amount of money, pulse rate, weight, number of people living in your town, and the
number of students who take statistics are examples of quantitative data. Quantitative data may be either
discrete or continuous.
All data that are the result of counting are called quantitative discrete data. These data take on only certain
numerical values. If you count the number of phone calls you receive for each day of the week, you might
get 0, 1, 2, 3, etc.
All data that are the result of measuring are quantitative continuous data assuming that we can measure
accurately. Measuring angles in radians might result in the numbers
π
6
,
π
3
,
π
2
, π ,

4
, etc. If you and your
friends carry backpacks with books in them to school, the numbers of books in the backpacks are discrete
data and the weights of the backpacks are continuous data.
Example 1.2: Data Sample of Quantitative Discrete Data
The data are the number of books students carry in their backpacks. You sample five students.
Two students carry 3 books, one student carries 4 books, one student carries 2 books, and one
student carries 1 book. The numbers of books (3, 4, 2, and 1) are the quantitative discrete data.
Example 1.3: Data Sample of Quantitative Continuous Data
The data are the weights of the backpacks with the books in it. You sample the same five students.
The weights (in pounds) of their backpacks are 6.2, 7, 6.8, 9.1, 4.3. Notice that backpacks carrying
three books can have different weights. Weights are quantitative continuous data because weights
are measured.
Example 1.4: Data Sample of Qualitative Data
The data are the colors of backpacks. Again, you sample the same five students. One student has
a red backpack, two students have black backpacks, one student has a green backpack, and one
student has a gray backpack. The colors red, black, black, green, and gray are qualitative data.
NOTE: You may collect data as numbers and report it categorically. For example, the quiz scores
for each student are recorded throughout the term. At the end of the term, the quiz scores are
reported as A, B, C, D, or F.
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Example 1.5
Work collaboratively to determine the correct data type (quantitative or qualitative). Indicate
whether quantitative data are continuous or discrete. Hint: Data that are discrete often start with
the words "the number of."
1. The number of pairs of shoes you own.
2. The type of car you drive.
3. Where you go on vacation.
4. The distance it is from your home to the nearest grocery store.
5. The number of classes you take per school year.
6. The tuition for your classes
7. The type of calculator you use.
8. Movie ratings.
9. Political party preferences.
10. Weight of sumo wrestlers.
11. Amount of money (in dollars) won playing poker.
12. Number of correct answers on a quiz.
13. Peoples’ attitudes toward the government.
14. IQ scores. (This may cause some discussion.)
1.6 Sampling
6
Gathering information about an entire population often costs too much or is virtually impossible. Instead,
we use a sample of the population. A sample should have the same characteristics as the population it
is representing. Most statisticians use various methods of random sampling in an attempt to achieve this
goal. This section will describe a few of the most common methods.
There are several different methods of random sampling. In each form of random sampling, each member
of a population initially has an equal chance of being selected for the sample. Each method has pros and
cons. The easiest method to describe is called a simple random sample. Any group of n individuals is
equally likely to be chosen by any other group of n individuals if the simple random sampling technique is
used. In other words, each sample of the same size has an equal chance of being selected. For example, sup-
pose Lisa wants to form a four-person study group (herself and three other people) from her pre-calculus
class, which has 31 members not including Lisa. To choose a simple random sample of size 3 from the other
members of her class, Lisa could put all 31 names in a hat, shake the hat, close her eyes, and pick out 3
names. A more technological way is for Lisa to first list the last names of the members of her class together
with a two-digit number as shown below.
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Class Roster
ID Name
00 Anselmo
01 Bautista
02 Bayani
03 Cheng
04 Cuarismo
05 Cuningham
06 Fontecha
07 Hong
08 Hoobler
09 Jiao
10 Khan
11 King
12 Legeny
13 Lundquist
14 Macierz
15 Motogawa
16 Okimoto
17 Patel
18 Price
19 Quizon
20 Reyes
21 Roquero
22 Roth
23 Rowell
24 Salangsang
25 Slade
26 Stracher
27 Tallai
28 Tran
29 Wai
30 Wood
Table 1.1
Lisa can either use a table of random numbers (found in many statistics books as well as mathematical
handbooks) or a calculator or computer to generate random numbers. For this example, suppose Lisa
chooses to generate random numbers from a calculator. The numbers generated are:
20 CHAPTER 1. SAMPLING AND DATA
.94360; .99832; .14669; .51470; .40581; .73381; .04399
Lisa reads two-digit groups until she has chosen three class members (that is, she reads .94360 as the groups
94, 43, 36, 60). Each random number may only contribute one class member. If she needed to, Lisa could
have generated more random numbers.
The random numbers .94360 and .99832 do not contain appropriate two digit numbers. However the third
randomnumber, .14669, contains 14 (the fourth randomnumber also contains 14), the fifth randomnumber
contains 05, and the seventh randomnumber contains 04. The two-digit number 14 corresponds to Macierz,
05 corresponds to Cunningham, and 04 corresponds to Cuarismo. Besides herself, Lisa’s group will consist
of Marcierz, and Cunningham, and Cuarismo.
Besides simple random sampling, there are other forms of sampling that involve a chance process for get-
ting the sample. Other well-known random sampling methods are the stratified sample, the cluster
sample, and the systematic sample.
To choose a stratified sample, divide the population into groups called strata and then take a proportionate
number fromeach stratum. For example, you could stratify (group) your college population by department
and then choose a proportionate simple randomsample fromeach stratum(each department) to get a strat-
ified random sample. To choose a simple random sample from each department, number each member of
the first department, number each member of the second department and do the same for the remaining de-
partments. Then use simple random sampling to choose proportionate numbers from the first department
and do the same for each of the remaining departments. Those numbers picked from the first department,
picked from the second department and so on represent the members who make up the stratified sample.
To choose a cluster sample, divide the population into clusters (groups) and then randomly select some of
the clusters. All the members from these clusters are in the cluster sample. For example, if you randomly
sample four departments from your college population, the four departments make up the cluster sample.
For example, divide your college faculty by department. The departments are the clusters. Number each
department and then choose four different numbers using simple random sampling. All members of the
four departments with those numbers are the cluster sample.
To choose a systematic sample, randomly select a starting point and take every nth piece of data from a
listing of the population. For example, suppose you have to do a phone survey. Your phone book contains
20,000 residence listings. You must choose 400 names for the sample. Number the population 1 - 20,000
and then use a simple random sample to pick a number that represents the first name of the sample. Then
choose every 50th name thereafter until you have a total of 400 names (you might have to go back to the of
your phone list). Systematic sampling is frequently chosen because it is a simple method.
A type of sampling that is nonrandom is convenience sampling. Convenience sampling involves using
results that are readily available. For example, a computer software store conducts a marketing study by
interviewing potential customers who happen to be in the store browsing through the available software.
The results of convenience sampling may be very good in some cases and highly biased (favors certain
outcomes) in others.
Sampling data should be done very carefully. Collecting data carelessly can have devastating results. Sur-
veys mailed to households and then returned may be very biased (for example, they may favor a certain
group). It is better for the person conducting the survey to select the sample respondents.
True random sampling is done with replacement. That is, once a member is picked that member goes
back into the population and thus may be chosen more than once. However for practical reasons, in most
populations, simple random sampling is done without replacement. Surveys are typically done without
replacement. That is, a member of the population may be chosen only once. Most samples are taken from
large populations and the sample tends to be small in comparison to the population. Since this is the case,
21
sampling without replacement is approximately the same as sampling with replacement because the chance
of picking the same individual more than once using with replacement is very low.
For example, in a college population of 10,000 people, suppose you want to randomly pick a sample of 1000
for a survey. For any particular sample of 1000, if you are sampling with replacement,
• the chance of picking the first person is 1000 out of 10,000 (0.1000);
• the chance of picking a different second person for this sample is 999 out of 10,000 (0.0999);
• the chance of picking the same person again is 1 out of 10,000 (very low).
If you are sampling without replacement,
• the chance of picking the first person for any particular sample is 1000 out of 10,000 (0.1000);
• the chance of picking a different second person is 999 out of 9,999 (0.0999);
• you do not replace the first person before picking the next person.
Compare the fractions 999/10,000 and 999/9,999. For accuracy, carry the decimal answers to 4 place deci-
mals. To 4 decimal places, these numbers are equivalent (0.0999).
Sampling without replacement instead of sampling with replacement only becomes a mathematics issue
when the population is small which is not that common. For example, if the population is 25 people, the
sample is 10 and you are sampling with replacement for any particular sample,
• the chance of picking the first person is 10 out of 25 and a different second person is 9 out of 25 (you
replace the first person).
If you sample without replacement,
• the chance of picking the first person is 10 out of 25 and then the second person (which is different) is
9 out of 24 (you do not replace the first person).
Compare the fractions 9/25 and 9/24. To 4 decimal places, 9/25 = 0.3600 and 9/24 = 0.3750. To 4 decimal
places, these numbers are not equivalent.
When you analyze data, it is important to be aware of sampling errors and nonsampling errors. The actual
process of sampling causes sampling errors. For example, the sample may not be large enough. Factors
not related to the sampling process cause nonsampling errors. A defective counting device can cause a
nonsampling error.
In reality, a sample will never be exactly representative of the population so there will always be
some sampling error. As a rule, the larger the sample, the smaller the sampling error.
In statistics, a sampling bias is created when a sample is collected from a population and some
members of the population are not as likely to be chosen as others (remember, each member of the
population should have an equally likely chance of being chosen). When a sampling bias happens, there
can be incorrect conclusions drawn about the population that is being studied.
Example 1.6
Determine the type of sampling used (simple random, stratified, systematic, cluster, or conve-
nience).
1. A soccer coach selects 6 players from a group of boys aged 8 to 10, 7 players from a group of
boys aged 11 to 12, and 3 players from a group of boys aged 13 to 14 to form a recreational
soccer team.
2. A pollster interviews all human resource personnel in five different high tech companies.
22 CHAPTER 1. SAMPLING AND DATA
3. A high school educational researcher interviews 50 high school female teachers and 50 high
school male teachers.
4. A medical researcher interviews every third cancer patient from a list of cancer patients at a
local hospital.
5. A high school counselor uses a computer to generate 50 random numbers and then picks
students whose names correspond to the numbers.
6. A student interviews classmates in his algebra class to determine how many pairs of jeans a
student owns, on the average.
Solution
1. stratified
2. cluster
3. stratified
4. systematic
5. simple random
6. convenience
If we were to examine two samples representing the same population, even if we used random sampling
methods for the samples, they would not be exactly the same. Just as there is variation in data, there is
variation in samples. As you become accustomed to sampling, the variability will seem natural.
Example 1.7
Suppose ABC College has 10,000 part-time students (the population). We are interested in the
average amount of money a part-time student spends on books in the fall term. Asking all 10,000
students is an almost impossible task.
Suppose we take two different samples.
First, we use convenience sampling and survey 10 students from a first term organic chemistry
class. Many of these students are taking first term calculus in addition to the organic chemistry
class . The amount of money they spend is as follows:
$128; $87; $173; $116; $130; $204; $147; $189; $93; $153
The second sample is taken by using a list from the P.E. department of senior citizens who take
P.E. classes and taking every 5th senior citizen on the list, for a total of 10 senior citizens. They
spend:
$50; $40; $36; $15; $50; $100; $40; $53; $22; $22
Problem 1
Do you think that either of these samples is representative of (or is characteristic of) the entire
10,000 part-time student population?
Solution
No. The first sample probably consists of science-oriented students. Besides the chemistry course,
some of them are taking first-term calculus. Books for these classes tend to be expensive. Most
of these students are, more than likely, paying more than the average part-time student for their
books. The second sample is a group of senior citizens who are, more than likely, taking courses
for health and interest. The amount of money they spend on books is probably much less than the
average part-time student. Both samples are biased. Also, in both cases, not all students have a
chance to be in either sample.
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Problem 2
Since these samples are not representative of the entire population, is it wise to use the results to
describe the entire population?
Solution
No. For these samples, each member of the population did not have an equally likely chance of
being chosen.
Now, suppose we take a third sample. We choose ten different part-time students from the dis-
ciplines of chemistry, math, English, psychology, sociology, history, nursing, physical education,
art, and early childhood development. (We assume that these are the only disciplines in which
part-time students at ABC College are enrolled and that an equal number of part-time students
are enrolled in each of the disciplines.) Each student is chosen using simple random sampling.
Using a calculator, random numbers are generated and a student from a particular discipline is
selected if he/she has a corresponding number. The students spend:
$180; $50; $150; $85; $260; $75; $180; $200; $200; $150
Problem 3
Is the sample biased?
Solution
The sample is unbiased, but a larger sample would be recommended to increase the likelihood
that the sample will be close to representative of the population. However, for a biased sampling
technique, even a large sample runs the risk of not being representative of the population.
Students often ask if it is "good enough" to take a sample, instead of surveying the entire popula-
tion. If the survey is done well, the answer is yes.
1.6.1 Optional Collaborative Classroom Exercise
Exercise 1.6.1
As a class, determine whether or not the following samples are representative. If they are not,
discuss the reasons.
1. To find the average GPA of all students in a university, use all honor students at the univer-
sity as the sample.
2. To find out the most popular cereal among young people under the age of 10, stand outside
a large supermarket for three hours and speak to every 20th child under age 10 who enters
the supermarket.
3. To find the average annual income of all adults in the United States, sample U.S. congress-
men. Create a cluster sample by considering each state as a stratum(group). By using simple
randomsampling, select states to be part of the cluster. Then survey every U.S. congressman
in the cluster.
4. To determine the proportion of people taking public transportation to work, survey 20 peo-
ple in New York City. Conduct the survey by sitting in Central Park on a bench and inter-
viewing every person who sits next to you.
5. To determine the average cost of a two day stay in a hospital in Massachusetts, survey 100
hospitals across the state using simple random sampling.
24 CHAPTER 1. SAMPLING AND DATA
1.7 Variation
7
1.7.1 Variation in Data
Variation is present in any set of data. For example, 16-ounce cans of beverage may contain more or less
than 16 ounces of liquid. In one study, eight 16 ounce cans were measured and produced the following
amount (in ounces) of beverage:
15.8; 16.1; 15.2; 14.8; 15.8; 15.9; 16.0; 15.5
Measurements of the amount of beverage in a 16-ounce can may vary because different people make the
measurements or because the exact amount, 16 ounces of liquid, was not put into the cans. Manufacturers
regularly run tests to determine if the amount of beverage in a 16-ounce can falls within the desired range.
Be aware that as you take data, your data may vary somewhat from the data someone else is taking for the
same purpose. This is completely natural. However, if two or more of you are taking the same data and
get very different results, it is time for you and the others to reevaluate your data-taking methods and your
accuracy.
1.7.2 Variation in Samples
It was mentioned previously that two or more samples from the same population, taken randomly, and
having close to the same characteristics of the population are different fromeach other. Suppose Doreen and
Jung both decide to study the average amount of time students at their college sleep each night. Doreen and
Jung each take samples of 500 students. Doreen uses systematic sampling and Jung uses cluster sampling.
Doreen’s sample will be different from Jung’s sample. Even if Doreen and Jung used the same sampling
method, in all likelihood their samples would be different. Neither would be wrong, however.
Think about what contributes to making Doreen’s and Jung’s samples different.
If Doreen and Jung took larger samples (i.e. the number of data values is increased), their sample results
(the average amount of time a student sleeps) might be closer to the actual population average. But still,
their samples would be, in all likelihood, different from each other. This variability in samples cannot be
stressed enough.
1.7.2.1 Size of a Sample
The size of a sample (often called the number of observations) is important. The examples you have seen
in this book so far have been small. Samples of only a few hundred observations, or even smaller, are
sufficient for many purposes. In polling, samples that are from 1200 to 1500 observations are considered
large enough and good enough if the survey is random and is well done. You will learn why when you
study confidence intervals.
Be aware that many large samples are biased. For example, call-in surveys are invariable biased
because people choose to respond or not.
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1.7.2.2 Optional Collaborative Classroom Exercise
Exercise 1.7.1
Divide into groups of two, three, or four. Your instructor will give each group one 6-sided die.
Try this experiment twice. Roll one fair die (6-sided) 20 times. Record the number of ones, twos,
threes, fours, fives, and sixes you get below ("frequency" is the number of times a particular face
of the die occurs):
First Experiment (20 rolls)
Face on Die Frequency
1
2
3
4
5
6
Table 1.2
Second Experiment (20 rolls)
Face on Die Frequency
1
2
3
4
5
6
Table 1.3
Did the two experiments have the same results? Probably not. If you did the experiment a third
time, do you expect the results to be identical to the first or second experiment? (Answer yes or
no.) Why or why not?
Which experiment had the correct results? They both did. The job of the statistician is to see
through the variability and draw appropriate conclusions.
1.7.3 Critical Evaluation
We need to critically evaluate the statistical studies we read about and analyze before accepting the results
of the study. Common problems to be aware of include
• Problems with Samples: A sample should be representative of the population. A sample that is not
representative of the population is biased. Biased samples that are not representative of the popula-
tion give results that are inaccurate and not valid.
26 CHAPTER 1. SAMPLING AND DATA
• Self-Selected Samples: Responses only by people who choose to respond, such as call-in surveys are
often unreliable.
• Sample Size Issues: Samples that are too small may be unreliable. Larger samples are better if possible.
In some situations, small samples are unavoidable and can still be used to draw conclusions, even
though larger samples are better. Examples: Crash testing cars, medical testing for rare conditions.
• Undue influence: Collecting data or asking questions in a way that influences the response.
• Non-response or refusal of subject to participate: The collected responses may no longer be represen-
tative of the population. Often, people with strong positive or negative opinions may answer surveys,
which can affect the results.
• Causality: A relationship between two variables does not mean that one causes the other to occur.
They may both be related (correlated) because of their relationship through a different variable.
• Self-Funded or Self-Interest Studies: A study performed by a person or organization in order to sup-
port their claim. Is the study impartial? Read the study carefully to evaluate the work. Do not
automatically assume that the study is good but do not automatically assume the study is bad either.
Evaluate it on its merits and the work done.
• Misleading Use of Data: Improperly displayed graphs, incomplete data, lack of context.
• Confounding: When the effects of multiple factors on a response cannot be separated. Confounding
makes it difficult or impossible to draw valid conclusions about the effect of each factor.
1.8 Answers and Rounding Off
8
A simple way to round off answers is to carry your final answer one more decimal place than was present
in the original data. Round only the final answer. Do not round any intermediate results, if possible. If it
becomes necessary to round intermediate results, carry them to at least twice as many decimal places as the
final answer. For example, the average of the three quiz scores 4, 6, 9 is 6.3, rounded to the nearest tenth,
because the data are whole numbers. Most answers will be rounded in this manner.
It is not necessary to reduce most fractions in this course. Especially in Probability Topics (Section 3.1), the
chapter on probability, it is more helpful to leave an answer as an unreduced fraction.
1.9 Frequency
9
Twenty students were asked how many hours they worked per day. Their responses, in hours, are listed
below:
5; 6; 3; 3; 2; 4; 7; 5; 2; 3; 5; 6; 5; 4; 4; 3; 5; 2; 5; 3
Below is a frequency table listing the different data values in ascending order and their frequencies.
8
This content is available online at <http://cnx.org/content/m16006/1.7/>.
9
This content is available online at <http://cnx.org/content/m16012/1.20/>.
27
Frequency Table of Student Work Hours
DATA VALUE FREQUENCY
2 3
3 5
4 3
5 6
6 2
7 1
Table 1.4
A frequency is the number of times a given datum occurs in a data set. According to the table above,
there are three students who work 2 hours, five students who work 3 hours, etc. The total of the frequency
column, 20, represents the total number of students included in the sample.
A relative frequency is the fraction or proportion of times an answer occurs. To find the relative fre-
quencies, divide each frequency by the total number of students in the sample - in this case, 20. Relative
frequencies can be written as fractions, percents, or decimals.
Frequency Table of Student Work Hours w/ Relative Frequency
DATA VALUE FREQUENCY RELATIVE FREQUENCY
2 3
3
20
or 0.15
3 5
5
20
or 0.25
4 3
3
20
or 0.15
5 6
6
20
or 0.30
6 2
2
20
or 0.10
7 1
1
20
or 0.05
Table 1.5
The sum of the relative frequency column is
20
20
, or 1.
Cumulative relative frequency is the accumulation of the previous relative frequencies. To find the cumu-
lative relative frequencies, add all the previous relative frequencies to the relative frequency for the current
row.
Frequency Table of Student Work Hours w/ Relative and Cumulative Relative Frequency
DATA VALUE FREQUENCY RELATIVE
FREQUENCY
CUMULATIVE RELA-
TIVE
FREQUENCY
continued on next page
28 CHAPTER 1. SAMPLING AND DATA
2 3
3
20
or 0.15 0.15
3 5
5
20
or 0.25 0.15 + 0.25 = 0.40
4 3
3
20
or 0.15 0.40 + 0.15 = 0.55
5 6
6
20
or 0.30 0.55 + 0.30 = 0.85
6 2
2
20
or 0.10 0.85 + 0.10 = 0.95
7 1
1
20
or 0.05 0.95 + 0.05 = 1.00
Table 1.6
The last entry of the cumulative relative frequency column is one, indicating that one hundred percent of
the data has been accumulated.
NOTE: Because of rounding, the relative frequency column may not always sumto one and the last
entry in the cumulative relative frequency column may not be one. However, they each should be
close to one.
The following table represents the heights, in inches, of a sample of 100 male semiprofessional soccer play-
ers.
Frequency Table of Soccer Player Height
HEIGHTS
(INCHES)
FREQUENCY RELATIVE
FREQUENCY
CUMULATIVE
RELATIVE
FREQUENCY
59.95 - 61.95 5
5
100
= 0.05 0.05
61.95 - 63.95 3
3
100
= 0.03 0.05 + 0.03 = 0.08
63.95 - 65.95 15
15
100
= 0.15 0.08 + 0.15 = 0.23
65.95 - 67.95 40
40
100
= 0.40 0.23 + 0.40 = 0.63
67.95 - 69.95 17
17
100
= 0.17 0.63 + 0.17 = 0.80
69.95 - 71.95 12
12
100
= 0.12 0.80 + 0.12 = 0.92
71.95 - 73.95 7
7
100
= 0.07 0.92 + 0.07 = 0.99
73.95 - 75.95 1
1
100
= 0.01 0.99 + 0.01 = 1.00
Total = 100 Total = 1.00
Table 1.7
The data in this table has been grouped into the following intervals:
• 59.95 - 61.95 inches
• 61.95 - 63.95 inches
• 63.95 - 65.95 inches
• 65.95 - 67.95 inches
• 67.95 - 69.95 inches
• 69.95 - 71.95 inches
• 71.95 - 73.95 inches
• 73.95 - 75.95 inches
29
NOTE: This example is used again in the Descriptive Statistics (Section 2.1) chapter, where the
method used to compute the intervals will be explained.
In this sample, there are 5 players whose heights are between 59.95 - 61.95 inches, 3 players whose heights
fall within the interval 61.95 - 63.95 inches, 15 players whose heights fall within the interval 63.95 - 65.95
inches, 40 players whose heights fall within the interval 65.95 - 67.95 inches, 17 players whose heights
fall within the interval 67.95 - 69.95 inches, 12 players whose heights fall within the interval 69.95 - 71.95,
7 players whose height falls within the interval 71.95 - 73.95, and 1 player whose height falls within the
interval 73.95 - 75.95. All heights fall between the endpoints of an interval and not at the endpoints.
Example 1.8
From the table, find the percentage of heights that are less than 65.95 inches.
Solution
If you look at the first, second, and third rows, the heights are all less than 65.95 inches. There are
5 + 3 + 15 = 23 males whose heights are less than 65.95 inches. The percentage of heights less than
65.95 inches is then
23
100
or 23%. This percentage is the cumulative relative frequency entry in the
third row.
Example 1.9
From the table, find the percentage of heights that fall between 61.95 and 65.95 inches.
Solution
Add the relative frequencies in the second and third rows: 0.03 + 0.15 = 0.18 or 18%.
Example 1.10
Use the table of heights of the 100 male semiprofessional soccer players. Fill in the blanks and
check your answers.
1. The percentage of heights that are from 67.95 to 71.95 inches is:
2. The percentage of heights that are from 67.95 to 73.95 inches is:
3. The percentage of heights that are more than 65.95 inches is:
4. The number of players in the sample who are between 61.95 and 71.95 inches tall is:
5. What kind of data are the heights?
6. Describe how you could gather this data (the heights) so that the data are characteristic of all
male semiprofessional soccer players.
Remember, you count frequencies. To find the relative frequency, divide the frequency by the
total number of data values. To find the cumulative relative frequency, add all of the previous
relative frequencies to the relative frequency for the current row.
1.9.1 Optional Collaborative Classroom Exercise
Exercise 1.9.1
In your class, have someone conduct a survey of the number of siblings (brothers and sisters) each
student has. Create a frequency table. Add to it a relative frequency column and a cumulative
relative frequency column. Answer the following questions:
30 CHAPTER 1. SAMPLING AND DATA
1. What percentage of the students in your class has 0 siblings?
2. What percentage of the students has from 1 to 3 siblings?
3. What percentage of the students has fewer than 3 siblings?
Example 1.11
Nineteen people were asked how many miles, to the nearest mile they commute to work each
day. The data are as follows:
2; 5; 7; 3; 2; 10; 18; 15; 20; 7; 10; 18; 5; 12; 13; 12; 4; 5; 10
The following table was produced:
Frequency of Commuting Distances
DATA FREQUENCY RELATIVEFREQUENCY CUMULATIVERELATIVEFREQUENCY
3 3
3
19
0.1579
4 1
1
19
0.2105
5 3
3
19
0.1579
7 2
2
19
0.2632
10 3
4
19
0.4737
12 2
2
19
0.7895
13 1
1
19
0.8421
15 1
1
19
0.8948
18 1
1
19
0.9474
20 1
1
19
1.0000
Table 1.8
Problem (Solution on p. 48.)
1. Is the table correct? If it is not correct, what is wrong?
2. True or False: Three percent of the people surveyed commute 3 miles. If the statement is not
correct, what should it be? If the table is incorrect, make the corrections.
3. What fraction of the people surveyed commute 5 or 7 miles?
4. What fraction of the people surveyed commute 12 miles or more? Less than 12 miles? Be-
tween 5 and 13 miles (does not include 5 and 13 miles)?
31
1.10 Summary
10
Statistics
• Deals with the collection, analysis, interpretation, and presentation of data
Probability
• Mathematical tool used to study randomness
Key Terms
• Population
• Parameter
• Sample
• Statistic
• Variable
• Data
Types of Data
• Quantitative Data (a number)
· Discrete (You count it.)
· Continuous (You measure it.)
• Qualitative Data (a category, words)
Sampling
• With Replacement: A member of the population may be chosen more than once
• Without Replacement: A member of the population may be chosen only once
Random Sampling
• Each member of the population has an equal chance of being selected
Sampling Methods
• Random
· Simple random sample
· Stratified sample
· Cluster sample
· Systematic sample
• Not Random
· Convenience sample
Frequency (freq. or f)
• The number of times an answer occurs
Relative Frequency (rel. freq. or RF)
• The proportion of times an answer occurs
• Can be interpreted as a fraction, decimal, or percent
Cumulative Relative Frequencies (cum. rel. freq. or cum RF)
• An accumulation of the previous relative frequencies
10
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32 CHAPTER 1. SAMPLING AND DATA
1.11 Practice: Sampling and Data
11
1.11.1 Student Learning Outcomes
• The student will construct frequency tables.
• The student will differentiate between key terms.
• The student will compare sampling techniques.
1.11.2 Given
Studies are often done by pharmaceutical companies to determine the effectiveness of a treatment program.
Suppose that a new AIDS antibody drug is currently under study. It is given to patients once the AIDS
symptoms have revealed themselves. Of interest is the average(mean) length of time in months patients
live once starting the treatment. Two researchers each follow a different set of 40 AIDS patients from the
start of treatment until their deaths. The following data (in months) are collected.
Researcher A 3; 4; 11; 15; 16; 17; 22; 44; 37; 16; 14; 24; 25; 15; 26; 27; 33; 29; 35; 44; 13; 21; 22; 10; 12; 8; 40; 32;
26; 27; 31; 34; 29; 17; 8; 24; 18; 47; 33; 34
Researcher B 3; 14; 11; 5; 16; 17; 28; 41; 31; 18; 14; 14; 26; 25; 21; 22; 31; 2; 35; 44; 23; 21; 21; 16; 12; 18; 41; 22;
16; 25; 33; 34; 29; 13; 18; 24; 23; 42; 33; 29
1.11.3 Organize the Data
Complete the tables below using the data provided.
Researcher A
Survival
Length
(in
months)
Frequency Relative Frequency Cumulative Relative Fre-
quency
0.5 - 6.5
6.5 -
12.5
12.5 -
18.5
18.5 -
24.5
24.5 -
30.5
continued on next page
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33
30.5 -
36.5
36.5 -
42.5
42.5 -
48.5
Table 1.9
Researcher B
Survival Length (in
months)
Frequency Relative Frequency Cumulative Relative Fre-
quency
0.5 - 6.5
6.5 - 12.5
12.5 - 18.5
18.5 - 24.5
24.5 - 30.5
30.5 - 36.5
36.5 - 42.5
42.5 - 48.5
Table 1.10
1.11.4 Key Terms
Define the key terms based upon the above example for Researcher A.
Exercise 1.11.1
Population
Exercise 1.11.2
Sample
Exercise 1.11.3
Parameter
Exercise 1.11.4
Statistic
Exercise 1.11.5
Variable
Exercise 1.11.6
Data
34 CHAPTER 1. SAMPLING AND DATA
1.11.5 Discussion Questions
Discuss the following questions and then answer in complete sentences.
Exercise 1.11.7
List two reasons why the data may differ.
Exercise 1.11.8
Can you tell if one researcher is correct and the other one is incorrect? Why?
Exercise 1.11.9
Would you expect the data to be identical? Why or why not?
Exercise 1.11.10
How could the researchers gather random data?
Exercise 1.11.11
Suppose that the first researcher conducted his survey by randomly choosing one state in the
nation and then randomly picking 40 patients from that state. What sampling method would that
researcher have used?
Exercise 1.11.12
Suppose that the second researcher conducted his survey by choosing 40 patients he knew. What
sampling method would that researcher have used? What concerns would you have about this
data set, based upon the data collection method?
35
1.12 Homework
12
Exercise 1.12.1 (Solution on p. 48.)
For each item below:
i. Identify the type of data (quantitative - discrete, quantitative - continuous, or qualitative) that
would be used to describe a response.
ii. Give an example of the data.
a. Number of tickets sold to a concert
b. Amount of body fat
c. Favorite baseball team
d. Time in line to buy groceries
e. Number of students enrolled at Evergreen Valley College
f. Most–watched television show
g. Brand of toothpaste
h. Distance to the closest movie theatre
i. Age of executives in Fortune 500 companies
j. Number of competing computer spreadsheet software packages
Exercise 1.12.2
Fifty part-time students were asked how many courses they were taking this term. The (incom-
plete) results are shown below:
Part-time Student Course Loads
# of Courses Frequency Relative Frequency Cumulative Relative
Frequency
1 30 0.6
2 15
3
Table 1.11
a. Fill in the blanks in the table above.
b. What percent of students take exactly two courses?
c. What percent of students take one or two courses?
Exercise 1.12.3 (Solution on p. 48.)
Sixty adults with gum disease were asked the number of times per week they used to floss before
their diagnoses. The (incomplete) results are shown below:
Flossing Frequency for Adults with Gum Disease
# Flossing per Week Frequency Relative Frequency Cumulative Relative Freq.
0 27 0.4500
1 18
3 0.9333
6 3 0.0500
7 1 0.0167
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36 CHAPTER 1. SAMPLING AND DATA
Table 1.12
a. Fill in the blanks in the table above.
b. What percent of adults flossed six times per week?
c. What percent flossed at most three times per week?
Exercise 1.12.4
Afitness center is interested in the mean amount of time a client exercises in the center each week.
Define the following in terms of the study. Give examples where appropriate.
a. Population
b. Sample
c. Parameter
d. Statistic
e. Variable
f. Data
Exercise 1.12.5 (Solution on p. 48.)
Ski resorts are interested in the mean age that children take their first ski and snowboard lessons.
They need this information to optimally plan their ski classes. Define the following in terms of the
study. Give examples where appropriate.
a. Population
b. Sample
c. Parameter
d. Statistic
e. Variable
f. Data
Exercise 1.12.6
A cardiologist is interested in the mean recovery period for her patients who have had heart
attacks. Define the following in terms of the study. Give examples where appropriate.
a. Population
b. Sample
c. Parameter
d. Statistic
e. Variable
f. Data
Exercise 1.12.7 (Solution on p. 49.)
Insurance companies are interested in the mean health costs each year for their clients, so that
they can determine the costs of health insurance. Define the following in terms of the study. Give
examples where appropriate.
a. Population
b. Sample
c. Parameter
d. Statistic
e. Variable
f. Data
37
Exercise 1.12.8
A politician is interested in the proportion of voters in his district that think he is doing a good
job. Define the following in terms of the study. Give examples where appropriate.
a. Population
b. Sample
c. Parameter
d. Statistic
e. Variable
f. Data
Exercise 1.12.9 (Solution on p. 49.)
A marriage counselor is interested in the proportion the clients she counsels that stay married.
Define the following in terms of the study. Give examples where appropriate.
a. Population
b. Sample
c. Parameter
d. Statistic
e. Variable
f. Data
Exercise 1.12.10
Political pollsters may be interested in the proportion of people that will vote for a particular
cause. Define the following in terms of the study. Give examples where appropriate.
a. Population
b. Sample
c. Parameter
d. Statistic
e. Variable
f. Data
Exercise 1.12.11 (Solution on p. 49.)
A marketing company is interested in the proportion of people that will buy a particular product.
Define the following in terms of the study. Give examples where appropriate.
a. Population
b. Sample
c. Parameter
d. Statistic
e. Variable
f. Data
Exercise 1.12.12
Airline companies are interested in the consistency of the number of babies on each flight, so that
they have adequate safety equipment. Suppose an airline conducts a survey. Over Thanksgiving
weekend, it surveys 6 flights from Boston to Salt Lake City to determine the number of babies on
the flights. It determines the amount of safety equipment needed by the result of that study.
a. Using complete sentences, list three things wrong with the way the survey was conducted.
b. Using complete sentences, list three ways that you would improve the survey if it were to be
repeated.
38 CHAPTER 1. SAMPLING AND DATA
Exercise 1.12.13
Suppose you want to determine the mean number of students per statistics class in your state.
Describe a possible sampling method in 3 – 5 complete sentences. Make the description detailed.
Exercise 1.12.14
Suppose you want to determine the mean number of cans of soda drunk each month by persons
in their twenties. Describe a possible sampling method in 3 - 5 complete sentences. Make the
description detailed.
Exercise 1.12.15 (Solution on p. 49.)
771 distance learning students at Long Beach City College responded to surveys in the 2010-
11 academic year. Highlights of the summary report are listed in the table below. (Source:
http://de.lbcc.edu/reports/2010-11/future/highlights.html#focus).
LBCC Distance Learning Survey Results
Have computer at home 96%
Unable to come to campus for classes 65%
Age 41 or over 24%
Would like LBCC to offer more DL courses 95%
Took DL classes due to a disability 17%
Live at least 16 miles from campus 13%
Took DL courses to fulfill transfer requirements 71%
Table 1.13
a. What percent of the students surveyed do not have a computer at home?
b. About how many students in the survey live at least 16 miles from campus?
c. If the same survey was done at Great Basin College in Elko, Nevada, do you think the percent-
ages would be the same? Why?
Exercise 1.12.16
Nineteen immigrants to the U.S were asked how many years, to the nearest year, they have lived
in the U.S. The data are as follows:
2; 5; 7; 2; 2; 10; 20; 15; 0; 7; 0; 20; 5; 12; 15; 12; 4; 5; 10
The following table was produced:
39
Frequency of Immigrant Survey Responses
Data Frequency Relative Frequency Cumulative Relative Frequency
0 2
2
19
0.1053
2 3
3
19
0.2632
4 1
1
19
0.3158
5 3
3
19
0.1579
7 2
2
19
0.5789
10 2
2
19
0.6842
12 2
2
19
0.7895
15 1
1
19
0.8421
20 1
1
19
1.0000
Table 1.14
a. Fix the errors on the table. Also, explain how someone might have arrived at the incorrect
number(s).
b. Explain what is wrong with this statement: “47 percent of the people surveyed have lived in
the U.S. for 5 years.”
c. Fix the statement above to make it correct.
d. What fraction of the people surveyed have lived in the U.S. 5 or 7 years?
e. What fraction of the people surveyed have lived in the U.S. at most 12 years?
f. What fraction of the people surveyed have lived in the U.S. fewer than 12 years?
g. What fraction of the people surveyed have lived in the U.S. from 5 to 20 years, inclusive?
Exercise 1.12.17
A “random survey” was conducted of 3274 people of the “microprocessor generation” (people
born since 1971, the year the microprocessor was invented). It was reported that 48% of those
individuals surveyed stated that if they had $2000 to spend, they would use it for computer
equipment. Also, 66% of those surveyed considered themselves relatively savvy computer users.
(Source: San Jose Mercury News)
a. Do you consider the sample size large enough for a study of this type? Why or why not?
b. Based on your “gut feeling,” do you believe the percents accurately reflect the U.S. population
for those individuals born since 1971? If not, do you think the percents of the population are
actually higher or lower than the sample statistics? Why?
Additional information: The survey was reported by Intel Corporation of individuals who visited
the Los Angeles Convention Center to see the Smithsonian Institure’s road showcalled “America’s
Smithsonian.”
c. With this additional information, do you feel that all demographic and ethnic groups were
equally represented at the event? Why or why not?
d. With the additional information, comment on how accurately you think the sample statistics
reflect the population parameters.
Exercise 1.12.18
40 CHAPTER 1. SAMPLING AND DATA
a. List some practical difficulties involved in getting accurate results from a telephone survey.
b. List some practical difficulties involved in getting accurate results from a mailed survey.
c. With your classmates, brainstorm some ways to overcome these problems if you needed to
conduct a phone or mail survey.
1.12.1 Try these multiple choice questions
The next four questions refer to the following: A Lake Tahoe Community College instructor is interested
in the mean number of days Lake Tahoe Community College math students are absent from class during a
quarter.
Exercise 1.12.19 (Solution on p. 49.)
What is the population she is interested in?
A. All Lake Tahoe Community College students
B. All Lake Tahoe Community College English students
C. All Lake Tahoe Community College students in her classes
D. All Lake Tahoe Community College math students
Exercise 1.12.20 (Solution on p. 49.)
Consider the following:
X = number of days a Lake Tahoe Community College math student is absent
In this case, X is an example of a:
A. Variable
B. Population
C. Statistic
D. Data
Exercise 1.12.21 (Solution on p. 49.)
The instructor takes her sample by gathering data on 5 randomly selected students from each
Lake Tahoe Community College math class. The type of sampling she used is
A. Cluster sampling
B. Stratified sampling
C. Simple random sampling
D. Convenience sampling
Exercise 1.12.22 (Solution on p. 49.)
The instructor’s sample produces an mean number of days absent of 3.5 days. This value is an
example of a
A. Parameter
B. Data
C. Statistic
D. Variable
The next two questions refer to the following relative frequency table on hurricanes that have made direct
hits on the U.S between 1851 and 2004. Hurricanes are given a strength category rating based on the
minimum wind speed generated by the storm. (http://www.nhc.noaa.gov/gifs/table5.gif
13
)
13
http://www.nhc.noaa.gov/gifs/table5.gif
41
Frequency of Hurricane Direct Hits
Category Number of Direct Hits Relative Frequency Cumulative Frequency
1 109 0.3993 0.3993
2 72 0.2637 0.6630
3 71 0.2601
4 18 0.9890
5 3 0.0110 1.0000
Total = 273
Table 1.15
Exercise 1.12.23 (Solution on p. 49.)
What is the relative frequency of direct hits that were category 4 hurricanes?
A. 0.0768
B. 0.0659
C. 0.2601
D. Not enough information to calculate
Exercise 1.12.24 (Solution on p. 49.)
What is the relative frequency of direct hits that were AT MOST a category 3 storm?
A. 0.3480
B. 0.9231
C. 0.2601
D. 0.3370
The next three questions refer to the following: A study was done to determine the age, number of times
per week and the duration (amount of time) of resident use of a local park in San Jose. The first house in
the neighborhood around the park was selected randomly and then every 8th house in the neighborhood
around the park was interviewed.
Exercise 1.12.25 (Solution on p. 49.)
“‘Number of times per week”’ is what type of data?
A. qualitative
B. quantitative - discrete
C. quantitative - continuous
Exercise 1.12.26 (Solution on p. 49.)
The sampling method was:
A. simple random
B. systematic
C. stratified
D. cluster
Exercise 1.12.27 (Solution on p. 49.)
“‘Duration (amount of time)”’ is what type of data?
42 CHAPTER 1. SAMPLING AND DATA
A. qualitative
B. quantitative - discrete
C. quantitative - continuous
Exercises 28 and 29 are not multiple choice exercises.
Exercise 1.12.28 (Solution on p. 49.)
Name the sampling method used in each of the following situations:
A. A woman in the airport is handing out questionnaires to travelers asking them to evaluate the
airport’s service. She does not ask travelers who are hurrying through the airport with their
hands full of luggage, but instead asks all travelers sitting near gates and who are not taking
naps while they wait.
B. A teacher wants to know if her students are doing homework so she randomly selects rows 2
and 5, and then calls on all students in row 2 and all students in row 5 to present the solution
to homework problems to the class.
C. The marketing manager for an electronics chain store wants information about the ages of its
customers. Over the next two weeks, at each store location, 100 randomly selected customers
are given questionnaires to fill out which asks for information about age, as well as about
other variables of interest.
D. The librarian at a public library wants to determine what proportion of the library users are
children. The librarian has a tally sheet on which she marks whether the books are checked
out by an adult or a child. She records this data for every 4th patron who checks out books.
E. A political party wants to know the reaction of voters to a debate between the candidates. The
day after the debate, the party’s polling staff calls 1200 randomly selected phone numbers.
If a registered voter answers the phone or is available to come to the phone, that registered
voter is asked who he/she intends to vote for and whether the debate changed his/her
opinion of the candidates.
** Contributed by Roberta Bloom
Exercise 1.12.29 (Solution on p. 50.)
Several online textbook retailers advertise that they have lower prices than on-campus book-
stores. However, an important factor is whether the internet retailers actually have the textbooks
that students need in stock. Students need to be able to get textbooks promptly at the beginning of
the college term. If the book is not available, then a student would not be able to get the textbook
at all, or might get a delayed delivery if the book is back ordered.
A college newspaper reporter is investigating textbook availability at online retailers. He
decides to investigate one textbook for each of the following 7 subjects: calculus, biology,
chemistry, physics, statistics, geology, and general engineering. He consults textbook industry
sales data and selects the most popular nationally used textbook in each of these subjects. He
visits websites for a random sample of major online textbook sellers and looks up each of these 7
textbooks to see if they are available in stock for quick delivery through these retailers. Based on
his investigation, he writes an article in which he draws conclusions about the overall availability
of all college textbooks through online textbook retailers.
Write an analysis of his study that addresses the following issues: Is his sample representa-
tive of the population of all college textbooks? Explain why or why not. Describe some possible
sources of bias in this study, and how it might affect the results of the study. Give some sugges-
tions about what could be done to improve the study.
** Contributed by Roberta Bloom
43
1.13 Lab 1: Data Collection
14
Class Time:
Names:
1.13.1 Student Learning Outcomes
• The student will demonstrate the systematic sampling technique.
• The student will construct Relative Frequency Tables.
• The student will interpret results and their differences from different data groupings.
1.13.2 Movie Survey
Ask five classmates from a different class how many movies they saw last month at the theater. Do not
include rented movies.
1. Record the data
2. In class, randomly pick one person. On the class list, mark that person’s name. Move down four
people’s names on the class list. Mark that person’s name. Continue doing this until you have marked
12 people’s names. You may need to go back to the start of the list. For each marked name record
below the five data values. You now have a total of 60 data values.
3. For each name marked, record the data:
______ ______ ______ ______ ______ ______ ______ ______ ______ ______
______ ______ ______ ______ ______ ______ ______ ______ ______ ______
______ ______ ______ ______ ______ ______ ______ ______ ______ ______
______ ______ ______ ______ ______ ______ ______ ______ ______ ______
______ ______ ______ ______ ______ ______ ______ ______ ______ ______
______ ______ ______ ______ ______ ______ ______ ______ ______ ______
Table 1.16
1.13.3 Order the Data
Complete the two relative frequency tables below using your class data.
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44 CHAPTER 1. SAMPLING AND DATA
Frequency of Number of Movies Viewed
Number of Movies Frequency Relative Frequency Cumulative Relative Frequency
0
1
2
3
4
5
6
7+
Table 1.17
Frequency of Number of Movies Viewed
Number of Movies Frequency Relative Frequency Cumulative Relative Frequency
0-1
2-3
4-5
6-7+
Table 1.18
1. Using the tables, find the percent of data that is at most 2. Which table did you use and why?
2. Using the tables, find the percent of data that is at most 3. Which table did you use and why?
3. Using the tables, find the percent of data that is more than 2. Which table did you use and why?
4. Using the tables, find the percent of data that is more than 3. Which table did you use and why?
1.13.4 Discussion Questions
1. Is one of the tables above "more correct" than the other? Why or why not?
2. In general, why would someone group the data in different ways? Are there any advantages to either
way of grouping the data?
3. Why did you switch between tables, if you did, when answering the question above?
45
1.14 Lab 2: Sampling Experiment
15
Class Time:
Names:
1.14.1 Student Learning Outcomes
• The student will demonstrate the simple random, systematic, stratified, and cluster sampling tech-
niques.
• The student will explain each of the details of each procedure used.
In this lab, you will be asked to pick several random samples. In each case, describe your procedure briefly,
including how you might have used the random number generator, and then list the restaurants in the
sample you obtained
NOTE: The following section contains restaurants stratified by city into columns and grouped
horizontally by entree cost (clusters).
1.14.2 A Simple Random Sample
Pick a simple random sample of 15 restaurants.
1. Describe the procedure:
2.
1. __________ 6. __________ 11. __________
2. __________ 7. __________ 12. __________
3. __________ 8. __________ 13. __________
4. __________ 9. __________ 14. __________
5. __________ 10. __________ 15. __________
Table 1.19
1.14.3 A Systematic Sample
Pick a systematic sample of 15 restaurants.
1. Describe the procedure:
2.
1. __________ 6. __________ 11. __________
2. __________ 7. __________ 12. __________
3. __________ 8. __________ 13. __________
4. __________ 9. __________ 14. __________
5. __________ 10. __________ 15. __________
Table 1.20
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46 CHAPTER 1. SAMPLING AND DATA
1.14.4 A Stratified Sample
Pick a stratified sample, by city, of 20 restaurants. Use 25% of the restaurants from each stratum. Round to
the nearest whole number.
1. Describe the procedure:
2.
1. __________ 6. __________ 11. __________ 16. __________
2. __________ 7. __________ 12. __________ 17. __________
3. __________ 8. __________ 13. __________ 18. __________
4. __________ 9. __________ 14. __________ 19. __________
5. __________ 10. __________ 15. __________ 20. __________
Table 1.21
1.14.5 A Stratified Sample
Pick a stratified sample, by entree cost, of 21 restaurants. Use 25% of the restaurants from each stratum.
Round to the nearest whole number.
1. Describe the procedure:
2.
1. __________ 6. __________ 11. __________ 16. __________
2. __________ 7. __________ 12. __________ 17. __________
3. __________ 8. __________ 13. __________ 18. __________
4. __________ 9. __________ 14. __________ 19. __________
5. __________ 10. __________ 15. __________ 20. __________
21. __________
Table 1.22
1.14.6 A Cluster Sample
Pick a cluster sample of restaurants from two cities. The number of restaurants will vary.
1. Describe the procedure:
2.
1. __________ 6. __________ 11. __________ 16. __________ 21. __________
2. __________ 7. __________ 12. __________ 17. __________ 22. __________
3. __________ 8. __________ 13. __________ 18. __________ 23. __________
4. __________ 9. __________ 14. __________ 19. __________ 24. __________
5. __________ 10. __________ 15. __________ 20. __________ 25. __________
Table 1.23
1.14.7 Restaurants Stratified by City and Entree Cost
Restaurants Used in Sample
47
Entree Cost → Under $10 $10 to under $15 $15 to under $20 Over $20
San Jose El Abuelo Taq,
Pasta Mia,
Emma’s Express,
Bamboo Hut
Emperor’s Guard,
Creekside Inn
Agenda, Gervais,
Miro’s
Blake’s, Eulipia,
Hayes Mansion,
Germania
Palo Alto Senor Taco, Olive
Garden, Taxi’s
Ming’s, P.A. Joe’s,
Stickney’s
Scott’s Seafood,
Poolside Grill,
Fish Market
Sundance Mine,
Maddalena’s,
Spago’s
Los Gatos Mary’s Patio,
Mount Everest,
Sweet Pea’s,
Andele Taqueria
Lindsey’s, Willow
Street
Toll House Charter House, La
Maison Du Cafe
Mountain View Maharaja, New
Ma’s, Thai-Rific,
Garden Fresh
Amber Indian, La
Fiesta, Fiesta del
Mar, Dawit
Austin’s, Shiva’s,
Mazeh
Le Petit Bistro
Cupertino Hobees, Hung Fu,
Samrat, Panda Ex-
press
Santa Barb. Grill,
Mand. Gourmet,
Bombay Oven,
Kathmandu West
Fontana’s, Blue
Pheasant
Hamasushi, He-
lios
Sunnyvale Chekijababi, Taj
India, Full Throt-
tle, Tia Juana,
Lemon Grass
Pacific Fresh,
Charley Brown’s,
Cafe Cameroon,
Faz, Aruba’s
Lion & Compass,
The Palace, Beau
Sejour
Santa Clara Rangoli, Ar-
madillo Willy’s,
Thai Pepper,
Pasand
Arthur’s, Katie’s
Cafe, Pedro’s, La
Galleria
Birk’s, Truya
Sushi, Valley
Plaza
Lakeside, Mari-
ani’s
Table 1.24
NOTE: The original lab was designed and contributed by Carol Olmstead.
48 CHAPTER 1. SAMPLING AND DATA
Solutions to Exercises in Chapter 1
Solution to Example 1.5, Problem (p. 18)
Items 1, 5, 11, and 12 are quantitative discrete; items 4, 6, 10, and 14 are quantitative continuous; and items
2, 3, 7, 8, 9, and 13 are qualitative.
Solution to Example 1.10, Problem (p. 29)
1. 29%
2. 36%
3. 77%
4. 87
5. quantitative continuous
6. get rosters from each team and choose a simple random sample from each
Solution to Example 1.11, Problem (p. 30)
1. No. Frequency column sums to 18, not 19. Not all cumulative relative frequencies are correct.
2. False. Frequency for 3 miles should be 1; for 2 miles (left out), 2. Cumulative relative frequency
column should read: 0.1052, 0.1579, 0.2105, 0.3684, 0.4737, 0.6316, 0.7368, 0.7895, 0.8421, 0.9474, 1.
3.
5
19
4.
7
19
,
12
19
,
7
19
Solutions to Homework
Solution to Exercise 1.12.1 (p. 35)
a. quantitative - discrete
b. quantitative - continuous
c. qualitative
d. quantitative - continuous
e. quantitative - discrete
f. qualitative
g. qualitative
h. quantitative - continuous
i. quantitative - continuous
j. quantitative - discrete
Solution to Exercise 1.12.3 (p. 35)
a. Cum. Rel. Freq. for 0 is 0.4500
Rel. Freq. for 1 is 0.3000 and Cum. Rel. Freq. for 1 or less is 0.7500
Freq. for 3 is 11 and Rel. Freq. is 0.1833
Cum. Rel. Freq. for 6 or less is 0.9833
Cum. Rel. Freq. for 7 or less is 1
b. 5.00%
c. 93.33%
Solution to Exercise 1.12.5 (p. 36)
a. Children who take ski or snowboard lessons
b. A group of these children
c. The population mean
d. The sample mean
e. X = the age of one child who takes the first ski or snowboard lesson
49
f. Values for X, such as 3, 7, etc.
Solution to Exercise 1.12.7 (p. 36)
a. The clients of the insurance companies
b. A group of the clients
c. The mean health costs of the clients
d. The mean health costs of the sample
e. X = the health costs of one client
f. Values for X, such as 34, 9, 82, etc.
Solution to Exercise 1.12.9 (p. 37)
a. All the clients of the counselor
b. A group of the clients
c. The proportion of all her clients who stay married
d. The proportion of the sample who stay married
e. X = the number of couples who stay married
f. yes, no
Solution to Exercise 1.12.11 (p. 37)
a. All people (maybe in a certain geographic area, such as the United States)
b. A group of the people
c. The proportion of all people who will buy the product
d. The proportion of the sample who will buy the product
e. X = the number of people who will buy it
f. buy, not buy
Solution to Exercise 1.12.15 (p. 38)
a: 4%
b: 100
Solution to Exercise 1.12.19 (p. 40)
D
Solution to Exercise 1.12.20 (p. 40)
A
Solution to Exercise 1.12.21 (p. 40)
B
Solution to Exercise 1.12.22 (p. 40)
C
Solution to Exercise 1.12.23 (p. 41)
B
Solution to Exercise 1.12.24 (p. 41)
B
Solution to Exercise 1.12.25 (p. 41)
B
Solution to Exercise 1.12.26 (p. 41)
B
Solution to Exercise 1.12.27 (p. 41)
C
Solution to Exercise 1.12.28 (p. 42)
A. Convenience
50 CHAPTER 1. SAMPLING AND DATA
B. Cluster
C. Stratified
D. Systematic
E. Simple Random
Solution to Exercise 1.12.29 (p. 42)
The answer below contains some of the issues that students might discuss for this problem. Individual
student’s answers may also identify other issues that pertain to this problem that are not included in the
answer below.
The sample is not representative of the population of all college textbooks. Two reasons why it is
not representative are that he only sampled 7 subjects and he only investigated one textbook in each
subject. There are several possible sources of bias in the study. The 7 subjects that he investigated are
all in mathematics and the sciences; there are many subjects in the humanities, social sciences, and many
other subject areas, (for example: literature, art, history, psychology, sociology, business) that he did not
investigate at all. It may be that different subject areas exhibit different patterns of textbook availability,
but his sample would not detect such results.
He also only looked at the most popular textbook in each of the subjects he investigated. The avail-
ability of the most popular textbooks may differ from the availability of other textbooks in one of two
ways:
• the most popular textbooks may be more readily available online, because more new copies are
printed and more students nationwide selling back their used copies OR
• the most popular textbooks may be harder to find available online, because more student demand
exhausts the supply more quickly.
In reality, many college students do not use the most popular textbook in their subject, and this study gives
no useful information about the situation for those less popular textbooks.
He could improve this study by
• expanding the selection of subjects he investigates so that it is more representative of all subjects
studied by college students and
• expanding the selection of textbooks he investigates within each subject to include a mixed represen-
tation of both the popular and less popular textbooks.
Chapter 2
Descriptive Statistics
2.1 Descriptive Statistics
1
2.1.1 Student Learning Outcomes
By the end of this chapter, the student should be able to:
• Display data graphically and interpret graphs: stemplots, histograms and boxplots.
• Recognize, describe, and calculate the measures of location of data: quartiles and percentiles.
• Recognize, describe, and calculate the measures of the center of data: mean, median, and mode.
• Recognize, describe, and calculate the measures of the spread of data: variance, standard deviation,
and range.
2.1.2 Introduction
Once you have collected data, what will you do with it? Data can be described and presented in many
different formats. For example, suppose you are interested in buying a house in a particular area. You may
have no clue about the house prices, so you might ask your real estate agent to give you a sample data set
of prices. Looking at all the prices in the sample often is overwhelming. A better way might be to look
at the median price and the variation of prices. The median and variation are just two ways that you will
learn to describe data. Your agent might also provide you with a graph of the data.
In this chapter, you will study numerical and graphical ways to describe and display your data. This area
of statistics is called "Descriptive Statistics". You will learn to calculate, and even more importantly, to
interpret these measurements and graphs.
2.2 Displaying Data
2
A statistical graph is a tool that helps you learn about the shape or distribution of a sample. The graph can
be a more effective way of presenting data than a mass of numbers because we can see where data clusters
and where there are only a few data values. Newspapers and the Internet use graphs to show trends and
to enable readers to compare facts and figures quickly.
Statisticians often graph data first to get a picture of the data. Then, more formal tools may be applied.
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52 CHAPTER 2. DESCRIPTIVE STATISTICS
Some of the types of graphs that are used to summarize and organize data are the dot plot, the bar chart,
the histogram, the stem-and-leaf plot, the frequency polygon (a type of broken line graph), pie charts, and
the boxplot. In this chapter, we will briefly look at stem-and-leaf plots, line graphs and bar graphs. Our
emphasis will be on histograms and boxplots.
2.3 Stem and Leaf Graphs (Stemplots), Line Graphs and Bar Graphs
3
One simple graph, the stem-and-leaf graph or stemplot, comes fromthe field of exploratory data analysis.It
is a good choice when the data sets are small. To create the plot, divide each observation of data into a stem
and a leaf. The leaf consists of a final significant digit. For example, 23 has stem 2 and leaf 3. Four hundred
thirty-two (432) has stem43 and leaf 2. Five thousand four hundred thirty-two (5,432) has stem543 and leaf
2. The decimal 9.3 has stem 9 and leaf 3. Write the stems in a vertical line from smallest the largest. Draw a
vertical line to the right of the stems. Then write the leaves in increasing order next to their corresponding
stem.
Example 2.1
For Susan Dean’s spring pre-calculus class, scores for the first exam were as follows (smallest to
largest):
33; 42; 49; 49; 53; 55; 55; 61; 63; 67; 68; 68; 69; 69; 72; 73; 74; 78; 80; 83; 88; 88; 88; 90; 92; 94; 94; 94; 94;
96; 100
Stem-and-Leaf Diagram
Stem Leaf
3 3
4 299
5 355
6 1378899
7 2348
8 03888
9 0244446
10 0
Table 2.1
The stemplot shows that most scores fell in the 60s, 70s, 80s, and 90s. Eight out of the 31 scores or
approximately 26% of the scores were in the 90’s or 100, a fairly high number of As.
The stemplot is a quick way to graph and gives an exact picture of the data. You want to look for an overall
pattern and any outliers. An outlier is an observation of data that does not fit the rest of the data. It is
sometimes called an extreme value. When you graph an outlier, it will appear not to fit the pattern of the
graph. Some outliers are due to mistakes (for example, writing down 50 instead of 500) while others may
indicate that something unusual is happening. It takes some background information to explain outliers.
In the example above, there were no outliers.
Example 2.2
Create a stem plot using the data:
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53
1.1; 1.5; 2.3; 2.5; 2.7; 3.2; 3.3; 3.3; 3.5; 3.8; 4.0; 4.2; 4.5; 4.5; 4.7; 4.8; 5.5; 5.6; 6.5; 6.7; 12.3
The data are the distance (in kilometers) from a home to the nearest supermarket.
Problem (Solution on p. 105.)
1. Are there any outliers?
2. Do the data seem to have any concentration of values?
HINT: The leaves are to the right of the decimal.
Another type of graph that is useful for specific data values is a line graph. In the particular line graph
shown in the example, the x-axis consists of data values and the y-axis consists of frequency points. The
frequency points are connected.
Example 2.3
In a survey, 40 mothers were asked how many times per week a teenager must be reminded to do
his/her chores. The results are shown in the table and the line graph.
Number of times teenager is reminded Frequency
0 2
1 5
2 8
3 14
4 7
5 4
Table 2.2
Bar graphs consist of bars that are separated from each other. The bars can be rectangles or they can be
rectangular boxes and they can be vertical or horizontal.
The bar graph shown in Example 4 has age groups represented on the x-axis and proportions on the y-axis.
54 CHAPTER 2. DESCRIPTIVE STATISTICS
Example 2.4
By the end of 2011, in the United States, Facebook had over 146 million users. The table
shows three age groups, the number of users in each age group and the proportion (%) of
users in each age group. Source: http://www.kenburbary.com/2011/03/facebook-demographics-
revisited-2011-statistics-2/
Age groups Number of Facebook users Proportion (%) of Facebook users
13 - 25 65,082,280 45%
26 - 44 53,300,200 36%
45 - 64 27,885,100 19%
Table 2.3
Example 2.5
The columns in the table below contain the race/ethnicity of U.S. Public Schools: High School
Class of 2011, percentages for the Advanced Placement Examinee Population for that class
and percentages for the Overall Student Population. The 3-dimensional graph shows the
Race/Ethnicity of U.S. Public Schools (qualitative data) on the x-axis and Advanced Placement
Examinee Population percentages on the y-axis. (Source: http://www.collegeboard.com and
Source: http://apreport.collegeboard.org/goals-and-findings/promoting-equity)
Race/Ethnicity AP Examinee Population Overall Student Population
1 = Asian, Asian American or Pa-
cific Islander
10.3% 5.7%
continued on next page
55
2 = Black or African American 9.0% 14.7%
3 = Hispanic or Latino 17.0% 17.6%
4 = American Indian or Alaska
Native
0.6% 1.1%
5 = White 57.1% 59.2%
6 = Not reported/other 6.0% 1.7%
Table 2.4
Go to Outcomes of Education Figure 22
4
for an example of a bar graph that shows unemployment rates of
persons 25 years and older for 2009.
NOTE: This book contains instructions for constructing a histogram and a box plot for the TI-83+
and TI-84 calculators. You can find additional instructions for using these calculators on the Texas
Instruments (TI) website
5
.
2.4 Histograms
6
For most of the work you do in this book, you will use a histogram to display the data. One advantage of a
histogram is that it can readily display large data sets. A rule of thumb is to use a histogram when the data
set consists of 100 values or more.
A histogram consists of contiguous boxes. It has both a horizontal axis and a vertical axis. The horizontal
axis is labeled with what the data represents (for instance, distance from your home to school). The vertical
axis is labeled either Frequency or relative frequency. The graph will have the same shape with either
label. The histogram (like the stemplot) can give you the shape of the data, the center, and the spread of the
data. (The next section tells you how to calculate the center and the spread.)
4
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56 CHAPTER 2. DESCRIPTIVE STATISTICS
The relative frequency is equal to the frequency for an observed value of the data divided by the total
number of data values in the sample. (In the chapter on Sampling and Data (Section 1.1), we defined
frequency as the number of times an answer occurs.) If:
• f = frequency
• n = total number of data values (or the sum of the individual frequencies), and
• RF = relative frequency,
then:
RF =
f
n
(2.1)
For example, if 3 students in Mr. Ahab’s English class of 40 students received from 90% to 100%, then,
f = 3 , n = 40 , and RF =
f
n
=
3
40
= 0.075
Seven and a half percent of the students received 90% to 100%. Ninety percent to 100 % are quantitative
measures.
To construct a histogram, first decide how many bars or intervals, also called classes, represent the data.
Many histograms consist of from 5 to 15 bars or classes for clarity. Choose a starting point for the first
interval to be less than the smallest data value. A convenient starting point is a lower value carried out
to one more decimal place than the value with the most decimal places. For example, if the value with the
most decimal places is 6.1 and this is the smallest value, a convenient starting point is 6.05 (6.1 - 0.05 = 6.05).
We say that 6.05 has more precision. If the value with the most decimal places is 2.23 and the lowest value
is 1.5, a convenient starting point is 1.495 (1.5 - 0.005 = 1.495). If the value with the most decimal places is
3.234 and the lowest value is 1.0, a convenient starting point is 0.9995 (1.0 - .0005 = 0.9995). If all the data
happen to be integers and the smallest value is 2, then a convenient starting point is 1.5 (2 - 0.5 = 1.5). Also,
when the starting point and other boundaries are carried to one additional decimal place, no data value
will fall on a boundary.
Example 2.6
The following data are the heights (in inches to the nearest half inch) of 100 male semiprofessional
soccer players. The heights are continuous data since height is measured.
60; 60.5; 61; 61; 61.5
63.5; 63.5; 63.5
64; 64; 64; 64; 64; 64; 64; 64.5; 64.5; 64.5; 64.5; 64.5; 64.5; 64.5; 64.5
66; 66; 66; 66; 66; 66; 66; 66; 66; 66; 66.5; 66.5; 66.5; 66.5; 66.5; 66.5; 66.5; 66.5; 66.5; 66.5; 66.5; 67; 67;
67; 67; 67; 67; 67; 67; 67; 67; 67; 67; 67.5; 67.5; 67.5; 67.5; 67.5; 67.5; 67.5
68; 68; 69; 69; 69; 69; 69; 69; 69; 69; 69; 69; 69.5; 69.5; 69.5; 69.5; 69.5
70; 70; 70; 70; 70; 70; 70.5; 70.5; 70.5; 71; 71; 71
72; 72; 72; 72.5; 72.5; 73; 73.5
74
The smallest data value is 60. Since the data with the most decimal places has one decimal (for
instance, 61.5), we want our starting point to have two decimal places. Since the numbers 0.5,
0.05, 0.005, etc. are convenient numbers, use 0.05 and subtract it from 60, the smallest value, for
the convenient starting point.
57
60 - 0.05 = 59.95 which is more precise than, say, 61.5 by one decimal place. The starting point is,
then, 59.95.
The largest value is 74. 74+ 0.05 = 74.05 is the ending value.
Next, calculate the width of each bar or class interval. To calculate this width, subtract the starting
point from the ending value and divide by the number of bars (you must choose the number of
bars you desire). Suppose you choose 8 bars.
74.05 −59.95
8
= 1.76 (2.2)
NOTE: We will round up to 2 and make each bar or class interval 2 units wide. Rounding up to 2 is
one way to prevent a value from falling on a boundary. Rounding to the next number is necessary
even if it goes against the standard rules of rounding. For this example, using 1.76 as the width
would also work.
The boundaries are:
• 59.95
• 59.95 + 2 = 61.95
• 61.95 + 2 = 63.95
• 63.95 + 2 = 65.95
• 65.95 + 2 = 67.95
• 67.95 + 2 = 69.95
• 69.95 + 2 = 71.95
• 71.95 + 2 = 73.95
• 73.95 + 2 = 75.95
The heights 60 through 61.5 inches are in the interval 59.95 - 61.95. The heights that are 63.5 are
in the interval 61.95 - 63.95. The heights that are 64 through 64.5 are in the interval 63.95 - 65.95.
The heights 66 through 67.5 are in the interval 65.95 - 67.95. The heights 68 through 69.5 are in the
interval 67.95 - 69.95. The heights 70 through 71 are in the interval 69.95 - 71.95. The heights 72
through 73.5 are in the interval 71.95 - 73.95. The height 74 is in the interval 73.95 - 75.95.
The following histogram displays the heights on the x-axis and relative frequency on the y-axis.
58 CHAPTER 2. DESCRIPTIVE STATISTICS
Example 2.7
The following data are the number of books bought by 50 part-time college students at ABC
College. The number of books is discrete data since books are counted.
1; 1; 1; 1; 1; 1; 1; 1; 1; 1; 1
2; 2; 2; 2; 2; 2; 2; 2; 2; 2
3; 3; 3; 3; 3; 3; 3; 3; 3; 3; 3; 3; 3; 3; 3; 3
4; 4; 4; 4; 4; 4
5; 5; 5; 5; 5
6; 6
Eleven students buy 1 book. Ten students buy 2 books. Sixteen students buy 3 books. Six students
buy 4 books. Five students buy 5 books. Two students buy 6 books.
Because the data are integers, subtract 0.5 from 1, the smallest data value and add 0.5 to 6, the
largest data value. Then the starting point is 0.5 and the ending value is 6.5.
Problem (Solution on p. 105.)
Next, calculate the width of each bar or class interval. If the data are discrete and there are not too
many different values, a width that places the data values in the middle of the bar or class interval
is the most convenient. Since the data consist of the numbers 1, 2, 3, 4, 5, 6 and the starting point is
0.5, a width of one places the 1 in the middle of the interval from 0.5 to 1.5, the 2 in the middle of
the interval from 1.5 to 2.5, the 3 in the middle of the interval from 2.5 to 3.5, the 4 in the middle of
the interval from _______ to _______, the 5 in the middle of the interval from _______ to _______,
and the _______ in the middle of the interval from _______ to _______ .
59
Calculate the number of bars as follows:
6.5 −0.5
bars
= 1 (2.3)
where 1 is the width of a bar. Therefore, bars = 6.
The following histogram displays the number of books on the x-axis and the frequency on the
y-axis.
2.4.1 Optional Collaborative Exercise
Count the money (bills and change) in your pocket or purse. Your instructor will record the amounts. As a
class, construct a histogram displaying the data. Discuss how many intervals you think is appropriate. You
may want to experiment with the number of intervals. Discuss, also, the shape of the histogram.
Record the data, in dollars (for example, 1.25 dollars).
Construct a histogram.
2.5 Box Plots
7
Box plots or box-whisker plots give a good graphical image of the concentration of the data. They also
show how far from most of the data the extreme values are. The box plot is constructed from five values:
the smallest value, the first quartile, the median, the third quartile, and the largest value. The median, the
first quartile, and the third quartile will be discussed here, and then again in the section on measuring data
in this chapter. We use these values to compare how close other data values are to them.
The median, a number, is a way of measuring the "center" of the data. You can think of the median as the
"middle value," although it does not actually have to be one of the observed values. It is a number that
separates ordered data into halves. Half the values are the same number or smaller than the median and
half the values are the same number or larger. For example, consider the following data:
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60 CHAPTER 2. DESCRIPTIVE STATISTICS
1; 11.5; 6; 7.2; 4; 8; 9; 10; 6.8; 8.3; 2; 2; 10; 1
Ordered from smallest to largest:
1; 1; 2; 2; 4; 6; 6.8; 7.2; 8; 8.3; 9; 10; 10; 11.5
The median is between the 7th value, 6.8, and the 8th value 7.2. To find the median, add the two values
together and divide by 2.
6.8 +7.2
2
= 7 (2.4)
The median is 7. Half of the values are smaller than 7 and half of the values are larger than 7.
Quartiles are numbers that separate the data into quarters. Quartiles may or may not be part of the data.
To find the quartiles, first find the median or second quartile. The first quartile is the middle value of the
lower half of the data and the third quartile is the middle value of the upper half of the data. To get the
idea, consider the same data set shown above:
1; 1; 2; 2; 4; 6; 6.8; 7.2; 8; 8.3; 9; 10; 10; 11.5
The median or second quartile is 7. The lower half of the data is 1, 1, 2, 2, 4, 6, 6.8. The middle value of the
lower half is 2.
1; 1; 2; 2; 4; 6; 6.8
The number 2, which is part of the data, is the first quartile. One-fourth of the values are the same or less
than 2 and three-fourths of the values are more than 2.
The upper half of the data is 7.2, 8, 8.3, 9, 10, 10, 11.5. The middle value of the upper half is 9.
7.2; 8; 8.3; 9; 10; 10; 11.5
The number 9, which is part of the data, is the third quartile. Three-fourths of the values are less than 9
and one-fourth of the values are more than 9.
To construct a box plot, use a horizontal number line and a rectangular box. The smallest and largest data
values label the endpoints of the axis. The first quartile marks one end of the box and the third quartile
marks the other end of the box. The middle fifty percent of the data fall inside the box. The "whiskers"
extend from the ends of the box to the smallest and largest data values. The box plot gives a good quick
picture of the data.
NOTE: You may encounter box and whisker plots that have dots marking outlier values. In those
cases, the whiskers are not extending to the minimum and maximum values.
Consider the following data:
1; 1; 2; 2; 4; 6; 6.8 ; 7.2; 8; 8.3; 9; 10; 10; 11.5
The first quartile is 2, the median is 7, and the third quartile is 9. The smallest value is 1 and the largest
value is 11.5. The box plot is constructed as follows (see calculator instructions in the back of this book or
on the TI web site
8
):
8
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61
The two whiskers extend from the first quartile to the smallest value and from the third quartile to the
largest value. The median is shown with a dashed line.
Example 2.8
The following data are the heights of 40 students in a statistics class.
59; 60; 61; 62; 62; 63; 63; 64; 64; 64; 65; 65; 65; 65; 65; 65; 65; 65; 65; 66; 66; 67; 67; 68; 68; 69; 70; 70; 70;
70; 70; 71; 71; 72; 72; 73; 74; 74; 75; 77
Construct a box plot with the following properties:
• Smallest value = 59
• Largest value = 77
• Q1: First quartile = 64.5
• Q2: Second quartile or median= 66
• Q3: Third quartile = 70
a. Each quarter has 25% of the data.
b. The spreads of the four quarters are 64.5 - 59 = 5.5 (first quarter), 66 - 64.5 = 1.5 (second quarter),
70 - 66 = 4 (3rd quarter), and 77 - 70 = 7 (fourth quarter). So, the second quarter has the
smallest spread and the fourth quarter has the largest spread.
c. Interquartile Range: IQR = Q3 −Q1 = 70 −64.5 = 5.5.
d. The interval 59 through 65 has more than 25% of the data so it has more data in it than the
interval 66 through 70 which has 25% of the data.
e. The middle 50% (middle half) of the data has a range of 5.5 inches.
For some sets of data, some of the largest value, smallest value, first quartile, median, and third
quartile may be the same. For instance, you might have a data set in which the median and the
third quartile are the same. In this case, the diagram would not have a dotted line inside the box
displaying the median. The right side of the box would display both the third quartile and the
median. For example, if the smallest value and the first quartile were both 1, the median and the
third quartile were both 5, and the largest value was 7, the box plot would look as follows:
62 CHAPTER 2. DESCRIPTIVE STATISTICS
Example 2.9
Test scores for a college statistics class held during the day are:
99; 56; 78; 55.5; 32; 90; 80; 81; 56; 59; 45; 77; 84.5; 84; 70; 72; 68; 32; 79; 90
Test scores for a college statistics class held during the evening are:
98; 78; 68; 83; 81; 89; 88; 76; 65; 45; 98; 90; 80; 84.5; 85; 79; 78; 98; 90; 79; 81; 25.5
Problem (Solution on p. 105.)
• What are the smallest and largest data values for each data set?
• What is the median, the first quartile, and the third quartile for each data set?
• Create a boxplot for each set of data.
• Which boxplot has the widest spread for the middle 50% of the data (the data between the
first and third quartiles)? What does this mean for that set of data in comparison to the other
set of data?
• For each data set, what percent of the data is between the smallest value and the first quar-
tile? (Answer: 25%) the first quartile and the median? (Answer: 25%) the median and the
third quartile? the third quartile and the largest value? What percent of the data is between
the first quartile and the largest value? (Answer: 75%)
The first data set (the top box plot) has the widest spread for the middle 50% of the data. IQR =
Q3 − Q1 is 82.5 − 56 = 26.5 for the first data set and 89 − 78 = 11 for the second data set.
So, the first set of data has its middle 50% of scores more spread out.
25% of the data is between M and Q3 and 25% is between Q3 and Xmax.
2.6 Measures of the Location of the Data
9
The common measures of location are quartiles and percentiles (%iles). Quartiles are special percentiles.
The first quartile, Q
1
is the same as the 25th percentile (25th %ile) and the third quartile, Q
3
, is the same as
the 75th percentile (75th %ile). The median, M, is called both the second quartile and the 50th percentile
(50th %ile).
To calculate quartiles and percentiles, the data must be ordered from smallest to largest. Recall that
quartiles divide ordered data into quarters. Percentiles divide ordered data into hundredths. To score in
the 90th percentile of an exam does not mean, necessarily, that you received 90% on a test. It means that
90% of test scores are the same or less than your score and 10% of the test scores are the same or greater
than your test score.
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Percentiles are useful for comparing values. For this reason, universities and colleges use percentiles
extensively.
Percentiles are mostly used with very large populations. Therefore, if you were to say that 90% of
the test scores are less (and not the same or less) than your score, it would be acceptable because removing
one particular data value is not significant.
The interquartile range is a number that indicates the spread of the middle half or the middle 50% of the
data. It is the difference between the third quartile (Q
3
) and the first quartile (Q
1
).
IQR = Q
3
−Q
1
(2.5)
The IQR can help to determine potential outliers. A value is suspected to be a potential outlier if it is
less than (1.5) (IQR) below the first quartile or more than (1.5) (IQR) above the third quartile. Potential
outliers always need further investigation.
Example 2.10
For the following 13 real estate prices, calculate the IQR and determine if any prices are outliers.
Prices are in dollars. (Source: San Jose Mercury News)
389,950; 230,500; 158,000; 479,000; 639,000; 114,950; 5,500,000; 387,000; 659,000; 529,000; 575,000;
488,800; 1,095,000
Solution
Order the data from smallest to largest.
114,950; 158,000; 230,500; 387,000; 389,950; 479,000; 488,800; 529,000; 575,000; 639,000; 659,000;
1,095,000; 5,500,000
M = 488, 800
Q
1
=
230500+387000
2
= 308750
Q
3
=
639000+659000
2
= 649000
IQR = 649000 −308750 = 340250
(1.5) (IQR) = (1.5) (340250) = 510375
Q
1
−(1.5) (IQR) = 308750 −510375 = −201625
Q
3
+ (1.5) (IQR) = 649000 +510375 = 1159375
No house price is less than -201625. However, 5,500,000 is more than 1,159,375. Therefore,
5,500,000 is a potential outlier.
Example 2.11
For the two data sets in the test scores example (p. 62), find the following:
a. The interquartile range. Compare the two interquartile ranges.
b. Any outliers in either set.
c. The 30th percentile and the 80th percentile for each set. How much data falls below the 30th
percentile? Above the 80th percentile?
64 CHAPTER 2. DESCRIPTIVE STATISTICS
Example 2.12: Finding Quartiles and Percentiles Using a Table
Fifty statistics students were asked how much sleep they get per school night (rounded to the
nearest hour). The results were (student data):
AMOUNT OF SLEEP
PER SCHOOL NIGHT
(HOURS)
FREQUENCY RELATIVE FRE-
QUENCY
CUMULATIVE RELA-
TIVE FREQUENCY
4 2 0.04 0.04
5 5 0.10 0.14
6 7 0.14 0.28
7 12 0.24 0.52
8 14 0.28 0.80
9 7 0.14 0.94
10 3 0.06 1.00
Table 2.5
Find the 28th percentile: Notice the 0.28 in the "cumulative relative frequency" column. 28% of 50
data values = 14. There are 14 values less than the 28th %ile. They include the two 4s, the five 5s,
and the seven 6s. The 28th %ile is between the last 6 and the first 7. The 28th %ile is 6.5.
Find the median: Look again at the "cumulative relative frequency " column and find 0.52. The
median is the 50th %ile or the second quartile. 50% of 50 = 25. There are 25 values less than the
median. They include the two 4s, the five 5s, the seven 6s, and eleven of the 7s. The median or
50th %ile is between the 25th (7) and 26th (7) values. The median is 7.
Find the third quartile: The third quartile is the same as the 75th percentile. You can "eyeball" this
answer. If you look at the "cumulative relative frequency" column, you find 0.52 and 0.80. When
you have all the 4s, 5s, 6s and 7s, you have 52% of the data. When you include all the 8s, you have
80% of the data. The 75th %ile, then, must be an 8 . Another way to look at the problem is to find
75% of 50 (= 37.5) and round up to 38. The third quartile, Q
3
, is the 38th value which is an 8. You
can check this answer by counting the values. (There are 37 values below the third quartile and 12
values above.)
Example 2.13
Using the table:
1. Find the 80th percentile.
2. Find the 90th percentile.
3. Find the first quartile. What is another name for the first quartile?
4. Construct a box plot of the data.
Collaborative Classroom Exercise: Your instructor or a member of the class will ask everyone in class how
many sweaters they own. Answer the following questions.
1. How many students were surveyed?
2. What kind of sampling did you do?
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3. Find the mean and standard deviation.
4. Find the mode.
5. Construct 2 different histograms. For each, starting value = _____ ending value = ____.
6. Find the median, first quartile, and third quartile.
7. Construct a box plot.
8. Construct a table of the data to find the following:
• The 10th percentile
• The 70th percentile
• The percent of students who own less than 4 sweaters
Interpreting Percentiles, Quartiles, and Median
A percentile indicates the relative standing of a data value when data are sorted into numerical order, from
smallest to largest. p% of data values are less than or equal to the pth percentile. For example, 15% of data
values are less than or equal to the 15th percentile.
• Low percentiles always correspond to lower data values.
• High percentiles always correspond to higher data values.
A percentile may or may not correspond to a value judgment about whether it is "good" or "bad". The
interpretation of whether a certain percentile is good or bad depends on the context of the situation to
which the data applies. In some situations, a low percentile would be considered "good’; in other contexts
a high percentile might be considered "good". In many situations, there is no value judgment that applies.
Understanding how to properly interpret percentiles is important not only when describing data,
but is also important in later chapters of this textbook when calculating probabilities.
Guideline:
When writing the interpretation of a percentile in the context of the given data, the sentence should
contain the following information:
• information about the context of the situation being considered,
• the data value (value of the variable) that represents the percentile,
• the percent of individuals or items with data values below the percentile.
• Additionally, you may also choose to state the percent of individuals or items with data values above
the percentile.
Example 2.14
On a timed math test, the first quartile for times for finishing the exam was 35 minutes. Interpret
the first quartile in the context of this situation.
• 25% of students finished the exam in 35 minutes or less.
• 75% of students finished the exam in 35 minutes or more.
• A low percentile could be considered good, as finishing more quickly on a timed exam is
desirable. (If you take too long, you might not be able to finish.)
Example 2.15
On a 20 question math test, the 70th percentile for number of correct answers was 16. Interpret
the 70th percentile in the context of this situation.
• 70% of students answered 16 or fewer questions correctly.
• 30% of students answered 16 or more questions correctly.
• Note: A high percentile could be considered good, as answering more questions correctly is
desirable.
66 CHAPTER 2. DESCRIPTIVE STATISTICS
Example 2.16
At a certain community college, it was found that the 30th percentile of credit units that students
are enrolled for is 7 units. Interpret the 30th percentile in the context of this situation.
• 30% of students are enrolled in 7 or fewer credit units
• 70% of students are enrolled in 7 or more credit units
• In this example, there is no "good" or "bad" value judgment associated with a higher or
lower percentile. Students attend community college for varied reasons and needs, and their
course load varies according to their needs.
Do the following Practice Problems for Interpreting Percentiles
Exercise 2.6.1 (Solution on p. 106.)
a. For runners in a race, a low time means a faster run. The winners in a race have the shortest
running times. Is it more desirable to have a finish time with a high or a low percentile when
running a race?
b. The 20th percentile of run times in a particular race is 5.2 minutes. Write a sentence interpreting
the 20th percentile in the context of the situation.
c. A bicyclist in the 90th percentile of a bicycle race between two towns completed the race in 1
hour and 12 minutes. Is he among the fastest or slowest cyclists in the race? Write a sentence
interpreting the 90th percentile in the context of the situation.
Exercise 2.6.2 (Solution on p. 107.)
a. For runners in a race, a higher speed means a faster run. Is it more desirable to have a speed
with a high or a low percentile when running a race?
b. The 40th percentile of speeds in a particular race is 7.5 miles per hour. Write a sentence inter-
preting the 40th percentile in the context of the situation.
Exercise 2.6.3 (Solution on p. 107.)
On an exam, would it be more desirable to earn a grade with a high or low percentile? Explain.
Exercise 2.6.4 (Solution on p. 107.)
Mina is waiting in line at the Department of Motor Vehicles (DMV). Her wait time of 32 minutes
is the 85th percentile of wait times. Is that good or bad? Write a sentence interpreting the 85th
percentile in the context of this situation.
Exercise 2.6.5 (Solution on p. 107.)
In a survey collecting data about the salaries earned by recent college graduates, Li found that her
salary was in the 78th percentile. Should Li be pleased or upset by this result? Explain.
Exercise 2.6.6 (Solution on p. 107.)
In a study collecting data about the repair costs of damage to automobiles in a certain type of
crash tests, a certain model of car had $1700 in damage and was in the 90th percentile. Should the
manufacturer and/or a consumer be pleased or upset by this result? Explain. Write a sentence
that interprets the 90th percentile in the context of this problem.
Exercise 2.6.7 (Solution on p. 107.)
The University of California has two criteria used to set admission standards for freshman to be
admitted to a college in the UC system:
a. Students’ GPAs and scores on standardized tests (SATs and ACTs) are entered into a formula
that calculates an "admissions index" score. The admissions index score is used to set eligi-
bility standards intended to meet the goal of admitting the top 12% of high school students
in the state. In this context, what percentile does the top 12% represent?
67
b. Students whose GPAs are at or above the 96th percentile of all students at their high school
are eligible (called eligible in the local context), even if they are not in the top 12% of all
students in the state. What percent of students from each high school are "eligible in the
local context"?
Exercise 2.6.8 (Solution on p. 107.)
Suppose that you are buying a house. You and your realtor have determined that the most expen-
sive house you can afford is the 34th percentile. The 34th percentile of housing prices is $240,000
in the town you want to move to. In this town, can you afford 34% of the houses or 66% of the
houses?
**With contributions from Roberta Bloom
2.7 Measures of the Center of the Data
10
The "center" of a data set is also a way of describing location. The two most widely used measures of the
"center" of the data are the mean (average) and the median. To calculate the mean weight of 50 people,
add the 50 weights together and divide by 50. To find the median weight of the 50 people, order the data
and find the number that splits the data into two equal parts (previously discussed under box plots in this
chapter). The median is generally a better measure of the center when there are extreme values or outliers
because it is not affected by the precise numerical values of the outliers. The mean is the most common
measure of the center.
NOTE: The words "mean" and "average" are often used interchangeably. The substitution of one
word for the other is common practice. The technical term is "arithmetic mean" and "average" is
technically a center location. However, in practice among non-statisticians, "average" is commonly
accepted for "arithmetic mean."
The mean can also be calculated by multiplying each distinct value by its frequency and then dividing the
sum by the total number of data values. The letter used to represent the sample mean is an x with a bar
over it (pronounced "x bar"): x.
The Greek letter µ (pronounced "mew") represents the population mean. One of the requirements for the
sample mean to be a good estimate of the population mean is for the sample taken to be truly random.
To see that both ways of calculating the mean are the same, consider the sample:
1; 1; 1; 2; 2; 3; 4; 4; 4; 4; 4
x =
1 +1 +1 +2 +2 +3 +4 +4 +4 +4 +4
11
= 2.7 (2.6)
x =
3 ×1 +2 ×2 +1 ×3 +5 ×4
11
= 2.7 (2.7)
In the second example, the frequencies are 3, 2, 1, and 5.
You can quickly find the location of the median by using the expression
n+1
2
.
The letter n is the total number of data values in the sample. If n is an odd number, the median is the middle
value of the ordered data (ordered smallest to largest). If n is an even number, the median is equal to the
two middle values added together and divided by 2 after the data has been ordered. For example, if the
total number of data values is 97, then
n+1
2
=
97+1
2
= 49. The median is the 49th value in the ordered data.
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68 CHAPTER 2. DESCRIPTIVE STATISTICS
If the total number of data values is 100, then
n+1
2
=
100+1
2
= 50.5. The median occurs midway between the
50th and 51st values. The location of the median and the value of the median are not the same. The upper
case letter M is often used to represent the median. The next example illustrates the location of the median
and the value of the median.
Example 2.17
AIDS data indicating the number of months an AIDS patient lives after taking a new antibody
drug are as follows (smallest to largest):
3; 4; 8; 8; 10; 11; 12; 13; 14; 15; 15; 16; 16; 17; 17; 18; 21; 22; 22; 24; 24; 25; 26; 26; 27; 27; 29; 29; 31; 32;
33; 33; 34; 34; 35; 37; 40; 44; 44; 47
Calculate the mean and the median.
Solution
The calculation for the mean is:
x =
[3+4+(8)(2)+10+11+12+13+14+(15)(2)+(16)(2)+...+35+37+40+(44)(2)+47]
40
= 23.6
To find the median, M, first use the formula for the location. The location is:
n+1
2
=
40+1
2
= 20.5
Starting at the smallest value, the median is located between the 20th and 21st values (the two
24s):
3; 4; 8; 8; 10; 11; 12; 13; 14; 15; 15; 16; 16; 17; 17; 18; 21; 22; 22; 24; 24; 25; 26; 26; 27; 27; 29; 29; 31; 32;
33; 33; 34; 34; 35; 37; 40; 44; 44; 47
M =
24+24
2
= 24
The median is 24.
Example 2.18
Suppose that, in a small town of 50 people, one person earns $5,000,000 per year and the other 49
each earn $30,000. Which is the better measure of the "center," the mean or the median?
Solution
x =
5000000+49×30000
50
= 129400
M = 30000
(There are 49 people who earn $30,000 and one person who earns $5,000,000.)
The median is a better measure of the "center" than the mean because 49 of the values are 30,000
and one is 5,000,000. The 5,000,000 is an outlier. The 30,000 gives us a better sense of the middle of
the data.
Another measure of the center is the mode. The mode is the most frequent value. If a data set has two
values that occur the same number of times, then the set is bimodal.
Example 2.19: Statistics exam scores for 20 students are as follows
Statistics exam scores for 20 students are as follows:
69
50 ; 53 ; 59 ; 59 ; 63 ; 63 ; 72 ; 72 ; 72 ; 72 ; 72 ; 76 ; 78 ; 81 ; 83 ; 84 ; 84 ; 84 ; 90 ; 93
Problem
Find the mode.
Solution
The most frequent score is 72, which occurs five times. Mode = 72.
Example 2.20
Five real estate exam scores are 430, 430, 480, 480, 495. The data set is bimodal because the scores
430 and 480 each occur twice.
When is the mode the best measure of the "center"? Consider a weight loss programthat advertises
a mean weight loss of six pounds the first week of the program. The mode might indicate that most
people lose two pounds the first week, making the program less appealing.
NOTE: The mode can be calculated for qualitative data as well as for quantitative data.
Statistical software will easily calculate the mean, the median, and the mode. Some graphing
calculators can also make these calculations. In the real world, people make these calculations
using software.
2.7.1 The Law of Large Numbers and the Mean
The Law of Large Numbers says that if you take samples of larger and larger size from any population,
then the mean x of the sample is very likely to get closer and closer to µ. This is discussed in more detail in
The Central Limit Theorem.
NOTE: The formula for the mean is located in the Summary of Formulas (Section 2.10) section
course.
2.7.2 Sampling Distributions and Statistic of a Sampling Distribution
You can think of a sampling distribution as a relative frequency distribution with a great many samples.
(See Sampling and Data for a review of relative frequency). Suppose thirty randomly selected students
were asked the number of movies they watched the previous week. The results are in the relative frequency
table shown below.
# of movies Relative Frequency
0 5/30
1 15/30
2 6/30
3 4/30
4 1/30
Table 2.6
70 CHAPTER 2. DESCRIPTIVE STATISTICS
If you let the number of samples get very large (say, 300 million or more), the relative frequency table
becomes a relative frequency distribution.
A statistic is a number calculated from a sample. Statistic examples include the mean, the median and the
mode as well as others. The sample mean x is an example of a statistic which estimates the population
mean µ.
2.8 Skewness and the Mean, Median, and Mode
11
Consider the following data set:
4 ; 5 ; 6 ; 6 ; 6 ; 7 ; 7 ; 7 ; 7 ; 7 ; 7 ; 8 ; 8 ; 8 ; 9 ; 10
This data set produces the histogram shown below. Each interval has width one and each value is located
in the middle of an interval.
The histogram displays a symmetrical distribution of data. A distribution is symmetrical if a vertical line
can be drawn at some point in the histogram such that the shape to the left and the right of the vertical
line are mirror images of each other. The mean, the median, and the mode are each 7 for these data. In a
perfectly symmetrical distribution, the mean and the median are the same. This example has one mode
(unimodal) and the mode is the same as the mean and median. In a symmetrical distribution that has two
modes (bimodal), the two modes would be different from the mean and median.
The histogram for the data:
4 ; 5 ; 6 ; 6 ; 6 ; 7 ; 7 ; 7 ; 7 ; 8
is not symmetrical. The right-hand side seems "chopped off" compared to the left side. The shape distribu-
tion is called skewed to the left because it is pulled out to the left.
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The mean is 6.3, the median is 6.5, and the mode is 7. Notice that the mean is less than the median and
they are both less than the mode. The mean and the median both reflect the skewing but the mean more
so.
The histogram for the data:
6 ; 7 ; 7 ; 7 ; 7 ; 8 ; 8 ; 8 ; 9 ; 10
is also not symmetrical. It is skewed to the right.
The mean is 7.7, the median is 7.5, and the mode is 7. Of the three statistics, the mean is the largest, while
the mode is the smallest. Again, the mean reflects the skewing the most.
To summarize, generally if the distribution of data is skewed to the left, the mean is less than the median,
which is often less than the mode. If the distribution of data is skewed to the right, the mode is often less
than the median, which is less than the mean.
Skewness and symmetry become important when we discuss probability distributions in later chapters.
72 CHAPTER 2. DESCRIPTIVE STATISTICS
2.9 Measures of the Spread of the Data
12
An important characteristic of any set of data is the variation in the data. In some data sets, the data values
are concentrated closely near the mean; in other data sets, the data values are more widely spread out from
the mean. The most common measure of variation, or spread, is the standard deviation.
The standard deviation is a number that measures how far data values are from their mean.
The standard deviation
• provides a numerical measure of the overall amount of variation in a data set
• can be used to determine whether a particular data value is close to or far from the mean
The standard deviation provides a measure of the overall variation in a data set
The standard deviation is always positive or 0. The standard deviation is small when the data are all
concentrated close to the mean, exhibiting little variation or spread. The standard deviation is larger when
the data values are more spread out from the mean, exhibiting more variation.
Suppose that we are studying waiting times at the checkout line for customers at supermarket A and
supermarket B; the average wait time at both markets is 5 minutes. At market A, the standard deviation
for the waiting time is 2 minutes; at market B the standard deviation for the waiting time is 4 minutes.
Because market B has a higher standard deviation, we know that there is more variation in the wait-
ing times at market B. Overall, wait times at market B are more spread out from the average; wait times at
market A are more concentrated near the average.
The standard deviation can be used to determine whether a data value is close to or far from the mean.
Suppose that Rosa and Binh both shop at Market A. Rosa waits for 7 minutes and Binh waits for 1 minute
at the checkout counter. At market A, the mean wait time is 5 minutes and the standard deviation is 2
minutes. The standard deviation can be used to determine whether a data value is close to or far from the
mean.
Rosa waits for 7 minutes:
• 7 is 2 minutes longer than the average of 5; 2 minutes is equal to one standard deviation.
• Rosa’s wait time of 7 minutes is 2 minutes longer than the average of 5 minutes.
• Rosa’s wait time of 7 minutes is one standard deviation above the average of 5 minutes.
Binh waits for 1 minute.
• 1 is 4 minutes less than the average of 5; 4 minutes is equal to two standard deviations.
• Binh’s wait time of 1 minute is 4 minutes less than the average of 5 minutes.
• Binh’s wait time of 1 minute is two standard deviations below the average of 5 minutes.
• A data value that is two standard deviations from the average is just on the borderline for what many
statisticians would consider to be far from the average. Considering data to be far from the mean if it
is more than 2 standard deviations away is more of an approximate "rule of thumb" than a rigid rule.
In general, the shape of the distribution of the data affects how much of the data is further away than
2 standard deviations. (We will learn more about this in later chapters.)
The number line may help you understand standard deviation. If we were to put 5 and 7 on a number line,
7 is to the right of 5. We say, then, that 7 is one standard deviation to the right of 5 because
5 + (1) (2) = 7.
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73
If 1 were also part of the data set, then 1 is two standard deviations to the left of 5 because
5 + (−2) (2) = 1.
• In general, a value = mean + (#ofSTDEV)(standard deviation)
• where #ofSTDEVs = the number of standard deviations
• 7 is one standard deviation more than the mean of 5 because: 7=5+(1)(2)
• 1 is two standard deviations less than the mean of 5 because: 1=5+(−2)(2)
The equation value = mean + (#ofSTDEVs)(standard deviation) can be expressed for a sample and for a
population:
• sample: x = x + (#o f STDEV) (s)
• Population: x = µ + (#o f STDEV) (σ)
The lower case letter s represents the sample standard deviation and the Greek letter σ (sigma, lower case)
represents the population standard deviation.
The symbol x is the sample mean and the Greek symbol µ is the population mean.
Calculating the Standard Deviation
If x is a number, then the difference "x - mean" is called its deviation. In a data set, there are as many
deviations as there are items in the data set. The deviations are used to calculate the standard deviation.
If the numbers belong to a population, in symbols a deviation is x − µ . For sample data, in symbols a
deviation is x− x .
The procedure to calculate the standard deviation depends on whether the numbers are the entire popula-
tion or are data from a sample. The calculations are similar, but not identical. Therefore the symbol used
to represent the standard deviation depends on whether it is calculated from a population or a sample.
The lower case letter s represents the sample standard deviation and the Greek letter σ (sigma, lower case)
represents the population standard deviation. If the sample has the same characteristics as the population,
then s should be a good estimate of σ.
To calculate the standard deviation, we need to calculate the variance first. The variance is an average of
the squares of the deviations (the x− x values for a sample, or the x − µ values for a population). The
symbol σ
2
represents the population variance; the population standard deviation σ is the square root of
the population variance. The symbol s
2
represents the sample variance; the sample standard deviation s is
the square root of the sample variance. You can think of the standard deviation as a special average of the
deviations.
If the numbers come from a census of the entire population and not a sample, when we calculate the aver-
age of the squared deviations to find the variance, we divide by N, the number of items in the population.
If the data are from a sample rather than a population, when we calculate the average of the squared devi-
ations, we divide by n-1, one less than the number of items in the sample. You can see that in the formulas
below.
74 CHAPTER 2. DESCRIPTIVE STATISTICS
Formulas for the Sample Standard Deviation
• s =
_
Σ(x−x)
2
n−1
or s =
_
Σf ·(x−x)
2
n−1
• For the sample standard deviation, the denominator is n-1, that is the sample size MINUS 1.
Formulas for the Population Standard Deviation
• σ =
_
Σ(x−µ)
2
N
or σ =
_
Σf ·(x−µ)
2
N
• For the population standard deviation, the denominator is N, the number of items in the population.
In these formulas, f represents the frequency with which a value appears. For example, if a value appears
once, f is 1. If a value appears three times in the data set or population, f is 3.
Sampling Variability of a Statistic
The statistic of a sampling distribution was discussed in Descriptive Statistics: Measuring the Center of
the Data. Howmuch the statistic varies fromone sample to another is known as the sampling variability of
a statistic. You typically measure the sampling variability of a statistic by its standard error. The standard
error of the mean is an example of a standard error. It is a special standard deviation and is known as the
standard deviation of the sampling distribution of the mean. You will cover the standard error of the mean
in The Central Limit Theorem (not now). The notation for the standard error of the mean is
σ

n
where σ is
the standard deviation of the population and n is the size of the sample.
NOTE: In practice, USE A CALCULATOR OR COMPUTER SOFTWARE TO CALCULATE
THE STANDARD DEVIATION. If you are using a TI-83,83+,84+ calculator, you need to select
the appropriate standard deviation σ
x
or s
x
from the summary statistics. We will concentrate on
using and interpreting the information that the standard deviation gives us. However you should
study the following step-by-step example to help you understand how the standard deviation
measures variation from the mean.
Example 2.21
In a fifth grade class, the teacher was interested in the average age and the sample standard
deviation of the ages of her students. The following data are the ages for a SAMPLE of n = 20 fifth
grade students. The ages are rounded to the nearest half year:
9 ; 9.5 ; 9.5 ; 10 ; 10 ; 10 ; 10 ; 10.5 ; 10.5 ; 10.5 ; 10.5 ; 11 ; 11 ; 11 ; 11 ; 11 ; 11 ; 11.5 ; 11.5 ; 11.5
x =
9 +9.5 ×2 +10 ×4 +10.5 ×4 +11 ×6 +11.5 ×3
20
= 10.525 (2.8)
The average age is 10.53 years, rounded to 2 places.
The variance may be calculated by using a table. Then the standard deviation is calculated by
taking the square root of the variance. We will explain the parts of the table after calculating s.
Data Freq. Deviations Deviations
2
(Freq.)(Deviations
2
)
x f (x −x) (x −x)
2
( f ) (x −x)
2
9 1 9 −10.525 = −1.525 (−1.525)
2
= 2.325625 1 ×2.325625 = 2.325625
9.5 2 9.5 −10.525 = −1.025 (−1.025)
2
= 1.050625 2 ×1.050625 = 2.101250
10 4 10 −10.525 = −0.525 (−0.525)
2
= 0.275625 4 ×.275625 = 1.1025
10.5 4 10.5 −10.525 = −0.025 (−0.025)
2
= 0.000625 4 ×.000625 = .0025
11 6 11 −10.525 = 0.475 (0.475)
2
= 0.225625 6 ×.225625 = 1.35375
11.5 3 11.5 −10.525 = 0.975 (0.975)
2
= 0.950625 3 ×.950625 = 2.851875
75
Table 2.7
The sample variance, s
2
, is equal to the sumof the last column (9.7375) divided by the total number
of data values minus one (20 - 1):
s
2
=
9.7375
20−1
= 0.5125
The sample standard deviation s is equal to the square root of the sample variance:
s =

0.5125 = .0715891 Rounded to two decimal places, s = 0.72
Typically, you do the calculation for the standard deviation on your calculator or computer. The
intermediate results are not rounded. This is done for accuracy.
Problem 1
Verify the mean and standard deviation calculated above on your calculator or computer.
Solution
For the TI-83,83+,84+, enter data into the list editor.
Put the data values in list L1 and the frequencies in list L2.
STAT CALC 1-VarStats L1, L2
x=10.525
Use Sx because this is sample data (not a population): Sx=.715891
• For the following problems, recall that value = mean + (#ofSTDEVs)(standard deviation)
• For a sample: x = x + (#ofSTDEVs)(s)
• For a population: x = µ + (#ofSTDEVs)( σ)
• For this example, use x = x + (#ofSTDEVs)(s) because the data is from a sample
Problem 2
Find the value that is 1 standard deviation above the mean. Find (x +1s).
Solution
(x +1s) = 10.53 + (1) (0.72) = 11.25
Problem 3
Find the value that is two standard deviations below the mean. Find (x −2s).
Solution
(x −2s) = 10.53 −(2) (0.72) = 9.09
Problem 4
Find the values that are 1.5 standard deviations from (below and above) the mean.
Solution
• (x −1.5s) = 10.53 −(1.5) (0.72) = 9.45
• (x +1.5s) = 10.53 + (1.5) (0.72) = 11.61
76 CHAPTER 2. DESCRIPTIVE STATISTICS
Explanation of the standard deviation calculation shown in the table
The deviations show how spread out the data are about the mean. The data value 11.5 is farther from the
mean than is the data value 11. The deviations 0.97 and 0.47 indicate that. Apositive deviation occurs when
the data value is greater than the mean. A negative deviation occurs when the data value is less than the
mean; the deviation is -1.525 for the data value 9. If you add the deviations, the sum is always zero. (For
this example, there are n=20 deviations.) So you cannot simply add the deviations to get the spread of the
data. By squaring the deviations, you make them positive numbers, and the sum will also be positive. The
variance, then, is the average squared deviation.
The variance is a squared measure and does not have the same units as the data. Taking the square root
solves the problem. The standard deviation measures the spread in the same units as the data.
Notice that instead of dividing by n=20, the calculation divided by n-1=20-1=19 because the data is a sam-
ple. For the sample variance, we divide by the sample size minus one (n −1). Why not divide by n? The
answer has to do with the population variance. The sample variance is an estimate of the population vari-
ance. Based on the theoretical mathematics that lies behind these calculations, dividing by (n −1) gives a
better estimate of the population variance.
NOTE: Your concentration should be on what the standard deviation tells us about the data. The
standard deviation is a number which measures how far the data are spread from the mean. Let a
calculator or computer do the arithmetic.
The standard deviation, s or σ, is either zero or larger than zero. When the standard deviation is 0, there is
no spread; that is, the all the data values are equal to each other. The standard deviation is small when the
data are all concentrated close to the mean, and is larger when the data values show more variation from
the mean. When the standard deviation is a lot larger than zero, the data values are very spread out about
the mean; outliers can make s or σ very large.
The standard deviation, when first presented, can seem unclear. By graphing your data, you can get a
better "feel" for the deviations and the standard deviation. You will find that in symmetrical distributions,
the standard deviation can be very helpful but in skewed distributions, the standard deviation may not be
much help. The reason is that the two sides of a skewed distribution have different spreads. In a skewed
distribution, it is better to look at the first quartile, the median, the third quartile, the smallest value, and
the largest value. Because numbers can be confusing, always graph your data.
NOTE: The formula for the standard deviation is at the end of the chapter.
Example 2.22
Use the following data (first exam scores) from Susan Dean’s spring pre-calculus class:
33; 42; 49; 49; 53; 55; 55; 61; 63; 67; 68; 68; 69; 69; 72; 73; 74; 78; 80; 83; 88; 88; 88; 90; 92; 94; 94; 94; 94;
96; 100
a. Create a chart containing the data, frequencies, relative frequencies, and cumulative relative
frequencies to three decimal places.
b. Calculate the following to one decimal place using a TI-83+ or TI-84 calculator:
i. The sample mean
ii. The sample standard deviation
iii. The median
iv. The first quartile
v. The third quartile
77
vi. IQR
c. Construct a box plot and a histogram on the same set of axes. Make comments about the box
plot, the histogram, and the chart.
Solution
a.
Data Frequency Relative Frequency Cumulative Relative Frequency
33 1 0.032 0.032
42 1 0.032 0.064
49 2 0.065 0.129
53 1 0.032 0.161
55 2 0.065 0.226
61 1 0.032 0.258
63 1 0.032 0.29
67 1 0.032 0.322
68 2 0.065 0.387
69 2 0.065 0.452
72 1 0.032 0.484
73 1 0.032 0.516
74 1 0.032 0.548
78 1 0.032 0.580
80 1 0.032 0.612
83 1 0.032 0.644
88 3 0.097 0.741
90 1 0.032 0.773
92 1 0.032 0.805
94 4 0.129 0.934
96 1 0.032 0.966
100 1 0.032 0.998 (Why isn’t this value 1?)
Table 2.8
b. i. The sample mean = 73.5
ii. The sample standard deviation = 17.9
iii. The median = 73
iv. The first quartile = 61
v. The third quartile = 90
vi. IQR = 90 - 61 = 29
c. The x-axis goes from 32.5 to 100.5; y-axis goes from -2.4 to 15 for the histogram; number of
intervals is 5 for the histogram so the width of an interval is (100.5 - 32.5) divided by 5 which
is equal to 13.6. Endpoints of the intervals: starting point is 32.5, 32.5+13.6 = 46.1, 46.1+13.6 =
59.7, 59.7+13.6 = 73.3, 73.3+13.6 = 86.9, 86.9+13.6 = 100.5 = the ending value; No data values
fall on an interval boundary.
78 CHAPTER 2. DESCRIPTIVE STATISTICS
Figure 2.1
The long left whisker in the box plot is reflected in the left side of the histogram. The spread of
the exam scores in the lower 50% is greater (73 - 33 = 40) than the spread in the upper 50% (100 -
73 = 27). The histogram, box plot, and chart all reflect this. There are a substantial number of A
and B grades (80s, 90s, and 100). The histogram clearly shows this. The box plot shows us that the
middle 50% of the exam scores (IQR = 29) are Ds, Cs, and Bs. The box plot also shows us that the
lower 25% of the exam scores are Ds and Fs.
Comparing Values from Different Data Sets
The standard deviation is useful when comparing data values that come fromdifferent data sets. If the data
sets have different means and standard deviations, it can be misleading to compare the data values directly.
• For each data value, calculate how many standard deviations the value is away from its mean.
• Use the formula: value = mean + (#ofSTDEVs)(standard deviation); solve for #ofSTDEVs.
• #o f STDEVs =
value−mean
standard deviation
• Compare the results of this calculation.
#ofSTDEVs is often called a "z-score"; we can use the symbol z. In symbols, the formulas become:
Sample x = x + z s z =
x−x
s
Population x = µ + z σ z =
x−µ
σ
Table 2.9
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Example 2.23
Two students, John and Ali, from different high schools, wanted to find out who had the highest
G.P.A. when compared to his school. Which student had the highest G.P.A. when compared to his
school?
Student GPA School Mean GPA School Standard Deviation
John 2.85 3.0 0.7
Ali 77 80 10
Table 2.10
Solution
For each student, determine how many standard deviations (#ofSTDEVs) his GPA is away from
the average, for his school. Pay careful attention to signs when comparing and interpreting the
answer.
#o f STDEVs =
value−mean
standard deviation
; z =
x−µ
σ
For John, z = #o f STDEVs =
2.85−3.0
0.7
= −0.21
For Ali, z = #ofSTDEVs =
77−80
10
= −0.3
John has the better G.P.A. when compared to his school because his G.P.A. is 0.21 standard
deviations below his school’s mean while Ali’s G.P.A. is 0.3 standard deviations below his
school’s mean.
John’s z-score of −0.21 is higher than Ali’s z-score of −0.3 . For GPA, higher values are
better, so we conclude that John has the better GPA when compared to his school.
The following lists give a few facts that provide a little more insight into what the standard deviation tells
us about the distribution of the data.
For ANY data set, no matter what the distribution of the data is:
• At least 75% of the data is within 2 standard deviations of the mean.
• At least 89% of the data is within 3 standard deviations of the mean.
• At least 95% of the data is within 4 1/2 standard deviations of the mean.
• This is known as Chebyshev’s Rule.
For data having a distribution that is MOUND-SHAPED and SYMMETRIC:
• Approximately 68% of the data is within 1 standard deviation of the mean.
• Approximately 95% of the data is within 2 standard deviations of the mean.
• More than 99% of the data is within 3 standard deviations of the mean.
• This is known as the Empirical Rule.
• It is important to note that this rule only applies when the shape of the distribution of the data is
mound-shaped and symmetric. We will learn more about this when studying the "Normal" or "Gaus-
sian" probability distribution in later chapters.
**With contributions from Roberta Bloom
80 CHAPTER 2. DESCRIPTIVE STATISTICS
2.10 Summary of Formulas
13
Commonly Used Symbols
• The symbol Σ means to add or to find the sum.
• n = the number of data values in a sample
• N = the number of people, things, etc. in the population
• x = the sample mean
• s = the sample standard deviation
• µ = the population mean
• σ = the population standard deviation
• f = frequency
• x = numerical value
Commonly Used Expressions
• x ∗ f = A value multiplied by its respective frequency
• ∑x = The sum of the values
• ∑x ∗ f = The sum of values multiplied by their respective frequencies
• (x −x) or (x −µ) = Deviations from the mean (how far a value is from the mean)
• (x −x)
2
or (x −µ)
2
= Deviations squared
• f (x −x)
2
or f (x −µ)
2
= The deviations squared and multiplied by their frequencies
Mean Formulas:
• x =
∑x
n
or x =
∑ f · x
n
• µ =
∑x
N
or µ=
∑ f ·x
N
Standard Deviation Formulas:
• s =
_
Σ(x−x)
2
n−1
or s =
_
Σf ·(x−x)
2
n−1
• σ =
_
Σ(x−µ)
2
N
or σ =
_
Σf ·(x−µ)
2
N
Formulas Relating a Value, the Mean, and the Standard Deviation:
• value = mean + (#ofSTDEVs)(standard deviation), where #ofSTDEVs = the number of standard devi-
ations
• x = x+ (#ofSTDEVs)(s)
• x = µ + (#ofSTDEVs)(σ)
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2.11 Practice 1: Center of the Data
14
2.11.1 Student Learning Outcomes
• The student will calculate and interpret the center, spread, and location of the data.
• The student will construct and interpret histograms an box plots.
2.11.2 Given
Sixty-five randomly selected car salespersons were asked the number of cars they generally sell in one
week. Fourteen people answered that they generally sell three cars; nineteen generally sell four cars; twelve
generally sell five cars; nine generally sell six cars; eleven generally sell seven cars.
2.11.3 Complete the Table
Data Value (# cars) Frequency Relative Frequency Cumulative Relative Frequency
Table 2.11
2.11.4 Discussion Questions
Exercise 2.11.1 (Solution on p. 107.)
What does the frequency column sum to? Why?
Exercise 2.11.2 (Solution on p. 107.)
What does the relative frequency column sum to? Why?
Exercise 2.11.3
What is the difference between relative frequency and frequency for each data value?
Exercise 2.11.4
What is the difference between cumulative relative frequency and relative frequency for each data
value?
2.11.5 Enter the Data
Enter your data into your calculator or computer.
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82 CHAPTER 2. DESCRIPTIVE STATISTICS
2.11.6 Construct a Histogram
Determine appropriate minimum and maximum x and y values and the scaling. Sketch the histogram
below. Label the horizontal and vertical axes with words. Include numerical scaling.
2.11.7 Data Statistics
Calculate the following values:
Exercise 2.11.5 (Solution on p. 107.)
Sample mean = x =
Exercise 2.11.6 (Solution on p. 107.)
Sample standard deviation = s
x
=
Exercise 2.11.7 (Solution on p. 107.)
Sample size = n =
2.11.8 Calculations
Use the table in section 2.11.3 to calculate the following values:
Exercise 2.11.8 (Solution on p. 107.)
Median =
Exercise 2.11.9 (Solution on p. 107.)
Mode =
Exercise 2.11.10 (Solution on p. 107.)
First quartile =
Exercise 2.11.11 (Solution on p. 108.)
Second quartile = median = 50th percentile =
Exercise 2.11.12 (Solution on p. 108.)
Third quartile =
Exercise 2.11.13 (Solution on p. 108.)
Interquartile range (IQR) = _____ - _____ = _____
Exercise 2.11.14 (Solution on p. 108.)
10th percentile =
Exercise 2.11.15 (Solution on p. 108.)
70th percentile =
83
Exercise 2.11.16 (Solution on p. 108.)
Find the value that is 3 standard deviations:
a. Above the mean
b. Below the mean
2.11.9 Box Plot
Construct a box plot below. Use a ruler to measure and scale accurately.
2.11.10 Interpretation
Looking at your box plot, does it appear that the data are concentrated together, spread out evenly, or
concentrated in some areas, but not in others? How can you tell?
84 CHAPTER 2. DESCRIPTIVE STATISTICS
2.12 Practice 2: Spread of the Data
15
2.12.1 Student Learning Outcomes
• The student will calculate measures of the center of the data.
• The student will calculate the spread of the data.
2.12.2 Given
The population parameters below describe the full-time equivalent number of students (FTES) each year
at Lake Tahoe Community College from 1976-77 through 2004-2005. (Source: Graphically Speaking by Bill
King, LTCC Institutional Research, December 2005).
Use these values to answer the following questions:
• µ = 1000 FTES
• Median = 1014 FTES
• σ = 474 FTES
• First quartile = 528.5 FTES
• Third quartile = 1447.5 FTES
• n = 29 years
2.12.3 Calculate the Values
Exercise 2.12.1 (Solution on p. 108.)
A sample of 11 years is taken. About how many are expected to have a FTES of 1014 or above?
Explain how you determined your answer.
Exercise 2.12.2 (Solution on p. 108.)
75% of all years have a FTES:
a. At or below:
b. At or above:
Exercise 2.12.3 (Solution on p. 108.)
The population standard deviation =
Exercise 2.12.4 (Solution on p. 108.)
What percent of the FTES were from 528.5 to 1447.5? How do you know?
Exercise 2.12.5 (Solution on p. 108.)
What is the IQR? What does the IQR represent?
Exercise 2.12.6 (Solution on p. 108.)
How many standard deviations away from the mean is the median?
Additional Information: The population FTES for 2005-2006 through 2010-2011 was given in an updated
report. (Source: http://www.ltcc.edu/data/ResourcePDF/LTCC_FactBook_2010-11.pdf). The data are re-
ported here.
Year 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11
Total FTES 1585 1690 1735 1935 2021 1890
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Table 2.12
Exercise 2.12.7 (Solution on p. 108.)
Calculate the mean, median, standard deviation, first quartile, the third quartile and the IQR.
Round to one decimal place.
Exercise 2.12.8
Construct a boxplot for the FTES for 2005-2006 through 2010-2011 and a boxplot for the FTES for
1976-1977 through 2004-2005.
Exercise 2.12.9 (Solution on p. 108.)
Compare the IQR for the FTES for 1976-77 through 2004-2005 with the IQR for the FTES for 2005-
2006 through 2010-2011. Why do you suppose the IQRs are so different?
86 CHAPTER 2. DESCRIPTIVE STATISTICS
2.13 Homework
16
Exercise 2.13.1 (Solution on p. 108.)
Twenty-five randomly selected students were asked the number of movies they watched the pre-
vious week. The results are as follows:
# of movies Frequency Relative Frequency Cumulative Relative Frequency
0 5
1 9
2 6
3 4
4 1
Table 2.13
a. Find the sample mean x
b. Find the sample standard deviation, s
c. Construct a histogram of the data.
d. Complete the columns of the chart.
e. Find the first quartile.
f. Find the median.
g. Find the third quartile.
h. Construct a box plot of the data.
i. What percent of the students saw fewer than three movies?
j. Find the 40th percentile.
k. Find the 90th percentile.
l. Construct a line graph of the data.
m. Construct a stem plot of the data.
Exercise 2.13.2
The median age for U.S. blacks currently is 30.9 years; for U.S. whites it is 42.3
years. ((Source: http://www.usatoday.com/news/nation/story/2012-05-17/minority-births-
census/55029100/1) )
a. Based upon this information, give two reasons why the black median age could be lower than
the white median age.
b. Does the lower median age for blacks necessarily mean that blacks die younger than whites?
Why or why not?
c. How might it be possible for blacks and whites to die at approximately the same age, but for
the median age for whites to be higher?
Exercise 2.13.3 (Solution on p. 109.)
Forty randomly selected students were asked the number of pairs of sneakers they owned. Let X
= the number of pairs of sneakers owned. The results are as follows:
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87
X Frequency Relative Frequency Cumulative Relative Frequency
1 2
2 5
3 8
4 12
5 12
7 1
Table 2.14
a. Find the sample mean x
b. Find the sample standard deviation, s
c. Construct a histogram of the data.
d. Complete the columns of the chart.
e. Find the first quartile.
f. Find the median.
g. Find the third quartile.
h. Construct a box plot of the data.
i. What percent of the students owned at least five pairs?
j. Find the 40th percentile.
k. Find the 90th percentile.
l. Construct a line graph of the data
m. Construct a stem plot of the data
Exercise 2.13.4
600 adult Americans were asked by telephone poll, What do you think constitutes a middle-class
income? The results are below. Also, include left endpoint, but not the right endpoint. (Source:
Time magazine; survey by Yankelovich Partners, Inc.)
NOTE: "Not sure" answers were omitted from the results.
Salary ($) Relative Frequency
< 20,000 0.02
20,000 - 25,000 0.09
25,000 - 30,000 0.19
30,000 - 40,000 0.26
40,000 - 50,000 0.18
50,000 - 75,000 0.17
75,000 - 99,999 0.02
100,000+ 0.01
Table 2.15
a. What percent of the survey answered "not sure" ?
88 CHAPTER 2. DESCRIPTIVE STATISTICS
b. What percent think that middle-class is from $25,000 - $50,000 ?
c. Construct a histogram of the data
a. Should all bars have the same width, based on the data? Why or why not?
b. How should the <20,000 and the 100,000+ intervals be handled? Why?
d. Find the 40th and 80th percentiles
e. Construct a bar graph of the data
Exercise 2.13.5 (Solution on p. 109.)
Following are the published weights (in pounds) of all of the team members of the San Francisco
49ers from a previous year (Source: San Jose Mercury News)
177; 205; 210; 210; 232; 205; 185; 185; 178; 210; 206; 212; 184; 174; 185; 242; 188; 212; 215; 247; 241;
223; 220; 260; 245; 259; 278; 270; 280; 295; 275; 285; 290; 272; 273; 280; 285; 286; 200; 215; 185; 230;
250; 241; 190; 260; 250; 302; 265; 290; 276; 228; 265
a. Organize the data from smallest to largest value.
b. Find the median.
c. Find the first quartile.
d. Find the third quartile.
e. Construct a box plot of the data.
f. The middle 50% of the weights are from _______ to _______.
g. If our population were all professional football players, would the above data be a sample of
weights or the population of weights? Why?
h. If our population were the San Francisco 49ers, would the above data be a sample of weights
or the population of weights? Why?
i. Assume the population was the San Francisco 49ers. Find:
i. the population mean, µ.
ii. the population standard deviation, σ.
iii. the weight that is 2 standard deviations below the mean.
iv. When Steve Young, quarterback, played football, he weighed 205 pounds. How many
standard deviations above or below the mean was he?
j. That same year, the mean weight for the Dallas Cowboys was 240.08 pounds with a standard
deviation of 44.38 pounds. Emmit Smith weighed in at 209 pounds. With respect to his team,
who was lighter, Smith or Young? How did you determine your answer?
Exercise 2.13.6
An elementary school class ran 1 mile with a mean of 11 minutes and a standard deviation of 3
minutes. Rachel, a student in the class, ran 1 mile in 8 minutes. A junior high school class ran 1
mile with a mean of 9 minutes and a standard deviation of 2 minutes. Kenji, a student in the class,
ran 1 mile in 8.5 minutes. A high school class ran 1 mile with a mean of 7 minutes and a standard
deviation of 4 minutes. Nedda, a student in the class, ran 1 mile in 8 minutes.
a. Why is Kenji considered a better runner than Nedda, even though Nedda ran faster than he?
b. Who is the fastest runner with respect to his or her class? Explain why.
Exercise 2.13.7
In a survey of 20 year olds in China, Germany and America, people were asked the number of
foreign countries they had visited in their lifetime. The following box plots display the results.
89
a. In complete sentences, describe what the shape of each box plot implies about the distribution
of the data collected.
b. Explain howit is possible that more Americans than Germans surveyed have been to over eight
foreign countries.
c. Compare the three box plots. What do they imply about the foreign travel of twenty year old
residents of the three countries when compared to each other?
Exercise 2.13.8
One hundred teachers attended a seminar on mathematical problem solving. The attitudes of
a representative sample of 12 of the teachers were measured before and after the seminar. A
positive number for change in attitude indicates that a teacher’s attitude toward math became
more positive. The twelve change scores are as follows:
3; 8; -1; 2; 0; 5; -3; 1; -1; 6; 5; -2
a. What is the mean change score?
b. What is the standard deviation for this population?
c. What is the median change score?
d. Find the change score that is 2.2 standard deviations below the mean.
Exercise 2.13.9 (Solution on p. 109.)
Three students were applying to the same graduate school. They came fromschools with different
grading systems. Which student had the best G.P.A. when compared to his school? Explain how
you determined your answer.
Student G.P.A. School Ave. G.P.A. School Standard Deviation
Thuy 2.7 3.2 0.8
Vichet 87 75 20
Kamala 8.6 8 0.4
Table 2.16
90 CHAPTER 2. DESCRIPTIVE STATISTICS
Exercise 2.13.10
Given the following box plot:
a. Which quarter has the smallest spread of data? What is that spread?
b. Which quarter has the largest spread of data? What is that spread?
c. Find the Inter Quartile Range (IQR).
d. Are there more data in the interval 5 - 10 or in the interval 10 - 13? How do you know this?
e. Which interval has the fewest data in it? How do you know this?
I. 0-2
II. 2-4
III. 10-12
IV. 12-13
Exercise 2.13.11
Given the following box plot:
a. Think of an example (in words) where the data might fit into the above box plot. In 2-5 sen-
tences, write down the example.
b. What does it mean to have the first and second quartiles so close together, while the second to
fourth quartiles are far apart?
Exercise 2.13.12
Santa Clara County, CA, has approximately 27,873 Japanese-Americans. Their ages are as follows.
(Source: West magazine)
Age Group Percent of Community
0-17 18.9
18-24 8.0
25-34 22.8
35-44 15.0
45-54 13.1
55-64 11.9
65+ 10.3
Table 2.17
a. Construct a histogram of the Japanese-American community in Santa Clara County, CA. The
bars will not be the same width for this example. Why not?
91
b. What percent of the community is under age 35?
c. Which box plot most resembles the information above?
Exercise 2.13.13
Suppose that three book publishers were interested in the number of fiction paperbacks adult
consumers purchase per month. Each publisher conducted a survey. In the survey, each asked
adult consumers the number of fiction paperbacks they had purchased the previous month. The
results are below.
Publisher A
# of books Freq. Rel. Freq.
0 10
1 12
2 16
3 12
4 8
5 6
6 2
8 2
Table 2.18
92 CHAPTER 2. DESCRIPTIVE STATISTICS
Publisher B
# of books Freq. Rel. Freq.
0 18
1 24
2 24
3 22
4 15
5 10
7 5
9 1
Table 2.19
Publisher C
# of books Freq. Rel. Freq.
0-1 20
2-3 35
4-5 12
6-7 2
8-9 1
Table 2.20
a. Find the relative frequencies for each survey. Write them in the charts.
b. Using either a graphing calculator, computer, or by hand, use the frequency column to construct
a histogram for each publisher’s survey. For Publishers A and B, make bar widths of 1. For
Publisher C, make bar widths of 2.
c. In complete sentences, give two reasons why the graphs for Publishers Aand B are not identical.
d. Would you have expected the graph for Publisher C to look like the other two graphs? Why or
why not?
e. Make new histograms for Publisher A and Publisher B. This time, make bar widths of 2.
f. Now, compare the graph for Publisher C to the new graphs for Publishers A and B. Are the
graphs more similar or more different? Explain your answer.
Exercise 2.13.14
Often, cruise ships conduct all on-board transactions, with the exception of gambling, on a cash-
less basis. At the end of the cruise, guests pay one bill that covers all on-board transactions. Sup-
pose that 60 single travelers and 70 couples were surveyed as to their on-board bills for a seven-day
cruise from Los Angeles to the Mexican Riviera. Below is a summary of the bills for each group.
93
Singles
Amount($) Frequency Rel. Frequency
51-100 5
101-150 10
151-200 15
201-250 15
251-300 10
301-350 5
Table 2.21
Couples
Amount($) Frequency Rel. Frequency
100-150 5
201-250 5
251-300 5
301-350 5
351-400 10
401-450 10
451-500 10
501-550 10
551-600 5
601-650 5
Table 2.22
a. Fill in the relative frequency for each group.
b. Construct a histogram for the Singles group. Scale the x-axis by $50. widths. Use relative
frequency on the y-axis.
c. Construct a histogram for the Couples group. Scale the x-axis by $50. Use relative frequency on
the y-axis.
d. Compare the two graphs:
i. List two similarities between the graphs.
ii. List two differences between the graphs.
iii. Overall, are the graphs more similar or different?
e. Construct a new graph for the Couples by hand. Since each couple is paying for two indi-
viduals, instead of scaling the x-axis by $50, scale it by $100. Use relative frequency on the
y-axis.
f. Compare the graph for the Singles with the new graph for the Couples:
i. List two similarities between the graphs.
ii. Overall, are the graphs more similar or different?
94 CHAPTER 2. DESCRIPTIVE STATISTICS
i. By scaling the Couples graph differently, how did it change the way you compared it to the
Singles?
j. Based on the graphs, do you think that individuals spend the same amount, more or less, as
singles as they do person by person in a couple? Explain why in one or two complete sen-
tences.
Exercise 2.13.15 (Solution on p. 109.)
Refer to the following histograms and box plot. Determine which of the following are true and
which are false. Explain your solution to each part in complete sentences.
a. The medians for all three graphs are the same.
b. We cannot determine if any of the means for the three graphs is different.
c. The standard deviation for (b) is larger than the standard deviation for (a).
d. We cannot determine if any of the third quartiles for the three graphs is different.
Exercise 2.13.16
Refer to the following box plots.
95
a. In complete sentences, explain why each statement is false.
i. Data 1 has more data values above 2 than Data 2 has above 2.
ii. The data sets cannot have the same mode.
iii. For Data 1, there are more data values below 4 than there are above 4.
b. For which group, Data 1 or Data 2, is the value of “7” more likely to be an outlier? Explain why
in complete sentences
Exercise 2.13.17 (Solution on p. 110.)
In a recent issue of the IEEE Spectrum, 84 engineering conferences were announced. Four con-
ferences lasted two days. Thirty-six lasted three days. Eighteen lasted four days. Nineteen lasted
five days. Four lasted six days. One lasted seven days. One lasted eight days. One lasted nine
days. Let X = the length (in days) of an engineering conference.
a. Organize the data in a chart.
b. Find the median, the first quartile, and the third quartile.
c. Find the 65th percentile.
d. Find the 10th percentile.
e. Construct a box plot of the data.
f. The middle 50% of the conferences last from _______ days to _______ days.
g. Calculate the sample mean of days of engineering conferences.
h. Calculate the sample standard deviation of days of engineering conferences.
i. Find the mode.
j. If you were planning an engineering conference, which would you choose as the length of the
conference: mean; median; or mode? Explain why you made that choice.
k. Give two reasons why you think that 3 - 5 days seem to be popular lengths of engineering
conferences.
Exercise 2.13.18
A survey of enrollment at 35 community colleges across the United States yielded the following
figures (source: Microsoft Bookshelf ):
6414; 1550; 2109; 9350; 21828; 4300; 5944; 5722; 2825; 2044; 5481; 5200; 5853; 2750; 10012; 6357;
27000; 9414; 7681; 3200; 17500; 9200; 7380; 18314; 6557; 13713; 17768; 7493; 2771; 2861; 1263; 7285;
28165; 5080; 11622
a. Organize the data into a chart with five intervals of equal width. Label the two columns "En-
rollment" and "Frequency."
b. Construct a histogram of the data.
96 CHAPTER 2. DESCRIPTIVE STATISTICS
c. If you were to build a new community college, which piece of information would be more
valuable: the mode or the mean?
d. Calculate the sample mean.
e. Calculate the sample standard deviation.
f. A school with an enrollment of 8000 would be how many standard deviations away from the
mean?
Exercise 2.13.19 (Solution on p. 110.)
The median age of the U.S. population in 1980 was 30.0 years. In 1991, the median age was 33.1
years. (Source: Bureau of the Census)
a. What does it mean for the median age to rise?
b. Give two reasons why the median age could rise.
c. For the median age to rise, is the actual number of children less in 1991 than it was in 1980?
Why or why not?
Exercise 2.13.20
A survey was conducted of 130 purchasers of new BMW 3 series cars, 130 purchasers of new
BMW 5 series cars, and 130 purchasers of new BMW 7 series cars. In it, people were asked the age
they were when they purchased their car. The following box plots display the results.
a. In complete sentences, describe what the shape of each box plot implies about the distribution
of the data collected for that car series.
b. Which group is most likely to have an outlier? Explain how you determined that.
c. Compare the three box plots. What do they imply about the age of purchasing a BMW from the
series when compared to each other?
d. Look at the BMW 5 series. Which quarter has the smallest spread of data? What is that spread?
e. Look at the BMW 5 series. Which quarter has the largest spread of data? What is that spread?
f. Look at the BMW 5 series. Estimate the Inter Quartile Range (IQR).
g. Look at the BMW 5 series. Are there more data in the interval 31-38 or in the interval 45-55?
How do you know this?
h. Look at the BMW 5 series. Which interval has the fewest data in it? How do you know this?
i. 31-35
ii. 38-41
iii. 41-64
97
Exercise 2.13.21 (Solution on p. 110.)
The following box plot shows the U.S. population for 1990, the latest available year. (Source:
Bureau of the Census, 1990 Census)
a. Are there fewer or more children (age 17 and under) than senior citizens (age 65 and over)?
How do you know?
b. 12.6% are age 65 and over. Approximately what percent of the population are of working age
adults (above age 17 to age 65)?
Exercise 2.13.22
Javier and Ercilia are supervisors at a shopping mall. Each was given the task of estimating the
mean distance that shoppers live from the mall. They each randomly surveyed 100 shoppers. The
samples yielded the following information:
Javier Ercilla
x 6.0 miles 6.0 miles
s 4.0 miles 7.0 miles
Table 2.23
a. How can you determine which survey was correct ?
b. Explain what the difference in the results of the surveys implies about the data.
c. If the two histograms depict the distribution of values for each supervisor, which one depicts
Ercilia’s sample? How do you know?
Figure 2.2
d. If the two box plots depict the distribution of values for each supervisor, which one depicts
Ercilia’s sample? How do you know?
98 CHAPTER 2. DESCRIPTIVE STATISTICS
Figure 2.3
Exercise 2.13.23 (Solution on p. 110.)
Student grades on a chemistry exam were:
77, 78, 76, 81, 86, 51, 79, 82, 84, 99
a. Construct a stem-and-leaf plot of the data.
b. Are there any potential outliers? If so, which scores are they? Why do you consider them
outliers?
2.13.1 Try these multiple choice questions (Exercises 24 - 30).
The next three questions refer to the following information. We are interested in the number of years
students in a particular elementary statistics class have lived in California. The information in the following
table is from the entire section.
Number of years Frequency
7 1
14 3
15 1
18 1
19 4
20 3
22 1
23 1
26 1
40 2
42 2
Total = 20
Table 2.24
Exercise 2.13.24 (Solution on p. 110.)
What is the IQR?
A. 8
99
B. 11
C. 15
D. 35
Exercise 2.13.25 (Solution on p. 110.)
What is the mode?
A. 19
B. 19.5
C. 14 and 20
D. 22.65
Exercise 2.13.26 (Solution on p. 110.)
Is this a sample or the entire population?
A. sample
B. entire population
C. neither
The next two questions refer to the following table. X = the number of days per week that 100 clients use
a particular exercise facility.
x Frequency
0 3
1 12
2 33
3 28
4 11
5 9
6 4
Table 2.25
Exercise 2.13.27 (Solution on p. 110.)
The 80th percentile is:
A. 5
B. 80
C. 3
D. 4
Exercise 2.13.28 (Solution on p. 110.)
The number that is 1.5 standard deviations BELOW the mean is approximately:
A. 0.7
B. 4.8
C. -2.8
D. Cannot be determined
100 CHAPTER 2. DESCRIPTIVE STATISTICS
The next two questions refer to the following histogram. Suppose one hundred eleven people who
shopped in a special T-shirt store were asked the number of T-shirts they own costing more than $19 each.
Exercise 2.13.29 (Solution on p. 110.)
The percent of people that own at most three (3) T-shirts costing more than $19 each is approxi-
mately:
A. 21
B. 59
C. 41
D. Cannot be determined
Exercise 2.13.30 (Solution on p. 110.)
If the data were collected by asking the first 111 people who entered the store, then the type of
sampling is:
A. cluster
B. simple random
C. stratified
D. convenience
Exercise 2.13.31 (Solution on p. 110.)
Below are the 2010 obesity rates by U.S. states and Washington, DC.(Source:
http://www.cdc.gov/obesity/data/adult.html) )
101
State Percent (%) State Percent (%)
Alabama 32.2 Montana 23.0
Alaska 24.5 Nebraska 26.9
Arizona 24.3 Nevada 22.4
Arkansas 30.1 New Hampshire 25.0
California 24.0 New Jersey 23.8
Colorado 21.0 New Mexico 25.1
Connecticut 22.5 New York 23.9
Delaware 28.0 North Carolina 27.8
Washington, DC 22.2 North Dakota 27.2
Florida 26.6 Ohio 29.2
Georgia 29.6 Oklahoma 30.4
Hawaii 22.7 Oregon 26.8
Idaho 26.5 Pennsylvania 28.6
Illinois 28.2 Rhode Island 25.5
Indiana 29.6 South Carolina 31.5
Iowa 28.4 South Dakota 27.3
Kansas 29.4 Tennessee 30.8
Kentucky 31.3 Texas 31.0
Louisiana 31.0 Utah 22.5
Maine 26.8 Vermont 23.2
Maryland 27.1 Virginia 26.0
Massachusetts 23.0 Washington 25.5
Michigan 30.9 West Virginia 32.5
Minnesota 24.8 Wisconsin 26.3
Mississippi 34.0 Wyoming 25.1
Missouri 30.5
Table 2.26
a.. Construct a bar graph of obesity rates of your state and the four states closest to your state.
Hint: Label the x-axis with the states.
b.. Use a randomnumber generator to randomly pick 8 states. Construct a bar graph of the obesity
rates of those 8 states.
c.. Construct a bar graph for all the states beginning with the letter "A."
d.. Construct a bar graph for all the states beginning with the letter "M."
Exercise 2.13.32 (Solution on p. 111.)
A music school has budgeted to purchase 3 musical instruments. They plan to purchase a piano
costing $3000, a guitar costing $550, and a drum set costing $600. The mean cost for a piano is
102 CHAPTER 2. DESCRIPTIVE STATISTICS
$4,000 with a standard deviation of $2,500. The mean cost for a guitar is $500 with a standard
deviation of $200. The mean cost for drums is $700 with a standard deviation of $100. Which cost
is the lowest, when compared to other instruments of the same type? Which cost is the highest
when compared to other instruments of the same type. Justify your answer numerically.
Exercise 2.13.33 (Solution on p. 111.)
Suppose that a publisher conducted a survey asking adult consumers the number of fiction pa-
perback books they had purchased in the previous month. The results are summarized in the table
below. (Note that this is the data presented for publisher B in homework exercise 13).
Publisher B
# of books Freq. Rel. Freq.
0 18
1 24
2 24
3 22
4 15
5 10
7 5
9 1
Table 2.27
a. Are there any outliers in the data? Use an appropriate numerical test involving the IQR to
identify outliers, if any, and clearly state your conclusion.
b. If a data value is identified as an outlier, what should be done about it?
c. Are any data values further than 2 standard deviations away from the mean? In some situ-
ations, statisticians may use this criteria to identify data values that are unusual, compared
to the other data values. (Note that this criteria is most appropriate to use for data that is
mound-shaped and symmetric, rather than for skewed data.)
d. Do parts (a) and (c) of this problem give the same answer?
e. Examine the shape of the data. Which part, (a) or (c), of this question gives a more appropri-
ate result for this data?
f. Based on the shape of the data which is the most appropriate measure of center for this data:
mean, median or mode?
**Exercises 32 and 33 contributed by Roberta Bloom
103
2.14 Lab: Descriptive Statistics
17
Class Time:
Names:
2.14.1 Student Learning Outcomes
• The student will construct a histogram and a box plot.
• The student will calculate univariate statistics.
• The student will examine the graphs to interpret what the data implies.
2.14.2 Collect the Data
Record the number of pairs of shoes you own:
1. Randomly survey 30 classmates. Record their values.
Survey Results
_____ _____ _____ _____ _____
_____ _____ _____ _____ _____
_____ _____ _____ _____ _____
_____ _____ _____ _____ _____
_____ _____ _____ _____ _____
_____ _____ _____ _____ _____
Table 2.28
2. Construct a histogram. Make 5-6 intervals. Sketch the graph using a ruler and pencil. Scale the axes.
17
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104 CHAPTER 2. DESCRIPTIVE STATISTICS
Figure 2.4
3. Calculate the following:
• x =
• s =
4. Are the data discrete or continuous? How do you know?
5. Describe the shape of the histogram. Use complete sentences.
6. Are there any potential outliers? Which value(s) is (are) it (they)? Use a formula to check the end
values to determine if they are potential outliers.
2.14.3 Analyze the Data
1. Determine the following:
• Minimum value =
• Median =
• Maximum value =
• First quartile =
• Third quartile =
• IQR =
2. Construct a box plot of data
3. What does the shape of the box plot imply about the concentration of data? Use complete sentences.
4. Using the box plot, how can you determine if there are potential outliers?
5. How does the standard deviation help you to determine concentration of the data and whether or not
there are potential outliers?
6. What does the IQR represent in this problem?
7. Show your work to find the value that is 1.5 standard deviations:
a. Above the mean:
b. Below the mean:
105
Solutions to Exercises in Chapter 2
Solution to Example 2.2, Problem (p. 53)
The value 12.3 may be an outlier. Values appear to concentrate at 3 and 4 kilometers.
Stem Leaf
1 1 5
2 3 5 7
3 2 3 3 5 8
4 0 2 5 5 7 8
5 5 6
6 5 7
7
8
9
10
11
12 3
Table 2.29
Solution to Example 2.7, Problem (p. 58)
• 3.5 to 4.5
• 4.5 to 5.5
• 6
• 5.5 to 6.5
Solution to Example 2.9, Problem (p. 62)
First Data Set
• Xmin = 32
• Q1 = 56
• M = 74.5
• Q3 = 82.5
• Xmax = 99
Second Data Set
• Xmin = 25.5
• Q1 = 78
• M = 81
• Q3 = 89
• Xmax = 98
106 CHAPTER 2. DESCRIPTIVE STATISTICS
Solution to Example 2.11, Problem (p. 63)
For the IQRs, see the answer to the test scores example (Solution to Example 2.9: p. 105). The first data set
has the larger IQR, so the scores between Q3 and Q1 (middle 50%) for the first data set are more spread out
and not clustered about the median.
First Data Set

_
3
2
_
· (IQR) =
_
3
2
_
· (26.5) = 39.75
• Xmax − Q3 = 99 − 82.5 = 16.5
• Q1 − Xmin = 56 − 32 = 24
_
3
2
_
· (IQR) = 39.75 is larger than 16.5 and larger than 24, so the first set has no outliers.
Second Data Set

_
3
2
_
· (IQR) =
_
3
2
_
· (11) = 16.5
• Xmax − Q3 = 98 − 89 = 9
• Q1 − Xmin = 78 − 25.5 = 52.5
_
3
2
_
· (IQR) = 16.5 is larger than 9 but smaller than 52.5, so for the second set 45 and 25.5 are outliers.
To find the percentiles, create a frequency, relative frequency, and cumulative relative frequency chart (see
"Frequency" from the Sampling and Data Chapter (Section 1.9)). Get the percentiles from that chart.
First Data Set
• 30th %ile (between the 6th and 7th values) =
(56 + 59)
2
= 57.5
• 80th %ile (between the 16th and 17th values) =
(84 + 84.5)
2
= 84.25
Second Data Set
• 30th %ile (7th value) = 78
• 80th %ile (18th value) = 90
30% of the data falls below the 30th %ile, and 20% falls above the 80th %ile.
Solution to Example 2.13, Problem (p. 64)
1.
(8 + 9)
2
= 8.5
2. 9
3. 6
4. First Quartile = 25th %ile
Solution to Exercise 2.6.1 (p. 66)
a. For runners in a race it is more desirable to have a low percentile for finish time. A low percentile means
a short time, which is faster.
107
b. INTERPRETATION: 20% of runners finished the race in 5.2 minutes or less. 80% of runners finished the
race in 5.2 minutes or longer.
c. He is among the slowest cyclists (90% of cyclists were faster than him.) INTERPRETATION: 90% of
cyclists had a finish time of 1 hour, 12 minutes or less.Only 10% of cyclists had a finish time of 1 hour,
12 minutes or longer
Solution to Exercise 2.6.2 (p. 66)
a. For runners in a race it is more desirable to have a high percentile for speed. A high percentile means a
higher speed, which is faster.
b. INTERPRETATION: 40% of runners ran at speeds of 7.5 miles per hour or less (slower). 60% of runners
ran at speeds of 7.5 miles per hour or more (faster).
Solution to Exercise 2.6.3 (p. 66)
On an exam you would prefer a high percentile; higher percentiles correspond to higher grades on the
exam.
Solution to Exercise 2.6.4 (p. 66)
When waiting in line at the DMV, the 85th percentile would be a long wait time compared to the other
people waiting. 85% of people had shorter wait times than you did. In this context, you would prefer a
wait time corresponding to a lower percentile. INTERPRETATION: 85% of people at the DMV waited 32
minutes or less. 15% of people at the DMV waited 32 minutes or longer.
Solution to Exercise 2.6.5 (p. 66)
Li should be pleased. Her salary is relatively high compared to other recent college grads. 78% of recent
college graduates earn less than Li does. 22% of recent college graduates earn more than Li does.
Solution to Exercise 2.6.6 (p. 66)
The manufacturer and the consumer would be upset. This is a large repair cost for the damages, compared
to the other cars in the sample. INTERPRETATION: 90% of the crash tested cars had damage repair costs
of $1700 or less; only 10% had damage repair costs of $1700 or more.
Solution to Exercise 2.6.7 (p. 66)
a. The top 12% of students are those who are at or above the 88th percentile of admissions index scores.
b. The top 4%of students’ GPAs are at or above the 96th percentile, making the top 4%of students "eligible
in the local context".
Solution to Exercise 2.6.8 (p. 67)
You can afford 34% of houses. 66% of the houses are too expensive for your budget. INTERPRETATION:
34% of houses cost $240,000 or less. 66% of houses cost $240,000 or more.
Solutions to Practice 1: Center of the Data
Solution to Exercise 2.11.1 (p. 81)
65
Solution to Exercise 2.11.2 (p. 81)
1
Solution to Exercise 2.11.5 (p. 82)
4.75
Solution to Exercise 2.11.6 (p. 82)
1.39
Solution to Exercise 2.11.7 (p. 82)
65
Solution to Exercise 2.11.8 (p. 82)
4
Solution to Exercise 2.11.9 (p. 82)
4
108 CHAPTER 2. DESCRIPTIVE STATISTICS
Solution to Exercise 2.11.10 (p. 82)
4
Solution to Exercise 2.11.11 (p. 82)
4
Solution to Exercise 2.11.12 (p. 82)
6
Solution to Exercise 2.11.13 (p. 82)
6 − 4 = 2
Solution to Exercise 2.11.14 (p. 82)
3
Solution to Exercise 2.11.15 (p. 82)
6
Solution to Exercise 2.11.16 (p. 83)
a. 8.93
b. 0.58
Solutions to Practice 2: Spread of the Data
Solution to Exercise 2.12.1 (p. 84)
6
Solution to Exercise 2.12.2 (p. 84)
a. 1447.5
b. 528.5
Solution to Exercise 2.12.3 (p. 84)
474 FTES
Solution to Exercise 2.12.4 (p. 84)
50%
Solution to Exercise 2.12.5 (p. 84)
919
Solution to Exercise 2.12.6 (p. 84)
0.03
Solution to Exercise 2.12.7 (p. 85)
mean = 1809.3
median = 1812.5
standard deviation = 151.2
First quartile = 1690
Third quartile = 1935
IQR = 245
Solution to Exercise 2.12.9 (p. 85)
Hint: Think about the number of years covered by each time period and what happened to higher educa-
tion during those periods.
Solutions to Homework
Solution to Exercise 2.13.1 (p. 86)
a. 1.48
b. 1.12
e. 1
f. 1
109
g. 2
h.
i. 80%
j. 1
k. 3
Solution to Exercise 2.13.3 (p. 86)
a. 3.78
b. 1.29
e. 3
f. 4
g. 5
h.
i. 32.5%
j. 4
k. 5
Solution to Exercise 2.13.5 (p. 88)
b. 241
c. 205.5
d. 272.5
e.
f. 205.5, 272.5
g. sample
h. population
i. i. 236.34
ii. 37.50
iii. 161.34
iv. 0.84 std. dev. below the mean
j. Young
Solution to Exercise 2.13.9 (p. 89)
Kamala
Solution to Exercise 2.13.15 (p. 94)
a. True
110 CHAPTER 2. DESCRIPTIVE STATISTICS
b. True
c. True
d. False
Solution to Exercise 2.13.17 (p. 95)
b. 4,3,5
c. 4
d. 3
e.
f. 3,5
g. 3.94
h. 1.28
i. 3
j. mode
Solution to Exercise 2.13.19 (p. 96)
c. Maybe
Solution to Exercise 2.13.21 (p. 97)
a. more children
b. 62.4%
Solution to Exercise 2.13.23 (p. 98)
b. 51,99
Solution to Exercise 2.13.24 (p. 98)
A
Solution to Exercise 2.13.25 (p. 99)
A
Solution to Exercise 2.13.26 (p. 99)
B
Solution to Exercise 2.13.27 (p. 99)
D
Solution to Exercise 2.13.28 (p. 99)
A
Solution to Exercise 2.13.29 (p. 100)
C
Solution to Exercise 2.13.30 (p. 100)
D
Solution to Exercise 2.13.31 (p. 100)
Example solution for b using the random number generator for the Ti-84 Plus to generate a simple random
sample of 8 states. Instructions are below.
Number the entries in the table 1 - 51 (Includes Washington, DC; Numbered vertically)
Press MATH
Arrow over to PRB
Press 5:randInt(
111
Enter 51,1,8)
Eight numbers are generated (use the right arrow key to scroll through the numbers). The
numbers correspond to the numbered states (for this example: {47 21 9 23 51 13 25 4}. If
any numbers are repeated, generate a different number by using 5:randInt(51,1)). Here, the
states (and Washington DC) are {Arkansas, Washington DC, Idaho, Maryland, Michigan, Missis-
sippi, Virginia, Wyoming}. Corresponding percents are {28.7 21.8 24.5 26 28.9 32.8 25 24.6}.
Solution to Exercise 2.13.32 (p. 101)
For pianos, the cost of the piano is 0.4 standard deviations BELOW the mean. For guitars, the cost of the
guitar is 0.25 standard deviations ABOVE the mean. For drums, the cost of the drum set is 1.0 standard
deviations BELOW the mean. Of the three, the drums cost the lowest in comparison to the cost of other
instruments of the same type. The guitar cost the most in comparison to the cost of other instruments of the
same type.
Solution to Exercise 2.13.33 (p. 102)
• IQR = 4 – 1 = 3 ; Q1 – 1.5*IQR = 1 – 1.5(3) = -3.5 ; Q3 + 1.5*IQR = 4 + 1.5(3) = 8.5 ;The data value of 9 is
larger than 8.5. The purchase of 9 books in one month is an outlier.
• The outlier should be investigated to see if there is an error or some other problem in the data; then a
decision whether to include or exclude it should be made based on the particular situation. If it was
a correct value then the data value should remain in the data set. If there is a problem with this data
value, then it should be corrected or removed from the data. For example: If the data was recorded
incorrectly (perhaps a 9 was miscoded and the correct value was 6) then the data should be corrected.
If it was an error but the correct value is not known it should be removed from the data set.
• xbar – 2s = 2.45 – 2*1.88 = -1.31 ; xbar + 2s = 2.45 + 2*1.88 = 6.21 ; Using this method, the five data values
of 7 books purchased and the one data value of 9 books purchased would be considered unusual.
• No: part (a) identifies only the value of 9 to be an outlier but part (c) identifies both 7 and 9.
• The data is skewed (to the right). It would be more appropriate to use the method involving the IQR
in part (a), identifying only the one value of 9 books purchased as an outlier. Note that part (c) remarks
that identifying unusual data values by using the criteria of being further than 2 standard deviations
away from the mean is most appropriate when the data are mound-shaped and symmetric.
• The data are skewed to the right. For skewed data it is more appropriate to use the median as a
measure of center.
112 CHAPTER 2. DESCRIPTIVE STATISTICS
Chapter 12
Linear Regression and Correlation
12.1 Linear Regression and Correlation
1
12.1.1 Student Learning Outcomes
By the end of this chapter, the student should be able to:
• Discuss basic ideas of linear regression and correlation.
• Create and interpret a line of best fit.
• Calculate and interpret the correlation coefficient.
• Calculate and interpret outliers.
12.1.2 Introduction
Professionals often want to know how two or more numeric variables are related. For example, is there a
relationship between the grade on the second math exam a student takes and the grade on the final exam?
If there is a relationship, what is it and how strong is the relationship?
In another example, your income may be determined by your education, your profession, your years of
experience, and your ability. The amount you pay a repair person for labor is often determined by an initial
amount plus an hourly fee. These are all examples in which regression can be used.
The type of data described in the examples is bivariate data - "bi" for two variables. In reality, statisticians
use multivariate data, meaning many variables.
In this chapter, you will be studying the simplest form of regression, "linear regression" with one indepen-
dent variable (x). This involves data that fits a line in two dimensions. You will also study correlation which
measures how strong the relationship is.
12.2 Linear Equations
2
Linear regression for two variables is based on a linear equation with one independent variable. It has the
form:
y = a +bx (12.1)
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516 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
where a and b are constant numbers.
x is the independent variable, and y is the dependent variable. Typically, you choose a value to substitute
for the independent variable and then solve for the dependent variable.
Example 12.1
The following examples are linear equations.
y = 3 +2x (12.2)
y = −0.01 +1.2x (12.3)
The graph of a linear equation of the form y = a +bx is a straight line. Any line that is not vertical can be
described by this equation.
Example 12.2
Figure 12.1: Graph of the equation y = −1 +2x.
Linear equations of this form occur in applications of life sciences, social sciences, psychology, business,
economics, physical sciences, mathematics, and other areas.
Example 12.3
Aaron’s Word Processing Service (AWPS) does word processing. Its rate is $32 per hour plus a
$31.50 one-time charge. The total cost to a customer depends on the number of hours it takes to
do the word processing job.
Problem
Find the equation that expresses the total cost in terms of the number of hours required to finish
the word processing job.
Solution
Let x = the number of hours it takes to get the job done.
Let y = the total cost to the customer.
The $31.50 is a fixed cost. If it takes x hours to complete the job, then (32) (x) is the cost of the
word processing only. The total cost is:
517
y = 31.50 +32x
12.3 Slope and Y-Intercept of a Linear Equation
3
For the linear equation y = a + bx, b = slope and a = y-intercept.
From algebra recall that the slope is a number that describes the steepness of a line and the y-intercept is
the y coordinate of the point (0, a) where the line crosses the y-axis.
(a) (b) (c)
Figure 12.2: Three possible graphs of y = a + bx. (a) If b > 0, the line slopes upward to the right. (b) If
b = 0, the line is horizontal. (c) If b < 0, the line slopes downward to the right.
Example 12.4
Svetlana tutors to make extra money for college. For each tutoring session, she charges a one
time fee of $25 plus $15 per hour of tutoring. A linear equation that expresses the total amount of
money Svetlana earns for each session she tutors is y = 25 +15x.
Problem
What are the independent and dependent variables? What is the y-intercept and what is the
slope? Interpret them using complete sentences.
Solution
The independent variable (x) is the number of hours Svetlana tutors each session. The dependent
variable (y) is the amount, in dollars, Svetlana earns for each session.
The y-intercept is 25 (a = 25). At the start of the tutoring session, Svetlana charges a one-time fee
of $25 (this is when x = 0). The slope is 15 (b = 15). For each session, Svetlana earns $15 for each
hour she tutors.
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518 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
12.4 Scatter Plots
4
Before we take up the discussion of linear regression and correlation, we need to examine a way to display
the relation between two variables x and y. The most common and easiest way is a scatter plot. The
following example illustrates a scatter plot.
Example 12.5
From an article in the Wall Street Journal : In Europe and Asia, m-commerce is popular. M-
commerce users have special mobile phones that work like electronic wallets as well as provide
phone and Internet services. Users can do everything from paying for parking to buying a TV set
or soda from a machine to banking to checking sports scores on the Internet. For the years 2000
through 2004, was there a relationship between the year and the number of m-commerce users?
Construct a scatter plot. Let x = the year and let y = the number of m-commerce users, in millions.
x (year) y (# of users)
2000 0.5
2002 20.0
2003 33.0
2004 47.0
(a)
(b)
Figure 12.3: (a) Table showing the number of m-commerce users (in millions) by year. (b) Scatter plot
showing the number of m-commerce users (in millions) by year.
A scatter plot shows the direction and strength of a relationship between the variables. A clear direction
happens when there is either:
• High values of one variable occurring with high values of the other variable or low values of one
variable occurring with low values of the other variable.
• High values of one variable occurring with low values of the other variable.
You can determine the strength of the relationship by looking at the scatter plot and seeing how close the
points are to a line, a power function, an exponential function, or to some other type of function.
When you look at a scatterplot, you want to notice the overall pattern and any deviations from the pattern.
The following scatterplot examples illustrate these concepts.
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519
(a) Positive Linear Pattern (Strong) (b) Linear Pattern w/ One Deviation
Figure 12.4
(a) Negative Linear Pattern (Strong) (b) Negative Linear Pattern (Weak)
Figure 12.5
(a) Exponential Growth Pattern (b) No Pattern
Figure 12.6
In this chapter, we are interested in scatter plots that show a linear pattern. Linear patterns are quite com-
mon. The linear relationship is strong if the points are close to a straight line. If we think that the points
show a linear relationship, we would like to draw a line on the scatter plot. This line can be calculated
through a process called linear regression. However, we only calculate a regression line if one of the vari-
ables helps to explain or predict the other variable. If x is the independent variable and y the dependent
variable, then we can use a regression line to predict y for a given value of x.
520 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
12.5 The Regression Equation
5
Data rarely fit a straight line exactly. Usually, you must be satisfied with rough predictions. Typically, you
have a set of data whose scatter plot appears to "fit" a straight line. This is called a Line of Best Fit or Least
Squares Line.
12.5.1 Optional Collaborative Classroom Activity
If you know a person’s pinky (smallest) finger length, do you think you could predict that person’s height?
Collect data from your class (pinky finger length, in inches). The independent variable, x, is pinky finger
length and the dependent variable, y, is height.
For each set of data, plot the points on graph paper. Make your graph big enough and use a ruler. Then
"by eye" draw a line that appears to "fit" the data. For your line, pick two convenient points and use them
to find the slope of the line. Find the y-intercept of the line by extending your lines so they cross the y-axis.
Using the slopes and the y-intercepts, write your equation of "best fit". Do you think everyone will have
the same equation? Why or why not?
Using your equation, what is the predicted height for a pinky length of 2.5 inches?
Example 12.6
A random sample of 11 statistics students produced the following data where x is the third exam
score, out of 80, and y is the final exam score, out of 200. Can you predict the final exam score of a
random student if you know the third exam score?
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521
x (third exam score) y (final exam score)
65 175
67 133
71 185
71 163
66 126
75 198
67 153
70 163
71 159
69 151
69 159
(a)
(b)
Figure 12.7: (a) Table showing the scores on the final exambased on scores fromthe third exam. (b) Scatter
plot showing the scores on the final exam based on scores from the third exam.
The third exam score, x, is the independent variable and the final exam score, y, is the dependent variable.
We will plot a regression line that best "fits" the data. If each of you were to fit a line "by eye", you would
draw different lines. We can use what is called a least-squares regression line to obtain the best fit line.
Consider the following diagram. Each point of data is of the the form (x, y)and each point of the line of
best fit using least-squares linear regression has the form
_
x,
^
y
_
.
The
^
y
is read "y hat" and is the estimated value of y. It is the value of y obtained using the regression line.
It is not generally equal to y from data.
522 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Figure 12.8
The term y
0

^
y
0
=
0
is called the "error" or residual. It is not an error in the sense of a mistake. The
absolute value of a residual measures the vertical distance between the actual value of y and the estimated
value of y. In other words, it measures the vertical distance between the actual data point and the predicted
point on the line.
If the observed data point lies above the line, the residual is positive, and the line underestimates the
actual data value for y. If the observed data point lies below the line, the residual is negative, and the line
overestimates that actual data value for y.
In the diagram above, y
0

^
y
0
=
0
is the residual for the point shown. Here the point lies above the line
and the residual is positive.
= the Greek letter epsilon
For each data point, you can calculate the residuals or errors, y
i

^
y
i
=
i
for i = 1, 2, 3, ..., 11.
Each || is a vertical distance.
For the example about the third exam scores and the final exam scores for the 11 statistics students, there
are 11 data points. Therefore, there are 11 values. If you square each and add, you get
(
1
)
2
+ (
2
)
2
+... + (
11
)
2
=
11
Σ
i = 1

2
This is called the Sum of Squared Errors (SSE).
Using calculus, you can determine the values of a and b that make the SSE a minimum. When you make
the SSE a minimum, you have determined the points that are on the line of best fit. It turns out that the line
of best fit has the equation:
^
y
= a +bx (12.4)
523
where a = y −b · x and b =
Σ(x−x)·(y−y)
Σ(x−x)
2
.
x and y are the sample means of the x values and the y values, respectively. The best fit line always passes
through the point (x, y).
The slope b can be written as b = r ·
_
s
y
s
x
_
where s
y
= the standard deviation of the y values and s
x
= the
standard deviation of the x values. r is the correlation coefficient which is discussed in the next section.
Least Squares Criteria for Best Fit
The process of fitting the best fit line is called linear regression. The idea behind finding the best fit line is
based on the assumption that the data are scattered about a straight line. The criteria for the best fit line is
that the sum of the squared errors (SSE) is minimized, that is made as small as possible. Any other line you
might choose would have a higher SSE than the best fit line. This best fit line is called the least squares
regression line .
NOTE: Computer spreadsheets, statistical software, and many calculators can quickly calculate the
best fit line and create the graphs. The calculations tend to be tedious if done by hand. Instructions
to use the TI-83, TI-83+, and TI-84+ calculators to find the best fit line and create a scatterplot are
shown at the end of this section.
THIRD EXAM vs FINAL EXAM EXAMPLE:
The graph of the line of best fit for the third exam/final exam example is shown below:
Figure 12.9
The least squares regression line (best fit line) for the third exam/final exam example has the equation:
^
y
= −173.51 +4.83x (12.5)
524 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
NOTE:
Remember, it is always important to plot a scatter diagram first. If the scatter plot indicates that
there is a linear relationship between the variables, then it is reasonable to use a best fit line
to make predictions for y given x within the domain of x-values in the sample data, but not
necessarily for x-values outside that domain.
You could use the line to predict the final exam score for a student who earned a grade of 73 on
the third exam.
You should NOT use the line to predict the final exam score for a student who earned a grade of
50 on the third exam, because 50 is not within the domain of the x-values in the sample data,
which are between 65 and 75.
UNDERSTANDING SLOPE
The slope of the line, b, describes how changes in the variables are related. It is important to interpret
the slope of the line in the context of the situation represented by the data. You should be able to write a
sentence interpreting the slope in plain English.
INTERPRETATION OF THE SLOPE: The slope of the best fit line tells us how the dependent variable (y)
changes for every one unit increase in the independent (x) variable, on average.
THIRD EXAM vs FINAL EXAM EXAMPLE
Slope: The slope of the line is b = 4.83.
Interpretation: For a one point increase in the score on the third exam, the final exam score increases by
4.83 points, on average.
12.5.2 Using the TI-83+ and TI-84+ Calculators
Using the Linear Regression T Test: LinRegTTest
Step 1. In the STAT list editor, enter the X data in list L1 and the Y data in list L2, paired so that the corre-
sponding (x,y) values are next to each other in the lists. (If a particular pair of values is repeated, enter
it as many times as it appears in the data.)
Step 2. On the STAT TESTS menu, scroll down with the cursor to select the LinRegTTest. (Be careful to select
LinRegTTest as some calculators may also have a different item called LinRegTInt.)
Step 3. On the LinRegTTest input screen enter: Xlist: L1 ; Ylist: L2 ; Freq: 1
Step 4. On the next line, at the prompt β or ρ, highlight "= 0" and press ENTER
Step 5. Leave the line for "RegEq:" blank
Step 6. Highlight Calculate and press ENTER.
525
Figure 12.10
The output screen contains a lot of information. For now we will focus on a few items from the output, and
will return later to the other items.
The second line says y=a+bx. Scroll down to find the values a=-173.513, and b=4.8273 ; the equation of the
best fit line is
^
y
= −173.51 +4.83x
The two items at the bottom are r
2
= .43969 and r=.663. For now, just note where to find these values; we
will discuss them in the next two sections.
Graphing the Scatterplot and Regression Line
Step 1. We are assuming your X data is already entered in list L1 and your Y data is in list L2
Step 2. Press 2nd STATPLOT ENTER to use Plot 1
Step 3. On the input screen for PLOT 1, highlight On and press ENTER
Step 4. For TYPE: highlight the very first icon which is the scatterplot and press ENTER
Step 5. Indicate Xlist: L1 and Ylist: L2
Step 6. For Mark: it does not matter which symbol you highlight.
Step 7. Press the ZOOM key and then the number 9 (for menu item "ZoomStat") ; the calculator will fit the
window to the data
Step 8. To graph the best fit line, press the "Y=" key and type the equation -173.5+4.83X into equation Y1.
(The X key is immediately left of the STAT key). Press ZOOM 9 again to graph it.
Step 9. Optional: If you want to change the viewing window, press the WINDOW key. Enter your desired
window using Xmin, Xmax, Ymin, Ymax
**With contributions from Roberta Bloom
526 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
12.6 Correlation Coefficient and Coefficient of Determination
6
12.6.1 The Correlation Coefficient r
Besides looking at the scatter plot and seeing that a line seems reasonable, how can you tell if the line is a
good predictor? Use the correlation coefficient as another indicator (besides the scatterplot) of the strength
of the relationship between x and y.
The correlation coefficient, r, developed by Karl Pearson in the early 1900s, is a numerical measure of the
strength of association between the independent variable x and the dependent variable y.
The correlation coefficient is calculated as
r =
n · Σx · y −(Σx) · (Σy)
_
_
n · Σx
2
−(Σx)
2
_
·
_
n · Σy
2
−(Σy)
2
_
(12.6)
where n = the number of data points.
If you suspect a linear relationship between x and y, then r can measure how strong the linear relationship
is.
What the VALUE of r tells us:
• The value of r is always between -1 and +1: −1 ≤ r ≤ 1.
• The size of the correlation r indicates the strength of the linear relationship between x and y. Values
of r close to -1 or to +1 indicate a stronger linear relationship between x and y.
• If r = 0 there is absolutely no linear relationship between x and y (no linear correlation).
• If r = 1, there is perfect positive correlation. If r = −1, there is perfect negative correlation. In both
these cases, all of the original data points lie on a straight line. Of course, in the real world, this will
not generally happen.
What the SIGN of r tells us
• A positive value of r means that when x increases, y tends to increase and when x decreases, y tends
to decrease (positive correlation).
• A negative value of r means that when x increases, y tends to decrease and when x decreases, y tends
to increase (negative correlation).
• The sign of r is the same as the sign of the slope, b, of the best fit line.
NOTE: Strong correlation does not suggest that x causes y or y causes x. We say "correlation does
not imply causation." For example, every person who learned math in the 17th century is dead.
However, learning math does not necessarily cause death!
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(a) Positive Correlation (b) Negative Correlation (c) Zero Correlation
Figure 12.11: (a) A scatter plot showing data with a positive correlation. 0 < r < 1 (b) A scatter plot
showing data with a negative correlation. −1 < r < 0 (c) Ascatter plot showing data with zero correlation.
r=0
The formula for r looks formidable. However, computer spreadsheets, statistical software, and many cal-
culators can quickly calculate r. The correlation coefficient r is the bottom item in the output screens for the
LinRegTTest on the TI-83, TI-83+, or TI-84+ calculator (see previous section for instructions).
12.6.2 The Coefficient of Determination
r
2
is called the coefficient of determination. r
2
is the square of the correlation coefficient , but is usually
stated as a percent, rather than in decimal form. r
2
has an interpretation in the context of the data:
• r
2
, when expressed as a percent, represents the percent of variation in the dependent variable y that
can be explained by variation in the independent variable x using the regression (best fit) line.
• 1-r
2
, when expressed as a percent, represents the percent of variation in y that is NOT explained by
variation in x using the regression line. This can be seen as the scattering of the observed data points
about the regression line.
Consider the third exam/final exam example introduced in the previous section
The line of best fit is:
^
y
= −173.51 +4.83x
The correlation coefficient is r = 0.6631
The coefficient of determination is r
2
= 0.6631
2
= 0.4397
Interpretation of r
2
in the context of this example:
Approximately 44% of the variation (0.4397 is approximately 0.44) in the final exam grades can be ex-
plained by the variation in the grades on the third exam, using the best fit regression line.
Therefore approximately 56% of the variation (1 - 0.44 = 0.56) in the final exam grades can NOT be ex-
plained by the variation in the grades on the third exam, using the best fit regression line. (This is
seen as the scattering of the points about the line.)
**With contributions from Roberta Bloom.
528 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
12.7 Testing the Significance of the Correlation Coefficient
7
12.7.1 Testing the Significance of the Correlation Coefficient
The correlation coefficient, r, tells us about the strength of the linear relationship between x and y. However,
the reliability of the linear model also depends on how many observed data points are in the sample. We
need to look at both the value of the correlation coefficient r and the sample size n, together.
We perform a hypothesis test of the "significance of the correlation coefficient" to decide whether the
linear relationship in the sample data is strong enough to use to model the relationship in the population.
The sample data is used to compute r, the correlation coefficient for the sample. If we had data for the
entire population, we could find the population correlation coefficient. But because we only have sample
data, we can not calculate the population correlation coefficient. The sample correlation coefficient, r, is our
estimate of the unknown population correlation coefficient.
The symbol for the population correlation coefficient is ρ, the Greek letter "rho".
ρ = population correlation coefficient (unknown)
r = sample correlation coefficient (known; calculated from sample data)
The hypothesis test lets us decide whether the value of the population correlation coefficient ρ is "close to
0" or "significantly different from 0". We decide this based on the sample correlation coefficient r and the
sample size n.
If the test concludes that the correlation coefficient is significantly different from 0, we say that the
correlation coefficient is "significant".
• Conclusion: "There is sufficient evidence to conclude that there is a significant linear relationship
between x and y because the correlation coefficient is significantly different from 0."
• What the conclusion means: There is a significant linear relationship between x and y. We can use the
regression line to model the linear relationship between x and y in the population.
If the test concludes that the correlation coefficient is not significantly different from 0 (it is close to 0),
we say that correlation coefficient is "not significant".
• Conclusion: "There is insufficient evidence to conclude that there is a significant linear relationship
between x and y because the correlation coefficient is not significantly different from 0."
• What the conclusion means: There is not a significant linear relationship between x and y. Therefore
we can NOT use the regression line to model a linear relationship between x and y in the population.
NOTE:
• If r is significant and the scatter plot shows a linear trend, the line can be used to predict the
value of y for values of x that are within the domain of observed x values.
• If r is not significant OR if the scatter plot does not show a linear trend, the line should not be
used for prediction.
• If r is significant and if the scatter plot shows a linear trend, the line may NOT be appropriate
or reliable for prediction OUTSIDE the domain of observed x values in the data.
PERFORMING THE HYPOTHESIS TEST
SETTING UP THE HYPOTHESES:
• Null Hypothesis: H
o
: ρ = 0
7
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529
• Alternate Hypothesis: H
a
: ρ = 0
What the hypotheses mean in words:
• Null Hypothesis H
o
: The population correlation coefficient IS NOT significantly different from 0.
There IS NOT a significant linear relationship(correlation) between x and y in the population.
• Alternate Hypothesis H
a
: The population correlation coefficient IS significantly DIFFERENT FROM
0. There IS A SIGNIFICANT LINEAR RELATIONSHIP (correlation) between x and y in the popula-
tion.
DRAWING A CONCLUSION:
There are two methods to make the decision. Both methods are equivalent and give the same result.
Method 1: Using the p-value
Method 2: Using a table of critical values
In this chapter of this textbook, we will always use a significance level of 5%, α = 0.05
Note: Using the p-value method, you could choose any appropriate significance level you want; you are
not limited to using α = 0.05. But the table of critical values provided in this textbook assumes that
we are using a significance level of 5%, α = 0.05. (If we wanted to use a different significance level
than 5% with the critical value method, we would need different tables of critical values that are not
provided in this textbook.)
METHOD 1: Using a p-value to make a decision
The linear regression t-test LinRegTTEST on the TI-83+ or TI-84+ calculators calculates the p-value.
On the LinRegTTEST input screen, on the line prompt for β or ρ, highlight "= 0"
The output screen shows the p-value on the line that reads "p =".
(Most computer statistical software can calculate the p-value.)
If the p-value is less than the significance level (α = 0.05):
• Decision: REJECT the null hypothesis.
• Conclusion: "There is sufficient evidence to conclude that there is a significant linear relationship
between x and y because the correlation coefficient is significantly different from 0."
If the p-value is NOT less than the significance level (α = 0.05)
• Decision: DO NOT REJECT the null hypothesis.
• Conclusion: "There is insufficient evidence to conclude that there is a significant linear relationship
between x and y because the correlation coefficient is NOT significantly different from 0."
Calculation Notes:
You will use technology to calculate the p-value. The following describe the calculations to compute the
test statistics and the p-value:
The p-value is calculated using a t-distribution with n −2 degrees of freedom.
The formula for the test statistic is t =
r

n−2

1−r
2
. The value of the test statistic, t, is shown in the computer
or calculator output along with the p-value. The test statistic t has the same sign as the correlation
coefficient r.
The p-value is the combined area in both tails.
An alternative way to calculate the p-value (p) given by LinRegTTest is the command 2*tcdf(abs(t),10^99,
n-2) in 2nd DISTR.
THIRD EXAM vs FINAL EXAM EXAMPLE: p value method
530 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
• Consider the third exam/final exam example.
• The line of best fit is:
^
y
= −173.51 +4.83x with r = 0.6631 and there are n = 11 data points.
• Can the regression line be used for prediction? Given a third exam score (x value), can we use the
line to predict the final exam score (predicted y value)?
H
o
: ρ = 0
H
a
: ρ = 0
α = 0.05
The p-value is 0.026 (from LinRegTTest on your calculator or from computer software)
The p-value, 0.026, is less than the significance level of α = 0.05
Decision: Reject the Null Hypothesis H
o
Conclusion: There is sufficient evidence to conclude that there is a significant linear relationship between
x and y because the correlation coefficient is significantly different from 0.
Because r is significant and the scatter plot shows a linear trend, the regression line can be used to
predict final exam scores.
METHOD 2: Using a table of Critical Values to make a decision
The 95% Critical Values of the Sample Correlation Coefficient Table (Section 12.10) at the end of this
chapter (before the Summary (Section 12.11)) may be used to give you a good idea of whether the com-
puted value of r is significant or not. Compare r to the appropriate critical value in the table. If r is not
between the positive and negative critical values, then the correlation coefficient is significant. If r is signif-
icant, then you may want to use the line for prediction.
Example 12.7
Suppose you computed r = 0.801 using n = 10 data points. df = n − 2 = 10 − 2 = 8. The
critical values associated with df = 8 are -0.632 and + 0.632. If r< negative critical value or r >
positive critical value, then r is significant. Since r = 0.801 and 0.801 > 0.632, r is significant and
the line may be used for prediction. If you view this example on a number line, it will help you.
Figure 12.12: r is not significant between -0.632 and +0.632. r = 0.801 > +0.632. Therefore, r is significant.
Example 12.8
Suppose you computed r = −0.624 with 14 data points. df = 14 −2 = 12. The critical values are
-0.532 and 0.532. Since −0.624<−0.532, r is significant and the line may be used for prediction
Figure 12.13: r = −0.624<−0.532. Therefore, r is significant.
531
Example 12.9
Suppose you computed r = 0.776 and n = 6. df = 6 − 2 = 4. The critical values are -0.811
and 0.811. Since −0.811< 0.776 < 0.811, r is not significant and the line should not be used for
prediction.
Figure 12.14: −0.811<r = 0.776<0.811. Therefore, r is not significant.
THIRD EXAM vs FINAL EXAM EXAMPLE: critical value method
• Consider the third exam/final exam example.
• The line of best fit is:
^
y
= −173.51 +4.83x with r = 0.6631 and there are n = 11 data points.
• Can the regression line be used for prediction? Given a third exam score (x value), can we use the
line to predict the final exam score (predicted y value)?
H
o
: ρ = 0
H
a
: ρ = 0
α = 0.05
Use the "95% Critical Value" table for r with df = n −2 = 11 −2 = 9
The critical values are -0.602 and +0.602
Since 0.6631 > 0.602, r is significant.
Decision: Reject H
o
:
Conclusion:There is sufficient evidence to conclude that there is a significant linear relationship between
x and y because the correlation coefficient is significantly different from 0.
Because r is significant and the scatter plot shows a linear trend, the regression line can be used to
predict final exam scores.
Example 12.10: Additional Practice Examples using Critical Values
Suppose you computed the following correlation coefficients. Using the table at the end of the
chapter, determine if r is significant and the line of best fit associated with each r can be used to
predict a y value. If it helps, draw a number line.
1. r = −0.567 and the sample size, n, is 19. The df = n −2 = 17. The critical value is -0.456.
−0.567<−0.456 so r is significant.
2. r = 0.708 and the sample size, n, is 9. The df = n − 2 = 7. The critical value is 0.666.
0.708 > 0.666 so r is significant.
3. r = 0.134 and the sample size, n, is 14. The df = 14 −2 = 12. The critical value is 0.532.
0.134 is between -0.532 and 0.532 so r is not significant.
4. r = 0 and the sample size, n, is 5. No matter what the dfs are, r = 0 is between the two
critical values so r is not significant.
532 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
12.7.2 Assumptions in Testing the Significance of the Correlation Coefficient
Testing the significance of the correlation coefficient requires that certain assumptions about the data are
satisfied. The premise of this test is that the data are a sample of observed points taken from a larger
population. We have not examined the entire population because it is not possible or feasible to do so. We
are examining the sample to draw a conclusion about whether the linear relationship that we see between
x and y in the sample data provides strong enough evidence so that we can conclude that there is a linear
relationship between x and y in the population.
The regression line equation that we calculate from the sample data gives the best fit line for our particular
sample. We want to use this best fit line for the sample as an estimate of the best fit line for the population.
Examining the scatterplot and testing the significance of the correlation coefficient helps us determine if it
is appropriate to do this.
The assumptions underlying the test of significance are:
• There is a linear relationship in the population that models the average value of y for varying values
of x. In other words, the expected value of y for each particular value lies on a straight line in the
population. (We do not know the equation for the line for the population. Our regression line from
the sample is our best estimate of this line in the population.)
• The y values for any particular x value are normally distributed about the line. This implies that
there are more y values scattered closer to the line than are scattered farther away. Assumption (1)
above implies that these normal distributions are centered on the line: the means of these normal
distributions of y values lie on the line.
• The standard deviations of the population y values about the line are equal for each value of x. In
other words, each of these normal distributions of y values has the same shape and spread about the
line.
• The residual errors are mutually independent (no pattern).
Figure 12.15: The y values for each x value are normally distributed about the line with the same standard
deviation. For each x value, the mean of the y values lies on the regression line. More y values lie near the
line than are scattered further away from the line.
**With contributions from Roberta Bloom
533
12.8 Prediction
8
Recall the third exam/final exam example.
We examined the scatterplot and showed that the correlation coefficient is significant. We found the equa-
tion of the best fit line for the final exam grade as a function of the grade on the third exam. We can now
use the least squares regression line for prediction.
Suppose you want to estimate, or predict, the final exam score of statistics students who received 73 on the
third exam. The exam scores (x-values) range from 65 to 75. Since 73 is between the x-values 65 and 75,
substitute x = 73 into the equation. Then:
^
y
= −173.51 +4.83 (73) = 179.08 (12.8)
We predict that statistic students who earn a grade of 73 on the third exam will earn a grade of 179.08 on
the final exam, on average.
Example 12.11
Recall the third exam/final exam example.
Problem 1
What would you predict the final exam score to be for a student who scored a 66 on the third
exam?
Solution
145.27
Problem 2 (Solution on p. 571.)
What would you predict the final exam score to be for a student who scored a 90 on the third
exam?
**With contributions from Roberta Bloom
12.9 Outliers
9
In some data sets, there are values (observed data points) called outliers. Outliers are observed data
points that are far from the least squares line. They have large "errors", where the "error" or residual is the
vertical distance from the line to the point.
Outliers need to be examined closely. Sometimes, for some reason or another, they should not be included
in the analysis of the data. It is possible that an outlier is a result of erroneous data. Other times, an outlier
may hold valuable information about the population under study and should remain included in the data.
The key is to carefully examine what causes a data point to be an outlier.
Besides outliers, a sample may contain one or a few points that are called influential points. Influential
points are observed data points that are far from the other observed data points in the horizontal direction.
These points may have a big effect on the slope of the regression line. To begin to identify an influential
point, you can remove it from the data set and see if the slope of the regression line is changed significantly.
8
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9
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534 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Computers and many calculators can be used to identify outliers from the data. Computer output for
regression analysis will often identify both outliers and influential points so that you can examine them.
Identifying Outliers
We could guess at outliers by looking at a graph of the scatterplot and best fit line. However we would like
some guideline as to how far away a point needs to be in order to be considered an outlier. As a rough rule
of thumb, we can flag any point that is located further than two standard deviations above or below the
best fit line as an outlier. The standard deviation used is the standard deviation of the residuals or errors.
We can do this visually in the scatterplot by drawing an extra pair of lines that are two standard deviations
above and below the best fit line. Any data points that are outside this extra pair of lines are flagged as
potential outliers. Or we can do this numerically by calculating each residual and comparing it to twice the
standard deviation. On the TI-83, 83+, or 84+, the graphical approach is easier. The graphical procedure
is shown first, followed by the numerical calculations. You would generally only need to use one of these
methods.
Example 12.12
In the third exam/final exam example, you can determine if there is an outlier or not. If there is
an outlier, as an exercise, delete it and fit the remaining data to a new line. For this example, the
new line ought to fit the remaining data better. This means the SSE should be smaller and the
correlation coefficient ought to be closer to 1 or -1.
Solution
Graphical Identification of Outliers
With the TI-83,83+,84+ graphing calculators, it is easy to identify the outlier graphically and visu-
ally. If we were to measure the vertical distance from any data point to the corresponding point
on the line of best fit and that distance was equal to 2s or farther, then we would consider the data
point to be "too far" from the line of best fit. We need to find and graph the lines that are two
standard deviations below and above the regression line. Any points that are outside these two
lines are outliers. We will call these lines Y2 and Y3:
As we did with the equation of the regression line and the correlation coefficient, we will use
technology to calculate this standard deviation for us. Using the LinRegTTest with this data,
scroll down through the output screens to find s=16.412
Line Y2=-173.5+4.83x-2(16.4) and line Y3=-173.5+4.83x+2(16.4)
where
^
y
=-173.5+4.83x is the line of best fit. Y2 and Y3 have the same slope as the line of
best fit.
Graph the scatterplot with the best fit line in equation Y1, then enter the two extra lines as Y2 and
Y3 in the "Y="equation editor and press ZOOM 9. You will find that the only data point that is not
between lines Y2 and Y3 is the point x=65, y=175. On the calculator screen it is just barely outside
these lines. The outlier is the student who had a grade of 65 on the third exam and 175 on the final
exam; this point is further than 2 standard deviations away from the best fit line.
Sometimes a point is so close to the lines used to flag outliers on the graph that it is difficult to tell
if the point is between or outside the lines. On a computer, enlarging the graph may help; on a
small calculator screen, zooming in may make the graph clearer. Note that when the graph does
not give a clear enough picture, you can use the numerical comparisons to identify outliers.
535
Figure 12.16
Numerical Identification of Outliers
In the table below, the first two columns are the third exam and final exam data. The third
column shows the predicted
^
y
values calculated from the line of best fit:
^
y
=-173.5+4.83x. The
residuals, or errors, have been calculated in the fourth column of the table: observed y value −
predicted y value = y−
^
y
.
s is the standard deviation of all the y−
^
y
= values where n = the total number of data points. If
each residual is calculated and squared, and the results are added, we get the SSE. The standard
deviation of the residuals is calculated from the SSE as:
s =
_
SSE
n−2
Rather than calculate the value of s ourselves, we can find s using the computer or calculator. For
this example, the calculator function LinRegTTest found s = 16.4 as the standard deviation of the
residuals 35; -17; 16; -6; -19; 9; 3; -1; -10; -9; -1.
536 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
x y
^
y
y−
^
y
65 175 140 175 −140 = 35
67 133 150 133 −150 = −17
71 185 169 185 −169 = 16
71 163 169 163 −169 = −6
66 126 145 126 −145 = −19
75 198 189 198 −189 = 9
67 153 150 153 −150 = 3
70 163 164 163 −164 = −1
71 159 169 159 −169 = −10
69 151 160 151 −160 = −9
69 159 160 159 −160 = −1
Table 12.1
We are looking for all data points for which the residual is greater than 2s=2(16.4)=32.8 or less than
-32.8. Compare these values to the residuals in column 4 of the table. The only such data point is
the student who had a grade of 65 on the third exam and 175 on the final exam; the residual for
this student is 35.
How does the outlier affect the best fit line?
Numerically and graphically, we have identified the point (65,175) as an outlier. We should re-
examine the data for this point to see if there are any problems with the data. If there is an error
we should fix the error if possible, or delete the data. If the data is correct, we would leave it in
the data set. For this problem, we will suppose that we examined the data and found that this
outlier data was an error. Therefore we will continue on and delete the outlier, so that we can
explore how it affects the results, as a learning experience.
Compute a new best-fit line and correlation coefficient using the 10 remaining points:
On the TI-83, TI-83+, TI-84+ calculators, delete the outlier from L1 and L2. Using the LinRegTTest,
the new line of best fit and the correlation coefficient are:
^
y
= −355.19 +7.39x and r = 0.9121
The new line with r = 0.9121 is a stronger correlation than the original (r=0.6631) because r =
0.9121 is closer to 1. This means that the new line is a better fit to the 10 remaining data values.
The line can better predict the final exam score given the third exam score.
Numerical Identification of Outliers: Calculating s and Finding Outliers Manually
If you do not have the function LinRegTTest, then you can calculate the outlier in the first example by
doing the following.
First, square each |y−
^
y
| (See the TABLE above):
537
The squares are 35
2
; 17
2
; 16
2
; 6
2
; 19
2
; 9
2
; 3
2
; 1
2
; 10
2
; 9
2
; 1
2
Then, add (sum) all the |y−
^
y
| squared terms using the formula
11
Σ
i = 1
_
|y
i

^
y
i
|
_
2
=
11
Σ
i = 1

i
2
(Recall that y
i

^
y
i
=
i
.)
= 35
2
+17
2
+16
2
+6
2
+19
2
+9
2
+3
2
+1
2
+10
2
+9
2
+1
2
= 2440 = SSE. The result, SSE is the Sum of Squared Errors.
Next, calculate s, the standard deviation of all the y−
^
y
= values where n = the total number of data
points.
The calculation is s =
_
SSE
n−2
For the third exam/final exam problem, s =
_
2440
11−2
= 16.47
Next, multiply s by 1.9:
(1.9) · (16.47) = 31.29
31.29 is almost 2 standard deviations away from the mean of the y−
^
y
values.
If we were to measure the vertical distance from any data point to the corresponding point on the line of
best fit and that distance is at least 1.9s, then we would consider the data point to be "too far" from the line
of best fit. We call that point a potential outlier.
For the example, if any of the |y−
^
y
| values are at least 31.29, the corresponding (x, y) data point is a
potential outlier.
For the third exam/final exam problem, all the |y−
^
y
|’s are less than 31.29 except for the first one which is
35.
35 > 31.29 That is, |y−
^
y
| ≥ (1.9) · (s)
The point which corresponds to |y−
^
y
| = 35 is (65, 175). Therefore, the data point (65, 175) is a potential
outlier. For this example, we will delete it. (Remember, we do not always delete an outlier.)
The next step is to compute a new best-fit line using the 10 remaining points. The new line of best
fit and the correlation coefficient are:
^
y
= −355.19 +7.39x and r = 0.9121
Example 12.13
Using this new line of best fit (based on the remaining 10 data points), what would a student
who receives a 73 on the third exam expect to receive on the final exam? Is this the same as the
prediction made using the original line?
538 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Solution
Using the new line of best fit,
^
y
= −355.19 +7.39(73) = 184.28. A student who scored 73 points
on the third exam would expect to earn 184 points on the final exam.
The original line predicted
^
y
= −173.51 + 4.83(73) = 179.08 so the prediction using the
new line with the outlier eliminated differs from the original prediction.
Example 12.14
(From The Consumer Price Indexes Web site) The Consumer Price Index (CPI) measures the aver-
age change over time in the prices paid by urban consumers for consumer goods and services. The
CPI affects nearly all Americans because of the many ways it is used. One of its biggest uses is as
a measure of inflation. By providing information about price changes in the Nation’s economy to
government, business, and labor, the CPI helps them to make economic decisions. The President,
Congress, and the Federal Reserve Board use the CPI’s trends to formulate monetary and fiscal
policies. In the following table, x is the year and y is the CPI.
Data:
x y
1915 10.1
1926 17.7
1935 13.7
1940 14.7
1947 24.1
1952 26.5
1964 31.0
1969 36.7
1975 49.3
1979 72.6
1980 82.4
1986 109.6
1991 130.7
1999 166.6
Table 12.2
Problem
• Make a scatterplot of the data.
• Calculate the least squares line. Write the equation in the form
^
y
= a +bx.
• Draw the line on the scatterplot.
• Find the correlation coefficient. Is it significant?
• What is the average CPI for the year 1990?
539
Solution
• Scatter plot and line of best fit.

^
y
= −3204 +1.662x is the equation of the line of best fit.
• r = 0.8694
• The number of data points is n = 14. Use the 95% Critical Values of the Sample Correlation
Coefficient table at the end of Chapter 12. n −2 = 12. The corresponding critical value is
0.532. Since 0.8694 > 0.532, r is significant.

^
y
= −3204 +1.662 (1990) = 103.4 CPI
• Using the calculator LinRegTTest, we find that s = 25.4 ; graphing the lines Y2=-3204+1.662X-
2(25.4) and Y3=-3204+1.662X+2(25.4) shows that no data values are outside those lines, iden-
tifying no outliers. (Note that the year 1999 was very close to the upper line, but still inside
it.)
Figure 12.17
NOTE: In the example, notice the pattern of the points compared to the line. Although the correla-
tion coefficient is significant, the pattern in the scatterplot indicates that a curve would be a more
appropriate model to use than a line. In this example, a statistician should prefer to use other
methods to fit a curve to this data, rather than model the data with the line we found. In addition
to doing the calculations, it is always important to look at the scatterplot when deciding whether
a linear model is appropriate.
If you are interested in seeing more years of data, visit the Bureau of Labor Statistics CPI website
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt ; our data is taken from the column entitled
"Annual Avg." (third column from the right). For example you could add more current years of
data. Try adding the more recent years 2004 : CPI=188.9, 2008 : CPI=215.3 and 2011: CPI=224.9.
See how it affects the model. (Check:
^
y
= −4436 +2.295x. r = 0.9018. Is r significant? Is the fit
better with the addition of the new points?)
**With contributions from Roberta Bloom
540 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
12.10 95% Critical Values of the Sample Correlation Coefficient Table
10
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541
Degrees of Freedom: n −2 Critical Values: (+ and −)
1 0.997
2 0.950
3 0.878
4 0.811
5 0.754
6 0.707
7 0.666
8 0.632
9 0.602
10 0.576
11 0.555
12 0.532
13 0.514
14 0.497
15 0.482
16 0.468
17 0.456
18 0.444
19 0.433
20 0.423
21 0.413
22 0.404
23 0.396
24 0.388
25 0.381
26 0.374
continued on next page
542 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
27 0.367
28 0.361
29 0.355
30 0.349
40 0.304
50 0.273
60 0.250
70 0.232
80 0.217
90 0.205
100 0.195
Table 12.3
543
12.11 Summary
11
Bivariate Data: Each data point has two values. The form is (x, y).
Line of Best Fit or Least Squares Line (LSL):
^
y
= a +bx
x = independent variable; y = dependent variable
Residual: Actual y value −predicted y value = y−
^
y
Correlation Coefficient r:
1. Used to determine whether a line of best fit is good for prediction.
2. Between -1 and 1 inclusive. The closer r is to 1 or -1, the closer the original points are to a straight line.
3. If r is negative, the slope is negative. If r is positive, the slope is positive.
4. If r = 0, then the line is horizontal.
Sum of Squared Errors (SSE): The smaller the SSE, the better the original set of points fits the line of best
fit.
Outlier: A point that does not seem to fit the rest of the data.
11
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544 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
12.12 Practice: Linear Regression
12
12.12.1 Student Learning Outcomes
• The student will evaluate bivariate data and determine if a line is an appropriate fit to the data.
12.12.2 Given
Below are real data for the first two decades of AIDS reporting. (Source: Centers for Disease Control and
Prevention, National Center for HIV, STD, and TB Prevention)
Adults and Adolescents only, United States
Year # AIDS cases diagnosed # AIDS deaths
Pre-1981 91 29
1981 319 121
1982 1,170 453
1983 3,076 1,482
1984 6,240 3,466
1985 11,776 6,878
1986 19,032 11,987
1987 28,564 16,162
1988 35,447 20,868
1989 42,674 27,591
1990 48,634 31,335
1991 59,660 36,560
1992 78,530 41,055
1993 78,834 44,730
1994 71,874 49,095
1995 68,505 49,456
1996 59,347 38,510
1997 47,149 20,736
1998 38,393 19,005
1999 25,174 18,454
2000 25,522 17,347
2001 25,643 17,402
2002 26,464 16,371
Total 802,118 489,093
Table 12.4
12
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545
NOTE: We will use the columns “year” and “# AIDS cases diagnosed” for all questions unless
otherwise stated.
12.12.3 Graphing
Graph “year” vs. “# AIDS cases diagnosed.” Plot the points on the graph located below in the section
titled "Plot" . Do not include pre-1981. Label both axes with words. Scale both axes.
12.12.4 Data
Exercise 12.12.1
Enter your data into your calculator or computer. The pre-1981 data should not be included. Why
is that so?
12.12.5 Linear Equation
Write the linear equation below, rounding to 4 decimal places:
NOTE: For any prediction questions, the answers are calculated using the least squares (best fit)
line equation cited in the solution.
Exercise 12.12.2 (Solution on p. 571.)
Calculate the following:
a. a =
b. b =
c. corr. =
d. n =(# of pairs)
Exercise 12.12.3 (Solution on p. 571.)
equation:
^
y
=
12.12.6 Solve
Exercise 12.12.4 (Solution on p. 571.)
Solve.
a. When x = 1985,
^
y
=
b. When x = 1990,
^
y
=
546 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
12.12.7 Plot
Plot the 2 above points on the graph below. Then, connect the 2 points to form the regression line.
Obtain the graph on your calculator or computer.
12.12.8 Discussion Questions
Look at the graph above.
Exercise 12.12.5
Does the line seem to fit the data? Why or why not?
Exercise 12.12.6
Do you think a linear fit is best? Why or why not?
Exercise 12.12.7
Hand draw a smooth curve on the graph above that shows the flow of the data.
Exercise 12.12.8
What does the correlation imply about the relationship between time (years) and the number of
diagnosed AIDS cases reported in the U.S.?
Exercise 12.12.9
Why is “year” the independent variable and “# AIDS cases diagnosed.” the dependent variable
(instead of the reverse)?
Exercise 12.12.10 (Solution on p. 571.)
Solve.
a. When x = 1970,
^
y
=:
b. Why doesn’t this answer make sense?
547
12.13 Homework
13
Exercise 12.13.1 (Solution on p. 571.)
For each situation below, state the independent variable and the dependent variable.
a. A study is done to determine if elderly drivers are involved in more motor vehicle fatalities
than all other drivers. The number of fatalities per 100,000 drivers is compared to the age of
drivers.
b. A study is done to determine if the weekly grocery bill changes based on the number of family
members.
c. Insurance companies base life insurance premiums partially on the age of the applicant.
d. Utility bills vary according to power consumption.
e. A study is done to determine if a higher education reduces the crime rate in a population.
NOTE: For any prediction questions, the answers are calculated using the least squares (best fit)
line equation cited in the solution.
Exercise 12.13.2
Recently, the annual number of driver deaths per 100,000
for the selected age groups was as follows (Source: http://
http://www.census.gov/compendia/statab/cats/transportation/motor_vehicle_accidents_and_fatalities.html
14
):
Age Number of Driver Deaths per 100,000
16-19 38
20-24 36
25-34 24
35-54 20
55-74 18
75+ 28
Table 12.5
a. For each age group, pick the midpoint of the interval for the x value. (For the 75+ group, use
80.)
b. Using “ages” as the independent variable and “Number of driver deaths per 100,000” as the
dependent variable, make a scatter plot of the data.
c. Calculate the least squares (best–fit) line. Put the equation in the form of:
^
y
= a +bx
d. Find the correlation coefficient. Is it significant?
e. Pick two ages and find the estimated fatality rates.
f. Use the two points in (e) to plot the least squares line on your graph from (b).
g. Based on the above data, is there a linear relationship between age of a driver and driver fatality
rate?
h. What is the slope of the least squares (best-fit) line? Interpret the slope.
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14
http://www.census.gov/compendia/statab/cats/transportation/motor_vehicle_accidents_and_fatalities.html
548 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Exercise 12.13.3 (Solution on p. 571.)
The average number of people in a family that received welfare for various years is given below.
(Source: House Ways and Means Committee, Health and Human Services Department )
Year Welfare family size
1969 4.0
1973 3.6
1975 3.2
1979 3.0
1983 3.0
1988 3.0
1991 2.9
Table 12.6
a. Using “year” as the independent variable and “welfare family size” as the dependent variable,
make a scatter plot of the data.
b. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
c. Find the correlation coefficient. Is it significant?
d. Pick two years between 1969 and 1991 and find the estimated welfare family sizes.
e. Use the two points in (d) to plot the least squares line on your graph from (b).
f. Based on the above data, is there a linear relationship between the year and the average number
of people in a welfare family?
g. Using the least squares line, estimate the welfare family sizes for 1960 and 1995. Does the least
squares line give an accurate estimate for those years? Explain why or why not.
h. Are there any outliers in the above data?
i. What is the estimated average welfare family size for 1986? Does the least squares line give an
accurate estimate for that year? Explain why or why not.
j. What is the slope of the least squares (best-fit) line? Interpret the slope.
Exercise 12.13.4
Use the AIDS data from the practice for this section (Section 12.12.2: Given), but this time use the
columns “year #” and “# new AIDS deaths in U.S.” Answer all of the questions from the practice
again, using the new columns.
Exercise 12.13.5 (Solution on p. 572.)
The height (sidewalk to roof) of notable tall buildings in America is compared to the number of
stories of the building (beginning at street level). (Source: Microsoft Bookshelf )
549
Height (in feet) Stories
1050 57
428 28
362 26
529 40
790 60
401 22
380 38
1454 110
1127 100
700 46
Table 12.7
a. Using “stories” as the independent variable and “height” as the dependent variable, make a
scatter plot of the data.
b. Does it appear from inspection that there is a relationship between the variables?
c. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
d. Find the correlation coefficient. Is it significant?
e. Find the estimated heights for 32 stories and for 94 stories.
f. Use the two points in (e) to plot the least squares line on your graph from (b).
g. Based on the above data, is there a linear relationship between the number of stories in tall
buildings and the height of the buildings?
h. Are there any outliers in the above data? If so, which point(s)?
i. What is the estimated height of a building with 6 stories? Does the least squares line give an
accurate estimate of height? Explain why or why not.
j. Based on the least squares line, adding an extra story is predicted to add about how many feet
to a building?
k. What is the slope of the least squares (best-fit) line? Interpret the slope.
Exercise 12.13.6
Below is the life expectancy for an individual born in the United States in certain years. (Source:
National Center for Health Statistics)
550 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Year of Birth Life Expectancy
1930 59.7
1940 62.9
1950 70.2
1965 69.7
1973 71.4
1982 74.5
1987 75
1992 75.7
2010 78.7
Table 12.8
a. Decide which variable should be the independent variable and which should be the dependent
variable.
b. Draw a scatter plot of the ordered pairs.
c. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
d. Find the correlation coefficient. Is it significant?
e. Find the estimated life expectancy for an individual born in 1950 and for one born in 1982.
f. Why aren’t the answers to part (e) the values on the above chart that correspond to those years?
g. Use the two points in (e) to plot the least squares line on your graph from (b).
h. Based on the above data, is there a linear relationship between the year of birth and life ex-
pectancy?
i. Are there any outliers in the above data?
j. Using the least squares line, find the estimated life expectancy for an individual born in 1850.
Does the least squares line give an accurate estimate for that year? Explain why or why not.
k. What is the slope of the least squares (best-fit) line? Interpret the slope.
Exercise 12.13.7 (Solution on p. 572.)
The percent of female wage and salary workers who are paid hourly rates is given below for the
years 1979 - 1992. (Source: Bureau of Labor Statistics, U.S. Dept. of Labor)
551
Year Percent of workers paid hourly rates
1979 61.2
1980 60.7
1981 61.3
1982 61.3
1983 61.8
1984 61.7
1985 61.8
1986 62.0
1987 62.7
1990 62.8
1992 62.9
Table 12.9
a. Using “year” as the independent variable and “percent” as the dependent variable, make a
scatter plot of the data.
b. Does it appear from inspection that there is a relationship between the variables? Why or why
not?
c. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
d. Find the correlation coefficient. Is it significant?
e. Find the estimated percents for 1991 and 1988.
f. Use the two points in (e) to plot the least squares line on your graph from (b).
g. Based on the above data, is there a linear relationship between the year and the percent of
female wage and salary earners who are paid hourly rates?
h. Are there any outliers in the above data?
i. What is the estimated percent for the year 2050? Does the least squares line give an accurate
estimate for that year? Explain why or why not?
j. What is the slope of the least squares (best-fit) line? Interpret the slope.
Exercise 12.13.8
The maximum discount value of the Entertainment® card for the “Fine Dining” section, Edition
10, for various pages is given below.
552 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Page number Maximum value ($)
4 16
14 19
25 15
32 17
43 19
57 15
72 16
85 15
90 17
Table 12.10
a. Decide which variable should be the independent variable and which should be the dependent
variable.
b. Draw a scatter plot of the ordered pairs.
c. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
d. Find the correlation coefficient. Is it significant?
e. Find the estimated maximum values for the restaurants on page 10 and on page 70.
f. Use the two points in (e) to plot the least squares line on your graph from (b).
g. Does it appear that the restaurants giving the maximum value are placed in the beginning of
the “Fine Dining” section? How did you arrive at your answer?
h. Suppose that there were 200 pages of restaurants. What do you estimate to be the maximum
value for a restaurant listed on page 200?
i. Is the least squares line valid for page 200? Why or why not?
j. What is the slope of the least squares (best-fit) line? Interpret the slope.
The next two questions refer to the following data: The cost of a leading liquid laundry detergent in
different sizes is given below.
Size (ounces) Cost ($) Cost per ounce
16 3.99
32 4.99
64 5.99
200 10.99
Table 12.11
Exercise 12.13.9 (Solution on p. 572.)
a. Using “size” as the independent variable and “cost” as the dependent variable, make a scatter
plot.
b. Does it appear from inspection that there is a relationship between the variables? Why or why
not?
553
c. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
d. Find the correlation coefficient. Is it significant?
e. If the laundry detergent were sold in a 40 ounce size, find the estimated cost.
f. If the laundry detergent were sold in a 90 ounce size, find the estimated cost.
g. Use the two points in (e) and (f) to plot the least squares line on your graph from (a).
h. Does it appear that a line is the best way to fit the data? Why or why not?
i. Are there any outliers in the above data?
j. Is the least squares line valid for predicting what a 300 ounce size of the laundry detergent
would cost? Why or why not?
k. What is the slope of the least squares (best-fit) line? Interpret the slope.
Exercise 12.13.10
a. Complete the above table for the cost per ounce of the different sizes.
b. Using “Size” as the independent variable and “Cost per ounce” as the dependent variable,
make a scatter plot of the data.
c. Does it appear from inspection that there is a relationship between the variables? Why or why
not?
d. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
e. Find the correlation coefficient. Is it significant?
f. If the laundry detergent were sold in a 40 ounce size, find the estimated cost per ounce.
g. If the laundry detergent were sold in a 90 ounce size, find the estimated cost per ounce.
h. Use the two points in (f) and (g) to plot the least squares line on your graph from (b).
i. Does it appear that a line is the best way to fit the data? Why or why not?
j. Are there any outliers in the above data?
k. Is the least squares line valid for predicting what a 300 ounce size of the laundry detergent
would cost per ounce? Why or why not?
l. What is the slope of the least squares (best-fit) line? Interpret the slope.
Exercise 12.13.11 (Solution on p. 572.)
According to flyer by a Prudential Insurance Company representative, the costs of approximate
probate fees and taxes for selected net taxable estates are as follows:
Net Taxable Estate ($) Approximate Probate Fees and Taxes ($)
600,000 30,000
750,000 92,500
1,000,000 203,000
1,500,000 438,000
2,000,000 688,000
2,500,000 1,037,000
3,000,000 1,350,000
Table 12.12
a. Decide which variable should be the independent variable and which should be the dependent
variable.
b. Make a scatter plot of the data.
554 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
c. Does it appear from inspection that there is a relationship between the variables? Why or why
not?
d. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
e. Find the correlation coefficient. Is it significant?
f. Find the estimated total cost for a net taxable estate of $1,000,000. Find the cost for $2,500,000.
g. Use the two points in (f) to plot the least squares line on your graph from (b).
h. Does it appear that a line is the best way to fit the data? Why or why not?
i. Are there any outliers in the above data?
j. Based on the above, what would be the probate fees and taxes for an estate that does not have
any assets?
k. What is the slope of the least squares (best-fit) line? Interpret the slope.
Exercise 12.13.12
The following are advertised sale prices of color televisions at Anderson’s.
Size (inches) Sale Price ($)
9 147
20 197
27 297
31 447
35 1177
40 2177
60 2497
Table 12.13
a. Decide which variable should be the independent variable and which should be the dependent
variable.
b. Make a scatter plot of the data.
c. Does it appear from inspection that there is a relationship between the variables? Why or why
not?
d. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
e. Find the correlation coefficient. Is it significant?
f. Find the estimated sale price for a 32 inch television. Find the cost for a 50 inch television.
g. Use the two points in (f) to plot the least squares line on your graph from (b).
h. Does it appear that a line is the best way to fit the data? Why or why not?
i. Are there any outliers in the above data?
j. What is the slope of the least squares (best-fit) line? Interpret the slope.
Exercise 12.13.13 (Solution on p. 572.)
Below are the average heights for American boys. (Source: Physician’s Handbook, 1990)
555
Age (years) Height (cm)
birth 50.8
2 83.8
3 91.4
5 106.6
7 119.3
10 137.1
14 157.5
Table 12.14
a. Decide which variable should be the independent variable and which should be the dependent
variable.
b. Make a scatter plot of the data.
c. Does it appear from inspection that there is a relationship between the variables? Why or why
not?
d. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
e. Find the correlation coefficient. Is it significant?
f. Find the estimated average height for a one year–old. Find the estimated average height for an
eleven year–old.
g. Use the two points in (f) to plot the least squares line on your graph from (b).
h. Does it appear that a line is the best way to fit the data? Why or why not?
i. Are there any outliers in the above data?
j. Use the least squares line to estimate the average height for a sixty–two year–old man. Do you
think that your answer is reasonable? Why or why not?
k. What is the slope of the least squares (best-fit) line? Interpret the slope.
Exercise 12.13.14
The following chart gives the gold medal times for every other Summer Olympics for the women’s
100 meter freestyle (swimming).
Year Time (seconds)
1912 82.2
1924 72.4
1932 66.8
1952 66.8
1960 61.2
1968 60.0
1976 55.65
1984 55.92
1992 54.64
2000 53.8
2008 53.1
556 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Table 12.15
a. Decide which variable should be the independent variable and which should be the dependent
variable.
b. Make a scatter plot of the data.
c. Does it appear from inspection that there is a relationship between the variables? Why or why
not?
d. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
e. Find the correlation coefficient. Is the decrease in times significant?
f. Find the estimated gold medal time for 1932. Find the estimated time for 1984.
g. Why are the answers from (f) different from the chart values?
h. Use the two points in (f) to plot the least squares line on your graph from (b).
i. Does it appear that a line is the best way to fit the data? Why or why not?
j. Use the least squares line to estimate the gold medal time for the next Summer Olympics. Do
you think that your answer is reasonable? Why or why not?
The next three questions use the following state information.
State # letters in name Year entered the
Union
Rank for entering
the Union
Area (square
miles)
Alabama 7 1819 22 52,423
Colorado 1876 38 104,100
Hawaii 1959 50 10,932
Iowa 1846 29 56,276
Maryland 1788 7 12,407
Missouri 1821 24 69,709
New Jersey 1787 3 8,722
Ohio 1803 17 44,828
South Carolina 13 1788 8 32,008
Utah 1896 45 84,904
Wisconsin 1848 30 65,499
Table 12.16
Exercise 12.13.15 (Solution on p. 573.)
We are interested in whether or not the number of letters in a state name depends upon the year
the state entered the Union.
a. Decide which variable should be the independent variable and which should be the dependent
variable.
b. Make a scatter plot of the data.
c. Does it appear from inspection that there is a relationship between the variables? Why or why
not?
d. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
e. Find the correlation coefficient. What does it imply about the significance of the relationship?
557
f. Find the estimated number of letters (to the nearest integer) a state would have if it entered
the Union in 1900. Find the estimated number of letters a state would have if it entered the
Union in 1940.
g. Use the two points in (f) to plot the least squares line on your graph from (b).
h. Does it appear that a line is the best way to fit the data? Why or why not?
i. Use the least squares line to estimate the number of letters a new state that enters the Union this
year would have. Can the least squares line be used to predict it? Why or why not?
Exercise 12.13.16
We are interested in whether there is a relationship between the ranking of a state and the area of
the state.
a. Let rank be the independent variable and area be the dependent variable.
b. What do you think the scatter plot will look like? Make a scatter plot of the data.
c. Does it appear from inspection that there is a relationship between the variables? Why or why
not?
d. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
e. Find the correlation coefficient. What does it imply about the significance of the relationship?
f. Find the estimated areas for Alabama and for Colorado. Are they close to the actual areas?
g. Use the two points in (f) to plot the least squares line on your graph from (b).
h. Does it appear that a line is the best way to fit the data? Why or why not?
i. Are there any outliers?
j. Use the least squares line to estimate the area of a new state that enters the Union. Can the least
squares line be used to predict it? Why or why not?
k. Delete “Hawaii” and substitute “Alaska” for it. Alaska is the fortieth state with an area of
656,424 square miles.
l. Calculate the new least squares line.
m. Find the estimated area for Alabama. Is it closer to the actual area with this new least squares
line or with the previous one that included Hawaii? Why do you think that’s the case?
n. Do you think that, in general, newer states are larger than the original states?
Exercise 12.13.17 (Solution on p. 573.)
We are interested in whether there is a relationship between the rank of a state and the year it
entered the Union.
a. Let year be the independent variable and rank be the dependent variable.
b. What do you think the scatter plot will look like? Make a scatter plot of the data.
c. Why must the relationship be positive between the variables?
d. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
e. Find the correlation coefficient. What does it imply about the significance of the relationship?
f. Let’s say a fifty-first state entered the union. Based upon the least squares line, when should
that have occurred?
g. Using the least squares line, how many states do we currently have?
h. Why isn’t the least squares line a good estimator for this year?
Exercise 12.13.18
Below are the percents of the U.S. labor force (excluding self-employed and unemployed ) that
are members of a union. We are interested in whether the decrease is significant. (Source: Bureau
of Labor Statistics, U.S. Dept. of Labor)
558 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Year Percent
1945 35.5
1950 31.5
1960 31.4
1970 27.3
1980 21.9
1993 15.8
2011 11.8
Table 12.17
a. Let year be the independent variable and percent be the dependent variable.
b. What do you think the scatter plot will look like? Make a scatter plot of the data.
c. Why will the relationship between the variables be negative?
d. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
e. Find the correlation coefficient. What does it imply about the significance of the relationship?
f. Based on your answer to (e), do you think that the relationship can be said to be decreasing?
g. If the trend continues, when will there no longer be any union members? Do you think that
will happen?
The next two questions refer to the following information: The data below reflects the 1991-92 Reunion
Class Giving. (Source: SUNY Albany alumni magazine)
Class Year Average Gift Total Giving
1922 41.67 125
1927 60.75 1,215
1932 83.82 3,772
1937 87.84 5,710
1947 88.27 6,003
1952 76.14 5,254
1957 52.29 4,393
1962 57.80 4,451
1972 42.68 18,093
1976 49.39 22,473
1981 46.87 20,997
1986 37.03 12,590
Table 12.18
Exercise 12.13.19 (Solution on p. 573.)
We will use the columns “class year” and “total giving” for all questions, unless otherwise stated.
559
a. What do you think the scatter plot will look like? Make a scatter plot of the data.
b. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
c. Find the correlation coefficient. What does it imply about the significance of the relationship?
d. For the class of 1930, predict the total class gift.
e. For the class of 1964, predict the total class gift.
f. For the class of 1850, predict the total class gift. Why doesn’t this value make any sense?
Exercise 12.13.20
We will use the columns “class year” and “average gift” for all questions, unless otherwise stated.
a. What do you think the scatter plot will look like? Make a scatter plot of the data.
b. Calculate the least squares line. Put the equation in the form of:
^
y
= a +bx
c. Find the correlation coefficient. What does it imply about the significance of the relationship?
d. For the class of 1930, predict the average class gift.
e. For the class of 1964, predict the average class gift.
f. For the class of 2010, predict the average class gift. Why doesn’t this value make any sense?
Exercise 12.13.21 (Solution on p. 573.)
We are interested in exploring the relationship between the weight of a vehicle and its fuel effi-
ciency (gasoline mileage). The data in the table show the weights, in pounds, and fuel efficiency,
measured in miles per gallon, for a sample of 12 vehicles.
Weight Fuel Efficiency
2715 24
2570 28
2610 29
2750 38
3000 25
3410 22
3640 20
3700 26
3880 21
3900 18
4060 18
4710 15
Table 12.19
a. Graph a scatterplot of the data.
b. Find the correlation coefficient and determine if it is significant.
c. Find the equation of the best fit line.
d. Write the sentence that interprets the meaning of the slope of the line in the context of the data.
e. What percent of the variation in fuel efficiency is explained by the variation in the weight of the
vehicles, using the regression line? (State your answer in a complete sentence in the context
of the data.)
560 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
f. Accurately graph the best fit line on your scatterplot.
g. For the vehicle that weights 3000 pounds, find the residual (y-yhat). Does the value predicted
by the line underestimate or overestimate the observed data value?
h. Identify any outliers, using either the graphical or numerical procedure demonstrated in the
textbook.
i. The outlier is a hybrid car that runs on gasoline and electric technology, but all other vehicles
in the sample have engines that use gasoline only. Explain why it would be appropriate to
remove the outlier from the data in this situation. Remove the outlier from the sample data.
Find the new correlation coefficient, coefficient of determination, and best fit line.
j. Compare the correlation coefficients and coefficients of determination before and after removing
the outlier, and explain in complete sentences what these numbers indicate about how the
model has changed.
Exercise 12.13.22 (Solution on p. 573.)
The four data sets below were created by statistician Francis Anscomb. They show why it is im-
portant to examine the scatterplots for your data, in addition to finding the correlation coefficient,
in order to evaluate the appropriateness of fitting a linear model.
Set 1 Set 2 Set 3 Set 4
x y x y x y x y
10 8.04 10 9.14 10 7.46 8 6.58
8 6.95 8 8.14 8 6.77 8 5.76
13 7.58 13 8.74 13 12.74 8 7.71
9 8.81 9 8.77 9 7.11 8 8.84
11 8.33 11 9.26 11 7.81 8 8.47
14 9.96 14 8.10 14 8.84 8 7.04
6 7.24 6 6.13 6 6.08 8 5.25
4 4.26 4 3.10 4 5.39 19 12.50
12 10.84 12 9.13 12 8.15 8 5.56
7 4.82 7 7.26 7 6.42 8 7.91
5 5.68 5 4.74 5 5.73 8 6.89
Table 12.20
a. For each data set, find the least squares regression line and the correlation coefficient. What did
you discover about the lines and values of r?
For each data set, create a scatter plot and graph the least squares regression line. Use the graphs
to answer the following questions:
b. For which data set does it appear that a curve would be a more appropriate model than a line?
c. Which data set has an influential point (point close to or on the line that greatly influences the
best fit line)?
d. Which data set has an outlier (obviously visible on the scatter plot with best fit line graphed)?
e. Which data set appears to be the most appropriate to model using the least squares regression
line?
561
12.13.1 Try these multiple choice questions
Exercise 12.13.23 (Solution on p. 574.)
A correlation coefficient of -0.95 means there is a ____________ between the two variables.
A. Strong positive correlation
B. Weak negative correlation
C. Strong negative correlation
D. No Correlation
Exercise 12.13.24 (Solution on p. 574.)
According to the data reported by the New York State Department of Health regarding West Nile
Virus (http://www.health.state.ny.us/nysdoh/westnile/update/update.htm) for the years 2000-
2008, the least squares line equation for the number of reported dead birds (x) versus the number
of human West Nile virus cases (y) is
^
y
= −10.2638 +0.0491x. If the number of dead birds reported
in a year is 732, how many human cases of West Nile virus can be expected? r = 0.5490
A. No prediction can be made.
B. 19.6
C. 15
D. 38.1
The next three questions refer to the following data: (showing the number of hurricanes by category to
directly strike the mainland U.S. each decade) obtained from www.nhc.noaa.gov/gifs/table6.gif
15
A major
hurricane is one with a strength rating of 3, 4 or 5.
Decade Total Number of Hurricanes Number of Major Hurricanes
1941-1950 24 10
1951-1960 17 8
1961-1970 14 6
1971-1980 12 4
1981-1990 15 5
1991-2000 14 5
2001 – 2004 9 3
Table 12.21
Exercise 12.13.25 (Solution on p. 574.)
Using only completed decades (1941 – 2000), calculate the least squares line for the number of
major hurricanes expected based upon the total number of hurricanes.
A.
^
y
= −1.67x +0.5
B.
^
y
= 0.5x −1.67
C.
^
y
= 0.94x −1.67
D.
^
y
= −2x +1
15
http://www.nhc.noaa.gov/gifs/table6.gif
562 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Exercise 12.13.26 (Solution on p. 574.)
The correlation coefficient is 0.942. Is this considered significant? Why or why not?
A. No, because 0.942 is greater than the critical value of 0.707
B. Yes, because 0.942 is greater than the critical value of 0.707
C. No, because 0942 is greater than the critical value of 0.811
D. Yes, because 0.942 is greater than the critical value of 0.811
Exercise 12.13.27 (Solution on p. 574.)
The data for 2001-2004 show 9 hurricanes have hit the mainland United States. The line of best fit
predicts 2.83 major hurricanes to hit mainland U.S. Can the least squares line be used to make this
prediction?
A. No, because 9 lies outside the independent variable values
B. Yes, because, in fact, there have been 3 major hurricanes this decade
C. No, because 2.83 lies outside the dependent variable values
D. Yes, because how else could we predict what is going to happen this decade.
**Exercises 21 and 22 contributed by Roberta Bloom
563
12.14 Lab 1: Regression (Distance from School)
16
Class Time:
Names:
12.14.1 Student Learning Outcomes:
• The student will calculate and construct the line of best fit between two variables.
• The student will evaluate the relationship between two variables to determine if that relationship is
significant.
12.14.2 Collect the Data
Use 8 members of your class for the sample. Collect bivariate data (distance an individual lives fromschool,
the cost of supplies for the current term).
1. Complete the table.
Distance from school Cost of supplies this term
Table 12.22
2. Which variable should be the dependent variable and which should be the independent variable?
Why?
3. Graph “distance” vs. “cost.” Plot the points on the graph. Label both axes with words. Scale both
axes.
16
This content is available online at <http://cnx.org/content/m17080/1.11/>.
564 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Figure 12.18
12.14.3 Analyze the Data
Enter your data into your calculator or computer. Write the linear equation below, rounding to 4 decimal
places.
1. Calculate the following:
a. a =
b. b=
c. correlation =
d. n =
e. equation:
^
y
=
f. Is the correlation significant? Why or why not? (Answer in 1-3 complete sentences.)
2. Supply an answer for the following senarios:
a. For a person who lives 8 miles from campus, predict the total cost of supplies this term:
b. For a person who lives 80 miles from campus, predict the total cost of supplies this term:
3. Obtain the graph on your calculator or computer. Sketch the regression line below.
565
Figure 12.19
12.14.4 Discussion Questions
1. Answer each with 1-3 complete sentences.
a. Does the line seem to fit the data? Why?
b. What does the correlation imply about the relationship between the distance and the cost?
2. Are there any outliers? If so, which point is an outlier?
3. Should the outlier, if it exists, be removed? Why or why not?
566 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
12.15 Lab 2: Regression (Textbook Cost)
17
Class Time:
Names:
12.15.1 Student Learning Outcomes:
• The student will calculate and construct the line of best fit between two variables.
• The student will evaluate the relationship between two variables to determine if that relationship is
significant.
12.15.2 Collect the Data
Survey 10 textbooks. Collect bivariate data (number of pages in a textbook, the cost of the textbook).
1. Complete the table.
Number of pages Cost of textbook
Table 12.23
2. Which variable should be the dependent variable and which should be the independent variable?
Why?
3. Graph “distance” vs. “cost.” Plot the points on the graph in "Analyze the Data". Label both axes with
words. Scale both axes.
12.15.3 Analyze the Data
Enter your data into your calculator or computer. Write the linear equation below, rounding to 4 decimal
places.
1. Calculate the following:
a. a =
b. b =
c. correlation =
d. n =
17
This content is available online at <http://cnx.org/content/m17087/1.9/>.
567
e. equation: y =
f. Is the correlation significant? Why or why not? (Answer in 1-3 complete sentences.)
2. Supply an answer for the following senarios:
a. For a textbook with 400 pages, predict the cost:
b. For a textbook with 600 pages, predict the cost:
3. Obtain the graph on your calculator or computer. Sketch the regression line below.
Figure 12.20
12.15.4 Discussion Questions
1. Answer each with 1-3 complete sentences.
a. Does the line seem to fit the data? Why?
b. What does the correlation imply about the relationship between the number of pages and the cost?
2. Are there any outliers? If so, which point(s) is an outlier?
3. Should the outlier, if it exists, be removed? Why or why not?
568 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
12.16 Lab 3: Regression (Fuel Efficiency)
18
Class Time:
Names:
12.16.1 Student Learning Outcomes:
• The student will calculate and construct the line of best fit between two variables.
• The student will evaluate the relationship between two variables to determine if that relationship is
significant.
12.16.2 Collect the Data
Use the most recent April issue of Consumer Reports. It will give the total fuel efficiency (in miles per
gallon) and weight (in pounds) of new model cars with automatic transmissions. We will use this data to
determine the relationship, if any, between the fuel efficiency of a car and its weight.
1. Which variable should be the independent variable and which should be the dependent variable?
Explain your answer in one or two complete sentences.
2. Using your random number generator, randomly select 20 cars from the list and record their weights
and fuel efficiency into the table below.
Weight Fuel Efficiency
18
This content is available online at <http://cnx.org/content/m17079/1.8/>.
569
Table 12.24
3. Which variable should be the dependent variable and which should be the independent variable?
Why?
4. By hand, do a scatterplot of “weight” vs. “fuel efficiency”. Plot the points on graph paper. Label both
axes with words. Scale both axes accurately.
Figure 12.21
12.16.3 Analyze the Data
Enter your data into your calculator or computer. Write the linear equation below, rounding to 4 decimal
places.
1. Calculate the following:
a. a =
b. b =
c. correlation =
d. n =
e. equation:
^
y
=
570 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
2. Obtain the graph of the regression line on your calculator. Sketch the regression line on the same axes
as your scatterplot.
12.16.4 Discussion Questions
1. Is the correlation significant? Explain how you determined this in complete sentences.
2. Is the relationship a positive one or a negative one? Explain how you can tell and what this means in
terms of weight and fuel efficiency.
3. In one or two complete sentences, what is the practical interpretation of the slope of the least squares
line in terms of fuel efficiency and weight?
4. For a car that weighs 4000 pounds, predict its fuel efficiency. Include units.
5. Can we predict the fuel efficiency of a car that weighs 10000 pounds using the least squares line?
Explain why or why not.
6. Questions. Answer each in 1 to 3 complete sentences.
a. Does the line seem to fit the data? Why or why not?
b. What does the correlation imply about the relationship between fuel efficiency and weight of a
car? Is this what you expected?
7. Are there any outliers? If so, which point is an outlier?
** This lab was designed and contributed by Diane Mathios.
571
Solutions to Exercises in Chapter 12
Solution to Example 12.11, Problem 2 (p. 533)
The x values in the data are between 65 and 75. 90 is outside of the domain of the observed x values in
the data (independent variable), so you cannot reliably predict the final exam score for this student. (Even
though it is possible to enter x into the equation and calculate a y value, you should not do so!)
To really understand how unreliable the prediction can be outside of the observed x values in the
data, make the substitution x = 90 into the equation.
^
y
= −173.51 +4.83 (90) = 261.19
The final exam score is predicted to be 261.19. The largest the final exam score can be is 200.
NOTE: The process of predicting inside of the observed x values in the data is called interpolation.
The process of predicting outside of the observed x values in the data is called extrapolation.
Solutions to Practice: Linear Regression
Solution to Exercise 12.12.2 (p. 545)
a. a = -3,448,225
b. b = 1750
c. corr. = 0.4526
d. n = 22
Solution to Exercise 12.12.3 (p. 545)
^
y
= -3,448,225 +1750x
Solution to Exercise 12.12.4 (p. 545)
a. 25,525
b. 34,275
Solution to Exercise 12.12.10 (p. 546)
a. -725
Solutions to Homework
Solution to Exercise 12.13.1 (p. 547)
a. Independent: Age; Dependent: Fatalities
d. Independent: Power Consumption; Dependent: Utility
Solution to Exercise 12.13.3 (p. 548)
b.
^
y
= 88.7206 −0.0432x
c. -0.8533, Yes
g. No
h. No.
i. 2.93, Yes
j. slope = -0.0432. As the year increases by one, the welfare family size tends to decrease by 0.0432 people.
572 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Solution to Exercise 12.13.5 (p. 548)
b. Yes
c.
^
y
= 102.4287 +11.7585x
d. 0.9436; yes
e. 478.70 feet; 1207.73 feet
g. Yes
h. Yes; (57, 1050)
i. 172.98; No
j. 11.7585 feet
k. slope = 11.7585. As the number of stories increases by one, the height of the building tends to increase
by 11.7585 feet.
Solution to Exercise 12.13.7 (p. 550)
b. Yes
c.
^
y
= −266.8863 +0.1656x
d. 0.9448; Yes
e. 62.8233; 62.3265
h. yes; (1987, 62.7)
i. 72.5937; No
j. slope = 0.1656. As the year increases by one, the percent of workers paid hourly rates tends to increase
by 0.1656.
Solution to Exercise 12.13.9 (p. 552)
b. Yes
c.
^
y
= 3.5984 +0.0371x
d. 0.9986; Yes
e. $5.08
f. $6.93
i. No
j. Not valid
k. slope = 0.0371. As the number of ounces increases by one, the cost of liquid detergent tends to increase
by $0.0371 or is predicted to increase by $0.0371 (about 4 cents).
Solution to Exercise 12.13.11 (p. 553)
c. Yes
d.
^
y
= −337, 424.6478 +0.5463x
e. 0.9964; Yes
f. $208,875.35; $1,028,325.35
h. Yes
i. No
k. slope = 0.5463. As the net taxable estate increases by one dollar, the approximate probate fees and taxes
tend to increase by 0.5463 dollars (about 55 cents).
Solution to Exercise 12.13.13 (p. 554)
c. Yes
d.
^
y
= 65.0876 +7.0948x
e. 0.9761; yes
f. 72.2 cm; 143.13 cm
573
h. Yes
i. No
j. 505.0 cm; No
k. slope = 7.0948. As the age of an American boy increases by one year, the average height tends to increase
by 7.0948 cm.
Solution to Exercise 12.13.15 (p. 556)
c. No
d.
^
y
= 47.03 −0.0216x
e. -0.4280
f. 6; 5
Solution to Exercise 12.13.17 (p. 557)
d.
^
y
= −480.5845 +0.2748x
e. 0.9553
f. 1934
Solution to Exercise 12.13.19 (p. 558)
b.
^
y
= −569, 770.2796 +296.0351x
c. 0.8302
d. $1577.46
e. $11,642.66
f. -$22,105.34
Solution to Exercise 12.13.21 (p. 559)
b. r = -0.8, significant
c. yhat = 48.4-0.00725x
d. For every one pound increase in weight, the fuel efficiency tends to decrease (or is predicted to decrease)
by 0.00725 miles per gallon. (For every one thousand pounds increase in weight, the fuel efficiency
tends to decrease by 7.25 miles per gallon.)
e. 64% of the variation in fuel efficiency is explained by the variation in weight using the regression line.
g. yhat=48.4-0.00725(3000)=26.65 mpg. y-yhat=25-26.65=-1.65. Because yhat=26.5 is greater than y=25, the
line overestimates the observed fuel efficiency.
h. (2750,38) is the outlier. Be sure you know how to justify it using the requested graphical or numerical
methods, not just by guessing.
i. yhat = 42.4-0.00578x
j. Without outlier, r=-0.885, rsquare=0.76; with outlier, r=-0.8, rsquare=0.64. The new linear model is a
better fit, after the outlier is removed from the data, because the new correlation coefficient is farther
from 0 and the new coefficient of determination is larger.
Solution to Exercise 12.13.22 (p. 560)
a. All four data sets have the same correlation coefficient r=0.816 and the same least squares regression line
yhat=3+0.5x
b. Set 2 ; c. Set 4 ; d. Set 3 ; e. Set 1
574 CHAPTER 12. LINEAR REGRESSION AND CORRELATION
Figure 12.22
Solution to Exercise 12.13.23 (p. 561)
C
Solution to Exercise 12.13.24 (p. 561)
A
Solution to Exercise 12.13.25 (p. 561)
B
Solution to Exercise 12.13.26 (p. 562)
D
Solution to Exercise 12.13.27 (p. 562)
A
markets
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1. DEMAND
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. Deñne the quantity demanded of a good or service and iIIustrate it using a demand scheduIe
and a demand curve.
2. Distinguish between the foIIowing pairs of concepts: demand and quantity demanded, de-
mand scheduIe and demand curve, movement aIong and shift in a demand curve.
3. Identify demand shifters and determine whether a change in a demand shifter causes the de-
mand curve to shift to the right or to the Ieft.
How many pizzas will people eat this yeai: How many doctoi visits will people make: How many
houses will people buy:
Each good oi seivice has its own special chaiacteiistics that deteimine the quantity people aie will-
ing and able to consume. One is the piice of the good oi seivice itself. Othei independent vaiiables that
aie impoitant deteiminants of demand include consumei piefeiences, piices of ielated goods and sei-
vices, income, demogiaphic chaiacteiistics such as population size, and buyei expectations. The num-
bei of pizzas people will puichase, foi example, depends veiy much on whethei they like pizza. It also
depends on the piices foi alteinatives such as hambuigeis oi spaghetti. The numbei of doctoi visits is
likely to vaiy with income-people with highei incomes aie likely to see a doctoi moie often than
people with lowei incomes. The demands foi pizza, foi doctoi visits, and foi housing aie ceitainly
afected by the age distiibution of the population and its size.
While difeient vaiiables play difeient ioles in infuencing the demands foi difeient goods and
seivices, economists pay special attention to one: the piice of the good oi seivice. Given the values of all
the othei vaiiables that afect demand, a highei piice tends to ieduce the quantity people demand, and
a lowei piice tends to inciease it. A medium pizza typically sells foi $3 to $10. Suppose the piice weie
$30. Chances aie, you would buy fewei pizzas at that piice than you do now. Suppose pizzas typically
sold foi $2 each. At that piice, people would be likely to buy moie pizzas than they do now.
We will discuss fist how piice afects the quantity demanded of a good oi seivice and then how
othei vaiiables afect demand.
1.1 Piice and the Demand Cuive
Because people will puichase difeient quantities of a good oi seivice at difeient piices, economists
must be caieful when speaking of the ¨demand" foi something. They have theiefoie developed some
specifc teims foi expiessing the geneial concept of demand.
The quantity demanded of a good oi seivice is the quantity buyeis aie willing and able to buy at
a paiticulai piice duiing a paiticulai peiiod, all othei things unchanged. (As we leained, we can substi-
tute the Latin phiase ¨ceteiis paiibus" foi ¨all othei things unchanged.") Suppose, foi example, that
100,000 movie tickets aie sold each month in a paiticulai town at a piice of $8 pei ticket. That quant-
ity-100,000-is the quantity of movie admissions demanded pei month at a piice of $8. If the piice
weie $12, we would expect the quantity demanded to be less. If it weie $4, we would expect the quant-
ity demanded to be gieatei. The quantity demanded at each piice would be difeient if othei things that
might afect it, such as the population of the town, weie to change. That is why we add the qualifei that
othei things have not changed to the defnition of quantity demanded.
A demand schedule is a table that shows the quantities of a good oi seivice demanded at difei-
ent piices duiing a paiticulai peiiod, all othei things unchanged. To intioduce the concept of a de-
mand schedule, let us considei the demand foi cofee in the United States. We will ignoie difeiences
among types of cofee beans and ioasts, and speak simply of cofee. The table in Figuie 3.1 shows
quantities of cofee that will be demanded each month at piices ianging fiom $9 to $4 pei pound; the
table is a demand schedule. We see that the highei the piice, the lowei the quantity demanded.
58 PRINCIPL£S OI £CONOMICS
demand curve
A g..p||c.| .ep.esert.t|cr c|
. Jen.rJ sc|eJu|e.
change in quantity
demanded
A ncvenert .|crg .
Jen.rJ cu.ve t|.t .esu|ts
|.cn . c|.rge |r p.|ce.
Iaw of demand
|c. v|.tu.||y .|| gccJs .rJ
se.v|ces, . ||g|e. p.|ce |e.Js
tc . .eJuct|cr |r ,u.rt|ty
Jen.rJeJ .rJ . |c.e. p.|ce
|e.Js tc .r |rc.e.se |r
,u.rt|ty Jen.rJeJ.
II GUR£ 3. 1 A Demand ScheduIe and a Demand Curve
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p..t|cu|.. p.|ces, .|| ct|e. t||rgs urc|.rgeJ. ¯|ese J.t. ..e t|er p|ctteJ cr t|e Jen.rJ cu.ve. At pc|rt A cr t|e
cu.ve, 25 n||||cr pcurJs c| cc|ee pe. ncrt| ..e Jen.rJeJ .t . p.|ce c| ´6 pe. pcurJ. At pc|rt b, 30 n||||cr
pcurJs c| cc|ee pe. ncrt| ..e Jen.rJeJ .t . p.|ce c| ´5 pe. pcurJ.
The infoimation given in a demand schedule can be piesented with a demand curve, which is a
giaphical iepiesentation of a demand schedule. A demand cuive thus shows the ielationship between
the piice and quantity demanded of a good oi seivice duiing a paiticulai peiiod, all othei things un-
changed. The demand cuive in Figuie 3.1 shows the piices and quantities of cofee demanded that aie
given in the demand schedule. At point A, foi example, we see that 23 million pounds of cofee pei
month aie demanded at a piice of $6 pei pound. By convention, economists giaph piice on the veitical
axis and quantity on the hoiizontal axis.
Piice alone does not deteimine the quantity of cofee oi any othei good that people buy. To isolate
the efect of changes in piice on the quantity of a good oi seivice demanded, howevei, we show the
quantity demanded at each piice, assuming that those othei vaiiables iemain unchanged. We do the
same thing in diawing a giaph of the ielationship between any two vaiiables; we assume that the values
of othei vaiiables that may afect the vaiiables shown in the giaph (such as income oi population) ie-
main unchanged foi the peiiod undei consideiation.
A change in piice, with no change in any of the othei vaiiables that afect demand, iesults in a
movement along the demand cuive. Foi example, if the piice of cofee falls fiom $6 to $3 pei pound,
consumption iises fiom 23 million pounds to 30 million pounds pei month. That is a movement fiom
point A to point B along the demand cuive in Figuie 3.1. A movement along a demand cuive that ies-
ults fiom a change in piice is called a change in quantity demanded. Note that a change in quantity
demanded is not a change oi shift in the demand cuive; it is a movement along the demand cuive.
The negative slope of the demand cuive in Figuie 3.1 suggests a key behavioial ielationship of eco-
nomics. All othei things unchanged, the law of demand holds that, foi viitually all goods and sei-
vices, a highei piice leads to a ieduction in quantity demanded and a lowei piice leads to an inciease in
quantity demanded.
The law of demand is called a law because the iesults of countless studies aie consistent with it.
Undoubtedly, you have obseived one manifestation of the law. When a stoie fnds itself with an ovei-
stock of some item, such as iunning shoes oi tomatoes, and needs to sell these items quickly, what does
it do: It typically has a sale, expecting that a lowei piice will inciease the quantity demanded. In genei-
al, we expect the law of demand to hold. Given the values of othei vaiiables that infuence demand, a
highei piice ieduces the quantity demanded. A lowei piice incieases the quantity demanded. Demand
cuives, in shoit, slope downwaid.
CHAP7£R 3 D£MAND AND SUPPLY 59
change in demand
A s|||t |r . Jen.rJ cu.ve.
1.2 Changes in Demand
Of couise, piice alone does not deteimine the quantity of a good oi seivice that people consume.
Cofee consumption, foi example, will be afected by such vaiiables as income and population. Piefei-
ences also play a iole. The stoiy at the beginning of the chaptei illustiates as much. Staibucks ¨tuined
people on" to cofee. We also expect othei piices to afect cofee consumption. People often eat dough-
nuts oi bagels with theii cofee, so a ieduction in the piice of doughnuts oi bagels might induce people
to diink moie cofee. An alteinative to cofee is tea, so a ieduction in the piice of tea might iesult in the
consumption of moie tea and less cofee. Thus, a change in any one of the vaiiables held constant in
constiucting a demand schedule will change the quantities demanded at each piice. The iesult will be a
shift in the entiie demand cuive iathei than a movement along the demand cuive. A shift in a demand
cuive is called a change in demand.
Suppose, foi example, that something happens to inciease the quantity of cofee demanded at each
piice. Seveial events could pioduce such a change: an inciease in incomes, an inciease in population,
oi an inciease in the piice of tea would each be likely to inciease the quantity of cofee demanded at
each piice. Any such change pioduces a new demand schedule. Figuie 3.2 shows such a change in the
demand schedule foi cofee. We see that the quantity of cofee demanded pei month is gieatei at each
piice than befoie. We show that giaphically as a shift in the demand cuive. The oiiginal cuive, labeled
D
1
, shifts to the iight to D
2
. At a piice of $6 pei pound, foi example, the quantity demanded iises fiom
23 million pounds pei month (point A) to 33 million pounds pei month (point A).
II GUR£ 3. 2 An Increase in Demand
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t|e c.|g|r.| Jen.rJ cu.ve |
1
s|||ts tc |
2
. |c|rt A cr |
1
cc..espcrJs tc . p.|ce c| ´6 pe. pcurJ .rJ . ,u.rt|ty
Jen.rJeJ c| 25 n||||cr pcurJs c| cc|ee pe. ncrt|. Or t|e re. Jen.rJ cu.ve |
2
, t|e ,u.rt|ty Jen.rJeJ .t t||s
p.|ce .|ses tc 35 n||||cr pcurJs c| cc|ee pe. ncrt| (pc|rt A).
Just as demand can inciease, it can deciease. In the case of cofee, demand might fall as a iesult of
events such as a ieduction in population, a ieduction in the piice of tea, oi a change in piefeiences. Foi
example, a defnitive fnding that the cafeine in cofee contiibutes to heait disease, which is cuiiently
being debated in the scientifc community, could change piefeiences and ieduce the demand foi cofee.
A ieduction in the demand foi cofee is illustiated in Figuie 3.3. The demand schedule shows that
less cofee is demanded at each piice than in Figuie 3.1. The iesult is a shift in demand fiom the oiigin-
al cuive D
1
to D
3
. The quantity of cofee demanded at a piice of $6 pei pound falls fiom 23 million
pounds pei month (point A) to 13 million pounds pei month (point A). Note, again, that a change in
quantity demanded, ceteiis paiibus, iefeis to a movement along the demand cuive, while a change in
demand iefeis to a shift in the demand cuive.
60 PRINCIPL£S OI £CONOMICS
demand shifter
A v..|.b|e t|.t c.r c|.rge
t|e ,u.rt|ty c| . gccJ c.
se.v|ce Jen.rJeJ .t e.c|
p.|ce.
compIements
¯.c gccJs |c. .||c| .r
|rc.e.se |r p.|ce c| cre
.eJuces t|e Jen.rJ |c. t|e
ct|e..
substitutes
¯.c gccJs |c. .||c| .r
|rc.e.se |r p.|ce c| cre
|rc.e.ses t|e Jen.rJ |c. t|e
ct|e..
II GUR£ 3. 3 A Reduction in Demand
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Jen.rJ sc|eJu|e s|c.s . |c.e. ,u.rt|ty c| cc|ee Jen.rJeJ .t e.c| p.|ce t|.r .e |.J |r ||gu.e 3.1. ¯|e
.eJuct|cr s|||ts t|e Jen.rJ cu.ve |c. cc|ee tc |
3
|.cn |
1
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ex.np|e, |.||s |.cn 25 n||||cr pcurJs pe. ncrt| (pc|rt A) tc 15 n||||cr pcurJs c| cc|ee pe. ncrt| (pc|rt A).
A vaiiable that can change the quantity of a good oi seivice demanded at each piice is called a de-
mand shifter. When these othei vaiiables change, the all-othei-things-unchanged conditions behind
the oiiginal demand cuive no longei hold. Although difeient goods and seivices will have difeient de-
mand shifteis, the demand shifteis aie likely to include (1) consumei piefeiences, (2) the piices of ie-
lated goods and seivices, (3) income, (4) demogiaphic chaiacteiistics, and (3) buyei expectations. Next
we look at each of these.
Preferences
Changes in piefeiences of buyeis can have impoitant consequences foi demand. We have alieady seen
how Staibucks supposedly incieased the demand foi cofee. Anothei example is ieduced demand foi
cigaiettes caused by concein about the efect of smoking on health. A change in piefeiences that makes
one good oi seivice moie populai will shift the demand cuive to the iight. A change that makes it less
populai will shift the demand cuive to the left.
Prices of ReIated Goods and Services
Suppose the piice of doughnuts weie to fall. Many people who diink cofee enjoy dunking doughnuts
in theii cofee; the lowei piice of doughnuts might theiefoie inciease the demand foi cofee, shifting
the demand cuive foi cofee to the iight. A lowei piice foi tea, howevei, would be likely to ieduce
cofee demand, shifting the demand cuive foi cofee to the left.
In geneial, if a ieduction in the piice of one good incieases the demand foi anothei, the two goods
aie called complements. If a ieduction in the piice of one good ieduces the demand foi anothei, the
two goods aie called substitutes. These defnitions hold in ieveise as well: two goods aie complements
if an inciease in the piice of one ieduces the demand foi the othei, and they aie substitutes if an in-
ciease in the piice of one incieases the demand foi the othei. Doughnuts and cofee aie complements;
tea and cofee aie substitutes.
Complementaiy goods aie goods used in conjunction with one anothei. Tennis iackets and tennis
balls, eggs and bacon, and stationeiy and postage stamps aie complementaiy goods. Substitute goods
aie goods used instead of one anothei. iPODs, foi example, aie likely to be substitutes foi CD playeis.
Bieakfast ceieal is a substitute foi eggs. A fle attachment to an e-mail is a substitute foi both a fax ma-
chine and postage stamps.
CHAP7£R 3 D£MAND AND SUPPLY 61
normaI good
A gccJ |c. .||c| Jen.rJ
|rc.e.ses .|er |rccne
|rc.e.ses.
inferior good
A gccJ |c. .||c| Jen.rJ
Jec.e.ses .|er |rccne
|rc.e.ses.
II GUR£ 3. 4
Income
As incomes iise, people inciease theii consumption of many goods and seivices, and as incomes fall,
theii consumption of these goods and seivices falls. Foi example, an inciease in income is likely to iaise
the demand foi gasoline, ski tiips, new cais, and jeweliy. Theie aie, howevei, goods and seivices foi
which consumption falls as income iises-and iises as income falls. As incomes iise, foi example,
people tend to consume moie fiesh fiuit but less canned fiuit.
A good foi which demand incieases when income incieases is called a normal good. A good foi
which demand decieases when income incieases is called an inferior good. An inciease in income
shifts the demand cuive foi fiesh fiuit (a noimal good) to the iight; it shifts the demand cuive foi
canned fiuit (an infeiioi good) to the left.
Demographic Characteristics
The numbei of buyeis afects the total quantity of a good oi seivice that will be bought; in geneial, the
gieatei the population, the gieatei the demand. Othei demogiaphic chaiacteiistics can afect demand
as well. As the shaie of the population ovei age 63 incieases, the demand foi medical seivices, ocean
ciuises, and motoi homes incieases. The biith iate in the United States fell shaiply between 1933 and
1973 but has giadually incieased since then. That inciease has iaised the demand foi such things as in-
fant supplies, elementaiy school teacheis, soccei coaches, in-line skates, and college education. De-
mand can thus shift as a iesult of changes in both the numbei and chaiacteiistics of buyeis.
8uyer £xpectations
The consumption of goods that can be easily stoied, oi whose consumption can be postponed, is
stiongly afected by buyei expectations. The expectation of newei TV technologies, such as high-defni-
tion TV, could slow down sales of iegulai TVs. If people expect gasoline piices to iise tomoiiow, they
will fll up theii tanks today to tiy to beat the piice inciease. The same will be tiue foi goods such as
automobiles and washing machines: an expectation of highei piices in the futuie will lead to moie pui-
chases today. If the piice of a good is expected to fall, howevei, people aie likely to ieduce theii pui-
chases today and await tomoiiow's lowei piices. The expectation that computei piices will fall, foi ex-
ample, can ieduce cuiient demand.
62 PRINCIPL£S OI £CONOMICS
Heads Up!
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k £ Y 7 A k £ A W A Y S
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7 R Y I 7 !
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CHAP7£R 3 D£MAND AND SUPPLY 63
Case in Point: SoIving Campus Parking ProbIems Without Adding More Parking
Spaces
÷ 2010 jupiterimages Corporation
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suggest scne subt|e., .rJ pe.|.ps pc||t|c.||y nc.e p.|.t.b|e, ne.su.es|r p..t|cu|.., s|||t|rg t|e Jen.rJ |c.
p..k|rg sp.ces tc t|e |e|t by |c.e.|rg t|e p.|ces c| subst|tutes.
¯.c ex.np|es t|ey rcteJ .e.e .t t|e |r|ve.s|ty c| \.s||rgtcr .rJ t|e |r|ve.s|ty c| ´c|c..Jc .t bcu|Je.. At
t|e |r|ve.s|ty c| \.s||rgtcr, c.. pcc|e.s n.y p..k |c. |.ee. ¯||s |rrcv.t|cr |.s .eJuceJ pu.c|.ses c| s|rg|e
cccup.rcy p..k|rg pe.n|ts by 32 cve. . Jec.Je. Accc.J|rg tc |r|ve.s|ty c| \.s||rgtcr .ss|st.rt J|.ectc. c|
t..rspc.t.t|cr se.v|ces |ete. |e.ey, ´\|t|cut v|gc.cus|y n.r.g|rg cu. p..k|rg .rJ p.cv|J|rg ccnnute. .|
te.r.t|ves, t|e ur|ve.s|ty .cu|J |.ve beer |.ceJ .|t| .JJ|rg .pp.cx|n.te|y 3,600 p..k|rg sp.ces, .t . ccst c|
cve. ´100 n||||cr.¯|e ur|ve.s|ty |.s c.e.teJ cppc.tur|t|es tc n.ke c.p|t.| |rvestnerts |r bu||J|rgs suppc.t
|rg eJuc.t|cr |rste.J c| st.uctu.es |c. c..s.´ At t|e |r|ve.s|ty c| ´c|c..Jc, |.ee pub||c t..rs|t |.s |rc.e.seJ use
c| buses .rJ ||g|t ..|| |.cn 300,000 tc 2 n||||cr t.|ps pe. ye.. cve. t|e |.st Jec.Je. ¯|e |rc.e.seJ use c| n.ss
t..rs|t |.s .||c.eJ t|e ur|ve.s|ty tc .vc|J ccrst.uct|rg re..|y 2,000 p..k|rg sp.ces, .||c| |.s s.veJ .bcut
´3.6 n||||cr .rru.||y.
.oo·ce· |o·|e| | |e··e,. |o. |o .o|.e ´o·¡o· |o·||·¸ |·o·|e·· /|||oo| ^JJ|·¸ /o·e |o·||·¸.' ¯|e ´|·o·|c|e o| ||¸|e· |Joco||o·. /o·c| 26.
2004. .ec||o· |. ¡¡ |22|23
64 PRINCIPL£S OI £CONOMICS
quantity suppIied
¯|e ,u.rt|ty se||e.s ..e
.||||rg tc se|| c| . gccJ c.
se.v|ce .t . p..t|cu|.. p.|ce
Ju.|rg . p..t|cu|.. pe.|cJ, .||
ct|e. t||rgs urc|.rgeJ.
A N S W £ R 7 O 7 R Y I 7 ! P R O 8 L £ M
S|rce gc|rg tc t|e ncv|es |s . subst|tute |c. ..tc||rg . |\| .t |cne, .r |rc.e.se |r t|e p.|ce c| gc|rg tc t|e
ncv|es s|cu|J c.use nc.e pecp|e tc s.|tc| |.cn gc|rg tc t|e ncv|es tc st.y|rg .t |cne .rJ .ert|rg |\|s.
¯|us, t|e Jen.rJ cu.ve |c. |\| .ert.|s .||| s|||t tc t|e .|g|t .|er t|e p.|ce c| ncv|e t|e.te. t|ckets |rc.e.ses
¦|.re| (.)¦.
A Jec.e.se |r |.n||y |rccne .||| c.use t|e Jen.rJ cu.ve tc s|||t tc t|e |e|t || |\| .ert.|s ..e . rc.n.| gccJ
but tc t|e .|g|t || |\| .ert.|s ..e .r |r|e.|c. gccJ. ¯|e |.tte. n.y be t|e c.se |c. scne |.n|||es, s|rce st.y|rg
.t |cne .rJ ..tc||rg |\|s |s . c|e.pe. |c.n c| erte.t.|rnert t|.r t.k|rg t|e |.n||y tc t|e ncv|es. |c.
ncst ct|e.s, |c.eve., |\| .ert.|s ..e p.cb.b|y . rc.n.| gccJ ¦|.re| (b)¦.
Ar |rc.e.se |r t|e p.|ce c| |\| .ert.|s Jces rct s|||t t|e Jen.rJ cu.ve |c. |\| .ert.|s .t .||, ..t|e., .r |r
c.e.se |r p.|ce, s.y |.cn |
1
tc |
2
, |s . ncvenert up...J tc t|e |e|t .|crg t|e Jen.rJ cu.ve. At . ||g|e. p.|ce,
pecp|e .||| .ert |e.e. |\|s, s.y (
2
|rste.J c| (
1
, cete.|s p..|bus ¦|.re| (c)¦.
2. SUPPLY
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. Deñne the quantity suppIied of a good or service and iIIustrate it using a suppIy scheduIe and a
suppIy curve.
2. Distinguish between the foIIowing pairs of concepts: suppIy and quantity suppIied, suppIy
scheduIe and suppIy curve, movement aIong and shift in a suppIy curve.
3. Identify suppIy shifters and determine whether a change in a suppIy shifter causes the suppIy
curve to shift to the right or to the Ieft.
What deteimines the quantity of a good oi seivice selleis aie willing to ofei foi sale: Piice is one
factoi; ceteiis paiibus, a highei piice is likely to induce selleis to ofei a gieatei quantity of a good oi
seivice. Pioduction cost is anothei deteiminant of supply. Vaiiables that afect pioduction cost include
the piices of factois used to pioduce the good oi seivice, ietuins fiom alteinative activities, technology,
the expectations of selleis, and natuial events such as weathei changes. Still anothei factoi afecting the
quantity of a good that will be ofeied foi sale is the numbei of selleis-the gieatei the numbei of
selleis of a paiticulai good oi seivice, the gieatei will be the quantity ofeied at any piice pei time
peiiod.
2.1 Piice and the Supply Cuive
The quantity supplied of a good oi seivice is the quantity selleis aie willing to sell at a paiticulai
piice duiing a paiticulai peiiod, all othei things unchanged. Ceteiis paiibus, the ieceipt of a highei
piice incieases piofts and induces selleis to inciease the quantity they supply.
In geneial, when theie aie many selleis of a good, an inciease in piice iesults in an inciease in
quantity supplied, and this ielationship is often iefeiied to as the law of supply. We will see, though,
thiough oui exploiation of micioeconomics, that theie aie a numbei of exceptions to this ielationship.
Theie aie cases in which a highei piice will not induce an inciease in quantity supplied. Goods that
cannot be pioduced, such as additional land on the coinei of Paik Avenue and 36th Stieet in Manhat-
tan, aie fxed in supply-a highei piice cannot induce an inciease in the quantity supplied. Theie aie
CHAP7£R 3 D£MAND AND SUPPLY 65
suppIy scheduIe
A t.b|e t|.t s|c.s ,u.rt|t|es
supp||eJ .t J||e.ert p.|ces
Ju.|rg . p..t|cu|.. pe.|cJ, .||
ct|e. t||rgs urc|.rgeJ.
suppIy curve
A g..p||c.| .ep.esert.t|cr c|
. supp|y sc|eJu|e.
change in quantity
suppIied
Vcvenert .|crg t|e supp|y
cu.ve c.useJ by . c|.rge |r
p.|ce.
change in suppIy
A s|||t |r t|e supp|y cu.ve.
even cases, which we investigate in micioeconomic analysis, in which a highei piice induces a ieduc-
tion in the quantity supplied.
Geneially speaking, howevei, when theie aie many selleis of a good, an inciease in piice iesults in
a gieatei quantity supplied. The ielationship between piice and quantity supplied is suggested in a
supply schedule, a table that shows quantities supplied at difeient piices duiing a paiticulai peiiod,
all othei things unchanged. Figuie 3.8 gives a supply schedule foi the quantities of cofee that will be
supplied pei month at vaiious piices, ceteiis paiibus. At a piice of $4 pei pound, foi example, piodu-
ceis aie willing to supply 13 million pounds of cofee pei month. A highei piice, say $6 pei pound, in-
duces selleis to supply a gieatei quantity-23 million pounds of cofee pei month.
II GUR£ 3. 8 A SuppIy ScheduIe and a SuppIy Curve
¯|e supp|y sc|eJu|e s|c.s t|e ,u.rt|ty c| cc|ee t|.t .||| be supp||eJ |r t|e |r|teJ St.tes e.c| ncrt| .t
p..t|cu|.. p.|ces, .|| ct|e. t||rgs urc|.rgeJ. ¯|e s.ne |r|c.n.t|cr |s g|ver g..p||c.||y |r t|e supp|y cu.ve. ¯|e
v.|ues g|ver |e.e suggest . pcs|t|ve .e|.t|crs||p bet.eer p.|ce .rJ ,u.rt|ty supp||eJ.
A supply curve is a giaphical iepiesentation of a supply schedule. It shows the ielationship between
piice and quantity supplied duiing a paiticulai peiiod, all othei things unchanged. Because the iela-
tionship between piice and quantity supplied is geneially positive, supply cuives aie geneially upwaid
sloping. The supply cuive foi cofee in Figuie 3.8 shows giaphically the values given in the supply
schedule.
A change in piice causes a movement along the supply cuive; such a movement is called a change
in quantity supplied. As is the case with a change in quantity demanded, a change in quantity sup-
plied does not shift the supply cuive. By defnition, it is a movement along the supply cuive. Foi ex-
ample, if the piice iises fiom $6 pei pound to $7 pei pound, the quantity supplied iises fiom 23 million
pounds pei month to 30 million pounds pei month. That's a movement fiom point A to point B along
the supply cuive in Figuie 3.8.
2.2 Changes in Supply
When we diaw a supply cuive, we assume that othei vaiiables that afect the willingness of selleis to
supply a good oi seivice aie unchanged. It follows that a change in any of those vaiiables will cause a
change in supply, which is a shift in the supply cuive. A change that incieases the quantity of a good
oi seivice supplied at each piice shifts the supply cuive to the iight. Suppose, foi example, that the
piice of feitilizei falls. That will ieduce the cost of pioducing cofee and thus inciease the quantity of
cofee pioduceis will ofei foi sale at each piice. The supply schedule in Figuie 3.9 shows an inciease in
the quantity of cofee supplied at each piice. We show that inciease giaphically as a shift in the supply
cuive fiom S
1
to S
2
. We see that the quantity supplied at each piice incieases by 10 million pounds of
cofee pei month. At point A on the oiiginal supply cuive S
1
, foi example, 23 million pounds of cofee
pei month aie supplied at a piice of $6 pei pound. Aftei the inciease in supply, 33 million pounds pei
month aie supplied at the same piice (point A on cuive S
2
).
66 PRINCIPL£S OI £CONOMICS
II GUR£ 3. 9 An Increase in SuppIy
|| t|e.e |s . c|.rge |r supp|y t|.t |rc.e.ses t|e ,u.rt|ty supp||eJ .t e.c| p.|ce, .s |s t|e c.se |r t|e supp|y sc|eJu|e
|e.e, t|e supp|y cu.ve s|||ts tc t|e .|g|t. At . p.|ce c| ´6 pe. pcurJ, |c. ex.np|e, t|e ,u.rt|ty supp||eJ .|ses |.cn
t|e p.ev|cus |eve| c| 25 n||||cr pcurJs pe. ncrt| cr supp|y cu.ve .
1
(pc|rt A) tc 35 n||||cr pcurJs pe. ncrt| cr
supp|y cu.ve .
2
(pc|rt A).
An event that ieduces the quantity supplied at each piice shifts the supply cuive to the left. An inciease
in pioduction costs and excessive iain that ieduces the yields fiom cofee plants aie examples of events
that might ieduce supply. Figuie 3.10 shows a ieduction in the supply of cofee. We see in the supply
schedule that the quantity of cofee supplied falls by 10 million pounds of cofee pei month at each
piice. The supply cuive thus shifts fiom S
1
to S
3
.
II GUR£ 3. 10 A Reduction in SuppIy
A c|.rge |r supp|y t|.t .eJuces t|e ,u.rt|ty supp||eJ .t e.c| p.|ce s|||ts t|e supp|y cu.ve tc t|e |e|t. At . p.|ce c|
´6 pe. pcurJ, |c. ex.np|e, t|e c.|g|r.| ,u.rt|ty supp||eJ ..s 25 n||||cr pcurJs c| cc|ee pe. ncrt| (pc|rt A).
\|t| . re. supp|y cu.ve .
3
, t|e ,u.rt|ty supp||eJ .t t|.t p.|ce |.||s tc 15 n||||cr pcurJs c| cc|ee pe. ncrt| (pc|rt
A).
CHAP7£R 3 D£MAND AND SUPPLY 67
suppIy shifter
A v..|.b|e t|.t c.r c|.rge
t|e ,u.rt|ty c| . gccJ c.
se.v|ce supp||eJ .t e.c| p.|ce.
A vaiiable that can change the quantity of a good oi seivice supplied at each piice is called a supply
shifter. Supply shifteis include (1) piices of factois of pioduction, (2) ietuins fiom alteinative activit-
ies, (3) technology, (4) sellei expectations, (3) natuial events, and (6) the numbei of selleis. When these
othei vaiiables change, the all-othei-things-unchanged conditions behind the oiiginal supply cuive no
longei hold. Let us look at each of the supply shifteis.
Prices of Iactors of Production
A change in the piice of laboi oi some othei factoi of pioduction will change the cost of pioducing any
given quantity of the good oi seivice. This change in the cost of pioduction will change the quantity
that supplieis aie willing to ofei at any piice. An inciease in factoi piices should deciease the quantity
supplieis will ofei at any piice, shifting the supply cuive to the left. A ieduction in factoi piices in-
cieases the quantity supplieis will ofei at any piice, shifting the supply cuive to the iight.
Suppose cofee gioweis must pay a highei wage to the woikeis they hiie to haivest cofee oi must
pay moie foi feitilizei. Such incieases in pioduction cost will cause them to pioduce a smallei quantity
at each piice, shifting the supply cuive foi cofee to the left. A ieduction in any of these costs incieases
supply, shifting the supply cuive to the iight.
Returns from AIternative Activities
To pioduce one good oi seivice means foigoing the pioduction of anothei. The concept of oppoitunity
cost in economics suggests that the value of the activity foigone is the oppoitunity cost of the activity
chosen; this cost should afect supply. Foi example, one oppoitunity cost of pioducing eggs is not
selling chickens. An inciease in the piice people aie willing to pay foi fiesh chicken would make it
moie pioftable to sell chickens and would thus inciease the oppoitunity cost of pioducing eggs. It
would shift the supply cuive foi eggs to the left, iefecting a deciease in supply.
7echnoIogy
A change in technology alteis the combinations of inputs oi the types of inputs iequiied in the pioduc-
tion piocess. An impiovement in technology usually means that fewei and/oi less costly inputs aie
needed. If the cost of pioduction is lowei, the piofts available at a given piice will inciease, and piodu-
ceis will pioduce moie. With moie pioduced at eveiy piice, the supply cuive will shift to the iight,
meaning an inciease in supply.
Impiessive technological changes have occuiied in the computei industiy in iecent yeais. Com-
puteis aie much smallei and aie fai moie poweiful than they weie only a few yeais ago-and they aie
much cheapei to pioduce. The iesult has been a huge inciease in the supply of computeis, shifting the
supply cuive to the iight.
While we usually think of technology as enhancing pioduction, declines in pioduction due to
pioblems in technology aie also possible. Outlawing the use of ceitain equipment without pollution-
contiol devices has incieased the cost of pioduction foi many goods and seivices, theieby ieducing
piofts available at any piice and shifting these supply cuives to the left.
SeIIer £xpectations
All supply cuives aie based in pait on sellei expectations about futuie maiket conditions. Many de-
cisions about pioduction and selling aie typically made long befoie a pioduct is ieady foi sale. Those
decisions necessaiily depend on expectations. Changes in sellei expectations can have impoitant efects
on piice and quantity.
Considei, foi example, the owneis of oil deposits. Oil pumped out of the giound and used today
will be unavailable in the futuie. If a change in the inteinational political climate leads many owneis to
expect that oil piices will iise in the futuie, they may decide to leave theii oil in the giound, planning to
sell it latei when the piice is highei. Thus, theie will be a deciease in supply; the supply cuive foi oil
will shift to the left.
NaturaI £vents
Stoims, insect infestations, and diought afect agiicultuial pioduction and thus the supply of agiicul-
tuial goods. If something destioys a substantial pait of an agiicultuial ciop, the supply cuive will shift
to the left. The teiiible cyclone that killed moie than 30,000 people in Myanmai in 2008 also destioyed
some of the countiy's piime iice giowing land. That shifted the supply cuive foi iice to the left. If theie
is an unusually good haivest, the supply cuive will shift to the iight.
68 PRINCIPL£S OI £CONOMICS
7he Number of SeIIers
The supply cuive foi an industiy, such as cofee, includes all the selleis in the industiy. A change in the
numbei of selleis in an industiy changes the quantity available at each piice and thus changes supply.
An inciease in the numbei of selleis supplying a good oi seivice shifts the supply cuive to the iight; a
ieduction in the numbei of selleis shifts the supply cuive to the left.
The maiket foi cellulai phone seivice has been afected by an inciease in the numbei of fims
ofeiing the seivice. Ovei the past decade, new cellulai phone companies emeiged, shifting the supply
cuive foi cellulai phone seivice to the iight.
Heads Up!
¯|e.e ..e t.c spec|.| t||rgs tc rcte .bcut supp|y cu.ves. ¯|e |.st |s s|n||.. tc t|e |e.Js |p! cr Jen.rJ
cu.ves. |t |s |npc.t.rt tc J|st|rgu|s| c..e|u||y bet.eer c|.rges |r supp|y .rJ c|.rges |r ,u.rt|ty supp||eJ. A
c|.rge |r supp|y .esu|ts |.cn . c|.rge |r . supp|y s|||te. .rJ |np||es . s|||t c| t|e supp|y cu.ve tc t|e .|g|t c.
|e|t. A c|.rge |r p.|ce p.cJuces . c|.rge |r ,u.rt|ty supp||eJ .rJ |rJuces . ncvenert .|crg t|e supp|y
cu.ve. A c|.rge |r p.|ce Jces rct s|||t t|e supp|y cu.ve.
¯|e seccrJ c.ut|cr .e|.tes tc t|e |rte.p.et.t|cr c| |rc.e.ses .rJ Jec.e.ses |r supp|y. |ct|ce t|.t |r ||gu.e 3.9
.r |rc.e.se |r supp|y |s s|c.r .s . s|||t c| t|e supp|y cu.ve tc t|e .|g|t, t|e cu.ve s|||ts |r t|e J|.ect|cr c| |r
c.e.s|rg ,u.rt|ty .|t| .espect tc t|e |c.|.crt.| .x|s. |r ||gu.e 3.10 . .eJuct|cr |r supp|y |s s|c.r .s . s|||t c|
t|e supp|y cu.ve tc t|e |e|t, t|e cu.ve s|||ts |r t|e J|.ect|cr c| Jec.e.s|rg ,u.rt|ty .|t| .espect tc t|e |c.|
.crt.| .x|s.
bec.use t|e supp|y cu.ve |s up...J s|cp|rg, . s|||t tc t|e .|g|t p.cJuces . re. cu.ve t|.t |r . serse ||es
´be|c.´ t|e c.|g|r.| cu.ve. StuJerts scnet|nes n.ke t|e n|st.ke c| t||rk|rg c| suc| . s|||t .s . s|||t ´Jc.r´
.rJ t|e.e|c.e .s . .eJuct|cr |r supp|y. S|n||..|y, |t |s e.sy tc n.ke t|e n|st.ke c| s|c.|rg .r |rc.e.se |r sup
p|y .|t| . re. cu.ve t|.t ||es ´.bcve´ t|e c.|g|r.| cu.ve. but t|.t |s . .eJuct|cr |r supp|y!
¯c .vc|J suc| e..c.s, |ccus cr t|e |.ct t|.t .r |rc.e.se |r supp|y |s .r |rc.e.se |r t|e ,u.rt|ty supp||eJ .t e.c|
p.|ce .rJ s|||ts t|e supp|y cu.ve |r t|e J|.ect|cr c| |rc.e.seJ ,u.rt|ty cr t|e |c.|.crt.| .x|s. S|n||..|y, . .eJuc
t|cr |r supp|y |s . .eJuct|cr |r t|e ,u.rt|ty supp||eJ .t e.c| p.|ce .rJ s|||ts t|e supp|y cu.ve |r t|e J|.ect|cr
c| . |c.e. ,u.rt|ty cr t|e |c.|.crt.| .x|s.
k £ Y 7 A k £ A W A Y S
< ¯|e ,u.rt|ty supp||eJ c| . gccJ c. se.v|ce |s t|e ,u.rt|ty se||e.s ..e .||||rg tc se|| .t . p..t|cu|.. p.|ce
Ju.|rg . p..t|cu|.. pe.|cJ, .|| ct|e. t||rgs urc|.rgeJ.
< A supp|y sc|eJu|e s|c.s t|e ,u.rt|t|es supp||eJ .t J||e.ert p.|ces Ju.|rg . p..t|cu|.. pe.|cJ, .|| ct|e.
t||rgs urc|.rgeJ. A supp|y cu.ve s|c.s t||s s.ne |r|c.n.t|cr g..p||c.||y.
< A c|.rge |r t|e p.|ce c| . gccJ c. se.v|ce c.uses . c|.rge |r t|e ,u.rt|ty supp||eJ. ncvenert o|o·¸
t|e supp|y cu.ve.
< A c|.rge |r . supp|y s|||te. c.uses . c|.rge |r supp|y, .||c| |s s|c.r .s . ·|||| c| t|e supp|y cu.ve.
Supp|y s|||te.s |rc|uJe p.|ces c| |.ctc.s c| p.cJuct|cr, .etu.rs |.cn .|te.r.t|ve .ct|v|t|es, tec|rc|cgy, se||e.
expect.t|crs, r.tu..| everts, .rJ t|e runbe. c| se||e.s.
< Ar |rc.e.se |r supp|y |s s|c.r .s . s|||t tc t|e .|g|t c| . supp|y cu.ve, . Jec.e.se |r supp|y |s s|c.r .s .
s|||t tc t|e |e|t.
CHAP7£R 3 D£MAND AND SUPPLY 69
7 R Y I 7 !
|| .|| ct|e. t||rgs ..e urc|.rgeJ, .|.t |.ppers tc t|e supp|y cu.ve |c. |\| .ert.|s || t|e.e |s (.) .r |rc.e.se
|r ..ges p.|J tc |\| .ert.| stc.e c|e.ks, (b) .r |rc.e.se |r t|e p.|ce c| |\| .ert.|s, c. (c) .r |rc.e.se |r t|e
runbe. c| |\| .ert.| stc.es` |... . g..p| t|.t s|c.s .|.t |.ppers tc t|e supp|y cu.ve |r e.c| c|.cun
st.rce. ¯|e supp|y cu.ve c.r s|||t tc t|e |e|t c. tc t|e .|g|t, c. st.y .|e.e |t |s. |enenbe. tc |.be| t|e .xes .rJ
cu.ves, .rJ .enenbe. tc spec||y t|e t|ne pe.|cJ (e.g., ´|\|s .erteJ pe. .eek´).
Case in Point: 7he Monks of St. 8enedict's Get Out of the £gg 8usiness
÷ 2010 jupiterimages Corporation
|t ..s ccck|es t|.t |u.eJ t|e ncrks c| St. bereJ|cts cut c| t|e egg bus|ress, .rJ rc. p.|v.te .et.e.t spcrsc.
s||p |s |u.|rg t|en ...y |.cn ccck|es.
St. bereJ|cts |s . bereJ|ct|re ncr.ste.y, rest|eJ cr . ..rc| ||g| |r t|e ´c|c..Jc |cck|es, .bcut 20 n||es
Jc.r t|e .c.J |.cn Asper. ¯|e ncr.ste.ys 15 ncrks cpe..te t|e ..rc| tc suppc.t t|ense|ves .rJ tc
p.cv|Je |e|p |c. pcc. pecp|e |r t|e ..e.. ¯|ey |e.se cut .bcut 3,500 .c.es c| t|e|. |.rJ tc c.tt|e .rJ s|eep
g...e.s, p.cJuce ccck|es, .rJ spcrsc. p.|v.te .et.e.ts. ¯|ey useJ tc p.cJuce eggs.
Att..cteJ by pctert|.| p.c|ts .rJ t|e pe.ce|u| r.tu.e c| t|e .c.k, t|e ncrks .ert |rtc t|e egg bus|ress |r
196. ¯|ey |.J 10,000 c||ckers p.cJuc|rg t|e|. Vcr.ste.y |ggs b..rJ. |c. . .|||e, bus|ress ..s gccJ. \e.y
gccJ. ¯|er, |r t|e |.te 190s, t|e p.|ce c| c||cker |eeJ st..teJ tc .|se ..p|J|y.
´\|er .e st..teJ |r t|e bus|ress, .e .e.e p.y|rg ´60 tc ´80 . tcr |c. |eeJJe||ve.eJ,´ .ec.||s t|e ncr.s
te.ys .bbct, |.t|e. 'csep| bcy|e. ´by t|e |.te 190s, cu. ccst |.J nc.e t|.r Jcub|eJ. \e .e.e p.y|rg ´160 tc
´200 . tcr. ¯|.t .e.||y |u.t, bec.use |eeJ .ep.eserts . |..ge p..t c| t|e ccst c| p.cJuc|rg eggs.´
¯|e ncrks .J¦usteJ tc t|e b|c.. ´\|er g..|r p.|ces .e.e |c.e., .eJ pu|| . |er c| |c. . |e. .eeks tc nc|t,
t|er .etu.r |e. tc |.y|rg. A|te. g..|r p.|ces .ert up, |t ..s 12 ncrt|s c| |.y|rg .rJ |rtc t|e scup pct,´ |.t|e.
'csep| s.ys.
C..|r p.|ces ccrt|rueJ tc .|se |r t|e 1980s .rJ |rc.e.seJ t|e ccsts c| p.cJuct|cr |c. .|| egg p.cJuce.s. |t
c.useJ t|e supp|y c| eggs tc |.||. |en.rJ |e|| .t t|e s.ne t|ne, .s Ane.|c.rs .c..|eJ .bcut t|e c|c|este.c| |r
eggs. ¯|nes gct tcug|e. |r t|e egg bus|ress.
´\e .e.e st||| n.k|rg ncrey |r t|e |r.rc|.| serse,´ |.t|e. 'csep| s.ys. ´but .e t.|eJ .r expe.|nert |r 1985
p.cJuc|rg ccck|es, .rJ |t ..s . success. \e |r.||y Jec|JeJ t|.t Jevct|rg cu. t|ne .rJ ere.gy tc t|e ccck|es
.cu|J p.y c| bette. t|.r t|e egg bus|ress, sc .e ,u|t t|e egg bus|ress |r 1986.´
70 PRINCIPL£S OI £CONOMICS
¯|e n.||c.Je. ccck|e bus|ress ..s gccJ tc t|e ncrks. ¯|ey sc|J 200,000 curces c| Vcr.ste.y ´cck|es |r
198.
by 1998, |c.eve., t|ey |.J ||n|teJ t|e|. p.cJuct|cr c| ccck|es, se|||rg cr|y |cc.||y .rJ tc g||t s|cps. S|rce
2000, t|ey |.ve s.|tc|eJ tc ´p.cv|J|rg p.|v.te .et.e.ts |c. |rJ|v|Ju.|s .rJ g.cups.bcut 40 pecp|e pe.
ncrt|,´ .ccc.J|rg tc b.ct|e. ´|..|es.
¯|e ncrks c.|cu|.t|cr c| t|e|. cppc.tur|ty ccsts .eve.|eJ t|.t t|ey .cu|J e..r . ||g|e. .etu.r t|.cug| spcr
sc.s||p c| p.|v.te .et.e.ts t|.r |r e|t|e. ccck|es c. eggs. ¯||s p.c¦ect|cr |.s p.cveJ cc..ect.
ArJ t|e.e |s .rct|e. .Jv.rt.ge .s .e||.
´¯|e c||ckers J|Jrt stcp |.y|rg eggs cr SurJ.y,´ |.t|e. 'csep| c|uck|es. ´\|er .e s|||teJ tc ccck|es .e
ccu|J t.ke SurJ.ys c|. \e .e.ert |enneJ |r t|e ..y .e .e.e .|t| t|e c||ckers.´ ¯|e ncve tc p.cv|J|rg
.et.e.ts |s ever bette. |r t||s .eg..J. S|rce guests p.cv|Je t|e|. c.r ne.|s, ncst c| t|e ncr.ste.ys e|c.t gces
|rtc p|.rr|rg .rJ sc|eJu||rg, .||c| |.ees up ever nc.e c| t|e|. t|ne |c. ct|e. .c.|J|y .s .e|| .s sp|.|tu.|
pu.su|ts.
.oo·ce |e··o·o| |·|e·.|e.·
A N S W £ R 7 O 7 R Y I 7 ! P R O 8 L £ M
|\| .ert.| stc.e c|e.ks ..e . |.ctc. c| p.cJuct|cr |r t|e |\| .ert.| n..ket. Ar |rc.e.se |r t|e|. ..ges ..|ses
t|e ccst c| p.cJuct|cr, t|e.eby c.us|rg t|e supp|y cu.ve c| |\| .ert.|s tc s|||t tc t|e |e|t ¦|.re| (.)¦. (´oo||o·.
|t |s pcss|b|e t|.t ycu t|cug|t c| t|e ..ge |rc.e.se .s .r |rc.e.se |r |rccne, . Jen.rJ s|||te., t|.t .cu|J
|e.J tc .r |rc.e.se |r Jen.rJ, but t||s .cu|J be |rcc..ect. ¯|e ,uest|cr .e|e.s cr|y tc ..ges c| |\| .ert.|
stc.e c|e.ks. ¯|ey n.y .ert scne |\|, but t|e|. |np.ct cr tct.| Jen.rJ .cu|J be reg||g|b|e. bes|Jes, .e
|.ve rc |r|c.n.t|cr cr .|.t |.s |.ppereJ cve..|| tc |rccnes c| pecp|e .|c .ert |\|s. \e Jc krc.,
|c.eve., t|.t t|e ccst c| . |.ctc. c| p.cJuct|cr, .||c| |s . supp|y s|||te., |rc.e.seJ.)
Ar |rc.e.se |r t|e p.|ce c| |\| .ert.|s Jces rct s|||t t|e supp|y cu.ve .t .||, ..t|e., |t cc..espcrJs tc . ncve
nert up...J tc t|e .|g|t .|crg t|e supp|y cu.ve. At . ||g|e. p.|ce c| |
2
|rste.J c| |
1
, . g.e.te. ,u.rt|ty c|
|\| .ert.|s, s.y (
2
|rste.J c| (
1
, .||| be supp||eJ ¦|.re| (b)¦.
Ar |rc.e.se |r t|e runbe. c| stc.es .ert|rg |\|s .||| c.use t|e supp|y cu.ve tc s|||t tc t|e .|g|t ¦|.re| (c)¦.
CHAP7£R 3 D£MAND AND SUPPLY 71
modeI of demand and
suppIy
VcJe| t|.t uses Jen.rJ .rJ
supp|y cu.ves tc exp|.|r t|e
Jete.n|r.t|cr c| p.|ce .rJ
,u.rt|ty |r . n..ket.
equiIibrium price
¯|e p.|ce .t .||c| ,u.rt|ty
Jen.rJeJ e,u.|s ,u.rt|ty
supp||eJ.
equiIibrium quantity
¯|e ,u.rt|ty Jen.rJeJ .rJ
supp||eJ .t t|e e,u|||b.|un
p.|ce.
3. DEMAND, SUPPLY, AND EQUILIBRIUM
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. Use demand and suppIy to expIain how equiIibrium price and quantity are determined in a
market.
2. Understand the concepts of surpIuses and shortages and the pressures on price they generate.
3. £xpIain the impact of a change in demand or suppIy on equiIibrium price and quantity.
4. £xpIain how the circuIar 0ow modeI provides an overview of demand and suppIy in product
and factor markets and how the modeI suggests ways in which these markets are Iinked.
In this section we combine the demand and supply cuives we have just studied into a new model. The
model of demand and supply uses demand and supply cuives to explain the deteimination of piice
and quantity in a maiket.
3.1 The Deteimination of Piice and Quantity
The logic of the model of demand and supply is simple. The demand cuive shows the quantities of a
paiticulai good oi seivice that buyeis will be willing and able to puichase at each piice duiing a spe-
cifed peiiod. The supply cuive shows the quantities that selleis will ofei foi sale at each piice duiing
that same peiiod. By putting the two cuives togethei, we should be able to fnd a piice at which the
quantity buyeis aie willing and able to puichase equals the quantity selleis will ofei foi sale.
Figuie 3.14 combines the demand and supply data intioduced in Figuie 3.1 and Figuie 3.8 Notice
that the two cuives inteisect at a piice of $6 pei pound-at this piice the quantities demanded and sup-
plied aie equal. Buyeis want to puichase, and selleis aie willing to ofei foi sale, 23 million pounds of
cofee pei month. The maiket foi cofee is in equilibiium. Unless the demand oi supply cuive shifts,
theie will be no tendency foi piice to change. The equilibrium price in any maiket is the piice at
which quantity demanded equals quantity supplied. The equilibiium piice in the maiket foi cofee is
thus $6 pei pound. The equilibrium quantity is the quantity demanded and supplied at the equilibii-
um piice.
II GUR£ 3. 14 7he Determination of £quiIibrium Price and Quantity
\|er .e ccnb|re t|e Jen.rJ .rJ supp|y cu.ves |c. . gccJ |r . s|rg|e g..p|, t|e pc|rt .t .||c| t|ey |rte.sect
|Jert||es t|e e,u|||b.|un p.|ce .rJ e,u|||b.|un ,u.rt|ty. |e.e, t|e e,u|||b.|un p.|ce |s ´6 pe. pcurJ. ´crsune.s
Jen.rJ, .rJ supp||e.s supp|y, 25 n||||cr pcurJs c| cc|ee pe. ncrt| .t t||s p.|ce.
With an upwaid-sloping supply cuive and a downwaid-sloping demand cuive, theie is only a single
piice at which the two cuives inteisect. This means theie is only one piice at which equilibiium is
72 PRINCIPL£S OI £CONOMICS
surpIus
¯|e .ncurt by .||c| t|e
,u.rt|ty supp||eJ exceeJs
t|e ,u.rt|ty Jen.rJeJ .t
t|e cu..ert p.|ce.
achieved. It follows that at any piice othei than the equilibiium piice, the maiket will not be in equilib-
iium. We next examine what happens at piices othei than the equilibiium piice.
SurpIuses
Figuie 3.13 shows the same demand and supply cuives we have just examined, but this time the initial
piice is $8 pei pound of cofee. Because we no longei have a balance between quantity demanded and
quantity supplied, this piice is not the equilibiium piice. At a piice of $8, we iead ovei to the demand
cuive to deteimine the quantity of cofee consumeis will be willing to buy-13 million pounds pei
month. The supply cuive tells us what selleis will ofei foi sale-33 million pounds pei month. The
difeience, 20 million pounds of cofee pei month, is called a suiplus. Moie geneially, a surplus is the
amount by which the quantity supplied exceeds the quantity demanded at the cuiient piice. Theie is,
of couise, no suiplus at the equilibiium piice; a suiplus occuis only if the cuiient piice exceeds the
equilibiium piice.
II GUR£ 3. 15 A SurpIus in the Market for Coffee
At . p.|ce c| ´8, t|e ,u.rt|ty supp||eJ |s 35 n||||cr pcurJs c| cc|ee pe. ncrt| .rJ t|e ,u.rt|ty Jen.rJeJ |s 15
n||||cr pcurJs pe. ncrt|, t|e.e |s . su.p|us c| 20 n||||cr pcurJs c| cc|ee pe. ncrt|. C|ver . su.p|us, t|e p.|ce
.||| |.|| ,u|ck|y tc...J t|e e,u|||b.|un |eve| c| ´6.
A suiplus in the maiket foi cofee will not last long. With unsold cofee on the maiket, selleis will begin
to ieduce theii piices to cleai out unsold cofee. As the piice of cofee begins to fall, the quantity of
cofee supplied begins to decline. At the same time, the quantity of cofee demanded begins to iise. Re-
membei that the ieduction in quantity supplied is a movement along the supply cuive-the cuive itself
does not shift in iesponse to a ieduction in piice. Similaily, the inciease in quantity demanded is a
movement along the demand cuive-the demand cuive does not shift in iesponse to a ieduction in
piice. Piice will continue to fall until it ieaches its equilibiium level, at which the demand and supply
cuives inteisect. At that point, theie will be no tendency foi piice to fall fuithei. In geneial, suipluses in
the maiketplace aie shoit-lived. The piices of most goods and seivices adjust quickly, eliminating the
suiplus. Latei on, we will discuss some maikets in which adjustment of piice to equilibiium may occui
only veiy slowly oi not at all.
CHAP7£R 3 D£MAND AND SUPPLY 73
shortage
¯|e .ncurt by .||c| t|e
,u.rt|ty Jen.rJeJ exceeJs
t|e ,u.rt|ty supp||eJ .t t|e
cu..ert p.|ce.
Shortages
Just as a piice above the equilibiium piice will cause a suiplus, a piice below equilibiium will cause a
shoitage. A shortage is the amount by which the quantity demanded exceeds the quantity supplied at
the cuiient piice.
Figuie 3.16 shows a shoitage in the maiket foi cofee. Suppose the piice is $4 pei pound. At that
piice, 13 million pounds of cofee would be supplied pei month, and 33 million pounds would be de-
manded pei month. When moie cofee is demanded than supplied, theie is a shoitage.
II GUR£ 3. 16 A Shortage in the Market for Coffee
At . p.|ce c| ´4 pe. pcurJ, t|e ,u.rt|ty c| cc|ee Jen.rJeJ |s 35 n||||cr pcurJs pe. ncrt| .rJ t|e ,u.rt|ty
supp||eJ |s 15 n||||cr pcurJs pe. ncrt|. ¯|e .esu|t |s . s|c.t.ge c| 20 n||||cr pcurJs c| cc|ee pe. ncrt|.
In the face of a shoitage, selleis aie likely to begin to iaise theii piices. As the piice iises, theie will be
an inciease in the quantity supplied (but not a change in supply) and a ieduction in the quantity de-
manded (but not a change in demand) until the equilibiium piice is achieved.
74 PRINCIPL£S OI £CONOMICS
3.2 Shifts in Demand and Supply
II GUR£ 3. 17 Changes in Demand and SuppIy
A c|.rge |r Jen.rJ c. |r supp|y c|.rges t|e e,u|||b.|un sc|ut|cr |r t|e ncJe|. |.re|s (.) .rJ (b) s|c. .r
|rc.e.se .rJ . Jec.e.se |r Jen.rJ, .espect|ve|y, |.re|s (c) .rJ (J) s|c. .r |rc.e.se .rJ . Jec.e.se |r supp|y,
.espect|ve|y.
A change in one of the vaiiables (shifteis) held constant in any model of demand and supply will cieate
a change in demand oi supply. A shift in a demand oi supply cuive changes the equilibiium piice and
equilibiium quantity foi a good oi seivice. Figuie 3.17 combines the infoimation about changes in the
demand and supply of cofee piesented in Figuie 3.2 Figuie 3.3 Figuie 3.9 and Figuie 3.10 In each case,
the oiiginal equilibiium piice is $6 pei pound, and the coiiesponding equilibiium quantity is 23 mil-
lion pounds of cofee pei month. Figuie 3.17 shows what happens with an inciease in demand, a ieduc-
tion in demand, an inciease in supply, and a ieduction in supply. We then look at what happens if both
cuives shift simultaneously. Each of these possibilities is discussed in tuin below.
An Increase in Demand
An inciease in demand foi cofee shifts the demand cuive to the iight, as shown in Panel (a) of Figuie
3.17. The equilibiium piice iises to $7 pei pound. As the piice iises to the new equilibiium level, the
quantity supplied incieases to 30 million pounds of cofee pei month. Notice that the supply cuive does
not shift; iathei, theie is a movement along the supply cuive.
CHAP7£R 3 D£MAND AND SUPPLY 75
Demand shifteis that could cause an inciease in demand include a shift in piefeiences that leads to
gieatei cofee consumption; a lowei piice foi a complement to cofee, such as doughnuts; a highei piice
foi a substitute foi cofee, such as tea; an inciease in income; and an inciease in population. A change
in buyei expectations, peihaps due to piedictions of bad weathei loweiing expected yields on cofee
plants and incieasing futuie cofee piices, could also inciease cuiient demand.
A Decrease in Demand
Panel (b) of Figuie 3.17 shows that a deciease in demand shifts the demand cuive to the left. The equi-
libiium piice falls to $3 pei pound. As the piice falls to the new equilibiium level, the quantity supplied
decieases to 20 million pounds of cofee pei month.
Demand shifteis that could ieduce the demand foi cofee include a shift in piefeiences that makes
people want to consume less cofee; an inciease in the piice of a complement, such as doughnuts; a ie-
duction in the piice of a substitute, such as tea; a ieduction in income; a ieduction in population; and a
change in buyei expectations that leads people to expect lowei piices foi cofee in the futuie.
An Increase in SuppIy
An inciease in the supply of cofee shifts the supply cuive to the iight, as shown in Panel (c) of Figuie
3.17. The equilibiium piice falls to $3 pei pound. As the piice falls to the new equilibiium level, the
quantity of cofee demanded incieases to 30 million pounds of cofee pei month. Notice that the de-
mand cuive does not shift; iathei, theie is movement along the demand cuive.
Possible supply shifteis that could inciease supply include a ieduction in the piice of an input such
as laboi, a decline in the ietuins available fiom alteinative uses of the inputs that pioduce cofee, an
impiovement in the technology of cofee pioduction, good weathei, and an inciease in the numbei of
cofee-pioducing fims.
A Decrease in SuppIy
Panel (d) of Figuie 3.17 shows that a deciease in supply shifts the supply cuive to the left. The equilibii-
um piice iises to $7 pei pound. As the piice iises to the new equilibiium level, the quantity demanded
decieases to 20 million pounds of cofee pei month.
Possible supply shifteis that could ieduce supply include an inciease in the piices of inputs used in
the pioduction of cofee, an inciease in the ietuins available fiom alteinative uses of these inputs, a de-
cline in pioduction because of pioblems in technology (peihaps caused by a iestiiction on pesticides
used to piotect cofee beans), a ieduction in the numbei of cofee-pioducing fims, oi a natuial event,
such as excessive iain.
Heads Up!
+cu ..e ||ke|y tc be g|ver p.cb|ens |r .||c| ycu .||| |.ve tc s|||t . Jen.rJ c. supp|y cu.ve.
Suppcse ycu ..e tc|J t|.t .r |rv.s|cr c| pcJc.urc||rg |rsects |.s gcbb|eJ up |.|| t|e c.cp c| |.es| pe.s,
.rJ ycu ..e .skeJ tc use Jen.rJ .rJ supp|y .r.|ys|s tc p.eJ|ct .|.t .||| |.pper tc t|e p.|ce .rJ ,u.rt|ty c|
pe.s Jen.rJeJ .rJ supp||eJ. |e.e ..e scne suggest|crs.
|ut t|e ,u.rt|ty c| t|e gccJ ycu ..e .skeJ tc .r.|y.e cr t|e |c.|.crt.| .x|s .rJ |ts p.|ce cr t|e ve.t|c.| .x|s.
|... . Jc.r...Js|cp|rg ||re |c. Jen.rJ .rJ .r up...Js|cp|rg ||re |c. supp|y. ¯|e |r|t|.| e,u|||b.|un p.|ce
|s Jete.n|reJ by t|e |rte.sect|cr c| t|e t.c cu.ves. |.be| t|e e,u|||b.|un sc|ut|cr. +cu n.y |rJ |t |e|p|u| tc
use . runbe. |c. t|e e,u|||b.|un p.|ce |rste.J c| t|e |ette. ´|.´ ||ck . p.|ce t|.t seens p|.us|b|e, s.y, 9¯ pe.
pcurJ. |c rct .c..y .bcut t|e p.ec|se pcs|t|crs c| t|e Jen.rJ .rJ supp|y cu.ves, ycu c.rrct be expecteJ
tc krc. .|.t t|ey ..e.
76 PRINCIPL£S OI £CONOMICS
Step 2 c.r be t|e ncst J||cu|t step, t|e p.cb|en |s tc Jec|Je .||c| cu.ve tc s|||t. ¯|e key |s tc .enenbe. t|e
J||e.erce bet.eer . c|.rge |r Jen.rJ c. supp|y .rJ . c|.rge |r ,u.rt|ty Jen.rJeJ c. supp||eJ. At e.c|
p.|ce, .sk ycu.se|| .|et|e. t|e g|ver evert .cu|J c|.rge t|e ,u.rt|ty Jen.rJeJ. \cu|J t|e |.ct t|.t . bug
|.s .tt.ckeJ t|e pe. c.cp c|.rge t|e ,u.rt|ty Jen.rJeJ .t . p.|ce c|, s.y, 9¯ pe. pcurJ` ´|e..|y rct, rcre
c| t|e Jen.rJ s|||te.s |.ve c|.rgeJ. ¯|e evert .cu|J, |c.eve., .eJuce t|e ,u.rt|ty supp||eJ .t t||s p.|ce,
.rJ t|e supp|y cu.ve .cu|J s|||t tc t|e |e|t. ¯|e.e |s . c|.rge |r supp|y .rJ . .eJuct|cr |r t|e ,u.rt|ty Je
n.rJeJ. ¯|e.e |s rc c|.rge |r Jen.rJ.
|ext c|eck tc see .|et|e. t|e .esu|t ycu |.ve cbt.|reJ n.kes serse. ¯|e g..p| |r Step 2 n.kes serse, |t
s|c.s p.|ce .|s|rg .rJ ,u.rt|ty Jen.rJeJ |.|||rg.
|t |s e.sy tc n.ke . n|st.ke suc| .s t|e cre s|c.r |r t|e t||.J |gu.e c| t||s |e.Js |p! Ore n|g|t, |c. ex
.np|e, .e.scr t|.t .|er |e.e. pe.s ..e .v.||.b|e, |e.e. .||| be Jen.rJeJ, .rJ t|e.e|c.e t|e Jen.rJ cu.ve
.||| s|||t tc t|e |e|t. ¯||s suggests t|e p.|ce c| pe.s .||| |.||but t|.t Jces rct n.ke serse. || cr|y |.|| .s n.ry
|.es| pe.s .e.e .v.||.b|e, t|e|. p.|ce .cu|J su.e|y .|se. ¯|e e..c. |e.e ||es |r ccr|us|rg . c|.rge |r ,u.rt|ty Je
n.rJeJ .|t| . c|.rge |r Jen.rJ. +es, buye.s .||| erJ up buy|rg |e.e. pe.s. but rc, t|ey .||| rct Jen.rJ
|e.e. pe.s .t e.c| p.|ce t|.r be|c.e, t|e Jen.rJ cu.ve Jces rct s|||t.
SimuItaneous Shifts
As we have seen, when either the demand oi the supply cuive shifts, the iesults aie unambiguous; that
is, we know what will happen to both equilibiium piice and equilibiium quantity, so long as we know
whethei demand oi supply incieased oi decieased. Howevei, in piactice, seveial events may occui at
aiound the same time that cause both the demand and supply cuives to shift. To fguie out what hap-
pens to equilibiium piice and equilibiium quantity, we must know not only in which diiection the de-
mand and supply cuives have shifted but also the ielative amount by which each cuive shifts. Of
couise, the demand and supply cuives could shift in the same diiection oi in opposite diiections, de-
pending on the specifc events causing them to shift.
Foi example, all thiee panels of Figuie 3.19 show a deciease in demand foi cofee (caused peihaps
by a deciease in the piice of a substitute good, such as tea) and a simultaneous deciease in the supply of
cofee (caused peihaps by bad weathei). Since ieductions in demand and supply, consideied sepaiately,
each cause the equilibiium quantity to fall, the impact of both cuives shifting simultaneously to the left
means that the new equilibiium quantity of cofee is less than the old equilibiium quantity. The efect
on the equilibiium piice, though, is ambiguous. Whethei the equilibiium piice is highei, lowei, oi un-
changed depends on the extent to which each cuive shifts.
CHAP7£R 3 D£MAND AND SUPPLY 77
II GUR£ 3. 19 SimuItaneous Decreases in Demand and SuppIy
bct| t|e Jen.rJ .rJ t|e supp|y c| cc|ee Jec.e.se. S|rce Jec.e.ses |r Jen.rJ .rJ supp|y, ccrs|Je.eJ sep...te|y,
e.c| c.use e,u|||b.|un ,u.rt|ty tc |.||, t|e |np.ct c| bct| Jec.e.s|rg s|nu|t.recus|y ne.rs t|.t . re.
e,u|||b.|un ,u.rt|ty c| cc|ee nust be |ess t|.r t|e c|J e,u|||b.|un ,u.rt|ty. |r |.re| (.), t|e Jen.rJ cu.ve s|||ts
|..t|e. tc t|e |e|t t|.r Jces t|e supp|y cu.ve, sc e,u|||b.|un p.|ce |.||s. |r |.re| (b), t|e supp|y cu.ve s|||ts |..t|e. tc
t|e |e|t t|.r Jces t|e Jen.rJ cu.ve, sc t|e e,u|||b.|un p.|ce .|ses. |r |.re| (c), bct| cu.ves s|||t tc t|e |e|t by t|e
s.ne .ncurt, sc e,u|||b.|un p.|ce st.ys t|e s.ne.
If the demand cuive shifts faithei to the left than does the supply cuive, as shown in Panel (a) of Figuie
3.19, then the equilibiium piice will be lowei than it was befoie the cuives shifted. In this case the new
equilibiium piice falls fiom $6 pei pound to $3 pei pound. If the shift to the left of the supply cuive is
gieatei than that of the demand cuive, the equilibiium piice will be highei than it was befoie, as shown
in Panel (b). In this case, the new equilibiium piice iises to $7 pei pound. In Panel (c), since both
cuives shift to the left by the same amount, equilibiium piice does not change; it iemains $6 pei
pound.
Regaidless of the scenaiio, changes in equilibiium piice and equilibiium quantity iesulting fiom
two difeient events need to be consideied sepaiately. If both events cause equilibiium piice oi quantity
to move in the same diiection, then cleaily piice oi quantity can be expected to move in that diiection.
If one event causes piice oi quantity to iise while the othei causes it to fall, the extent by which each
cuive shifts is ciitical to fguiing out what happens. Figuie 3.20 summaiizes what may happen to equi-
libiium piice and quantity when demand and supply both shift.
78 PRINCIPL£S OI £CONOMICS
circuIar 0ow modeI
VcJe| t|.t p.cv|Jes . |cck .t
|c. n..kets .c.k .rJ |c.
t|ey ..e .e|.teJ tc e.c|
ct|e..
II GUR£ 3. 20 SimuItaneous Shifts in Demand and SuppIy
|| s|nu|t.recus s|||ts |r Jen.rJ .rJ supp|y c.use e,u|||b.|un p.|ce c. ,u.rt|ty tc ncve |r t|e s.ne J|.ect|cr,
t|er e,u|||b.|un p.|ce c. ,u.rt|ty c|e..|y ncves |r t|.t J|.ect|cr. || t|e s|||t |r cre c| t|e cu.ves c.uses e,u|||b.|un
p.|ce c. ,u.rt|ty tc .|se .|||e t|e s|||t |r t|e ct|e. cu.ve c.uses e,u|||b.|un p.|ce c. ,u.rt|ty tc |.||, t|er t|e
.e|.t|ve .ncurt by .||c| e.c| cu.ve s|||ts |s c.|t|c.| tc |gu.|rg cut .|.t |.ppers tc t|.t v..|.b|e.
As demand and supply cuives shift, piices adjust to maintain a balance between the quantity of a good
demanded and the quantity supplied. If piices did not adjust, this balance could not be maintained.
Notice that the demand and supply cuives that we have examined in this chaptei have all been
diawn as lineai. This simplifcation of the ieal woild makes the giaphs a bit easiei to iead without sac-
iifcing the essential point: whethei the cuives aie lineai oi nonlineai, demand cuives aie downwaid
sloping and supply cuives aie geneially upwaid sloping. As ciicumstances that shift the demand cuive
oi the supply cuive change, we can analyze what will happen to piice and what will happen to quantity.
3.3 An Oveiview of Demand and Supply: The Ciiculai Flow Model
Implicit in the concepts of demand and supply is a constant inteiaction and adjustment that econom-
ists illustiate with the ciiculai fow model. The circular ßow model piovides a look at how maikets
woik and how they aie ielated to each othei. It shows fows of spending and income thiough the
economy.
A gieat deal of economic activity can be thought of as a piocess of exchange between households
and fims. Fiims supply goods and seivices to households. Households buy these goods and seivices
fiom fims. Households supply factois of pioduction-laboi, capital, and natuial iesouices-that fims
iequiie. The payments fims make in exchange foi these factois iepiesent the incomes households
eain.
The fow of goods and seivices, factois of pioduction, and the payments they geneiate is illustiated
in Figuie 3.21. This ciiculai fow model of the economy shows the inteiaction of households and fims
as they exchange goods and seivices and factois of pioduction. Foi simplicity, the model heie shows
only the piivate domestic economy; it omits the goveinment and foieign sectois.
CHAP7£R 3 D£MAND AND SUPPLY 79
product markets
V..kets |r .||c| |.ns supp|y
gccJs .rJ se.v|ces
Jen.rJeJ by |cuse|c|Js.
factor markets
V..kets |r .||c| |cuse|c|Js
supp|y |.ctc.s c|
p.cJuct|cr|.bc., c.p|t.|,
.rJ r.tu..|
.escu.cesJen.rJeJ by
|.ns.
II GUR£ 3. 21 7he CircuIar IIow of £conomic Activity
¯||s s|np|||eJ c|.cu|.. |c. ncJe| s|c.s |c.s c| sperJ|rg bet.eer |cuse|c|Js .rJ |.ns t|.cug| p.cJuct .rJ
|.ctc. n..kets. ¯|e |rre. ...c.s s|c. gccJs .rJ se.v|ces |c.|rg |.cn |.ns tc |cuse|c|Js .rJ |.ctc.s c|
p.cJuct|cr |c.|rg |.cn |cuse|c|Js tc |.ns. ¯|e cute. |c.s s|c. t|e p.ynerts |c. gccJs, se.v|ces, .rJ |.ctc.s
c| p.cJuct|cr. ¯|ese |c.s, |r tu.r, .ep.esert n||||crs c| |rJ|v|Ju.| n..kets |c. p.cJucts .rJ |.ctc.s c| p.cJuct|cr.
The ciiculai fow model shows that goods and seivices that households demand aie supplied by fims
in product markets. The exchange foi goods and seivices is shown in the top half of Figuie 3.21. The
bottom half of the exhibit illustiates the exchanges that take place in factoi maikets. factor markets
aie maikets in which households supply factois of pioduction-laboi, capital, and natuial ie-
souices-demanded by fims.
Oui model is called a ciiculai fow model because households use the income they ieceive fiom
theii supply of factois of pioduction to buy goods and seivices fiom fims. Fiims, in tuin, use the pay-
ments they ieceive fiom households to pay foi theii factois of pioduction.
The demand and supply model developed in this chaptei gives us a basic tool foi undeistanding
what is happening in each of these pioduct oi factoi maikets and also allows us to see how these mai-
kets aie inteiielated. In Figuie 3.21, maikets foi thiee goods and seivices that households want-blue
jeans, haiicuts, and apaitments-cieate demands by fims foi textile woikeis, baibeis, and apaitment
buildings. The equilibiium of supply and demand in each maiket deteimines the piice and quantity of
that item. Moieovei, a change in equilibiium in one maiket will afect equilibiium in ielated maikets.
Foi example, an inciease in the demand foi haiicuts would lead to an inciease in demand foi baibeis.
Equilibiium piice and quantity could iise in both maikets. Foi some puiposes, it will be adequate to
simply look at a single maiket, wheieas at othei times we will want to look at what happens in ielated
maikets as well.
In eithei case, the model of demand and supply is one of the most widely used tools of economic
analysis. That widespiead use is no accident. The model yields iesults that aie, in fact, bioadly consist-
ent with what we obseive in the maiketplace. Youi masteiy of this model will pay big dividends in youi
study of economics.
80 PRINCIPL£S OI £CONOMICS
k £ Y 7 A k £ A W A Y S
< ¯|e e,u|||b.|un p.|ce |s t|e p.|ce .t .||c| t|e ,u.rt|ty Jen.rJeJ e,u.|s t|e ,u.rt|ty supp||eJ. |t |s
Jete.n|reJ by t|e |rte.sect|cr c| t|e Jen.rJ .rJ supp|y cu.ves.
< A su.p|us ex|sts || t|e ,u.rt|ty c| . gccJ c. se.v|ce supp||eJ exceeJs t|e ,u.rt|ty Jen.rJeJ .t t|e cu..ert
p.|ce, |t c.uses Jc.r...J p.essu.e cr p.|ce. A s|c.t.ge ex|sts || t|e ,u.rt|ty c| . gccJ c. se.v|ce
Jen.rJeJ exceeJs t|e ,u.rt|ty supp||eJ .t t|e cu..ert p.|ce, |t c.uses up...J p.essu.e cr p.|ce.
< Ar |rc.e.se |r Jen.rJ, .|| ct|e. t||rgs urc|.rgeJ, .||| c.use t|e e,u|||b.|un p.|ce tc .|se, ,u.rt|ty
supp||eJ .||| |rc.e.se. A Jec.e.se |r Jen.rJ .||| c.use t|e e,u|||b.|un p.|ce tc |.||, ,u.rt|ty supp||eJ .|||
Jec.e.se.
< Ar |rc.e.se |r supp|y, .|| ct|e. t||rgs urc|.rgeJ, .||| c.use t|e e,u|||b.|un p.|ce tc |.||, ,u.rt|ty
Jen.rJeJ .||| |rc.e.se. A Jec.e.se |r supp|y .||| c.use t|e e,u|||b.|un p.|ce tc .|se, ,u.rt|ty Jen.rJeJ
.||| Jec.e.se.
< ¯c Jete.n|re .|.t |.ppers tc e,u|||b.|un p.|ce .rJ e,u|||b.|un ,u.rt|ty .|er bct| t|e supp|y .rJ
Jen.rJ cu.ves s|||t, ycu nust krc. |r .||c| J|.ect|cr e.c| c| t|e cu.ves s|||ts .rJ t|e extert tc .||c|
e.c| cu.ve s|||ts.
< ¯|e c|.cu|.. |c. ncJe| p.cv|Jes .r cve.v|e. c| Jen.rJ .rJ supp|y |r p.cJuct .rJ |.ctc. n..kets .rJ
suggests |c. t|ese n..kets ..e ||rkeJ tc cre .rct|e..
7 R Y I 7 !
\|.t |.ppers tc t|e e,u|||b.|un p.|ce .rJ t|e e,u|||b.|un ,u.rt|ty c| |\| .ert.|s || t|e p.|ce c| ncv|e t|e.t
e. t|ckets |rc.e.ses .rJ ..ges p.|J tc |\| .ert.| stc.e c|e.ks |rc.e.se, .|| ct|e. t||rgs urc|.rgeJ` be su.e tc
s|c. .|| pcss|b|e scer..|cs, .s ..s Jcre |r ||gu.e 3.19. Ag.|r, ycu Jc rct reeJ .ctu.| runbe.s tc ...|ve .t .r
.rs.e.. 'ust |ccus cr t|e gere..| pcs|t|cr c| t|e cu.ve(s) be|c.e .rJ .|te. everts cccu..eJ.
Case in Point: Demand, SuppIy, and Obesity
÷ 2010 jupiterimages Corporation
\|y ..e sc n.ry Ane.|c.rs |.t` |ut sc c.uJe|y, t|e ,uest|cr n.y seen .uJe, but, |rJeeJ, t|e runbe. c|
cbese Ane.|c.rs |.s |rc.e.seJ by nc.e t|.r 50 cve. t|e |.st gere..t|cr, .rJ cbes|ty n.y rc. be t|e r.
t|crs runbe. cre |e.|t| p.cb|en. Accc.J|rg tc Stu.n |c|.rJ |r . .ecert |A|| ´c.pc..t|cr stuJy, ´Obes|ty
.ppe..s tc |.ve . st.crge. .sscc|.t|cr .|t| t|e cccu..erce c| c|.cr|c neJ|c.| ccrJ|t|crs, .eJuceJ p|ys|c.|
|e.|t|.e|.teJ ,u.||ty c| |||e .rJ |rc.e.seJ |e.|t| c..e .rJ neJ|c.t|cr experJ|tu.es t|.r snck|rg c. p.cb|en
J.|rk|rg.´
CHAP7£R 3 D£MAND AND SUPPLY 81
V.ry exp|.r.t|crs c| .|s|rg cbes|ty suggest ||g|e. Jen.rJ |c. |ccJ. \|.t nc.e .pt p|ctu.e c| cu. seJert..y
|||e sty|e |s t|e.e t|.r sperJ|rg t|e .|te.rccr ..tc||rg . b.||g.ne cr ¯\, .|||e e.t|rg c||ps .rJ s.|s., |c|
|c.eJ by . J|rre. c| . |.v|s||y tcppeJ, t.kecut p|...` ||g|e. |rccne |.s .|sc urJcubteJ|y ccrt.|buteJ tc .
.|g|t...J s|||t |r t|e Jen.rJ cu.ve |c. |ccJ. ||us, .ry .JJ|t|cr.| |ccJ |rt.ke t..rs|.tes |rtc nc.e .e|g|t |r
c.e.se bec.use .e sperJ sc |e. c.|c.|es p.ep..|rg |t, e|t|e. J|.ect|y c. |r t|e p.ccess c| e..r|rg t|e |rccne tc
buy |t. A stuJy by eccrcn|sts |..|us |.kJ...||. .rJ ¯cn.s |||||pscr suggests t|.t .bcut 60 c| t|e .ecert
g.c.t| |r .e|g|t n.y be exp|.|reJ |r t||s ..yt|.t |s, Jen.rJ |.s s|||teJ tc t|e .|g|t, |e.J|rg tc .r |r
c.e.se |r t|e e,u|||b.|un ,u.rt|ty c| |ccJ ccrsuneJ .rJ, g|ver cu. |ess st.erucus |||e sty|es, ever nc.e
.e|g|t g.|r t|.r c.r be exp|.|reJ s|np|y by t|e |rc.e.seJ .ncurt .e ..e e.t|rg.
\|.t .cccurts |c. t|e .en.|r|rg 40 c| t|e .e|g|t g.|r` |.kJ...||. .rJ |||||pscr |u.t|e. .e.scr t|.t . .|g|t
...J s|||t |r Jen.rJ .cu|J by |tse|| |e.J tc .r |rc.e.se |r t|e ,u.rt|ty c| |ccJ .s .e|| .s .r |rc.e.se |r t|e
p.|ce c| |ccJ. ¯|e p.cb|en t|ey |.ve .|t| t||s exp|.r.t|cr |s t|.t cve. t|e pcst\c.|J \.. || pe.|cJ, t|e .e|.t
|ve p.|ce c| |ccJ |.s Jec||reJ by .r .ve..ge c| 0.2 pe.cert.ge pc|rts pe. ye... ¯|ey exp|.|r t|e |.|| |r t|e p.|ce
c| |ccJ by ..gu|rg t|.t .g.|cu|tu..| |rrcv.t|cr |.s |eJ tc . subst.rt|.| .|g|t...J s|||t |r t|e supp|y cu.ve c|
|ccJ. As s|c.r, |c.e. |ccJ p.|ces .rJ . ||g|e. e,u|||b.|un ,u.rt|ty c| |ccJ |.ve .esu|teJ |.cn s|nu|t.recus
.|g|t...J s|||ts |r Jen.rJ .rJ supp|y .rJ t|.t t|e .|g|t...J s|||t |r t|e supp|y c| |ccJ |.cn .
1
tc .
2
|.s
beer subst.rt|.||y |..ge. t|.r t|e .|g|t...J s|||t |r t|e Jen.rJ cu.ve |.cn |
1
tc |
2
.
.oo·ce· |o|o·J. .|o··. ¯|e ||ec|· o| ´·e·||,. .·o||·¸. o·J |·o·|e· |·|·||·¸ o· ´|·o·|c /eJ|co| |·o·|e·· o·J |eo||| ´o·e ´o·|·.' |eo||| ^|o|··.
2002. 2¹(2: 245253 |o|Jo.o||o. |o·|o· o·J ¯o·o· |||||¡·o·. ¯|e O·o.|| o| ´·e·||, o·J ¯ec|·o|o¸|co| ´|o·¸e ^ ¯|eo·e||co| o·J |·¡|·|co|
|o·|·o||o·.' |o||o·o| |o·eoo o| |co·o·|c |e·eo·c| /o·||·¸ |o¡e· ·o .S946. /o, 2002
82 PRINCIPL£S OI £CONOMICS
A N S W £ R 7 O 7 R Y I 7 ! P R O 8 L £ M
Ar |rc.e.se |r t|e p.|ce c| ncv|e t|e.te. t|ckets (. subst|tute |c. |\| .ert.|s) .||| c.use t|e Jen.rJ cu.ve |c.
|\| .ert.|s tc s|||t tc t|e .|g|t. Ar |rc.e.se |r t|e ..ges p.|J tc |\| .ert.| stc.e c|e.ks (.r |rc.e.se |r t|e
ccst c| . |.ctc. c| p.cJuct|cr) s|||ts t|e supp|y cu.ve tc t|e |e|t. |.c| evert t.ker sep...te|y c.uses e,u|||b.|
un p.|ce tc .|se. \|et|e. e,u|||b.|un ,u.rt|ty .||| be ||g|e. c. |c.e. JeperJs cr .||c| cu.ve s|||teJ nc.e.
|| t|e Jen.rJ cu.ve s|||teJ nc.e, t|er t|e e,u|||b.|un ,u.rt|ty c| |\| .ert.|s .||| .|se ¦|.re| (.)¦.
|| t|e supp|y cu.ve s|||teJ nc.e, t|er t|e e,u|||b.|un ,u.rt|ty c| |\| .ert.|s .||| |.|| ¦|.re| (b)¦.
|| t|e cu.ves s|||teJ by t|e s.ne .ncurt, t|er t|e e,u|||b.|un ,u.rt|ty c| |\| .ert.|s .cu|J rct c|.rge
¦|.re| (c)¦.
4. REVIEW AND PRACTICE
Summary
|r t||s c|.pte. .e |.ve ex.n|reJ t|e ncJe| c| Jen.rJ .rJ supp|y. \e |curJ t|.t . Jen.rJ cu.ve s|c.s
t|e ,u.rt|ty Jen.rJeJ .t e.c| p.|ce, .|| ct|e. t||rgs urc|.rgeJ. ¯|e |.. c| Jen.rJ .sse.ts t|.t .r |rc.e.se
|r p.|ce .eJuces t|e ,u.rt|ty Jen.rJeJ .rJ . Jec.e.se |r p.|ce |rc.e.ses t|e ,u.rt|ty Jen.rJeJ, .|| ct|e.
t||rgs urc|.rgeJ. ¯|e supp|y cu.ve s|c.s t|e ,u.rt|ty c| . gccJ c. se.v|ce t|.t se||e.s .||| c|e. .t v..|cus
p.|ces, .|| ct|e. t||rgs urc|.rgeJ. Supp|y cu.ves ..e gere..||y up...J s|cp|rg. .r |rc.e.se |r p.|ce gere..||y
|rc.e.ses t|e ,u.rt|ty supp||eJ, .|| ct|e. t||rgs urc|.rgeJ.
¯|e e,u|||b.|un p.|ce cccu.s .|e.e t|e Jen.rJ .rJ supp|y cu.ves |rte.sect. At t||s p.|ce, t|e ,u.rt|ty Je
n.rJeJ e,u.|s t|e ,u.rt|ty supp||eJ. A p.|ce ||g|e. t|.r t|e e,u|||b.|un p.|ce |rc.e.ses t|e ,u.rt|ty sup
p||eJ .rJ .eJuces t|e ,u.rt|ty Jen.rJeJ, c.us|rg . su.p|us. A p.|ce |c.e. t|.r t|e e,u|||b.|un p.|ce |r
c.e.ses t|e ,u.rt|ty Jen.rJeJ .rJ .eJuces t|e ,u.rt|ty supp||eJ, c.us|rg . s|c.t.ge. |su.||y, n..ket su.
p|uses .rJ s|c.t.ges ..e s|c.t||veJ. ´|.rges |r Jen.rJ c. supp|y, c.useJ by c|.rges |r t|e Jete.n|r.rts c|
Jen.rJ .rJ supp|y ct|e..|se |e|J ccrst.rt |r t|e .r.|ys|s, c|.rge t|e e,u|||b.|un p.|ce .rJ cutput. ¯|e c|.
cu|.. |c. ncJe| .||c.s us tc see |c. Jen.rJ .rJ supp|y |r v..|cus n..kets ..e .e|.teJ tc cre .rct|e..
CHAP7£R 3 D£MAND AND SUPPLY 83
C O N C £ P 7 P R O 8 L £ M S
1. \|.t Jc ycu t||rk |.ppers tc t|e Jen.rJ |c. p|...s Ju.|rg t|e Supe. bc.|` \|y`
2. \||c| c| t|e |c||c.|rg gccJs ..e ||ke|y tc be c|.ss||eJ .s rc.n.| gccJs c. se.v|ces` |r|e.|c.` |e|erJ ycu.
.rs.e..
.. be.rs
b. ¯uxeJcs
c. |seJ c..s
J. |seJ c|ct||rg
e. ´cnpute.s
|. bccks .ev|e.eJ |r ¯|e |e. `o·| ¯|·e·
g. V.c..cr| .rJ c|eese
|. ´.|cu|.tc.s
|. ´|g..ettes
¦. ´.v|..
k. |eg.| se.v|ces
3. \||c| c| t|e |c||c.|rg p.|.s c| gccJs ..e ||ke|y tc be c|.ss||eJ .s subst|tutes` ´cnp|enerts` |e|erJ ycu.
.rs.e..
.. |e.rut butte. .rJ ¦e||y
b. |ggs .rJ |.n
c. ||ke b..rJ .rJ |eebck b..rJ sre.ke.s
J. |bV .rJ App|e V.c|rtcs| b..rJ ccnpute.s
e. |.ess s||.ts .rJ t|es
|. A|.||re t|ckets .rJ |cte|s
g. C.sc||re .rJ t|.es
|. bee. .rJ .|re
|. |.xes .rJ |.stc|.ss n.||
¦. ´e.e.| .rJ n||k
k. ´e.e.| .rJ eggs
4. A stuJy |curJ t|.t |c.e. .|.|..es |eJ scne pecp|e tc subst|tute |y|rg |c. J.|v|rg tc t|e|. v.c.t|cr
Jest|r.t|crs. ¯||s .eJuceJ t|e Jen.rJ |c. c.. t..ve| .rJ |eJ tc .eJuceJ t..|c |.t.||t|es, s|rce .|. t..ve| |s
s.|e. pe. p.sserge. n||e t|.r c.. t..ve|. |s|rg t|e |cg|c suggesteJ by t|.t stuJy, suggest |c. e.c| c| t|e
|c||c.|rg everts .cu|J .|ect t|e runbe. c| ||g|..y |.t.||t|es |r .ry cre ye...
.. Ar |rc.e.se |r t|e p.|ce c| g.sc||re
b. A |..ge .eJuct|cr |r .ert.| ..tes |c. p.sserge. v.rs
c. Ar |rc.e.se |r .|.|..es
5. ´|||J.er urJe. .ge 2 ..e rc. .||c.eJ tc |y |.ee cr |.S. .|.||res, t|ey usu.||y s|t |r t|e|. p..erts |.ps. Scne
s.|ety .Jvcc.tes |.ve u.geJ t|.t t|ey be .e,u|.eJ tc be st..ppeJ |r |r|.rt se.ts, .||c| .cu|J ne.r t|e|.
p..erts .cu|J |.ve tc pu.c|.se t|ckets |c. t|en. Scne eccrcn|sts |.ve ..gueJ t|.t suc| . ne.su.e
.cu|J .ctu.||y |rc.e.se |r|.rt |.t.||t|es. ´.r ycu s.y .|y`
6. ¯|e g..p|s be|c. s|c. |cu. pcss|b|e s|||ts |r Jen.rJ c. |r supp|y t|.t ccu|J cccu. |r p..t|cu|.. n..kets.
|e|.te e.c| c| t|e everts Jesc.|beJ be|c. tc cre c| t|en.
84 PRINCIPL£S OI £CONOMICS
.. |c. J|J t|e |e.vy ..|rs |r Scut| Ane.|c. |r 199 .|ect t|e n..ket |c. cc|ee`
b. ¯|e Su.gecr Cere..| Jec|Jes |.erc| |.|es ..e rct b.J |c. ycu. |e.|t| .|te. .|| .rJ |ssues . .epc.t
erJc.s|rg t|e|. use. \|.t |.ppers tc t|e n..ket |c. |.erc| |.|es`
c. |c. Jc ycu t||rk .|s|rg |rccnes .|ect t|e n..ket |c. sk| v.c.t|crs`
J. A re. tec|r|,ue |s J|sccve.eJ |c. n.ru|.ctu.|rg ccnpute.s t|.t g.e.t|y |c.e.s t|e|. p.cJuct|cr
ccst. \|.t |.ppers tc t|e n..ket |c. ccnpute.s`
e. |c. .cu|J . b.r cr snck|rg |r pub||c .|ect t|e n..ket |c. c|g..ettes`
. As |c.c..b J|ets |rc.e.seJ |r pcpu|..|ty, egg p.|ces .cse s|..p|y. |c. n|g|t t||s .|ect t|e ncrks supp|y
c| ccck|es c. p.|v.te .et.e.ts` (See t|e ´.se |r |c|rt cr t|e Vcrks c| St. bereJ|cts.)
8. C.sc||re p.|ces typ|c.||y .|se Ju.|rg t|e sunne., . t|ne c| |e.vy tcu.|st t..|c. A ´st.eet t.|k´ |e.tu.e cr .
..J|c st.t|cr scug|t tcu.|st .e.ct|cr tc ||g|e. g.sc||re p.|ces. |e.e ..s cre .espcrse. ´| Jcrt ||ke en ¦t|e
||g|e. p.|ces¦ nuc|. | t||rk t|e g.s ccnp.r|es ¦ust use .ry excuse tc ¦.ck up p.|ces, .rJ t|ey.e Jc|rg |t
.g.|r rc..´ |c. Jces t||s tcu.|sts pe.spect|ve J||e. |.cn t|.t c| eccrcn|sts .|c use t|e ncJe| c|
Jen.rJ .rJ supp|y`
9. ¯|e |rt.cJuct|cr tc t|e c|.pte. ..gues t|.t p.e|e.erces |c. cc|ee c|.rgeJ |r t|e 1990s .rJ t|.t
excess|ve ..|r |u.t y|e|Js |.cn cc|ee p|.rts. S|c. .rJ exp|.|r t|e e|ects c| t|ese t.c c|.cunst.rces cr
t|e cc|ee n..ket.
10. \|t| p.e|e.erces |c. cc|ee .en.|r|rg st.crg |r t|e e..|y p..t c| t|e certu.y, \|etr.n erte.eJ t|e n..ket
.s . n.¦c. expc.te. c| cc|ee. S|c. .rJ exp|.|r t|e e|ects c| t|ese t.c c|.cunst.rces cr t|e cc|ee
n..ket.
11. ¯|e stuJy cr t|e eccrcn|cs c| cbes|ty J|scusseJ |r t|e ´.se |r |c|rt |r t||s c|.pte. cr t|.t tcp|c .|sc
rcteJ t|.t .rct|e. |.ctc. be||rJ .|s|rg cbes|ty |s t|e Jec||re |r c|g..ette snck|rg .s t|e p.|ce c|
c|g..ettes |.s .|ser. S|c. .rJ exp|.|r t|e e|ect c| ||g|e. c|g..ette p.|ces cr t|e n..ket |c. |ccJ. \|.t
Jces t||s |rJ|rg |np|y .bcut t|e .e|.t|crs||p bet.eer c|g..ettes .rJ |ccJ`
12. |r 2004, ¯|e |e. `o·| ¯|·e· .epc.teJ t|.t |rJ|. n|g|t be |cs|rg |ts cutscu.c|rg eJge Jue tc .|s|rg ..ges
¦1¦
¯|e .epc.te. rcteJ t|.t . .ecert .epc.t ´p.c¦ecteJ t|.t || |rJ|. ccrt|rueJ tc p.cJuce cc||ege g..Ju.tes .t
t|e cu..ert ..te, Jen.rJ .cu|J exceeJ supp|y by 20 |r t|e n.|r cutscu.c|rg n..kets by 2008.´ |s|rg
t|e te.n|rc|cgy ycu |e..reJ |r t||s c|.pte., exp|.|r .|.t |e ne.rt tc s.y ..s |.pper|rg |r t|e n..ket
|c. |rJ|.r .c.ke.s |r cutscu.c|rg ¦cbs. |r p..t|cu|.., |s Jen.rJ |c. |rJ|.r .c.ke.s |rc.e.s|rg c.
Jec.e.s|rg` |s t|e supp|y c| |rJ|.r .c.ke.s |rc.e.s|rg c. Jec.e.s|rg` \||c| |s s|||t|rg |.ste.` |c. Jc ycu
krc.`
13. |c. nc.e t|.r . certu.y, n||k p.cJuce.s |.ve p.cJuceJ sk|n n||k, .||c| ccrt.|rs v|.tu.||y rc |.t, .|crg
.|t| .egu|.. n||k, .||c| ccrt.|rs 4 |.t. but . certu.y .gc, sk|n n||k .cccurteJ |c. cr|y .bcut 1 c| tct.|
p.cJuct|cr, .rJ nuc| c| |t ..s |eJ tc |cgs. ¯cJ.y, sk|n .rJ ct|e. .eJuceJ|.t n||ks n.ke up t|e bu|k c|
n||k s.|es. \|.t cu.ve s|||teJ, .rJ .|.t |.ctc. s|||teJ |t`
14. Suppcse |.ns |r t|e eccrcny .e.e tc p.cJuce |e.e. gccJs .rJ se.v|ces. |c. Jc ycu t||rk t||s .cu|J
.|ect |cuse|c|J sperJ|rg cr gccJs .rJ se.v|ces` (||·| |se t|e c|.cu|.. |c. ncJe| tc .r.|y.e t||s
,uest|cr.)
CHAP7£R 3 D£MAND AND SUPPLY 85
N U M £ R I C A L P R O 8 L £ M S
|.cb|ens 15 ..e b.seJ cr t|e g..p| be|c..
1. At . p.|ce c| ´1.50 pe. Jc.er, |c. n.ry b.ge|s ..e Jen.rJeJ pe. ncrt|`
2. At . p.|ce c| ´1.50 pe. Jc.er, |c. n.ry b.ge|s ..e supp||eJ pe. ncrt|`
3. At . p.|ce c| ´3.00 pe. Jc.er, |c. n.ry b.ge|s ..e Jen.rJeJ pe. ncrt|`
4. At . p.|ce c| ´3.00 pe. Jc.er, |c. n.ry b.ge|s ..e supp||eJ pe. ncrt|`
5. \|.t |s t|e e,u|||b.|un p.|ce c| b.ge|s` \|.t |s t|e e,u|||b.|un ,u.rt|ty pe. ncrt|`
|.cb|ens 69 ..e b.seJ cr t|e ncJe| c| Jen.rJ .rJ supp|y |c. cc|ee .s s|c.r |r ||gu.e 3.1 +cu c.r
g..p| t|e |r|t|.| Jen.rJ .rJ supp|y cu.ves by us|rg t|e |c||c.|rg v.|ues, .|t| .|| ,u.rt|t|es |r n||||crs c|
pcurJs c| cc|ee pe. ncrt|.
Price Quantity demanded Quantity suppIied
´3 40 10
4 35 15
5 30 20
6 25 25
20 30
8 15 35
9 10 40
6. Suppcse t|e ,u.rt|ty Jen.rJeJ .|ses by 20 n||||cr pcurJs c| cc|ee pe. ncrt| .t e.c| p.|ce. |... t|e
|r|t|.| Jen.rJ .rJ supp|y cu.ves b.seJ cr t|e v.|ues g|ver |r t|e t.b|e .bcve. ¯|er J... t|e re.
Jen.rJ cu.ve g|ver by t||s c|.rge, .rJ s|c. t|e re. e,u|||b.|un p.|ce .rJ ,u.rt|ty.
. Suppcse t|e ,u.rt|ty Jen.rJeJ |.||s, .e|.t|ve tc t|e v.|ues g|ver |r t|e .bcve t.b|e, by 20 n||||cr pcurJs
pe. ncrt| .t p.|ces bet.eer ´4 .rJ ´6 pe. pcurJ, .t p.|ces bet.eer ´ .rJ ´9 pe. pcurJ, t|e ,u.rt|ty
Jen.rJeJ beccnes .e.c. |... t|e re. Jen.rJ cu.ve .rJ s|c. t|e re. e,u|||b.|un p.|ce .rJ
,u.rt|ty.
8. Suppcse t|e ,u.rt|ty supp||eJ .|ses by 20 n||||cr pcurJs pe. ncrt| .t e.c| p.|ce, .|||e t|e ,u.rt|t|es
Jen.rJeJ .et.|r t|e v.|ues s|c.r |r t|e t.b|e .bcve. |... t|e re. supp|y cu.ve .rJ s|c. t|e re.
e,u|||b.|un p.|ce .rJ ,u.rt|ty.
9. Suppcse t|e ,u.rt|ty supp||eJ |.||s, .e|.t|ve tc t|e v.|ues g|ver |r t|e t.b|e .bcve, by 20 n||||cr pcurJs
pe. ncrt| .t p.|ces .bcve ´5, .t . p.|ce c| ´5 c. |ess pe. pcurJ, t|e ,u.rt|ty supp||eJ beccnes .e.c.
|... t|e re. supp|y cu.ve .rJ s|c. t|e re. e,u|||b.|un p.|ce .rJ ,u.rt|ty.
86 PRINCIPL£S OI £CONOMICS
|.cb|ens 1015 ..e b.seJ cr t|e Jen.rJ .rJ supp|y sc|eJu|es |c. g.sc||re be|c. (.|| ,u.rt|t|es ..e |r t|cu
s.rJs c| g.||crs pe. .eek).
Price per gaIIon Quantity demanded Quantity suppIied
´1 8 0
2 1
3 6 2
4 5 3
5 4 4
6 3 5
2 6
8 1
10. C..p| t|e Jen.rJ .rJ supp|y cu.ves .rJ s|c. t|e e,u|||b.|un p.|ce .rJ ,u.rt|ty.
11. At . p.|ce c| ´3 pe. g.||cr, .cu|J t|e.e be . su.p|us c. s|c.t.ge c| g.sc||re` |c. nuc| .cu|J t|e su.p|us
c. s|c.t.ge be` |rJ|c.te t|e su.p|us c. s|c.t.ge cr t|e g..p|.
12. At . p.|ce c| ´6 pe. g.||cr, .cu|J t|e.e be . su.p|us c. s|c.t.ge c| g.sc||re` |c. nuc| .cu|J t|e su.p|us
c. s|c.t.ge be` S|c. t|e su.p|us c. s|c.t.ge cr t|e g..p|.
13. Suppcse t|e ,u.rt|ty Jen.rJeJ |rc.e.seJ by 2,000 g.||crs pe. ncrt| .t e.c| p.|ce. At . p.|ce c| ´3 pe.
g.||cr, |c. nuc| .cu|J t|e su.p|us c. s|c.t.ge be` C..p| t|e Jen.rJ .rJ supp|y cu.ves .rJ s|c. t|e
su.p|us c. s|c.t.ge.
14. Suppcse t|e ,u.rt|ty supp||eJ Jec.e.seJ by 2,000 g.||crs pe. ncrt| .t e.c| p.|ce |c. p.|ces bet.eer ´4
.rJ ´8 pe. g.||cr. At p.|ces |ess t|.r ´4 pe. g.||cr t|e ,u.rt|ty supp||eJ beccnes .e.c, .|||e t|e
,u.rt|t|es Jen.rJeJ .et.|r t|e v.|ues s|c.r |r t|e t.b|e. At . p.|ce c| ´4 pe. g.||cr, |c. nuc| .cu|J
t|e su.p|us c. s|c.t.ge be` C..p| t|e Jen.rJ .rJ supp|y cu.ves .rJ s|c. t|e su.p|us c. s|c.t.ge.
15. || t|e Jen.rJ cu.ve s|||ts .s |r p.cb|en 13 .rJ t|e supp|y cu.ve s|||ts .s |r p.cb|en 14, .|t|cut J...|rg
. g..p| c. ccrsu|t|rg t|e J.t., c.r ycu p.eJ|ct .|et|e. e,u|||b.|un p.|ce |rc.e.ses c. Jec.e.ses` \|.t
.bcut e,u|||b.|un ,u.rt|ty` |c. J... . g..p| t|.t s|c.s .|.t t|e re. e,u|||b.|un p.|ce .rJ ,u.rt|ty
..e.
CHAP7£R 3 D£MAND AND SUPPLY 87
1.
ENDNOTES
|c.n Sc|e|be., ´As . ´erte. |c. Outscu.c|rg, |rJ|. ´cu|J be |cs|rg |ts |Jge,´ |e.
`o·| ¯|·e·, V.y 9, 2004, p. b|3.
88 PRINCIPL£S OI £CONOMICS
´ | A | ¯ | | 4
Applications of Demand and
Supply
S7AR7 UP: A COMPOS£R LOGS ON
´S|rce t|e .ge c| sever, | kre. t|.t | .cu|J be . nus|c|.r. ArJ |.cn .ge |cu.teer, | kre. t|.t | .cu|J be . ccn
pcse.,´ s.ys |s..e||bc.r O|e. berAncts. \|.t |e J|J rct krc. ..s t|.t |e .cu|J use ccnpute.s tc c...y cut ||s
.c.k. |e |s rc. . p.c|essc. c| nus|c .t ´c|c..Jc ´c||ege, .rJ |.. berAnctss ccnpcs|t|crs .rJ cpe..s |.ve beer
pe.|c.neJ |r t|e |r|teJ St.tes, |u.cpe, .rJ '.p.r.
|c. cve. 15 ye..s, |e |.s useJ nus|c.| rct.t|cr sc|t...e tc |e|p |r ccnpcs|rg nus|c. ´¯|e cutput |s ext.ene|y
e|eg.rt. |e.|c.ne.s er¦cy |cck|rg .t suc| . c|e.. .rJ c|e.r scc.e. ¯|e c.e.t|cr c| p..ts cut c| . |u|| scc.e |s .s e.sy
.s p.ess|rg t|e <||¯||> key cr t|e keybc..J.´ ´|.rges c.r e.s||y be |rse.teJ |rtc t|e rct.t|cr ||e, .||c| e||n|r
.tes t|e reeJ |c. .eccpy|rg. |r .JJ|t|cr, |.. berAncts uses ccnpute.s |c. p|.yb.ck. ´| c.r ||ster tc . .e|.t|ve|y .c
cu..te J|g|t.| pe.|c.n.rce c| t|e scc.e .t .ry g|ver pc|rt, .|t| .ry tenpc c. |rst.unert.t|cr | c|ccse. ¯|e scurJ
,u.||ty |.s |np.cveJ sc nuc| t|.t J|g|t.| ||es scurJ .|ncst |Jert|c.| tc .e.| pe.|c.n.rce.´ |e c.r .|sc p.cJuce
´|s cr ||s c.r .rJ c.e.te |cJc.sts sc t|.t .rycre |r t|e .c.|J c.r |e.. ||s nus|c. |e erg.ges |r se||pub||c.t|cr
c| scc.es .rJ se||n..ket|rg. ´|r ny c.se, | get tc keep t|e ccpy.|g|ts cr .|| c| ny nus|c. ¯||s .cu|J |.ve beer |n
pcss|b|e ter tc t.e|ve ye..s .gc .|er ccnpcse.s t..rs|e..eJ t|e|. .|g|ts tc pub||s|e.s. |cne p.ges cr t|e \c.|J
\|Je \eb .||c. ne tc p.cncte ny c.r .c.k.´ |.c|essc. berAncts .|sc c|.rgeJ t|e ..y |e te.c|es nus|c ccn
pcs|t|cr. |e. .pp||c.t|cr sc|t...e, suc| .s C...geb.rJ, |.s cpereJ t|e ..y |c. .rycre |rte.esteJ tc t.y tc ccn
pcse nus|c. \|e.e.s ||s nus|c ccnpcs|t|cr c|.sses useJ tc |.ve nus|c t|ec.y p.e.e,u|s|tes, tcJ.y ||s c|.sses ..e
cper tc .||.
|.. berAncts st..teJ cut |r 1989 .|t| . V.c|rtcs| S|30 t|.t |.J 4 neg.bytes c| ..rJcn .ccess nenc.y
(|AV) .rJ .r 80neg.byte |..J J.|ve. |t ccst ||n .bcut ´3,000. ¯cJ.y, |e uses . V.c|rtcs| |c.e.bcck C4 |.ptcp
.|t| 1.5 g|g.bytes c| nenc.y, bu||t|r |\|/´| bu.re., .rJ .|.e|ess |rte.ret ccrrect|crs. ||s re. ccnpute. ccst
.bcut ´2,000. |c. pe.scr.| ccnpute.s .cse sc J..n.t|c.||y |r pc.e. .s t|ey |e|| sc steep|y |r p.|ce |s ¦ust cre c|
t|e stc.|es .bcut n..kets .e .||| te|| |r t||s c|.pte., .||c| .|ns tc |e|p ycu urJe.st.rJ |c. t|e ncJe| c| Jen.rJ
.rJ supp|y .pp||es tc t|e .e.| .c.|J.
|r t|e |.st sect|cr c| t||s c|.pte., .e .||| |cck .t seve..| n..kets t|.t ycu ..e ||ke|y tc |.ve p..t|c|p.teJ |r c. be
|.n|||.. .|t|t|e n..ket |c. pe.scr.| ccnpute.s, t|e n..kets |c. c.uJe c|| .rJ |c. g.sc||re, .rJ t|e stcck n..ket.
+cu p.cb.b|y c.r c. |.ve .ccess tc . ccnpute.. |.c| c| us ..s .|ecteJ by t|e s|..p .|se |r c.uJe c|| .rJ g.sc||re
p.|ces |.cn 2004 tc n|J2008. ¯|e pe.|c.n.rce c| t|e stcck n..ket |s .|..ys . n.¦c. re.s |ten .rJ n.y .|ect
ycu pe.scr.||y, || rct rc., t|er |r t|e |utu.e. ¯|e ccrcepts c| Jen.rJ .rJ supp|y gc . |crg ..y |r exp|.|r|rg t|e
be|.v|c. c| e,u|||b.|un p.|ces .rJ ,u.rt|t|es |r .|| c| t|ese n..kets. ¯|e pu.pcse c| t||s sect|cr |s tc .||c. ycu tc
p..ct|ce us|rg t|e ncJe| c| Jen.rJ .rJ supp|y .rJ get ycu tc st..t t||rk|rg .bcut t|e ny.|.J ..ys t|e ncJe| c|
Jen.rJ .rJ supp|y c.r be .pp||eJ.
|r t|e seccrJ p..t c| t|e c|.pte. .e .||| |cck .t n..kets |r .||c| t|e gcve.rnert |.s ||stc.|c.||y p|.yeJ .
|..ge .c|e |r .egu|.t|rg p.|ces. by |eg|s|.t|rg n.x|nun c. n|r|nun p.|ces, t|e gcve.rnert |.s kept t|e p.|ces c|
ce.t.|r gccJs be|c. c. .bcve e,u|||b.|un. \e .||| |cck .t t|e ..gunerts |c. J|.ect gcve.rnert |rte.vert|cr |r
ccrt.c|||rg p.|ces .s .e|| .s t|e ccrse,uerces c| suc| pc||c|es. As .e s|.|| see, p.evert|rg t|e p.|ce c| . gccJ |.cn
|rJ|rg |ts c.r e,u|||b.|un c|ter |.s ccrse,uerces t|.t n.y be .t cJJs .|t| t|e |rtert|crs c| t|e pc||cy n.ke.s
.|c put t|e .egu|.t|crs |r p|.ce.
|r t|e t||.J sect|cr c| t|e c|.pte. .e .||| |cck .t t|e n..ket |c. |e.|t| c..e. ¯||s n..ket |s |rte.est|rg bec.use
|c. .e|| (c. pcc.|y) |t .c.ks c.r be . n.tte. c| |||e .rJ Je.t| .rJ bec.use |t |.s spec|.| c|...cte.|st|cs. |r p..t|cu
|.., n..kets |r .||c| p..t|c|p.rts Jc rct p.y |c. gccJs J|.ect|y, but ..t|e. p.y |rsu.e.s .|c t|er p.y t|e supp||e.s
c| t|e gccJs, cpe..te scne.|.t J||e.ert|y |.cn t|cse |r .||c| p..t|c|p.rts p.y J|.ect|y |c. t|e|. pu.c|.ses. ¯||s
exters|cr c| Jen.rJ .rJ supp|y .r.|ys|s .eve.|s nuc| .bcut |c. suc| n..kets cpe..te.
1. PUTTING DEMAND AND SUPPLY TO WORK
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. Learn how to appIy the modeI of demand and suppIy to expIaining the behavior of equiIibrium
prices and quantities in a variety of markets.
2. £xpIain how technoIogicaI change can be represented using the modeI of demand and suppIy.
3. £xpIain how the modeI of demand and suppIy can be used to expIain changes in prices of
shares of stock.
A shift in eithei demand oi supply, oi in both, leads to a change in equilibiium piice and equilibiium
quantity. We begin this chaptei by examining maikets in which piices adjust quickly to changes in de-
mand oi supply: the maiket foi peisonal computeis, the maikets foi ciude oil and gasoline, and the
stock maiket. These maikets aie thus diiect applications of the model of demand and supply.
1.1 The Peisonal Computei Maiket
In the 1960s, to speak of computeis was to speak of IBM, the dominant makei of laige mainfiame com-
puteis used by business and goveinment agencies. Then between 1976, when Apple Computei intio-
duced its fist desktop computei, and 1981, when IBM pioduced its fist peisonal computeis (PCs), the
old woild was tuined upside down. In 1984, just 8.2° of U.S. households owned a peisonal computei.
By 2007, Google estimates that 78° did. The tools of demand and supply tell the stoiy fiom an eco-
nomic peispective.
Technological change has been bieathtakingly swift in the computei industiy. Because peisonal
computeis have changed so diamatically in peifoimance and in the iange of the functions they pei-
foim, we shall speak of ¨quality-adjusted" peisonal computeis. The piice pei unit of quality-adjusted
desktop computeis fell by about half eveiy 30 months duiing the peiiod 1976-1989. In the fist half of
the 1990s, those piices fell by half eveiy 28 months. In the second half of the 1990s, the ¨halving time"
fell to eveiy 24 months.
[1]
Considei anothei indicatoi of the phenomenal change in computeis. Between 1993 and 1998, the
Buieau of Laboi Statistics estimates that cential piocessing unit (CPU) speed iose 1,263°, system
memoiy incieased 1,300°, haid diive capacity soaied by 3,700°, and monitoi size went up 13°. It
seems safe to say that the dizzying pace of change iecoided in the 1990s has incieased in this centuiy. A
¨computei" today is not the same good as a ¨computei" even fve yeais ago. To make them compai-
able, we must adjust foi these changes in quality.
Initially, most peisonal computeis weie manufactuied by Apple oi Compaq; both companies weie
veiy pioftable. The potential foi piofts attiacted IBM and othei fims to the industiy. Unlike laige
90 PRINCIPL£S OI £CONOMICS
mainfiame computeis, peisonal computei clones tuined out to be faiily easy things to manufactuie. As
shown in Table 4.1, the top fve peisonal computei manufactuieis pioduced only 48° of the peisonal
computeis sold in the woild in 2003, and the laigest manufactuiei, Dell, sold only about 19° of the
total in that yeai. This is a fai ciy fiom the moie than 90° of the mainfiame computei maiket that
IBM once held. The maiket has become fai moie competitive.
7A8L£ 4. 1 PersonaI Computer Shipments, Market Percentage Shares by Vendors, WorId and United
States
Company % of WorId Shipments Company % of U.S. Shipments
|e|| 18.9 |e|| 34
|e.|ett|.ck..J 15.4 |e.|ett|.ck..J 18.2
|bV 5.1 C.te..y 5.
|u¦|tsu Se|ners 4.6 |bV 4.3
Ace. 4 App|e 3.9
Ot|e.s 52 Ot|e.s 34
7otaI 100.0 7otaI 100.0
Source· IDC-Press Release 15 Apr 2005 ¨PC Market Approaches 11º Growth as International Demand Remains Strong, According to IDC¨
(http·//www.idc.com/getdoc.jsp?containerId=pr2005_04_14_17070722) (Totals may not add due to rounding)
Figuie 4.1 illustiates the changes that have occuiied in the computei maiket. The hoiizontal axis shows
the quantity of quality-adjusted peisonal computeis. Thus, the quantity axis can be thought of as a unit
of computing powei. Similaily, the piice axis shows the piice pei unit of computing powei. The iapid
inciease in the numbei of fims, togethei with diamatic technological impiovements, led to an inciease
in supply, shifting the supply cuive in Figuie 4.1 to the iight fiom S
1
to S
2
.
II GUR£ 4. 1 7he PersonaI Computer Market
¯|e supp|y cu.ve |c. ,u.||ty.J¦usteJ pe.scr.| ccnpute.s |.s s|||teJ n..keJ|y tc t|e .|g|t, .eJuc|rg t|e
e,u|||b.|un p.|ce |.cn |
1
tc |
2
.rJ |rc.e.s|rg t|e e,u|||b.|un ,u.rt|ty |.cn (
1
tc (
2
|r 2005.
Demand also shifted to the iight fiom D
1
to D
2
, as incomes iose and new uses foi computeis, fiom e-
mail and social netwoiking to Voice ovei Inteinet Piotocol (VoIP) and Radio Fiequency ID (RFID)
tags (which allow wiieless tiacking of commeicial shipments via desktop computeis), alteied the pief-
eiences of consumei and business useis. Because we obseive a fall in equilibiium piice and an inciease
in equilibiium quantity, we conclude that the iightwaid shift in supply has outweighed the iightwaid
shift in demand. The powei of maiket foices has piofoundly afected the way we live and woik.
CHAP7£R 4 APPLICA7IONS OI D£MAND AND SUPPLY 91
1.2 The Maikets foi Ciude Oil and foi Gasoline
The maiket foi ciude oil took a iadical tuin in 1973. The piice pei baiiel of ciude oil quadiupled in
1973 and 1974. Piice iemained high until the eaily 1980s but then fell back diastically and iemained
low foi about two decades. In 2004, the piice of oil began to move upwaid and by 2008 had ieached
$147 pei baiiel.
What caused the diamatic inciease in gasoline and oil piices in 2008: It appeaied to be incieasing
woildwide demand outpacing pioduceis' ability-oi willingness-to inciease pioduction much. This
inciease in demand is illustiated in Figuie 4.2.
II GUR£ 4. 2 7he Increasing Demand for Crude OiI
¯|e p.|ce c| c|| ..s ´35 pe. b...e| .t t|e beg|rr|rg c| 2004, .s Jete.n|reJ by t|e |rte.sect|cr c| .c.|J Jen.rJ,
|
1
, .rJ .c.|J supp|y, .
1
. |rc.e.s|rg .c.|J Jen.rJ, p.cnpteJ |..ge|y by |rc.e.s|rg Jen.rJ |.cn ´||r. .s .e|| .s
|.cn ct|e. ccurt.|es, s|||teJ .c.|J Jen.rJ tc |
2
, pus||rg t|e p.|ce .s ||g| .s ´140 pe. b...e| by t|e n|JJ|e c|
2008.
Highei oil piices also inciease the cost of pioducing viitually eveiy good oi seivice, as at a minimum,
the pioduction of most goods iequiies tianspoitation. These costs inevitably tianslate into highei
piices foi neaily all goods and seivices. Supply cuives of the goods and seivices thus afected shift to
the left, putting downwaid piessuie on output and upwaid piessuie on piices.
Giaphically, the impact of highei gasoline piices on businesses that use gasoline is illustiated in
Figuie 4.3. Because highei gasoline piices inciease the cost of doing business, they shift the supply
cuives foi neaily all businesses to the left, putting upwaid piessuie on piices and downwaid piessuie
on output. In the case shown heie, the supply cuive in a typical industiy shifts fiom S
1
to S
2
. This in-
cieases the equilibiium piice fiom P
1
to P
2
and ieduces the equilibiium quantity fiom Q
1
to Q
2
.
92 PRINCIPL£S OI £CONOMICS
soIe proprietorship
A |.n c.reJ by cre
|rJ|v|Ju.|.
partnership
A |.n c.reJ by seve..|
|rJ|v|Ju.|s.
corporation
A |.n c.reJ by
s|..e|c|Je.s .|c c.r stcck
|r t|e |.n.
corporate stock
S|..es |r t|e c.re.s||p c| .
cc.pc..t|cr.
stock market
¯|e set c| |rst|tut|crs |r
.||c| s|..es c| stcck ..e
bcug|t .rJ sc|J.
II GUR£ 4. 3 7he Impact of Higher GasoIine Prices
||g|e. g.sc||re p.|ces |rc.e.se t|e ccst c| p.cJuc|rg v|.tu.||y eve.y gccJ c. se.v|ce. |r t|e c.se s|c.r |e.e, t|e
supp|y cu.ve |r . typ|c.| |rJust.y s|||ts |.cn .
1
tc .
2
. ¯||s |rc.e.ses t|e e,u|||b.|un p.|ce |.cn |
1
tc |
2
.rJ .eJuces
e,u|||b.|un ,u.rt|ty |.cn (
1
tc (
2
.
Then, as the woild economy slowed diamatically in the second half of 2008, the demand cuive foi oil
shifted back to the left. By Novembei 2008, the piice pei baiiel had diopped back to below $60 pei bai-
iel. As gas piices also subsided, so did the thieat of highei piices in othei industiies.
1.3 The Stock Maiket
The ciiculai fow model suggests that capital, like othei factois of pioduction, is supplied by house-
holds to fims. Fiims, in tuin, pay income to those households foi the use of theii capital. Geneially
speaking, howevei, capital is actually owned by fims themselves. Geneial Motois owns its assembly
plants, and Wal-Mait owns its stoies; these fims theiefoie own theii capital. But fims, in tuin, aie
owned by people-and those people, of couise, live in households. It is thiough theii owneiship of
fims that households own capital.
A fim may be owned by one individual (a sole proprietorship), by seveial individuals (a part-
nership), oi by shaieholdeis who own stock in the fim (a corporation). Although most fims in the
United States aie sole piopiietoiships oi paitneiships, the bulk of the nation's total output (about 90°)
is pioduced by coipoiations. Coipoiations also own most of the capital (machines, plants, buildings,
and the like).
This section desciibes how the piices of shaies of corporate stock, shaies in the owneiship of a
coipoiation, aie deteimined by the inteiaction of demand and supply. Ultimately, the same foices that
deteimine the value of a fim's stock deteimine the value of a sole piopiietoiship oi paitneiship.
When a coipoiation needs funds to inciease its capital oi foi othei ieasons, one means at its dis-
posal is to issue new stock in the coipoiation. (Othei means include boiiowing funds oi using past
piofts.) Once the new shaies have been sold in what is called an initial public ofeiing (IPO), the coi-
poiation ieceives no fuithei funding as shaies of its stock aie bought and sold on the secondaiy mai-
ket. The secondaiy maiket is the maiket foi stocks that have been issued in the past, and the daily news
iepoits about stock piices almost always iefei to activity in the secondaiy maiket. Geneially, the coi-
poiations whose shaies aie tiaded aie not involved in these tiansactions.
The stock market is the set of institutions in which shaies of stock aie bought and sold. The New
Yoik Stock Exchange (NYSE) is one such institution. Theie aie many otheis all ovei the woild, such as
the DAX in Geimany and the Bolsa in Mexico. To buy oi sell a shaie of stock, one places an oidei with
a stockbiokei who ielays the oidei to one of the tiadeis at the NYSE oi at some othei exchange.
The piocess thiough which shaies of stock aie bought and sold can seem chaotic. At many ex-
changes, tiadeis with oideis fiom customeis who want to buy stock shout out the piices those custom-
eis aie willing to pay. Tiadeis with oideis fiom customeis who want to sell shout out ofeis of piices at
which theii customeis aie willing to sell. Some exchanges use electionic tiading, but the piinciple is the
same: if the piice someone is willing to pay matches the piice at which someone else is willing to sell,
CHAP7£R 4 APPLICA7IONS OI D£MAND AND SUPPLY 93
II GUR£ 4. 4 Demand and SuppIy in the
Stock Market
¯|e e,u|||b.|un p.|ce c| stcck s|..es |r |rte|
´c.pc..t|cr |s |r|t|.||y ´25, Jete.n|reJ by t|e
|rte.sect|cr c| Jen.rJ .rJ supp|y cu.ves |
1
.rJ .
1
, .t .||c| (
1
n||||cr s|..es ..e t..JeJ
e.c| J.y.
retained earnings
|.c|ts kept by . ccnp.ry.
dividends
|.c|ts J|st.|buteJ tc
s|..e|c|Je.s.
the tiade is made. The most iecent piice at which a stock has tiaded is iepoited almost instantaneously
thioughout the woild.
Figuie 4.4 applies the model of demand and supply to the deteimination of stock piices. Suppose
the demand cuive foi shaies in Intel Coipoiation is given by D
1
and the supply by S
1
. (Even though the
total numbei of shaies outstanding is fxed at any point in time, the supply cuive is not veitical. Rathei,
the supply cuive is upwaid sloping because it iepiesents how many shaies cuiient owneis aie piepaied
to sell at each piice, and that numbei will be gieatei at highei piices.) Suppose that these cuives intei-
sect at a piice of $23, at which Q
1
shaies aie tiaded each day. If the piice weie highei, moie shaies
would be ofeied foi sale than would be demanded, and the piice would quickly fall. If the piice weie
lowei, moie shaies would be demanded than would be supplied, and the piice would quickly iise. In
geneial, we can expect the piices of shaies of stock to move quickly to theii equilibiium levels.
The inteisection of the demand and supply cuives foi shaies of stock in a paiticu-
lai company deteimines the equilibiium piice foi a shaie of stock. But what deteimines
the demand and supply foi shaies of a company's stock:
The ownei of a shaie of a company's stock owns a shaie of the company, and,
hence, a shaie of its piofts; typically, a coipoiation will ietain and ieinvest some of its
piofts to inciease its futuie pioftability. The piofts kept by a company aie called re-
tained earnings. Piofts distiibuted to shaieholdeis aie called dividends. Because a
shaie of stock gives its ownei a claim on pait of a company's futuie piofts, it follows
that the expected level of futuie piofts plays a iole in deteimining the value of its stock.
Of couise, those futuie piofts cannot be known with ceitainty; investois can only
piedict what they might be, based on infoimation about futuie demand foi the com-
pany's pioducts, futuie costs of pioduction, infoimation about the soundness of a com-
pany's management, and so on. Stock piices in the ieal woild thus iefect estimates of a
company's piofts piojected into the futuie.
The downwaid slope of the demand cuive suggests that at lowei piices foi the
stock, moie people calculate that the fim's futuie eainings will justify the stock's pui-
chase. The upwaid slope of the supply cuive tells us that as the piice of the stock iises,
moie people conclude that the fim's futuie eainings do not justify holding the stock
and theiefoie ofei to sell it. At the equilibiium piice, the numbei of shaies supplied by
people who think holding the stock no longei makes sense just balances the numbei of
shaies demanded by people who think it does.
What factois, then, cause the demand oi supply cuives foi shaies of stocks to shift:
The most impoitant factoi is a change in the expectations of a company's futuie piofts.
Suppose Intel announces a new geneiation of computei chips that will lead to fastei
computeis with laigei memoiies. Cuiient owneis of Intel stock would adjust upwaid
theii estimates of what the value of a shaie of Intel stock should be. At the old equilibiium piice of $23
fewei owneis of Intel stock would be willing to sell. Since this would be tiue at eveiy possible shaie
piice, the supply cuive foi Intel stock would shift to the left, as shown in Figuie 4.3. Just as the expecta-
tion that a company will be moie pioftable shifts the supply cuive foi its stock to the left, that same
change in expectations will cause moie people to want to puichase the stock, shifting the demand cuive
to the iight. In Figuie 4.3, we see the supply cuive shifting to the left, fiom S
1
to S
2
, while the demand
cuive shifts to the iight, fiom D
1
to D
2
.
94 PRINCIPL£S OI £CONOMICS
II GUR£ 4. 5 A Change in £xpectations
Affects the Price of Corporate Stock
|| |r.rc|.| |rvestc.s Jec|Je t|.t . ccnp.ry |s
||ke|y tc be nc.e p.c|t.b|e, t|er t|e supp|y c|
t|e stcck s|||ts tc t|e |e|t (|r t||s c.se, |.cn .
1
tc .
2
), .rJ t|e Jen.rJ |c. t|e stcck s|||ts tc
t|e .|g|t (|r t||s c.se, |.cn |
1
tc |
2
), .esu|t|rg
|r .r |rc.e.se |r p.|ce |.cn |
1
tc |
2
.
Othei factois may altei the piice of an individual coipoiation's shaie of stock oi
the level of stock piices in geneial. Foi example, demogiaphic change and iising in-
comes have afected the demand foi stocks in iecent yeais. Foi example, with a laige
piopoition of the U.S. population neaiing ietiiement age and beginning to think about
and plan foi theii lives duiing ietiiement, the demand foi stocks has iisen.
Infoimation on the economy as a whole is also likely to afect stock piices. If the
economy oveiall is doing well and people expect that to continue, they may become
moie optimistic about how pioftable companies will be in geneial, and thus the piices
of stocks will iise. Conveisely, expectations of a sluggish economy, as happened in the
fall of 2008, could cause stock piices in geneial to fall.
The stock maiket is bombaided with new infoimation eveiy minute of eveiy day.
Fiims announce theii piofts of the pievious quaitei. They announce that they plan to
move into a new pioduct line oi sell theii goods in anothei countiy. We leain that the
piice of Company A's good, which is a substitute foi one sold by Company B, has iisen.
We leain that countiies sign tiade agieements, launch wais, oi make peace. All of this
infoimation may afect stock piices because any infoimation can afect how buyeis and
selleis value companies.
k £ Y 7 A k £ A W A Y S
< ¯ec|rc|cg|c.| c|.rge, .||c| |.s c.useJ t|e supp|y cu.ve |c. ccnput|rg pc.e. tc s|||t tc t|e .|g|t, |s t|e
n.|r .e.scr |c. t|e ..p|J |rc.e.se |r e,u|||b.|un ,u.rt|ty .rJ Jec.e.se |r e,u|||b.|un p.|ce c| pe.scr.|
ccnpute.s.
< ¯|e |rc.e.se |r c.uJe c|| .rJ g.sc||re p.|ces |r 2008 ..s J.|ver p.|n..||y by |rc.e.seJ Jen.rJ |c. c.uJe
c||, .r |rc.e.se t|.t ..s c.e.teJ by eccrcn|c g.c.t| t|.cug|cut t|e .c.|J. ´.uJe c|| .rJ g.s p.|ces |e||
n..keJ|y .s .c.|J eccrcn|c g.c.t| subs|JeJ |.te. |r t|e ye...
< ||g|e. g.sc||re p.|ces |rc.e.seJ t|e ccst c| p.cJuc|rg v|.tu.||y eve.y gccJ .rJ se.v|ce, s|||t|rg supp|y
cu.ves |c. ncst gccJs .rJ se.v|ces tc t|e |e|t. ¯||s terJeJ tc pus| p.|ces up .rJ cutput Jc.r.
< |en.rJ .rJ supp|y Jete.n|re p.|ces c| s|..es c| cc.pc..te stcck. ¯|e e,u|||b.|un p.|ce c| . s|..e c|
stcck st.|kes . b.|.rce bet.eer t|cse .|c t||rk t|e stcck |s .c.t| nc.e .rJ t|cse .|c t||rk |t |s .c.t|
|ess t|.r t|e cu..ert p.|ce.
< || . ccnp.rys p.c|ts ..e expecteJ tc |rc.e.se, t|e Jen.rJ cu.ve |c. |ts stcck s|||ts tc t|e .|g|t .rJ t|e
supp|y cu.ve s|||ts tc t|e |e|t, c.us|rg e,u|||b.|un p.|ce tc .|se. ¯|e cppcs|te .cu|J cccu. || . ccnp.rys
p.c|ts .e.e expecteJ tc Jec.e.se.
< Ot|e. |.ctc.s t|.t |r|uerce t|e p.|ce c| cc.pc..te stcck |rc|uJe Jencg..p||c .rJ |rccne c|.rges .rJ
t|e cve..|| |e.|t| c| t|e eccrcny.
7 R Y I 7 !
Suppcse .r .|.||re .rrcurces t|.t |ts e..r|rgs t||s ye.. ..e |c.e. t|.r expecteJ Jue tc .eJuceJ t|cket s.|es.
¯|e .|.||re spckespe.scr g|ves rc |r|c.n.t|cr cr |c. t|e ccnp.ry p|.rs tc tu.r t||rgs ..curJ. |se t|e
ncJe| c| Jen.rJ .rJ supp|y tc s|c. .rJ exp|.|r .|.t |s ||ke|y tc |.pper tc t|e p.|ce c| t|e .|.||res stcck.
CHAP7£R 4 APPLICA7IONS OI D£MAND AND SUPPLY 95
Case in Point: 9/11 and the Stock Market
÷ 2010 jupiterimages Corporation
¯|e |¡.ck|rg c| |cu. .|.p|.res .rJ t|e stee.|rg c| t|en |rtc bu||J|rgs |s pe.|.ps t|e cr|y J|s.ste. t|.t |.s be
ccne ur|ve.s.||y krc.r by |ts J.te. Septenbe. 11, 2001|erce, 9/11. ´9/11´ .||| .en.|r etc|eJ |r cu. cc|
|ect|ve nenc.y |c. . g.e.t n.ry gere..t|crs.
||s.ste.s suc| .s 9/11 .ep.esert t|e k|rJ c| ccnp|ete su.p.|ses t|.t J..n.t|c.||y .|ect stcck p.|ces, || cr|y
tenpc...||y. ¯|e |e. +c.k Stcck |xc|.rge ..s c|cseJ cr t|e J.y c| t|e .tt.ck .rJ .en.|reJ c|cseJ |c. s|x
J.ys. Or t|e J.y t|e n..ket cpereJ, t|e |c. 'cres |rJust.|.| Ave..ge (t|e ´|O\´, . .|Je|y useJ g.uge c|
stcck p.|ces) |e|| re..|y 685 pc|rts tc 8,920. |t ..s cre c| t|e b|ggest creJ.y Jec||re |r |.S. ||stc.y.
\|y J|J t|e .tt.cks cr Septenbe. 11, 2001, |.ve suc| . J..n.t|c s|c.tte.n |np.ct cr t|e stcck n..ket` ¯|e
.tt.cks c| 9/11 p|urgeJ t|e |r|teJ St.tes .rJ nuc| c| t|e .est c| t|e .c.|J |rtc . ve.y |.|g|ter|rg ...
.g.|rst te..c.|sn. ¯|e .e.||..t|cr t|.t te..c.|sts ccu|J st.|ke .ryt|ne .rJ |r .ry p|.ce s.ppeJ ccrsune. .rJ
bus|ress ccr|Jerce .||ke .rJ .|ecteJ bct| t|e Jen.rJ .rJ supp|y c| ncst stccks. ¯|e .tt.cks cr 9/11 p.c
vckeJ |e.. .rJ urce.t.|rtyt.c t||rgs t|.t ..e ce.t.|r tc b.|rg stcck p.|ces Jc.r, .t |e.st urt|| ct|e. everts
.rJ nc.e |r|c.n.t|cr c.use expect.t|crs tc c|.rge .g.|r |r t||s ve.y .espcrs|ve n..ket.
96 PRINCIPL£S OI £CONOMICS
price 0oor
A n|r|nun .||c..b|e p.|ce
set .bcve t|e e,u|||b.|un
p.|ce.
A N S W £ R 7 O 7 R Y I 7 ! P R O 8 L £ M
¯|e |r|c.n.t|cr g|ver |r t|e p.cb|en suggests t|.t t|e .|.||res p.c|ts ..e ||ke|y tc |.|| be|c. expect.t|crs.
´u..ert c.re.s c| t|e .|.||res stcck .rJ pctert|.| buye.s c| t|e stcck .cu|J .J¦ust Jc.r...J t|e|. est|n.tes
c| .|.t t|e v.|ue c| t|e cc.pc..t|crs stcck s|cu|J be. As . .esu|t t|e supp|y cu.ve |c. t|e stcck .cu|J |r
c.e.se, s|||t|rg |t tc t|e .|g|t, .|||e t|e Jen.rJ cu.ve |c. t|e stcck .cu|J Jec.e.se, s|||t|rg |t tc t|e |e|t. As .
.esu|t, e,u|||b.|un p.|ce c| t|e stcck |.||s |.cn |
1
tc |
2
. \|.t |.ppers tc e,u|||b.|un ,u.rt|ty JeperJs cr t|e
extert tc .||c| e.c| cu.ve s|||ts. |r t|e J|.g..n, e,u|||b.|un ,u.rt|ty |s s|c.r tc Jec.e.se |.cn (
1
tc (
2
.
2. GOVERNMENT INTERVENTION IN MARKET PRICES:
PRICE FLOORS AND PRICE CEILINGS
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. Use the modeI of demand and suppIy to expIain what happens when the government imposes
price 0oors or price ceiIings.
2. Discuss the reasons why governments sometimes choose to controI prices and the con-
sequences of price controI poIicies.
So fai in this chaptei and in the pievious chaptei, we have leained that maikets tend to move towaid
theii equilibiium piices and quantities. Suipluses and shoitages of goods aie shoit-lived as piices ad-
just to equate quantity demanded with quantity supplied.
In some maikets, howevei, goveinments have been called on by gioups of citizens to inteivene to
keep piices of ceitain items highei oi lowei than what would iesult fiom the maiket fnding its own
equilibiium piice. In this section we will examine agiicultuial maikets and apaitment iental mai-
kets-two maikets that have often been subject to piice contiols. Thiough these examples, we will
identify the efects of contiolling piices. In each case, we will look at ieasons why goveinments have
chosen to contiol piices in these maikets and the consequences of these policies.
2.1 Agiicultuial Piice Floois
Goveinments often seek to assist faimeis by setting piice foois in agiicultuial maikets. A minimum al-
lowable piice set above the equilibiium piice is a price ßoor. With a piice fooi, the goveinment foi-
bids a piice below the minimum. (Notice that, if the piice fooi weie foi whatevei ieason set below the
equilibiium piice, it would be iiielevant to the deteimination of the piice in the maiket since nothing
would piohibit the piice fiom iising to equilibiium.) A piice fooi that is set above the equilibiium
piice cieates a suiplus.
Figuie 4.8 shows the maiket foi wheat. Suppose the goveinment sets the piice of wheat at P
F
.
Notice that P
F
is above the equilibiium piice of P
E
. At P
F
, we iead ovei to the demand cuive to fnd
that the quantity of wheat that buyeis will be willing and able to puichase is V
1
bushels. Reading ovei
to the supply cuive, we fnd that selleis will ofei V
2
bushels of wheat at the piice fooi of P
F
. Because
CHAP7£R 4 APPLICA7IONS OI D£MAND AND SUPPLY 97
II GUR£ 4. 8 Price IIoors in Wheat
Markets
A p.|ce |cc. |c. .|e.t c.e.tes . su.p|us c|
.|e.t e,u.| tc (/
2
/
1
) bus|e|s.
II GUR£ 4. 9 SuppIy and Demand Shifts
for AgricuIturaI Products
A .e|.t|ve|y |..ge |rc.e.se |r t|e supp|y c|
.g.|cu|tu..| p.cJucts, .cccnp.r|eJ by .
.e|.t|ve|y sn.|| |rc.e.se |r Jen.rJ, |.s
.eJuceJ t|e p.|ce .ece|veJ by |..ne.s .rJ
|rc.e.seJ t|e ,u.rt|ty c| .g.|cu|tu..| gccJs.
P
F
is above the equilibiium piice, theie is a suiplus of wheat equal to (V
2
÷ V
1
) bushels. The suiplus
peisists because the goveinment does not allow the piice to fall.
Why have many goveinments aiound the woild set piice foois in agiicultuial
maikets: Faiming has changed diamatically ovei the past two centuiies. Technological
impiovements in the foim of new equipment, feitilizeis, pesticides, and new vaiieties
of ciops have led to diamatic incieases in ciop output pei acie. Woildwide pioduction
capacity has expanded maikedly. As we have leained, technological impiovements
cause the supply cuive to shift to the iight, ieducing the piice of food. While such piice
ieductions have been celebiated in computei maikets, faimeis have successfully lob-
bied foi goveinment piogiams aimed at keeping theii piices fiom falling.
While the supply cuive foi agiicultuial goods has shifted to the iight, the demand
has incieased with iising population and with iising income. But as incomes iise,
people spend a smallei and smallei fiaction of theii incomes on food. While the de-
mand foi food has incieased, that inciease has not been neaily as gieat as the inciease
in supply. Figuie 4.9 shows that the supply cuive has shifted much faithei to the iight,
fiom S
1
to S
2
, than the demand cuive has, fiom D
1
to D
2
. As a iesult, equilibiium
quantity has iisen diamatically, fiom Q
1
to Q
2
, and equilibiium piice has fallen, fiom
P
1
to P
2
.
On top of this long-teim histoiical tiend in agiicultuie, agiicultuial piices aie sub-
ject to wide swings ovei shoitei peiiods. Dioughts oi fieezes can shaiply ieduce sup-
plies of paiticulai ciops, causing sudden incieases in piices. Demand foi agiicultuial
goods of one countiy can suddenly diy up if the goveinment of anothei countiy im-
poses tiade iestiictions against its pioducts, and piices can fall. Such diamatic shifts in
piices and quantities make incomes of faimeis unstable.
The Gieat Depiession of the 1930s led to a majoi fedeial iole in agiicultuie. The
Depiession afected the entiie economy, but it hit faimeis paiticulaily haid. Piices ie-
ceived by faimeis plunged neaily two-thiids fiom 1930 to 1933. Many faimeis had a
tough time keeping up moitgage payments. By 1932, moie than half of all faim loans
weie in default.
Faim legislation passed duiing the Gieat Depiession has been modifed many
times, but the fedeial goveinment has continued its diiect involvement in agiicultuial
maikets. This has meant a vaiiety of goveinment piogiams that guaiantee a minimum
piice foi some types of agiicultuial pioducts. These piogiams have been accompanied
by goveinment puichases of any suiplus, by iequiiements to iestiict acieage in oidei to
limit those suipluses, by ciop oi pioduction iestiictions, and the like.
To see how such policies woik, look back at Figuie 4.8. At P
F
, V
2
bushels of wheat
will be supplied. With that much wheat on the maiket, theie is maiket piessuie on the
piice of wheat to fall. To pievent piice fiom falling, the goveinment buys the suiplus of
(V
2
- V
1
) bushels of wheat, so that only V
1
bushels aie actually available to piivate
consumeis foi puichase on the maiket. The goveinment can stoie the suipluses oi fnd
special uses foi them. Foi example, suipluses geneiated in the United States have been
shipped to developing countiies as giants-in-aid oi distiibuted to local school lunch
piogiams. As a vaiiation on this piogiam, the goveinment can iequiie faimeis who
want to paiticipate in the piice suppoit piogiam to ieduce acieage in oidei to limit the
size of the suipluses.
Aftei 1973, the goveinment stopped buying the suipluses (with some exceptions)
and simply guaianteed faimeis a ¨taiget piice." If the aveiage maiket piice foi a ciop
fell below the ciop's taiget piice, the goveinment paid the difeience. If, foi example, a
ciop had a maiket piice of $3 pei unit and a taiget piice of $4 pei unit, the goveinment
would give faimeis a payment of $1 foi each unit sold. Faimeis would thus ieceive the maiket piice of
$3 plus a goveinment payment of $1 pei unit. Foi faimeis to ieceive these payments, they had to agiee
to iemove acies fiom pioduction and to comply with ceitain conseivation piovisions. These iestiic-
tions sought to ieduce the size of the suiplus geneiated by the taiget piice, which acted as a kind of
piice fooi.
What aie the efects of such faim suppoit piogiams: The intention is to boost and stabilize faim
incomes. But, with piice foois, consumeis pay moie foi food than they would otheiwise, and govein-
ments spend heavily to fnance the piogiams. With the taiget piice appioach, consumeis pay less, but
goveinment fnancing of the piogiam continues. U.S. fedeial spending foi agiicultuie aveiaged well
ovei $22 billion pei yeai between 2003 and 2007, ioughly $70 pei peison.
Help to faimeis has sometimes been justifed on the giounds that it boosts incomes of ¨small"
faimeis. Howevei, since faim aid has geneially been allotted on the basis of how much faims pioduce
iathei than on a pei-faim basis, most fedeial faim suppoit has gone to the laigest faims. If the goal is
to eliminate poveity among faimeis, faim aid could be iedesigned to supplement the incomes of small
oi pooi faimeis iathei than to undeimine the functioning of agiicultuial maikets.
98 PRINCIPL£S OI £CONOMICS
II GUR£ 4. 10 £ffect of a Price CeiIing on
the Market for Apartments
A p.|ce ce|||rg cr .p..tnert .erts t|.t |s set
be|c. t|e e,u|||b.|un .ert c.e.tes . s|c.t.ge
c| .p..tnerts e,u.| tc (^
2
^
1
) .p..tnerts.
price ceiIing
A n.x|nun .||c..b|e p.|ce.
In 1996, the U.S. Congiess passed the Fedeial Agiicultuie Impiovement and Refoim Act of 1996,
oi FAIR. The thiust of the new legislation was to do away with the vaiious piogiams of piice suppoit
foi most ciops and hence piovide incentives foi faimeis to iespond to maiket piice signals. To piotect
faimeis thiough a tiansition peiiod, the act piovided foi continued payments that weie scheduled to
decline ovei a seven-yeai peiiod. Howevei, with piices foi many ciops falling in 1998, the U.S. Con-
giess passed an emeigency aid package that incieased payments to faimeis. In 2008, as faim piices
ieached iecoid highs, Congiess passed a faim bill that incieased subsidy payments to $40 billion. It did,
howevei, foi the fist time limit payments to the wealthiest faimeis. Individual faimeis whose faim in-
comes exceed $730,000 (oi $1.3 million foi couples) would be ineligible foi some subsidy piogiams.
2.2 Rental Piice Ceilings
The puipose of ient contiol is to make iental units cheapei foi tenants than they would otheiwise be.
Unlike agiicultuial piice contiols, ient contiol in the United States has been laigely a local phenomen-
on, although theie weie national ient contiols in efect duiing Woild Wai II. Cuiiently, about 200 cit-
ies and counties have some type of ient contiol piovisions, and about 10° of iental units in the United
States aie now subject to piice contiols. New Yoik City's ient contiol piogiam, which began in 1943, is
among the oldest in the countiy. Many othei cities in the United States adopted some foim of ient con-
tiol in the 1970s. Rent contiols have been peivasive in Euiope since Woild Wai I, and many laige cities
in pooiei countiies have also adopted ient contiols.
Rent contiols in difeient cities difei in teims of theii fexibility. Some cities allow ient incieases
foi specifed ieasons, such as to make impiovements in apaitments oi to allow ients to keep pace with
piice incieases elsewheie in the economy. Often, iental housing constiucted aftei the imposition of the
ient contiol oidinances is exempted. Apaitments that aie vacated may also be decontiolled. Foi simpli-
city, the model piesented heie assumes that apaitment ients aie contiolled at a piice that does not
change.
Figuie 4.10 shows the maiket foi iental apaitments. Notice that the demand and
supply cuives aie diawn to look like all the othei demand and supply cuives you have
encounteied so fai in this text: the demand cuive is downwaid-sloping and the supply
cuive is upwaid-sloping.
The demand cuive shows that a highei piice (ient) ieduces the quantity of apait-
ments demanded. Foi example, with highei ients, moie young people will choose to
live at home with theii paients. With lowei ients, moie will choose to live in apait-
ments. Highei ients may encouiage moie apaitment shaiing; lowei ients would induce
moie people to live alone.
The supply cuive is diawn to show that as ient incieases, piopeity owneis will be
encouiaged to ofei moie apaitments to ient. Even though an aeiial photogiaph of a
city would show apaitments to be fxed at a point in time, owneis of those piopeities
will decide how many to ient depending on the amount of ient they anticipate. Highei
ients may also induce some homeowneis to ient out apaitment space. In addition,
ienting out apaitments implies a ceitain level of seivice to ienteis, so that low ients
may lead some piopeity owneis to keep some apaitments vacant.
Rent contiol is an example of a price ceiling, a maximum allowable piice. With a
piice ceiling, the goveinment foibids a piice above the maximum. A piice ceiling that is
set below the equilibiium piice cieates a shoitage that will peisist.
Suppose the goveinment sets the piice of an apaitment at P
C
in Figuie 4.10. Notice
that P
C
is below the equilibiium piice of P
E
. At P
C
, we iead ovei to the supply cuive to
fnd that selleis aie willing to ofei A
1
apaitments. Reading ovei to the demand cuive,
we fnd that consumeis would like to ient A
2
apaitments at the piice ceiling of P
C
. Be-
cause P
C
is below the equilibiium piice, theie is a shoitage of apaitments equal to (A
2
- A
1
). (Notice
that if the piice ceiling weie set above the equilibiium piice it would have no efect on the maiket since
the law would not piohibit the piice fiom settling at an equilibiium piice that is lowei than the piice
ceiling.)
CHAP7£R 4 APPLICA7IONS OI D£MAND AND SUPPLY 99
II GUR£ 4. 11 7he Unintended
Consequences of Rent ControI
´crt.c|||rg .p..tnert .erts .t |
´
c.e.tes .
s|c.t.ge c| (^
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) .p..tnerts. |c. ^
1
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p.ynerts tc .p..tnert c.re.s.
If ient contiol cieates a shoitage of apaitments, why do some citizens nonetheless
clamoi foi ient contiol and why do goveinments often give in to the demands: The
ieason geneially given foi ient contiol is to keep apaitments afoidable foi low- and
middle-income tenants.
But the ieduced quantity of apaitments supplied must be iationed in some way,
since, at the piice ceiling, the quantity demanded would exceed the quantity supplied.
Cuiient occupants may be ieluctant to leave theii dwellings because fnding othei
apaitments will be dimcult. As apaitments do become available, theie will be a line of
potential ienteis waiting to fll them, any of whom is willing to pay the contiolled piice
of P
C
oi moie. In fact, ieading up to the demand cuive in Figuie 4.11 fiom A
1
apait-
ments, the quantity available at P
C
, you can see that foi A
1
apaitments, theie aie poten-
tial ienteis willing and able to pay P
B
. This often leads to vaiious ¨backdooi" payments
to apaitment owneis, such as laige secuiity deposits, payments foi things ienteis may
not want (such as fuinituie), so-called ¨key" payments (¨The monthly ient is $300 and
the key piice is $3,000"), oi simple biibes.
In the end, ient contiols and othei piice ceilings often end up huiting some of the
people they aie intended to help. Many people will have tiouble fnding apaitments to
ient. Iionically, some of those who do fnd apaitments may actually end up paying
moie than they would have paid in the absence of ient contiol. And many of the people
that the ient contiols do help (piimaiily cuiient occupants, iegaidless of theii income,
and those lucky enough to fnd apaitments) aie not those they aie intended to help (the
pooi). Theie aie also costs in goveinment administiation and enfoicement.
Because New Yoik City has the longest histoiy of ient contiols of any city in the
United States, its piogiam has been widely studied. Theie is geneial agieement that the
ient contiol piogiam has ieduced tenant mobility, led to a substantial gap between
ients on contiolled and uncontiolled units, and favoied long-teim iesidents at the expense of new-
comeis to the city.
[2]
These distoitions have giown ovei time, anothei fiequent consequence of piice
contiols.
A moie diiect means of helping pooi tenants, one that would avoid inteifeiing with the function-
ing of the maiket, would be to subsidize theii incomes. As with piice foois, inteifeiing with the maiket
mechanism may solve one pioblem, but it cieates many otheis at the same time.
k £ Y 7 A k £ A W A Y S
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100 PRINCIPL£S OI £CONOMICS
Case in Point: Corn: It Is Not 1ust Iood Any More
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CHAP7£R 4 APPLICA7IONS OI D£MAND AND SUPPLY 101
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^|o|··. /o,.o·e 200.. o·||·e .e··|o·. /|c|oe| O·o·.o|J. ¯|e ´|eo· |·e·¸, .co·.' ¯|·e ¹.¹¹4 (^¡·|| .. 200S: 4045
A N S W £ R 7 O 7 R Y I 7 ! P R O 8 L £ M
A n|r|nun ..ge (/
n|r
) t|.t |s set .bcve t|e e,u|||b.|un ..ge .cu|J c.e.te . su.p|us c| ursk|||eJ |.bc.
e,u.| tc (|
2
|
1
). ¯|.t |s, |
2
ur|ts c| ursk|||eJ |.bc. ..e c|e.eJ .t t|e n|r|nun ..ge, but ccnp.r|es cr|y
..rt tc use |
1
ur|ts .t t|.t ..ge. bec.use ursk|||eJ .c.ke.s ..e . subst|tute |c. . sk|||eJ .c.ke.s, |c.c|rg t|e
p.|ce c| ursk|||eJ .c.ke.s ||g|e. .cu|J |rc.e.se t|e Jen.rJ |c. sk|||eJ |.bc. .rJ t|us |rc.e.se t|e|. ..ges.
3. THE MARKET FOR HEALTH-CARE SERVICES
L £ A R N I N G O 8 1 £ C 7 I V £
1. Use the modeI of demand and suppIy to expIain the eñects of third-party payers on the heaIth-
care market and on heaIth-care spending.
Theie has been much discussion ovei the past thiee decades about the health-caie pioblem in the Un-
ited States. Much of this discussion has focused on iising spending foi health caie. In this section, we
will apply the model of demand and supply to health caie to see what we can leain about some of the
ieasons behind iising spending in this impoitant sectoi of the economy.
Figuie 4.14 shows the shaie of U.S. output devoted to health caie since 1960. In 1960, about 3° of
total output was devoted to health caie; by 2004 this shaie had iisen to 13.4°. That has meant that we
aie devoting moie of oui spending to health caie, and less to othei goods and seivices, than we would
be had health-caie spending not iisen so much.
102 PRINCIPL£S OI £CONOMICS
II GUR£ 4. 14 HeaIth-Care Spending as a Percentage of U.S. Output, 1960-2003
|e.|t| c..es s|..e c| tct.| |.S. cutput .cse |.cn .bcut 5 |r 1960 tc 15.3 |r 2003.
Data for period 19õ0-1992 from Health Care Finance Association (which was the predecessor to the Centers for Medicare and Medicaid Services),
Data for period 1993-2003 from Centers for Medicare and Medicaid Services, Opce of the Actuary· ^ational Health Statistics Group
http·//www.cms.hhs.gov/statistics/nhe/historical/t1.asp.
Why weie Ameiicans willing to inciease theii spending on health caie so diamatically: The model of
demand and supply gives us pait of the answei. As we apply the model to this pioblem, we will also
gain a bettei undeistanding of the iole of piices in a maiket economy.
3.1 The Demand and Supply foi Health Caie
When we speak of ¨health caie," we aie speaking of the entiie health-caie industiy. This industiy pio-
duces seivices ianging fiom heait tiansplant opeiations to theiapeutic massages; it pioduces goods
ianging fiom X-iay machines to aspiiin tablets. Cleaily each of these goods and seivices is exchanged
in a paiticulai maiket. To assess the maiket foices afecting health caie, we will focus fist on just one
of these maikets: the maiket foi physician omce visits. When you go to the doctoi, you aie pait of the
demand foi these visits. Youi doctoi, by seeing you, is pait of the supply.
Figuie 4.13 shows the maiket, assuming that it opeiates in a fashion similai to othei maikets. The
demand cuive D
1
and the supply cuive S
1
inteisect at point E, with an equilibiium piice of $30 pei
omce visit. The equilibiium quantity of omce visits pei week is 1,000,000.
CHAP7£R 4 APPLICA7IONS OI D£MAND AND SUPPLY 103
II GUR£ 4. 15 7otaI Spending for
Physician Office Visits
¯ct.| sperJ|rg cr p|ys|c|.r c|ce v|s|ts |s ´30
pe. v|s|t nu|t|p||eJ by 1,000,000 v|s|ts pe. .eek,
.||c| e,u.|s ´30,000,000. |t |s t|e s|.JeJ ..e.
bcurJeJ by p.|ce .rJ ,u.rt|ty.
third-party payer
Ar .gert ct|e. t|.r t|e
se||e. c. t|e buye. .|c p.ys
p..t c| t|e p.|ce c| . gccJ c.
se.v|ce.
We can use the demand and supply giaph to show total spending, which equals the
piice pei unit (in this case, $30 pei visit) times the quantity consumed (in this case,
1,000,000 visits pei week). Total spending foi physician omce visits thus equals
$30,000,000 pei week ($30 times 1,000,000 visits). We show total spending as the aiea
of a iectangle bounded by the piice and the quantity. It is the shaded iegion in Figuie
4.13.
The pictuie in Figuie 4.13 misses a ciucial featuie of the maiket. Most people in
the United States have health insuiance, piovided eithei by piivate fims, by piivate
puichases, oi by the goveinment. With health insuiance, people agiee to pay a fxed
amount to the insuiei in exchange foi the insuiei's agieement to pay foi most of the
health-caie expenses they incui. While insuiance plans difei in theii specifc piovi-
sions, let us suppose that all individuals have plans that iequiie them to pay $10 foi an
omce visit; the insuiance company will pay the iest.
How will this insuiance afect the maiket foi physician omce visits: If it costs only
$10 foi a visit instead of $30, people will visit theii doctois moie often. The quantity of
omce visits demanded will inciease. In Figuie 4.16, this is shown as a movement along
the demand cuive. Think about youi own choices. When you get a cold, do you go to
the doctoi: Piobably not, if it is a minoi cold. But if you feel like you aie dying, oi wish
you weie, you piobably head foi the doctoi. Cleaily, theie aie lots of colds in between
these two extiemes. Whethei you diag youiself to the doctoi will depend on the sevei-
ity of youi cold and what you will pay foi a visit. At a lowei piice, you aie moie likely to
go to the doctoi; at a highei piice, you aie less likely to go.
In the case shown, the quantity of omce visits iises to 1,300,000 pei week. But that
suggests a potential pioblem. The quantity of visits supplied at a piice of $30 pei visit was 1,000,000.
Accoiding to supply cuive S
1
, it will take a piice of $30 pei visit to inciease the quantity supplied to
1,300,000 visits (Point F on S
1
). But consumeis-patients-pay only $10.
Insuieis make up the difeience between the fees doctois ieceive and the piice patients pay. In oui
example, insuieis pay $40 pei visit of insuied patients to supplement the $10 that patients pay. When
an agent othei than the sellei oi the buyei pays pait of the piice of a good oi seivice, we say that the
agent is a third-party payer.
Notice how the piesence of a thiid-paity payei afects total spending on omce visits. When people
paid foi theii own visits, and the piice equaled $30 pei visit, total spending equaled $30 million pei
week. Now doctois ieceive $30 pei visit and piovide 1,300,000 visits pei week. Total spending has iisen
to $73 million pei week ($30 times 1,300,000 visits, shown by the daikly shaded iegion plus the lightly
shaded iegion).
II GUR£ 4. 16 7otaI Spending for Physician Office Visits Covered by Insurance
\|t| |rsu..rce, t|e ,u.rt|ty c| p|ys|c|.r c|ce v|s|ts Jen.rJeJ .|ses tc 1,500,000. ¯|e supp|y cu.ve s|c.s t|.t |t
t.kes . p.|ce c| ´50 pe. v|s|t tc |rc.e.se t|e ,u.rt|ty supp||eJ tc 1,500,000 v|s|ts. |.t|erts p.y ´10 pe. v|s|t .rJ
|rsu..rce p.ys ´40 pe. v|s|t. ¯ct.| sperJ|rg .|ses tc ´5,000,000 pe. .eek, s|c.r by t|e J..k|y s|.JeJ .eg|cr p|us
t|e ||g|t|y s|.JeJ .eg|cr.
104 PRINCIPL£S OI £CONOMICS
The iesponse desciibed in Figuie 4.16 holds foi many difeient types of goods and seivices coveied by
insuiance oi otheiwise paid foi by thiid-paity payeis. Foi example, the availability of scholaiships and
subsidized tuition at public and piivate univeisities incieases the quantity of education demanded and
the total expendituies on highei education. In maikets with thiid-paity payeis, an equilibiium is
achieved, but it is not at the inteisection of the demand and supply cuives. The efect of thiid-paity
payeis is to deciease the piice that consumeis diiectly pay foi the goods and seivices they consume and
to inciease the piice that supplieis ieceive. Consumeis use moie than they would in the absence of
thiid-paity payeis, and piovideis aie encouiaged to supply moie than they otheiwise would. The iesult
is incieased total spending.
k £ Y 7 A k £ A W A Y S
< ¯|e .|s|rg s|..e c| t|e cutput c| t|e |r|teJ St.tes JevcteJ tc |e.|t| c..e .ep.eserts . .|s|rg cppc.tur|ty
ccst. Vc.e sperJ|rg cr |e.|t| c..e ne.rs |ess sperJ|rg cr ct|e. gccJs .rJ se.v|ces, ccnp..eJ tc .|.t
.cu|J |.ve t..rsp|.eJ |.J |e.|t|c..e sperJ|rg rct .|ser sc nuc|.
< ¯|e ncJe| c| Jen.rJ .rJ supp|y c.r be useJ tc s|c. t|e e|ect c| t||.Jp..ty p.ye.s cr tct.| sperJ|rg.
\|t| t||.Jp..ty p.ye.s (|c. ex.np|e, |e.|t| |rsu.e.s), t|e ,u.rt|ty c| se.v|ces ccrsuneJ .|ses, .s Jces
sperJ|rg.
7 R Y I 7 !
¯|e p.cv|s|cr c| ur|ve.s|ty eJuc.t|cr t|.cug| t.xp.ye.suppc.teJ st.te ur|ve.s|t|es |s .rct|e. ex.np|e c| .
n..ket .|t| . t||.Jp..ty p.ye.. |se t|e ncJe| c| Jen.rJ .rJ supp|y tc J|scuss t|e |np.ct t||s |.s cr t|e
||g|e. eJuc.t|cr n..ket. Spec||c.||y, J... . g..p| s|n||.. tc ||gu.e 4.16. |c. .cu|J ycu |.be| t|e .xes`
S|c. t|e e,u|||b.|un p.|ce .rJ ,u.rt|ty |r t|e .bserce c| . t||.Jp..ty p.ye. .rJ |rJ|c.te tct.| sperJ|rg cr
eJuc.t|cr. |c. s|c. t|e |np.ct c| |c.e. tu|t|cr As . .esu|t c| st.te suppc.t |c. eJuc.t|cr. |c. nuc| eJuc.
t|cr Jc stuJerts Jen.rJ .t t|e |c.e. tu|t|cr` |c. nuc| tu|t|cr nust eJuc.t|cr.| |rst|tut|crs .ece|ve tc p.c
Juce t|.t nuc| eJuc.t|cr` |c. nuc| sperJ|rg cr eJuc.t|cr .||| cccu.` ´cnp..e tct.| sperJ|rg be|c.e
.rJ .|te. . t||.Jp..ty p.ye. erte.s t||s n..ket.
Case in Point: 7he Oregon PIan
÷ 2010 jupiterimages Corporation
CHAP7£R 4 APPLICA7IONS OI D£MAND AND SUPPLY 105
¯|e |e.|t|c..e |rJust.y p.eserts us .|t| . J||enn.. ´|e..|y, |t n.kes serse |c. pecp|e tc |.ve |e.|t| |rsu.
.rce. 'ust .s c|e..|y, |e.|t| |rsu..rce gere..tes . subst.rt|.| |rc.e.se |r sperJ|rg |c. |e.|t| c..e. || t|.t
sperJ|rg |s tc be ||n|teJ, scne nec|.r|sn nust be c|cser tc Jc |t. Ore nec|.r|sn .cu|J be tc .e,u|.e p.
t|erts tc p.y . |..ge. s|..e c| t|e|. c.r |e.|t|c..e ccrsunpt|cr J|.ect|y, .eJuc|rg t|e p.ynerts n.Je by
t||.Jp..ty p.ye.s. A||c.|rg pecp|e tc .ccunu|.te t.x|.ee p.|v.te neJ|c.| s.v|rgs .cccurts |s cre ..y tc Jc
t||s. Arct|e. cpt|cr |s tc ccrt|rue t|e cu..ert t.erJ tc use |rsu..rce ccnp.r|es .s t|e .gerts t|.t ||n|t
sperJ|rg. A t||.J cpt|cr |s gcve.rnert .egu|.t|cr, t||s ´.se |r |c|rt Jesc.|bes |c. t|e st.te c| O.egcr t.|eJ
tc ||n|t |e.|t|c..e sperJ|rg by essert|.||y .e|us|rg tc be . t||.Jp..ty p.ye. |c. ce.t.|r se.v|ces.
||ke .|| ct|e. st.tes, O.egcr |.s ..est|eJ .|t| t|e p.cb|en c| sc..|rg VeJ|c.|J ccsts. |ts sc|ut|cr tc t|e p.cb
|en |||ust..tes scne c| t|e c|c|ces scc|ety n|g|t n.ke |r seek|rg tc .eJuce |e.|t|c..e ccsts.
O.egcr useJ tc |.ve . p|.r s|n||.. tc p|.rs |r n.ry ct|e. st.tes. |cuse|c|Js .|cse |rccnes .e.e |c.e. t|.r
50 c| t|e pcve.ty ||re ,u.|||eJ |c. VeJ|c.|J. |r 198, t|e st.te beg.r .r e|c.t tc n.r.ge |ts VeJ|c.|J ccsts.
|t Jec|JeJ t|.t |t .cu|J rc |crge. |urJ c.g.r t..rsp|.rts .rJ t|.t |t .cu|J use t|e ncrey s.veJ tc g|ve bet
te. c..e tc p.egr.rt .cner. ¯|e Jec|s|cr tu.reJ cut tc be . p.|r|u| cre, t|e |.st ye.., . severye..c|J bcy
.|t| |euken|., .|c n|g|t |.ve beer s.veJ .|t| . bcre n...c. t..rsp|.rt, J|eJ. but st.te c|c|.|s ..gueJ
t|.t t|e s|||t c| experJ|tu.es tc p.egr.rt .cner .cu|J u|t|n.te|y s.ve nc.e ||ves.
¯|e st.te g..Ju.||y exp.rJeJ |ts ccrcept c| Jete.n|r|rg .|.t se.v|ces tc |urJ .rJ .|.t se.v|ces rct tc |urJ.
|t cc||.pseJ . ||st c| 10,000 J||e.ert J|.grcses t|.t |.J beer subn|tteJ tc |ts VeJ|c.|J p.cg..n |r t|e p.st |r
tc . ||st c| nc.e t|.r 00 ccrJ|t|crt.e.tnert p.|.s. Ore suc| p.|., |c. ex.np|e, |s .pperJ|c|t|s
.pperJectcny. |e.|t|c..e c|c|.|s t|er ..rkeJ t|ese p.|.s |r c.Je. c| p.|c.|ty. ¯|e ..rk|rgs .e.e b.seJ cr
suc| |.ctc.s .s t|e se.|cusress c| . p..t|cu|.. ccrJ|t|cr .rJ t|e ccst .rJ e|c.cy c| t.e.tnerts. ¯|e st.te .r
rcurceJ t|.t |t .cu|J p.cv|Je VeJ|c.|J tc .|| |cuse|c|Js be|c. t|e pcve.ty ||re, but t|.t |t .cu|J rct |urJ
.ry p.cceJu.e ..rkeJ be|c. . ce.t.|r |eve|, |r|t|.||y runbe. 588 cr |ts ||st. ¯|e p|.r .|sc set . buJget ||n|t |c.
.ry cre ye.., || sperJ|rg .cse .bcve t|.t ||n|t, t|e |eg|s|.tu.e nust .pp.cp.|.te .JJ|t|cr.| ncrey c. J.cp .J
J|t|cr.| p.cceJu.es |.cn t|e ||st c| t|cse ccve.eJ by t|e p|.r. ¯|e O.egcr |e.|t| ||.r c|c|.||y beg.r cpe..
t|cr |r 1994.
\|||e t|e O.egcr p|.r |.s beer .pp||eJ cr|y tc |cuse|c|Js be|c. t|e pcve.ty ||re t|.t ..e rct ccve.eJ by
ct|e. p.cg..ns, |t suggests . ne.rs c| .eJuc|rg |e.|t|c..e sperJ|rg. ´|e..|y, || p..t c| t|e |e.|t|c..e p.cb
|en |s excess|ve p.cv|s|cr c| se.v|ces, . systen Jes|greJ tc cut se.v|ces nust Jete.n|re .|.t t.e.tnerts rct
tc |urJ.
|.c|essc.s 'cr.t|.r Obe.|.rJe., ¯|ecJc.e V..nc., .rJ |...erce '.ccbs stuJ|eJ t|e |np.ct c| t||s p|.r |r
p..ct|ce t|.cug| t|e ye.. 2000 .rJ |curJ t|.t, |r ccrt..st tc |r|t|.| expect.t|crs, exc|uJeJ p.cceJu.es .e.e
gere..||y cres c| n..g|r.| neJ|c.| v.|ue, sc t|e ´||re |r t|e s.rJ´ |.J ||tt|e p..ct|c.| s|gr||c.rce. |r .JJ|t|cr,
t|ey |curJ t|.t p.t|erts .e.e c|ter .b|e tc .ece|ve suppcseJ|y exc|uJeJ se.v|ces .|er p|ys|c|.rs, |c. ex
.np|e, t.e.teJ .r urccve.eJ |||ress |r ccr¦urct|cr .|t| . ccve.eJ cre. |u.|rg t|e pe.|cJ c| t|e stuJy, t|e
runbe. c| pecp|e ccve.eJ by t|e p|.r exp.rJeJ subst.rt|.||y .rJ yet ..t|cr|rg c| se.v|ces essert|.||y J|J rct
cccu.. |c. Jc t|ey exp|.|r t||s seen|rg ccrt..J|ct|cr` ¸u|te s|np|y. st.te gcve.rnert |rc.e.seJ .everues
|.cn v..|cus scu.ces tc suppc.t t|e p|.r. |rJeeJ, t|ey ..gue t|.t, bec.use t.e.tnerts t|.t n|g|t rct be |r
c|uJeJ .e.e exp||c|t|y st.teJ, pc||t|c.| p.essu.e n.Je exc|uJ|rg t|en ever nc.e J||cu|t .rJ n.y |.ve |r.J
ve.tert|y |rc.e.seJ t|e ccst c| t|e p.cg..n.
|r t|e e..|y 2000s, O.egcr, ||ke n.ry ct|e. st.tes, ccr|.crteJ seve.e buJget..y p.essu.es. ¯c ||n|t sperJ|rg, |t
c|cse t|e pe.|.ps |ess v|s|b|e st..tegy c| .eJuc|rg t|e runbe. c| pecp|e ccve.eJ t|.cug| t|e p|.r. Orce
se.v|rg nc.e t|.r 100,000 pecp|e, buJget cuts .eJuceJ t|e runbe. se.veJ tc .bcut 1,000. \|e.e.s |r 1996,
11 c| O.egcr|.rs |.ckeJ |e.|t| |rsu..rce, |r 2008 16 J|J.
¯..||b|..|rg .g.|r, |r 2008 O.egcr .e.||.eJ t|.t |ts buJget .||c.eJ .ccn |c. ccve..ge |c. . |e. t|cus.rJ .JJ|
t|cr.| pecp|e. but |c. tc c|ccse .ncrg t|e 130,000 e||g|b|es` ¯|e sc|ut|cr. tc |c|J . |ctte.y. Vc.e t|.r
90,000 pecp|e ,ueueJ up, |cp|rg tc be |ucky .|rre.s.
.oo·ce· .o·o||o· ´·e·|o·Je·. ¯|eoJo·e /o··o·. o·J |o.·e·ce .oco··. |o||o·|·¸ /eJ|co| ´o·e ||e|o·|c o·J |eo|||, |· ||e ´·e¸o· |eo||| ||o·.'
´o·oJ|o· /eJ|co| ^··oc|o||o· .oo··o| ¹64 ¹¹ (/o, 29. 200¹: ¹5S3¹5S.. /||||o·`o·J|e,. |·o.|·¸ |o|· |o· |eo||| ´o·e.' ¯|e |e.`o·| ¯|·e·. /o·c|
¹3. 200S ¡ ^¹2
106 PRINCIPL£S OI £CONOMICS
A N S W £ R 7 O 7 R Y I 7 ! P R O 8 L £ M
\|t|cut . t||.Jp..ty p.ye. |c. eJuc.t|cr, t|e g..p| s|c.s e,u|||b.|un tu|t|cr c| |
1
.rJ e,u|||b.|un ,u.rt|ty
c| eJuc.t|cr c| (
1
. St.te suppc.t |c. eJuc.t|cr |c.e.s tu|t|cr t|.t stuJerts p.y tc |
2
. As . .esu|t, stuJerts Je
n.rJ (
2
ccu.ses pe. ye... ¯c p.cv|Je t|.t .ncurt c| eJuc.t|cr, eJuc.t|cr.| |rst|tut|crs .e,u|.e tu|t|cr pe.
ccu.se c| |
3
. \|t|cut . t||.Jp..ty p.ye., sperJ|rg cr eJuc.t|cr |s 0|
1
|(
1
. \|t| . t||.Jp..ty p.ye., sperJ|rg
.|ses tc 0|
3
|(
2
.
4. REVIEW AND PRACTICE
Summary
|r t||s c|.pte. .e useJ t|e tcc|s c| Jen.rJ .rJ supp|y tc urJe.st.rJ . .|Je v..|ety c| n..ket cutccnes. \e
|e..reJ t|.t tec|rc|cg|c.| c|.rge .rJ t|e ert.y c| re. se||e.s |.s c.useJ t|e supp|y cu.ve c| pe.scr.| ccn
pute.s tc s|||t n..keJ|y tc t|e .|g|t, t|e.eby .eJuc|rg e,u|||b.|un p.|ce .rJ |rc.e.s|rg e,u|||b.|un ,u.rt|ty.
V..ket |c.ces |.ve n.Je pe.scr.| ccnpute.s . ccnncr |ten |r c|ces .rJ |cnes.
´.uJe c|| .rJ g.sc||re p.|ces sc..eJ |r 2008 .rJ t|er |e|| b.ck. \e |cckeJ .t t|e c.uses c| t|ese |rc.e.ses .s
.e|| .s t|e|. |np.cts. ´.uJe c|| p.|ces .cse |r |..ge p..t As . .esu|t c| |rc.e.seJ Jen.rJ, p..t|cu|..|y |.cn ´|
|r.. ||g|e. p.|ces |c. c.uJe c|| |eJ tc ||g|e. p.|ces |c. g.sc||re. ¯|cse ||g|e. p.|ces rct cr|y |u.t ccrsune.s c|
g.sc||re, t|ey .|sc put up...J p.essu.e cr t|e p.|ces c| . .|Je ..rge c| gccJs .rJ se.v|ces. ´.uJe c|| .rJ
g.sc||re p.|ces t|er Jec.e.seJ J..n.t|c.||y |r t|e |.st p..t c| 2008, .s .c.|J g.c.t| Jec||reJ.
¯|e ncJe| c| Jen.rJ .rJ supp|y .|sc exp|.|rs t|e Jete.n|r.t|cr c| stcck p.|ces. ¯|e p.|ce pe. s|..e c| cc.
pc..te stcck .e|ects t|e n..kets est|n.te c| t|e expecteJ p.c|t.b|||ty c| t|e |.n. Ary |r|c.n.t|cr .bcut t|e
|.n t|.t c.uses pctert|.| buye.s c. cu..ert c.re.s c| cc.pc..te stcck tc .eev.|u.te |c. p.c|t.b|e t|ey t||rk
t|e |.n |s, c. .||| be, .||| c.use t|e e,u|||b.|un p.|ce c| t|e stcck tc c|.rge.
\e t|er ex.n|reJ n..kets |r .||c| scne |c.n c| gcve.rnert p.|ce ccrt.c| keeps p.|ce pe.n.rert|y .bcve
c. be|c. e,u|||b.|un. A p.|ce |cc. |e.Js tc pe.s|stert su.p|uses bec.use |t |s set .bcve t|e e,u|||b.|un p.|ce,
.|e.e.s . p.|ce ce|||rg, bec.use |t |s set be|c. t|e e,u|||b.|un p.|ce, |e.Js tc pe.s|stert s|c.t.ges. \e s..
t|.t |rte.|e.|rg .|t| t|e n..ket nec|.r|sn n.y sc|ve cre p.cb|en but c|ter c.e.tes ct|e. p.cb|ens .t t|e
s.ne t|ne. \e J|scusseJ .|.t scne c| t|ese ur|rterJeJ ccrse,uerces n|g|t be. |c. ex.np|e, .g.|cu|tu..|
p.|ce |cc.s .|neJ .t bccst|rg |..n |rccne |.ve .|sc ..|seJ p.|ces |c. ccrsune.s .rJ ccst t.xp.ye.s Je..|y,
.rJ t|e bu|k c| gcve.rnert p.ynerts |.ve gcre tc |..ge |..ns. |ert ccrt.c|s |.ve |c.e.eJ .erts, but t|ey
|.ve .|sc .eJuceJ t|e ,u.rt|ty c| .ert.| |cus|rg supp||eJ, c.e.teJ s|c.t.ges, .rJ scnet|nes |eJ tc v..|cus
|c.ns c| ´b.ckJcc.´ p.ynerts, .||c| scnet|nes |c.ce t|e p.|ce c| .ert.| |cus|rg .bcve .|.t .cu|J ex|st |r
t|e .bserce c| ccrt.c|s.
||r.||y, .e |cckeJ .t t|e n..ket |c. |e.|t| c..e .rJ . spec|.| |e.tu.e be||rJ Jen.rJ .rJ supp|y |r t||s n..ket
t|.t |e|ps tc exp|.|r .|y t|e s|..e c| cutput c| t|e |r|teJ St.tes t|.t |s JevcteJ tc |e.|t| c..e |.s .|ser.
|e.|t| c..e |s .r ex.np|e c| . n..ket |r .||c| t|e.e ..e t||.Jp..ty p.ye.s (p.|n..||y p.|v.te |rsu.e.s .rJ t|e
gcve.rnert). \|t| t||.Jp..ty p.ye.s t|e ,u.rt|ty c| |e.|t|c..e se.v|ces ccrsuneJ .|ses, .s Jces |e.|t|c..e
sperJ|rg.
CHAP7£R 4 APPLICA7IONS OI D£MAND AND SUPPLY 107
C O N C £ P 7 P R O 8 L £ M S
1. ||ke pe.scr.| ccnpute.s, J|g|t.| c.ne..s |.ve beccne . ccnncr |cuse|c|J |ten. ||g|t.| c.ne.. p.|ces
|.ve p|urgeJ |r t|e |.st 10 ye..s. |se t|e ncJe| c| Jen.rJ .rJ supp|y tc exp|.|r t|e |.|| |r p.|ce .rJ
|rc.e.se |r ,u.rt|ty.
2. |r.cr ´c.p. ..s cre c| seve..| cc.pc..t|crs ccrv|cteJ c| |..uJ |r |ts .cccurt|rg p..ct|ces Ju.|rg t|e e..|y
p..t c| t||s Jec.Je. |t |.J c.e.teJ Junny cc.pc..t|crs tc ||Je n.ss|ve bc..c.|rg .rJ tc g|ve |t t|e
.ppe...rce c| ext..c.J|r..y p.c|t.b|||ty. |se t|e ncJe| c| Jen.rJ .rJ supp|y tc exp|.|r t|e ||ke|y
|np.ct c| suc| ccrv|ct|crs cr t|e stccks c| ct|e. cc.pc..t|crs.
3. |u.|rg \c.|J \.. || t|e.e ..s . |.ee.e cr ..ges, .rJ cc.pc..t|crs |curJ t|ey ccu|J ev.Je t|e |.ee.e by
p.cv|J|rg ct|e. |.|rge bere|ts suc| .s .et|.enert |urJs |c. t|e|. enp|cyees. ¯|e O|ce c| |.|ce
AJn|r|st..t|cr, .||c| .Jn|r|ste.eJ t|e ..ge |.ee.e, .u|eJ t|.t t|e c|e. c| .et|.enert |urJs ..s rct .
v|c|.t|cr c| t|e |.ee.e. ¯|e |rte.r.| |everue Se.v|ce .ert .|crg .|t| t||s .rJ .u|eJ t|.t enp|cye.
|r.rceJ .et|.enert p|.rs .e.e rct t.x.b|e |rccne. \.s t|e ..ge |.ee.e .r ex.np|e c| . p.|ce |cc. c. .
p.|ce ce|||rg` |se t|e ncJe| c| Jen.rJ .rJ supp|y tc exp|.|r .|y enp|cye.s beg.r tc c|e. suc|
bere|ts tc t|e|. enp|cyees.
4. ¯|e text ..gues t|.t pc||t|c.| |rst.b|||ty |r pctert|.| supp||e.s c| c|| suc| .s |.., .rJ \ere.ue|. .cccurts |c.
. .e|.t|ve|y steep supp|y cu.ve |c. c.uJe c|| suc| .s t|e cre s|c.r |r ||gu.e 4.2 Suppcse t|.t t||s
|rst.b|||ty e.ses ccrs|Je..b|y .rJ t|.t t|e .c.|J supp|y cu.ve |c. c.uJe c|| beccnes nuc| |.tte.. |...
suc| . cu.ve, .rJ exp|.|r |ts |np||c.t|crs |c. t|e .c.|J eccrcny .rJ |c. typ|c.| ccrsune.s.
5. Suppcse t|.t tec|rc|cg|c.| c|.rge .|ects t|e J.|.y |rJust.y |r t|e s.ne ..y |t |.s .|ecteJ t|e
ccnpute. |rJust.y. |c.eve., suppcse t|.t J.|.y p.|ce suppc.ts .en.|r |r p|.ce. |c. .cu|J t||s .|ect
gcve.rnert sperJ|rg cr t|e J.|.y p.cg..n` |se t|e ncJe| c| Jen.rJ .rJ supp|y tc suppc.t ycu.
.rs.e..
6. |ecp|e c|ter ..gue t|.t t|e.e |s . ´s|c.t.ge´ c| c|||J c..e. |s|rg t|e ncJe| c| Jen.rJ .rJ supp|y,
ev.|u.te .|et|e. t||s ..gunert |s ||ke|y tc be cc..ect.
. ´|u.|rg ncst c| t|e p.st 50 ye..s t|e |r|teJ St.tes |.s |.J . su.p|us c| |..ne.s, .rJ t||s |.s beer t|e
.cct c| t|e |..n p.cb|en.´ ´cnnert.
8. Suppcse t|e |ep..tnert c| Ag.|cu|tu.e c.Je.eJ .|| |..ne.s tc .eJuce t|e .c.e.ge t|ey p|.rt by 10.
\cu|J ycu expect . 10 .eJuct|cr |r |ccJ p.cJuct|cr` \|y c. .|y rct`
9. ¯|e text ..gues t|.t t|e |rc.e.se |r g.sc||re p.|ces |.J . p..t|cu|..|y st.crg |np.ct cr |c.|rccne
pecp|e. |.ne scne ct|e. gccJs .rJ se.v|ces |c. .||c| . s|..p |rc.e.se |r p.|ce .cu|J |.ve . s|n||..
|np.ct cr pecp|e .|t| |c. |rccnes.
10. Suppcse t|.t t|e |r|teJ St.tes .rJ t|e |u.cpe.r |r|cr |npcse . p.|ce ce|||rg cr c.uJe c|| c| ´25 pe.
b...e|. |xp|.|r, .rJ |||ust..te g..p||c.||y, |c. t||s .cu|J .|ect t|e n..kets |c. c.uJe c|| .rJ |c. g.sc||re |r
t|e |r|teJ St.tes .rJ |r t|e |u.cpe.r |r|cr.
11. C|ver t|.t .ert ccrt.c|s c.r .ctu.||y |u.t |c.|rccne pecp|e, Jev|se . |cus|rg st..tegy t|.t .cu|J
p.cv|Je .|c.J.b|e |cus|rg |c. t|cse .|cse |rccnes |.|| be|c. t|e pcve.ty ||re (|r 2004, t||s ..s .bcut
´19,000 |c. . |.n||y c| |cu.).
12. |s|rg t|e ncJe| c| Jen.rJ .rJ supp|y, s|c. .rJ exp|.|r |c. .r |rc.e.se |r t|e s|..e |rJ|v|Ju.|s nust
p.y J|.ect|y |c. neJ|c.| c..e .|ects t|e ,u.rt|ty t|ey ccrsune. |xp|.|r |c. t||s .cu|J .JJ.ess t|e tct.|
.ncurt c| sperJ|rg cr |e.|t| c..e.
13. C|ver t|.t pecp|e p.y p.en|uns |c. t|e|. |e.|t| |rsu..rce, |c. c.r .e s.y t|.t |rsu..rce |c.e.s t|e
p.|ces pecp|e p.y |c. |e.|t|c..e se.v|ces`
14. Suppcse t|.t p|ys|c|.rs rc. c|..ge ´30 |c. .r c|ce v|s|t .rJ |rsu..rce pc||c|es .e,u|.e p.t|erts tc p.y
33 1/3 c| t|e .ncurt t|ey p.y t|e p|ys|c|.rs, sc t|e cutc|pccket ccst tc ccrsune.s |s ´10 pe. v|s|t. |r
.r e|c.t tc ccrt.c| ccsts, t|e gcve.rnert |npcses . p.|ce ce|||rg c| ´2 pe. c|ce v|s|t. |s|rg . Jen.rJ
.rJ supp|y ncJe|, s|c. |c. t||s pc||cy .cu|J .|ect t|e n..ket |c. |e.|t| c..e.
15. |c ycu t||rk t|e |.S. |e.|t|c..e systen .e,u|.es .e|c.n` \|y c. .|y rct` || ycu t||rk .e|c.n |s |r c.Je.,
exp|.|r t|e .pp.c.c| tc .e|c.n ycu .Jvcc.te.
108 PRINCIPL£S OI £CONOMICS
N U M £ R I C A L P R O 8 L £ M S
|.cb|ens 14 ..e b.seJ cr t|e |c||c.|rg Jen.rJ .rJ supp|y sc|eJu|es |c. cc.r (.|| ,u.rt|t|es ..e |r n||||crs
c| bus|e|s pe. ye..).
Price per busheI Quantity demanded Quantity suppIied
´0 6 0
1 5 1
2 4 2
3 3 3
4 2 4
5 1 5
6 0 6
1. |... t|e Jen.rJ .rJ supp|y cu.ves |c. cc.r. \|.t |s t|e e,u|||b.|un p.|ce` ¯|e e,u|||b.|un ,u.rt|ty`
2. Suppcse t|e gcve.rnert rc. |npcses . p.|ce |cc. .t ´4 pe. bus|e|. S|c. t|e e|ect c| t||s p.cg..n
g..p||c.||y. |c. |..ge |s t|e su.p|us c| cc.r`
3. \|t| t|e p.|ce |cc., |c. nuc| Jc |..ne.s .ece|ve |c. t|e|. cc.r` |c. nuc| .cu|J t|ey |.ve .ece|veJ ||
t|e.e .e.e rc p.|ce |cc.`
4. || t|e gcve.rnert buys .|| t|e su.p|us .|e.t, |c. nuc| .||| |t sperJ`
|.cb|ens 59 ..e b.seJ cr t|e |c||c.|rg |ypct|et|c.| Jen.rJ .rJ supp|y cu.ves |c. .p..tnerts
Rent/Month Number of Apts.
Demanded/Month
Number of Apts.
SuppIied/Month
´0 120,000 0
200 100,000 20,000
400 80,000 40,000
600 60,000 60,000
800 40,000 80,000
1000 20,000 100,000
1200 0 120,000
5. |... t|e Jen.rJ .rJ supp|y cu.ves |c. .p..tnerts.
6. \|.t |s t|e e,u|||b.|un .ert pe. ncrt|` At t||s .ert, .|.t |s t|e runbe. c| .p..tnerts Jen.rJeJ .rJ
supp||eJ pe. ncrt|`
. Suppcse . ce|||rg cr .erts |s set .t ´400 pe. ncrt|. ´|...cte.|.e t|e s|tu.t|cr t|.t .esu|ts |.cn t||s pc||cy.
8. At t|e .ert ce|||rg, |c. n.ry .p..tnerts ..e Jen.rJeJ` |c. n.ry ..e supp||eJ`
9. |c. nuc| ..e pecp|e .||||rg tc p.y |c. t|e runbe. c| .p..tnerts supp||eJ .t t|e ce|||rg` |esc.|be t|e
....rgenerts tc .||c| t||s s|tu.t|cr n|g|t |e.J.
CHAP7£R 4 APPLICA7IONS OI D£MAND AND SUPPLY 109
1.
2.
ENDNOTES
||kk. ¯ucn|, ´¯|e ||ves .rJ |e.t| c| Vcc.es |...´ |ttp.//....|.stncrJ.y.c.g/
|ssues/|ssue_11/tucn|/|rJex. ||··| /o·Jo, (|ttp.//....|.stncrJ.y.c.g) |s . pee.
.ev|e.eJ ¦cu.r.| cr t|e |rte.ret.
||c|..J A.rctt, ´¯|ne |c. |ev|s|cr|sn cr |ert ´crt.c|,´ .oo··o| o| |co·o·|c |e··¡ec|
|.e· 9(1) (\|rte., 1995). 99120.
110 PRINCIPL£S OI £CONOMICS
eIasticity
¯|e ..t|c c| t|e pe.cert.ge
c|.rge |r . JeperJert
v..|.b|e tc . pe.cert.ge
c|.rge |r .r |rJeperJert
v..|.b|e.
´ | A | ¯ | | 5
Elasticity: A Measure of
Response
S7AR7 UP: RAIS£ IAR£S1 LOW£R IAR£S1 WHA7'S A
PU8LIC 7RANSI7 MANAG£R 7O DO1
|n.g|re t|.t ycu ..e t|e n.r.ge. c| t|e pub||c t..rspc.t.t|cr systen |c. . |..ge net.cpc||t.r ..e.. Ope..t|rg
ccsts |c. t|e systen |.ve sc..eJ |r t|e |.st |e. ye..s, .rJ ycu ..e urJe. p.essu.e tc bccst .everues. \|.t Jc ycu
Jc`
Ar cbv|cus c|c|ce .cu|J be tc ..|se |..es. ¯|.t .||| n.ke ycu. custcne.s .rg.y, but .t |e.st |t .||| gere..te t|e
ext.. .everue ycu reeJc. .||| |t` ¯|e |.. c| Jen.rJ s.ys t|.t ..|s|rg |..es .||| .eJuce t|e runbe. c| p.sserge.s
.|J|rg cr ycu. systen. || t|e runbe. c| p.sserge.s |.||s cr|y . ||tt|e, t|er t|e ||g|e. |..es t|.t ycu. .en.|r|rg p.s
serge.s ..e p.y|rg n|g|t p.cJuce t|e ||g|e. .everues ycu reeJ. but .|.t || t|e runbe. c| p.sserge.s |.||s by sc
nuc| t|.t ycu. ||g|e. |..es .ctu.||y .eJuce ycu. .everues` || t|.t |.ppers, ycu .||| |.ve n.Je ycu. custcne.s
n.J .rJ ycu. |r.rc|.| p.cb|en .c.se!
V.ybe ycu s|cu|J .eccnnerJ |o.e· |..es. A|te. .||, t|e |.. c| Jen.rJ .|sc s.ys t|.t |c.e. |..es .||| |rc.e.se
t|e runbe. c| p.sserge.s. |.v|rg nc.e pecp|e use t|e pub||c t..rspc.t.t|cr systen ccu|J nc.e t|.r c|set .
|c.e. |..e ycu cc||ect |.cn e.c| pe.scr. but |t n|g|t rct. \|.t .||| ycu Jc`
+cu. ¦cb .rJ t|e |sc.| |e.|t| c| t|e pub||c t..rs|t systen ..e .|J|rg cr ycu. n.k|rg t|e cc..ect Jec|s|cr. ¯c Jc
sc, ycu reeJ tc krc. ¦ust |c. .espcrs|ve t|e ,u.rt|ty Jen.rJeJ |s tc . p.|ce c|.rge. +cu reeJ . ne.su.e c|
.espcrs|veress.
|ccrcn|sts use . ne.su.e c| .espcrs|veress c.||eJ e|.st|c|ty. £Iasticity |s t|e ..t|c c| t|e pe.cert.ge c|.rge
|r . JeperJert v..|.b|e tc . pe.cert.ge c|.rge |r .r |rJeperJert v..|.b|e. || t|e JeperJert v..|.b|e |s ,, .rJ t|e
|rJeperJert v..|.b|e |s , t|er t|e e|.st|c|ty c| , .|t| .espect tc . c|.rge |r |s g|ver by.
e
y, x
=
° change in y
° change in x
A v..|.b|e suc| .s , |s s.|J tc be nc.e e|.st|c (.espcrs|ve) || t|e pe.cert.ge c|.rge |r , |s |..ge .e|.t|ve tc t|e
pe.cert.ge c|.rge |r . |t |s |ess e|.st|c || t|e .eve.se |s t.ue.
As n.r.ge. c| t|e pub||c t..rs|t systen, |c. ex.np|e, ycu .||| ..rt tc krc. |c. .espcrs|ve t|e runbe. c|
p.sserge.s cr ycu. systen (t|e JeperJert v..|.b|e) .||| be tc . c|.rge |r |..es (t|e |rJeperJert v..|.b|e). ¯|e
ccrcept c| e|.st|c|ty .||| |e|p ycu sc|ve ycu. pub||c t..rs|t p.|c|rg p.cb|en .rJ . g.e.t n.ry ct|e. |ssues |r ecc
rcn|cs. \e .||| ex.n|re seve..| e|.st|c|t|es |r t||s c|.pte..|| .||| te|| us |c. .espcrs|ve cre v..|.b|e |s tc .
c|.rge |r .rct|e..
price eIasticity of demand
¯|e pe.cert.ge c|.rge |r
,u.rt|ty Jen.rJeJ c| .
p..t|cu|.. gccJ c. se.v|ce
J|v|JeJ by t|e pe.cert.ge
c|.rge |r t|e p.|ce c| t|.t
gccJ c. se.v|ce, .|| ct|e.
t||rgs urc|.rgeJ.
1. THE PRICE ELASTICITY OF DEMAND
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. £xpIain the concept of price eIasticity of demand and its caIcuIation.
2. £xpIain what it means for demand to be price ineIastic, unit price eIastic, price eIastic, perfectIy
price ineIastic, and perfectIy price eIastic.
3. £xpIain how and why the vaIue of the price eIasticity of demand changes aIong a Iinear de-
mand curve.
4. Understand the reIationship between totaI revenue and price eIasticity of demand.
5. Discuss the determinants of price eIasticity of demand.
We know fiom the law of demand how the quantity demanded will iespond to a piice change: it will
change in the opposite diiection. But how much will it change: It seems ieasonable to expect, foi ex-
ample, that a 10° change in the piice chaiged foi a visit to the doctoi would yield a difeient peicent-
age change in quantity demanded than a 10° change in the piice of a Foid Mustang. But how much is
this difeience:
To show how iesponsive quantity demanded is to a change in piice, we apply the concept of elasti-
city. The price elasticity of demand foi a good oi seivice, e
D
, is the peicentage change in quantity
demanded of a paiticulai good oi seivice divided by the peicentage change in the piice of that good oi
seivice, all othei things unchanged. Thus we can wiite
£QUA7I ON 5. 2
e
D
=
° change in quantity demanded
° change in piice
Because the piice elasticity of demand shows the iesponsiveness of quantity demanded to a piice
change, assuming that othei factois that infuence demand aie unchanged, it iefects movements along
a demand cuive. With a downwaid-sloping demand cuive, piice and quantity demanded move in op-
posite diiections, so the piice elasticity of demand is always negative. A positive peicentage change in
piice implies a negative peicentage change in quantity demanded, and vice veisa. Sometimes you will
see the absolute value of the piice elasticity measuie iepoited. In essence, the minus sign is ignoied be-
cause it is expected that theie will be a negative (inveise) ielationship between quantity demanded and
piice. In this text, howevei, we will ietain the minus sign in iepoiting piice elasticity of demand and
will say ¨the absolute value of the piice elasticity of demand" when that is what we aie desciibing.
Heads Up!
be c..e|u| rct tc ccr|use e|.st|c|ty .|t| s|cpe. ¯|e s|cpe c| . ||re |s t|e c|.rge |r t|e v.|ue c| t|e v..|.b|e cr
t|e ve.t|c.| .x|s J|v|JeJ by t|e c|.rge |r t|e v.|ue c| t|e v..|.b|e cr t|e |c.|.crt.| .x|s bet.eer t.c pc|rts.
||.st|c|ty |s t|e ..t|c c| t|e pe.cert.ge c|.rges. ¯|e s|cpe c| . Jen.rJ cu.ve, |c. ex.np|e, |s t|e ..t|c c| t|e
c|.rge |r p.|ce tc t|e c|.rge |r ,u.rt|ty bet.eer t.c pc|rts cr t|e cu.ve. ¯|e p.|ce e|.st|c|ty c| Jen.rJ |s
t|e ..t|c c| t|e pe.cert.ge c|.rge |r ,u.rt|ty tc t|e pe.cert.ge c|.rge |r p.|ce. As .e .||| see, .|er ccn
put|rg e|.st|c|ty .t J||e.ert pc|rts cr . ||re.. Jen.rJ cu.ve, t|e s|cpe |s ccrst.rtt|.t |s, |t Jces rct
c|.rgebut t|e v.|ue |c. e|.st|c|ty .||| c|.rge.
1.1 Computing the Piice Elasticity of Demand
Finding the piice elasticity of demand iequiies that we fist compute peicentage changes in piice and
in quantity demanded. We calculate those changes between two points on a demand cuive.
Figuie 3.1 shows a paiticulai demand cuive, a lineai demand cuive foi public tiansit iides. Sup-
pose the initial piice is $0.80, and the quantity demanded is 40,000 iides pei day; we aie at point A on
the cuive. Now suppose the piice falls to $0.70, and we want to iepoit the iesponsiveness of the quant-
ity demanded. We see that at the new piice, the quantity demanded iises to 60,000 iides pei day (point
B). To compute the elasticity, we need to compute the peicentage changes in piice and in quantity de-
manded between points A and B.
112 PRINCIPL£S OI £CONOMICS
arc eIasticity
Ve.su.e c| e|.st|c|ty b.seJ
cr pe.cert.ge c|.rges
.e|.t|ve tc t|e .ve..ge v.|ue
c| e.c| v..|.b|e bet.eer t.c
pc|rts.
II GUR£ 5. 1 Responsiveness and Demand
¯|e Jen.rJ cu.ve s|c.s |c. c|.rges |r p.|ce |e.J tc c|.rges |r t|e ,u.rt|ty Jen.rJeJ. A ncvenert |.cn
pc|rt A tc pc|rt b s|c.s t|.t . ´0.10 .eJuct|cr |r p.|ce |rc.e.ses t|e runbe. c| .|Jes pe. J.y by 20,000. A
ncvenert |.cn b tc A |s . ´0.10 |rc.e.se |r p.|ce, .||c| .eJuces ,u.rt|ty Jen.rJeJ by 20,000 .|Jes pe. J.y.
We measuie the peicentage change between two points as the change in the vaiiable divided by the av-
erage value of the vaiiable between the two points. Thus, the peicentage change in quantity between
points A and B in Figuie 3.1 is computed ielative to the average of the quantity values at points A and
B: (60,000 + 40,000)/2 = 30,000. The peicentage change in quantity, then, is 20,000/30,000, oi 40°.
Likewise, the peicentage change in piice between points A and B is based on the average of the two
piices: ($0.80+$0.70)/2=$0.73, and so we have a peicentage change of ÷0.10/0.73, oi ÷13.33°. The
piice elasticity of demand between points A and B is thus 40°/(÷13.33°)=÷3.00.
This measuie of elasticity, which is based on peicentage changes ielative to the aveiage value of
each vaiiable between two points, is called arc elasticity. The aic elasticity method has the advantage
that it yields the same elasticity whethei we go fiom point A to point B oi fiom point B to point A. It is
the method we shall use to compute elasticity.
Foi the aic elasticity method, we calculate the piice elasticity of demand using the aveiage value of
piice,
¯
P, and the aveiage value of quantity demanded,
¯
Q. We shall use the Gieek lettei A to mean
¨change in," so the change in quantity between two points is AQ and the change in piice is AP. Now we
can wiite the foimula foi the piice elasticity of demand as
£QUA7I ON 5. 3
e
D
=
AQ
/
¯
Q
AP
/
¯
P
The piice elasticity of demand between points A and B is thus:
e
D
=
20,000
(40,000 + 60,000)/2
-$0.10
($0.80 + $0.70)/2
=
40°
-13.33°
= -3.00
With the aic elasticity foimula, the elasticity is the same whethei we move fiom point A to point B oi
fiom point B to point A. If we stait at point B and move to point A, we have:
e
D
=
-20,000
(60,000 + 40,000)/2
0.10
($0.70 + $0.80)/2
=
-40°
13.33°
= -3.00
The aic elasticity method gives us an estimate of elasticity. It gives the value of elasticity at the mid-
point ovei a iange of change, such as the movement between points A and B. Foi a piecise
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 113
computation of elasticity, we would need to considei the iesponse of a dependent vaiiable to an ex-
tiemely small change in an independent vaiiable. The fact that aic elasticities aie appioximate suggests
an impoitant piactical iule in calculating aic elasticities: we should considei only small changes in in-
dependent vaiiables. We cannot apply the concept of aic elasticity to laige changes.
Anothei aigument foi consideiing only small changes in computing piice elasticities of demand
will become evident in the next section. We will investigate what happens to piice elasticities as we
move fiom one point to anothei along a lineai demand cuive.
Heads Up!
|ct|ce t|.t |r t|e ..c e|.st|c|ty |c.nu|., t|e net|cJ |c. ccnput|rg . pe.cert.ge c|.rge J||e.s |.cn t|e
st.rJ..J net|cJ .|t| .||c| ycu n.y be |.n|||... ¯|.t net|cJ ne.su.es t|e pe.cert.ge c|.rge |r . v..|.b|e
.e|.t|ve tc |ts c.|g|r.| v.|ue. |c. ex.np|e, us|rg t|e st.rJ..J net|cJ, .|er .e gc |.cn pc|rt A tc pc|rt b, .e
.cu|J ccnpute t|e pe.cert.ge c|.rge |r ,u.rt|ty .s 20,000/40,00050. ¯|e pe.cert.ge c|.rge |r p.|ce
.cu|J be ´0.10/´0.8012.5. ¯|e p.|ce e|.st|c|ty c| Jen.rJ .cu|J t|er be 50/(12.5)4.00. Cc|rg
|.cn pc|rt b tc pc|rt A, |c.eve., .cu|J y|e|J . J||e.ert e|.st|c|ty. ¯|e pe.cert.ge c|.rge |r ,u.rt|ty .cu|J
be 20,000/60,000, c. 33.33. ¯|e pe.cert.ge c|.rge |r p.|ce .cu|J be ´0.10/´0.014.29. ¯|e p.|ce
e|.st|c|ty c| Jen.rJ .cu|J t|us be 33.33/14.292.33. by us|rg t|e .ve..ge ,u.rt|ty .rJ .ve..ge p.|ce
tc c.|cu|.te pe.cert.ge c|.rges, t|e ..c e|.st|c|ty .pp.c.c| .vc|Js t|e recess|ty tc spec||y t|e J|.ect|cr c|
t|e c|.rge .rJ, t|e.eby, g|ves us t|e s.ne .rs.e. .|et|e. .e gc |.cn A tc b c. |.cn b tc A.
1.2 Piice Elasticities Along a Lineai Demand Cuive
What happens to the piice elasticity of demand when we tiavel along the demand cuive: The answei
depends on the natuie of the demand cuive itself. On a lineai demand cuive, such as the one in Figuie
3.2, elasticity becomes smallei (in absolute value) as we tiavel downwaid and to the iight.
II GUR£ 5. 2 Price £Iasticities of Demand for a Linear Demand Curve
¯|e p.|ce e|.st|c|ty c| Jen.rJ v..|es bet.eer J||e.ert p.|.s c| pc|rts .|crg . ||re.. Jen.rJ cu.ve. ¯|e |c.e. t|e p.|ce .rJ t|e g.e.te. t|e ,u.rt|ty
Jen.rJeJ, t|e |c.e. t|e .bsc|ute v.|ue c| t|e p.|ce e|.st|c|ty c| Jen.rJ.
Figuie 3.2 shows the same demand cuive we saw in Figuie 3.1. We have alieady calculated the piice
elasticity of demand between points A and B; it equals ÷3.00. Notice, howevei, that when we use the
same method to compute the piice elasticity of demand between othei sets of points, oui answei vaiies.
Foi each of the paiis of points shown, the changes in piice and quantity demanded aie the same (a
$0.10 deciease in piice and 20,000 additional iides pei day, iespectively). But at the high piices and low
quantities on the uppei pait of the demand cuive, the peicentage change in quantity is ielatively laige,
wheieas the peicentage change in piice is ielatively small. The absolute value of the piice elasticity of
demand is thus ielatively laige. As we move down the demand cuive, equal changes in quantity iepies-
ent smallei and smallei peicentage changes, wheieas equal changes in piice iepiesent laigei and laigei
peicentage changes, and the absolute value of the elasticity measuie declines. Between points C and D,
114 PRINCIPL£S OI £CONOMICS
totaI revenue
A |.ns cutput nu|t|p||eJ by
t|e p.|ce .t .||c| |t se||s t|.t
cutput.
foi example, the piice elasticity of demand is ÷1.00, and between points E and F the piice elasticity of
demand is ÷0.33.
On a lineai demand cuive, the piice elasticity of demand vaiies depending on the inteival ovei
which we aie measuiing it. Foi any lineai demand cuive, the absolute value of the piice elasticity of de-
mand will fall as we move down and to the iight along the cuive.
1.3 The Piice Elasticity of Demand and Changes in Total Revenue
Suppose the public tiansit authoiity is consideiing iaising faies. Will its total ievenues go up oi down:
Total revenue is the piice pei unit times the numbei of units sold.
[1]
In this case, it is the faie times
the numbei of iideis. The tiansit authoiity will ceitainly want to know whethei a piice inciease will
cause its total ievenue to iise oi fall. In fact, deteimining the impact of a piice change on total ievenue
is ciucial to the analysis of many pioblems in economics.
We will do two quick calculations befoie geneializing the piinciple involved. Given the demand
cuive shown in Figuie 3.2, we see that at a piice of $0.80, the tiansit authoiity will sell 40,000 iides pei
day. Total ievenue would be $32,000 pei day ($0.80 times 40,000). If the piice weie loweied by $0.10 to
$0.70, quantity demanded would inciease to 60,000 iides and total ievenue would inciease to $42,000
($0.70 times 60,000). The ieduction in faie increases total ievenue. Howevei, if the initial piice had
been $0.30 and the tiansit authoiity ieduced it by $0.10 to $0.20, total ievenue would decrease fiom
$42,000 ($0.30 times 140,000) to $32,000 ($0.20 times 160,000). So it appeais that the impact of a piice
change on total ievenue depends on the initial piice and, by implication, the oiiginal elasticity. We
geneialize this point in the iemaindei of this section.
The pioblem in assessing the impact of a piice change on total ievenue of a good oi seivice is that
a change in piice always changes the quantity demanded in the opposite diiection. An inciease in piice
ieduces the quantity demanded, and a ieduction in piice incieases the quantity demanded. The ques-
tion is how much. Because total ievenue is found by multiplying the piice pei unit times the quantity
demanded, it is not cleai whethei a change in piice will cause total ievenue to iise oi fall.
We have alieady made this point in the context of the tiansit authoiity. Considei the following
thiee examples of piice incieases foi gasoline, pizza, and diet cola.
Suppose that 1,000 gallons of gasoline pei day aie demanded at a piice of $4.00 pei gallon. Total
ievenue foi gasoline thus equals $4,000 pei day (=1,000 gallons pei day times $4.00 pei gallon). If an
inciease in the piice of gasoline to $4.23 ieduces the quantity demanded to 930 gallons pei day, total
ievenue iises to $4,037.30 pei day (=930 gallons pei day times $4.23 pei gallon). Even though people
consume less gasoline at $4.23 than at $4.00, total ievenue iises because the highei piice moie than
makes up foi the diop in consumption.
Next considei pizza. Suppose 1,000 pizzas pei week aie demanded at a piice of $9 pei pizza. Total
ievenue foi pizza equals $9,000 pei week (=1,000 pizzas pei week times $9 pei pizza). If an inciease in
the piice of pizza to $10 pei pizza ieduces quantity demanded to 900 pizzas pei week, total ievenue will
still be $9,000 pei week (=900 pizzas pei week times $10 pei pizza). Again, when piice goes up, con-
sumeis buy less, but this time theie is no change in total ievenue.
Now considei diet cola. Suppose 1,000 cans of diet cola pei day aie demanded at a piice of $0.30
pei can. Total ievenue foi diet cola equals $300 pei day (=1,000 cans pei day times $0.30 pei can). If an
inciease in the piice of diet cola to $0.33 pei can ieduces quantity demanded to 880 cans pei month,
total ievenue foi diet cola falls to $484 pei day (=880 cans pei day times $0.33 pei can). As in the case
of gasoline, people will buy less diet cola when the piice iises fiom $0.30 to $0.33, but in this example
total ievenue diops.
In oui fist example, an inciease in piice incieased total ievenue. In the second, a piice inciease left
total ievenue unchanged. In the thiid example, the piice iise ieduced total ievenue. Is theie a way to
piedict how a piice change will afect total ievenue: Theie is; the efect depends on the piice elasticity
of demand.
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 115
price eIastic
S|tu.t|cr |r .||c| t|e
.bsc|ute v.|ue c| t|e p.|ce
e|.st|c|ty c| Jen.rJ |s
g.e.te. t|.r 1.
unit price eIastic
S|tu.t|cr |r .||c| t|e
.bsc|ute v.|ue c| t|e p.|ce
e|.st|c|ty c| Jen.rJ |s e,u.|
tc 1.
price ineIastic
S|tu.t|cr |r .||c| t|e
.bsc|ute v.|ue c| t|e p.|ce c|
e|.st|c|ty c| Jen.rJ |s |ess
t|.r 1.
£Iastic, Unit £Iastic, and IneIastic Demand
To deteimine how a piice change will afect total ievenue, economists place piice elasticities of demand
in thiee categoiies, based on theii absolute value. If the absolute value of the piice elasticity of demand
is gieatei than 1, demand is teimed price elastic. If it is equal to 1, demand is unit price elastic. And
if it is less than 1, demand is price inelastic.
ReIating £Iasticity to Changes in 7otaI Revenue
When the piice of a good oi seivice changes, the quantity demanded changes in the opposite diiection.
Total ievenue will move in the diiection of the vaiiable that changes by the laigei peicentage. If the
vaiiables move by the same peicentage, total ievenue stays the same. If quantity demanded changes by
a laigei peicentage than piice (i.e., if demand is piice elastic), total ievenue will change in the diiection
of the quantity change. If piice changes by a laigei peicentage than quantity demanded (i.e., if demand
is piice inelastic), total ievenue will move in the diiection of the piice change. If piice and quantity de-
manded change by the same peicentage (i.e., if demand is unit piice elastic), then total ievenue does
not change.
When demand is piice inelastic, a given peicentage change in piice iesults in a smallei peicentage
change in quantity demanded. That implies that total ievenue will move in the diiection of the piice
change: a ieduction in piice will ieduce total ievenue, and an inciease in piice will inciease it.
Considei the piice elasticity of demand foi gasoline. In the example above, 1,000 gallons of gasol-
ine weie puichased each day at a piice of $4.00 pei gallon; an inciease in piice to $4.23 pei gallon ie-
duced the quantity demanded to 930 gallons pei day. We thus had an aveiage quantity of 973 gallons
pei day and an aveiage piice of $4.123. We can thus calculate the aic piice elasticity of demand foi
gasoline:
Peicentage change in quantity demanded = ÷30 / 973 = ÷3.1°
Peicentage change in piice = 0.23 / 4.123=6.06°
Piice elasticity of demand = ÷3.1°/ 6.06° = ÷0.84
The demand foi gasoline is piice inelastic, and total ievenue moves in the diiection of the piice change.
When piice iises, total ievenue iises. Recall that in oui example above, total spending on gasoline
(which equals total ievenues to selleis) iose fiom $4,000 pei day (=1,000 gallons pei day times $4.00) to
$4037.30 pei day (=930 gallons pei day times $4.23 pei gallon).
When demand is piice inelastic, a given peicentage change in piice iesults in a smallei peicentage
change in quantity demanded. That implies that total ievenue will move in the diiection of the piice
change: an inciease in piice will inciease total ievenue, and a ieduction in piice will ieduce it.
Considei again the example of pizza that we examined above. At a piice of $9 pei pizza, 1,000 piz-
zas pei week weie demanded. Total ievenue was $9,000 pei week (=1,000 pizzas pei week times $9 pei
pizza). When the piice iose to $10, the quantity demanded fell to 900 pizzas pei week. Total ievenue
iemained $9,000 pei week (=900 pizzas pei week times $10 pei pizza). Again, we have an aveiage
quantity of 930 pizzas pei week and an aveiage piice of $9.30. Using the aic elasticity method, we can
compute:
Peicentage change in quantity demanded = ÷ 100 / 930 = ÷ 10.3°
Peicentage change in piice = $1.00 / $9.30 = 10.3°
Piice elasticity of demand = ÷ 10.3°/ 10.3° = ÷ 1.0
Demand is unit piice elastic, and total ievenue iemains unchanged. Quantity demanded falls by the
same peicentage by which piice incieases.
Considei next the example of diet cola demand. At a piice of $0.30 pei can, 1,000 cans of diet cola
weie puichased each day. Total ievenue was thus $300 pei day (=$0.30 pei can times 1,000 cans pei
day). An inciease in piice to $0.33 ieduced the quantity demanded to 880 cans pei day. We thus have
an aveiage quantity of 940 cans pei day and an aveiage piice of $0.323 pei can. Computing the piice
elasticity of demand foi diet cola in this example, we have:
Peicentage change in quantity demanded = ÷ 120 / 940 = ÷ 12.8°
Peicentage change in piice = $0.03 / $0.323 = 9.3°
Piice elasticity of demand = ÷ 12.8°/ 9.3° = ÷ 1.3
The demand foi diet cola is piice elastic, so total ievenue moves in the diiection of the quantity change.
It falls fiom $300 pei day befoie the piice inciease to $484 pei day aftei the piice inciease.
A demand cuive can also be used to show changes in total ievenue. Figuie 3.3 shows the demand
cuive fiom Figuie 3.1 and Figuie 3.2. At point A, total ievenue fiom public tiansit iides is given by the
aiea of a iectangle diawn with point A in the uppei iight-hand coinei and the oiigin in the lowei left-
116 PRINCIPL£S OI £CONOMICS
hand coinei. The height of the iectangle is piice; its width is quantity. We have alieady seen that total
ievenue at point A is $32,000 ($0.80 × 40,000). When we ieduce the piice and move to point B, the
iectangle showing total ievenue becomes shoitei and widei. Notice that the aiea gained in moving to
the iectangle at B is gieatei than the aiea lost; total ievenue iises to $42,000 ($0.70 × 60,000). Recall
fiom Figuie 3.2 that demand is elastic between points A and B. In geneial, demand is elastic in the up-
pei half of any lineai demand cuive, so total ievenue moves in the diiection of the quantity change.
II GUR£ 5. 3 Changes in 7otaI Revenue and a Linear Demand Curve
Vcv|rg |.cn pc|rt A tc pc|rt b |np||es . .eJuct|cr |r p.|ce .rJ .r |rc.e.se |r t|e ,u.rt|ty Jen.rJeJ. |en.rJ |s
e|.st|c bet.eer t|ese t.c pc|rts. ¯ct.| .everue, s|c.r by t|e ..e.s c| t|e .ect.rg|es J...r |.cn pc|rts A .rJ b
tc t|e c.|g|r, .|ses. \|er .e ncve |.cn pc|rt | tc pc|rt |, .||c| |s |r t|e |re|.st|c .eg|cr c| t|e Jen.rJ cu.ve,
tct.| .everue |.||s.
A movement fiom point E to point F also shows a ieduction in piice and an inciease in quantity de-
manded. This time, howevei, we aie in an inelastic iegion of the demand cuive. Total ievenue now
moves in the diiection of the piice change-it falls. Notice that the iectangle diawn fiom point F is
smallei in aiea than the iectangle diawn fiom point E, once again confiming oui eailiei calculation.
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 117
perfectIy ineIastic
S|tu.t|cr |r .||c| t|e p.|ce
e|.st|c|ty c| Jen.rJ |s .e.c.
II GUR£ 5. 4
We have noted that a lineai demand cuive is moie elastic wheie piices aie ielatively high and quantit-
ies ielatively low and less elastic wheie piices aie ielatively low and quantities ielatively high. We can
be even moie specifc. For any linear demand curve, demand will be price elastic in the upper half of the
curve and price inelastic in its lower half. At the midpoint of a linear demand curve, demand is unit price
elastic.
1.4 Constant Piice Elasticity of Demand Cuives
Figuie 3.3 shows foui demand cuives ovei which piice elasticity of demand is the same at all points.
The demand cuive in Panel (a) is veitical. This means that piice changes have no efect on quantity de-
manded. The numeiatoi of the foimula given in Equation 3.2 foi the piice elasticity of demand
(peicentage change in quantity demanded) is zeio. The piice elasticity of demand in this case is theie-
foie zeio, and the demand cuive is said to be perfectly inelastic. This is a theoietically extieme case,
and no good that has been studied empiiically exactly fts it. A good that comes close, at least ovei a
specifc piice iange, is insulin. A diabetic will not consume moie insulin as its piice falls but, ovei some
piice iange, will consume the amount needed to contiol the disease.
118 PRINCIPL£S OI £CONOMICS
perfectIy eIastic
S|tu.t|cr |r .||c| t|e p.|ce
e|.st|c|ty c| Jen.rJ |s
|r|r|te.
II GUR£ 5. 5 Demand Curves with Constant Price £Iasticities
¯|e Jen.rJ cu.ve |r |.re| (.) |s pe.|ect|y |re|.st|c. ¯|e Jen.rJ cu.ve |r |.re| (b) |s pe.|ect|y e|.st|c. |.|ce e|.st|c|ty
c| Jen.rJ |s 1.00 .|| .|crg t|e Jen.rJ cu.ve |r |.re| (c), .|e.e.s |t |s 0.50 .|| .|crg t|e Jen.rJ cu.ve |r |.re|
(J).
As illustiated in Figuie 3.3, seveial othei types of demand cuives have the same elasticity at eveiy point
on them. The demand cuive in Panel (b) is hoiizontal. This means that even the smallest piice changes
have enoimous efects on quantity demanded. The denominatoi of the foimula given in Equation 3.2
foi the piice elasticity of demand (peicentage change in piice) appioaches zeio. The piice elasticity of
demand in this case is theiefoie infnite, and the demand cuive is said to be perfectly elastic.
[2]
This is
the type of demand cuive faced by pioduceis of standaidized pioducts such as wheat. If the wheat of
othei faims is selling at $4 pei bushel, a typical faim can sell as much wheat as it wants to at $4 but
nothing at a highei piice and would have no ieason to ofei its wheat at a lowei piice.
The nonlineai demand cuives in Panels (c) and (d) have piice elasticities of demand that aie neg-
ative; but, unlike the lineai demand cuive discussed above, the value of the piice elasticity is constant
all along each demand cuive. The demand cuive in Panel (c) has piice elasticity of demand equal to
÷1.00 thioughout its iange; in Panel (d) the piice elasticity of demand is equal to ÷0.30 thioughout its
iange. Empiiical estimates of demand often show cuives like those in Panels (c) and (d) that have the
same elasticity at eveiy point on the cuive.
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 119
Heads Up!
|c rct ccr|use p.|ce |re|.st|c Jen.rJ .rJ pe.|ect|y |re|.st|c Jen.rJ. |e.|ect|y |re|.st|c Jen.rJ ne.rs t|.t
t|e c|.rge |r ,u.rt|ty |s .e.c |c. .ry pe.cert.ge c|.rge |r p.|ce, t|e Jen.rJ cu.ve |r t||s c.se |s ve.t|c.|.
|.|ce |re|.st|c Jen.rJ ne.rs cr|y t|.t t|e pe.cert.ge c|.rge |r ,u.rt|ty |s |ess t|.r t|e pe.cert.ge c|.rge
|r p.|ce, rct t|.t t|e c|.rge |r ,u.rt|ty |s .e.c. \|t| p.|ce |re|.st|c (.s cppcseJ tc pe.|ect|y |re|.st|c) Jen.rJ,
t|e Jen.rJ cu.ve |tse|| |s st||| Jc.r...J s|cp|rg.
1.3 Deteiminants of the Piice Elasticity of Demand
The gieatei the absolute value of the piice elasticity of demand, the gieatei the iesponsiveness of
quantity demanded to a piice change. What deteimines whethei demand is moie oi less piice elastic:
The most impoitant deteiminants of the piice elasticity of demand foi a good oi seivice aie the avail-
ability of substitutes, the impoitance of the item in household budgets, and time.
AvaiIabiIity of Substitutes
The piice elasticity of demand foi a good oi seivice will be gieatei in absolute value if many close sub-
stitutes aie available foi it. If theie aie lots of substitutes foi a paiticulai good oi seivice, then it is easy
foi consumeis to switch to those substitutes when theie is a piice inciease foi that good oi seivice. Sup-
pose, foi example, that the piice of Foid automobiles goes up. Theie aie many close substitutes foi
Foids-Cheviolets, Chiysleis, Toyotas, and so on. The availability of close substitutes tends to make
the demand foi Foids moie piice elastic.
If a good has no close substitutes, its demand is likely to be somewhat less piice elastic. Theie aie
no close substitutes foi gasoline, foi example. The piice elasticity of demand foi gasoline in the intei-
mediate teim of, say, thiee-nine months is geneially estimated to be about ÷0.3. Since the absolute
value of piice elasticity is less than 1, it is piice inelastic. We would expect, though, that the demand foi
a paiticulai biand of gasoline will be much moie piice elastic than the demand foi gasoline in geneial.
Importance in HousehoId 8udgets
One ieason piice changes afect quantity demanded is that they change how much a consumei can buy;
a change in the piice of a good oi seivice afects the puichasing powei of a consumei's income and
thus afects the amount of a good the consumei will buy. This efect is stiongei when a good oi seivice
is impoitant in a typical household's budget.
A change in the piice of jeans, foi example, is piobably moie impoitant in youi budget than a
change in the piice of pencils. Suppose the piices of both weie to double. You had planned to buy foui
paiis of jeans this yeai, but now you might decide to make do with two new paiis. A change in pencil
piices, in contiast, might lead to veiy little ieduction in quantity demanded simply because pencils aie
not likely to loom laige in household budgets. The gieatei the impoitance of an item in household
budgets, the gieatei the absolute value of the piice elasticity of demand is likely to be.
7ime
Suppose the piice of electiicity iises tomoiiow moining. What will happen to the quantity demanded:
The answei depends in laige pait on how much time we allow foi a iesponse. If we aie inteiested
in the ieduction in quantity demanded by tomoiiow afteinoon, we can expect that the iesponse will be
veiy small. But if we give consumeis a yeai to iespond to the piice change, we can expect the iesponse
to be much gieatei. We expect that the absolute value of the piice elasticity of demand will be gieatei
when moie time is allowed foi consumei iesponses.
Considei the piice elasticity of ciude oil demand. Economist John C. B. Coopei estimated shoit-
and long-iun piice elasticities of demand foi ciude oil foi 23 industiialized nations foi the peiiod
1971-2000. Piofessoi Coopei found that foi viitually eveiy countiy, the piice elasticities weie negative,
and the long-iun piice elasticities weie geneially much gieatei (in absolute value) than weie the shoit-
iun piice elasticities. His iesults aie iepoited in Table 3.1. As you can see, the ieseaich was iepoited in
a jouinal published by OPEC (Oiganization of Petioleum Expoiting Countiies), an oiganization whose
membeis have piofted gieatly fiom the inelasticity of demand foi theii pioduct. By iestiicting supply,
OPEC, which pioduces about 43° of the woild's ciude oil, is able to put upwaid piessuie on the piice
of ciude. That incieases OPEC's (and all othei oil pioduceis') total ievenues and ieduces total costs.
120 PRINCIPL£S OI £CONOMICS
7A8L£ 5. 1 Short- and Long-Run Price £Iasticities of the Demand for Crude OiI in 23 Countries
|c. ncst ccurt.|es, p.|ce e|.st|c|ty c| Jen.rJ |c. c.uJe c|| terJs tc be g.e.te. (|r .bsc|ute v.|ue) |r t|e |crg .ur
t|.r |r t|e s|c.t .ur.
Country Short-Run Price £Iasticity of Demand Long-Run Price £Iasticity of Demand
Aust..||. 0.034 0.068
Aust.|. 0.059 0.092
´.r.J. 0.041 0.352
´||r. 0.001 0.005
|ern..k 0.026 0.191
||r|.rJ 0.016 0.033
|..rce 0.069 0.568
Ce.n.ry 0.024 0.29
C.eece 0.055 0.126
|ce|.rJ 0.109 0.452
|.e|.rJ 0.082 0.196
|t.|y 0.035 0.208
'.p.r 0.01 0.35
|c.e. 0.094 0.18
|et|e.|.rJs 0.05 0.244
|e. ¯e.|.rJ 0.054 0.326
|c...y 0.026 0.036
|c.tug.| 0.023 0.038
Sp.|r 0.08 0.146
S.eJer 0.043 0.289
S.|t.e.|.rJ 0.030 0.056
|r|teJ ||rgJcn 0.068 0.182
|r|teJ St.tes 0.061 0.453
Source· john C. B. Cooper, ¨Price Elasticity of Demand for Crude Oil· Estimates from 23 Countries,¨ OPEC Review· Energy Economics o Related
Issues, 27·1 (March 2003)· 4. The estimates are based on data for the period 1971-2000, except for China and South Korea, where the period is
1979-2000. Vhile the price elasticities for China and Portugal were positive, they were not statistically signifcant.
k £ Y 7 A k £ A W A Y S
< ¯|e p.|ce e|.st|c|ty c| Jen.rJ ne.su.es t|e .espcrs|veress c| ,u.rt|ty Jen.rJeJ tc c|.rges |r p.|ce, |t
|s c.|cu|.teJ by J|v|J|rg t|e pe.cert.ge c|.rge |r ,u.rt|ty Jen.rJeJ by t|e pe.cert.ge c|.rge |r p.|ce.
< |en.rJ |s p.|ce |re|.st|c || t|e .bsc|ute v.|ue c| t|e p.|ce e|.st|c|ty c| Jen.rJ |s |ess t|.r 1, |t |s ur|t p.|ce
e|.st|c || t|e .bsc|ute v.|ue |s e,u.| tc 1, .rJ |t |s p.|ce e|.st|c || t|e .bsc|ute v.|ue |s g.e.te. t|.r 1.
< |en.rJ |s p.|ce e|.st|c |r t|e uppe. |.|| c| .ry ||re.. Jen.rJ cu.ve .rJ p.|ce |re|.st|c |r t|e |c.e. |.||. |t
|s ur|t p.|ce e|.st|c .t t|e n|Jpc|rt.
< \|er Jen.rJ |s p.|ce |re|.st|c, tct.| .everue ncves |r t|e J|.ect|cr c| . p.|ce c|.rge. \|er Jen.rJ |s
ur|t p.|ce e|.st|c, tct.| .everue Jces rct c|.rge |r .espcrse tc . p.|ce c|.rge. \|er Jen.rJ |s p.|ce
e|.st|c, tct.| .everue ncves |r t|e J|.ect|cr c| . ,u.rt|ty c|.rge.
< ¯|e .bsc|ute v.|ue c| t|e p.|ce e|.st|c|ty c| Jen.rJ |s g.e.te. .|er subst|tutes ..e .v.||.b|e, .|er t|e
gccJ |s |npc.t.rt |r |cuse|c|J buJgets, .rJ .|er buye.s |.ve nc.e t|ne tc .J¦ust tc c|.rges |r t|e
p.|ce c| t|e gccJ.
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 121
7 R Y I 7 !
+cu ..e rc. .e.Jy tc p|.y t|e p..t c| t|e n.r.ge. c| t|e pub||c t..rs|t systen. +cu. |r.rce c|ce. |.s ¦ust
.Jv|seJ ycu t|.t t|e systen |.ces . Je|c|t. +cu. bc..J Jces rct ..rt ycu tc cut se.v|ce, .||c| ne.rs t|.t
ycu c.rrct cut ccsts. +cu. cr|y |cpe |s tc |rc.e.se .everue. \cu|J . |..e |rc.e.se bccst .everue`
+cu ccrsu|t t|e eccrcn|st cr ycu. st.| .|c |.s .ese..c|eJ stuJ|es cr pub||c t..rspc.t.t|cr e|.st|c|t|es. S|e
.epc.ts t|.t t|e est|n.teJ p.|ce e|.st|c|ty c| Jen.rJ |c. t|e |.st |e. ncrt|s .|te. . p.|ce c|.rge |s .bcut
0.3, but t|.t .|te. seve..| ye..s, |t .||| be .bcut 1.5.
1. |xp|.|r .|y t|e est|n.teJ v.|ues |c. p.|ce e|.st|c|ty c| Jen.rJ J||e..
2. ´cnpute .|.t .||| |.pper tc .|Je.s||p .rJ .everue cve. t|e rext |e. ncrt|s || ycu Jec|Je tc ..|se |..es
by 5.
3. ´cnpute .|.t .||| |.pper tc .|Je.s||p .rJ .everue cve. t|e rext |e. ye..s || ycu Jec|Je tc ..|se |..es by
5.
4. \|.t |.ppers tc tct.| .everue rc. .rJ .|te. seve..| ye..s || ycu c|ccse tc ..|se |..es`
Case in Point: £Iasticity and Stop Lights
÷ 2010 jupiterimages Corporation
\e .|| |.ce t|e s|tu.t|cr eve.y J.y. +cu ..e .pp.c.c||rg .r |rte.sect|cr. ¯|e ye||c. ||g|t ccnes cr. +cu krc.
t|.t ycu ..e suppcseJ tc s|c. Jc.r, but ycu ..e |r . b|t c| . |u..y. Sc, ycu speeJ up . ||tt|e tc t.y tc n.ke t|e
||g|t. but t|e .eJ ||g|t |.s|es cr ¦ust be|c.e ycu get tc t|e |rte.sect|cr. S|cu|J ycu .|sk |t .rJ gc t|.cug|`
V.ry pecp|e |.ceJ .|t| t|.t s|tu.t|cr t.ke t|e .|sky c|c|ce. |r 1998, 2,000 pecp|e |r t|e |r|teJ St.tes J|eJ .s
. .esu|t c| J.|ve.s .urr|rg .eJ ||g|ts .t |rte.sect|crs. |r .r e|c.t tc .eJuce t|e runbe. c| J.|ve.s .|c n.ke
suc| c|c|ces, n.ry ..e.s |.ve |rst.||eJ c.ne..s .t |rte.sect|crs. |.|ve.s .|c .ur .eJ ||g|ts |.ve t|e|. p|ctu.es
t.ker .rJ .ece|ve c|t.t|crs |r t|e n.||. ¯||s er|c.cenert net|cJ, tcget|e. .|t| .ecert |rc.e.ses |r t|e |res
|c. J.|v|rg t|.cug| .eJ ||g|ts .t |rte.sect|crs, |.s |eJ tc .r |rt.|gu|rg .pp||c.t|cr c| t|e ccrcept c| e|.st|c|ty.
|ccrcn|sts Avre. b..||.r c| t|e |r|ve.s|ty c| |.||. |r |s..e| .rJ b.uce S.ce.Jcte c| |..tncut| |r|ve.s|ty |.ve
est|n.teJ .|.t |s, |r e|ect, t|e p.|ce e|.st|c|ty |c. J.|v|rg t|.cug| stcp||g|ts .|t| .espect tc t..|c |res .t |r
te.sect|crs |r |s..e| .rJ |r S.r |..rc|scc.
|r |ecenbe. 1996, |s..e| s|..p|y |rc.e.seJ t|e |re |c. J.|v|rg t|.cug| . .eJ ||g|t. ¯|e c|J |re c| 400 s|eke|s
(t||s ..s e,u.| .t t|.t t|ne tc ´122 |r t|e |r|teJ St.tes) ..s |rc.e.seJ tc 1,000 s|eke|s (´305). |r '.ru..y
1998, ´.|||c.r|. ..|seJ |ts |re |c. t|e c|erse |.cn ´104 tc ´21. ¯|e ccurt.y c| |s..e| .rJ t|e c|ty c| S.r |..r
c|scc |rst.||eJ c.ne..s .t seve..| |rte.sect|crs. |.|ve.s .|c |grc.eJ stcp||g|ts gct t|e|. p|ctu.es t.ker .rJ
.utcn.t|c.||y .ece|veJ c|t.t|crs |npcs|rg t|e re. ||g|e. |res.
122 PRINCIPL£S OI £CONOMICS
\e c.r t||rk c| J.|v|rg t|.cug| .eJ ||g|ts .s .r .ct|v|ty |c. .||c| t|e.e |s . Jen.rJ.|te. .||, |grc.|rg . .eJ
||g|t speeJs up cres t.|p. |t n.y .|sc gere..te s.t|s|.ct|cr tc pecp|e .|c er¦cy J|scbey|rg t..|c |..s. ¯|e
ccrcept c| e|.st|c|ty g|ves us . ..y tc s|c. ¦ust |c. .espcrs|ve J.|ve.s .e.e tc t|e |rc.e.se |r |res.
|.c|essc.s b..||.r .rJ S.ce.Jcte cbt.|reJ |r|c.n.t|cr cr .|| t|e J.|ve.s c|teJ .t 3 |rte.sect|crs |r |s..e| .rJ
e|g|t |rte.sect|crs |r S.r |..rc|scc. |c. |s..e|, |c. ex.np|e, t|ey Je|reJ t|e pe.|cJ '.ru..y 1992 tc 'ure 1996
.s t|e ´be|c.e´ pe.|cJ. ¯|ey ccnp..eJ t|e runbe. c| v|c|.t|crs Ju.|rg t|e be|c.e pe.|cJ tc t|e runbe. c| v|
c|.t|crs |.cn 'u|y 1996 tc |ecenbe. 1999t|e ´.|te.´ pe.|cJ.rJ |curJ t|e.e ..s . .eJuct|cr |r t|ckets pe.
J.|ve. c| 31.5 pe. cert. Spec||c.||y, t|e .ve..ge runbe. c| t|ckets pe. J.|ve. ..s 0.03 Ju.|rg t|e pe.|cJ be
|c.e t|e |rc.e.se, |t |e|| tc 0.050 .|te. t|e |rc.e.se. ¯|e |rc.e.se |r t|e |re ..s 150 pe. cert. (|cte t|.t, be
c.use t|ey .e.e n.k|rg . ´be|c.e´ .rJ ´.|te.´ c.|cu|.t|cr, t|e .ut|c.s useJ t|e st.rJ..J net|cJ Jesc.|beJ |r
t|e |e.Js |p! cr ccnput|rg . pe.cert.ge c|.rge|.e., t|ey ccnputeJ t|e pe.cert.ge c|.rges |r ccnp..
|scr tc t|e c.|g|r.| v.|ues |rste.J c| t|e .ve..ge v.|ue c| t|e v..|.b|es.) ¯|e e|.st|c|ty c| c|t.t|crs .|t| .espect
tc t|e |re ..s t|us 0.21 ( 31.5/150).
¯|e eccrcn|sts est|n.teJ e|.st|c|t|es |c. p..t|cu|.. g.cups c| pecp|e. |c. ex.np|e, ycurg pecp|e (.ge 130)
|.J .r e|.st|c|ty c| 0.36, pecp|e cve. t|e .ge c| 30 |.J .r e|.st|c|ty c| 0.16. |r gere..|, e|.st|c|t|es |e|| |r .b
sc|ute v.|ue .s |rccne .cse. |c. S.r |..rc|scc .rJ |s..e| ccnb|reJ, t|e e|.st|c|ty ..s bet.eer 0.26 .rJ
0.33.
|r gere..|, t|e .esu|ts s|c.eJ t|.t pecp|e .espcrJeJ ..t|cr.||y tc t|e |rc.e.ses |r |res. |rc.e.s|rg t|e p.|ce
c| . p..t|cu|.. be|.v|c. .eJuceJ t|e |.e,uercy c| t|.t be|.v|c.. ¯|e stuJy .|sc pc|rts cut t|e e|ect|veress c|
c.ne..s .s .r er|c.cenert tec|r|,ue. \|t| c.ne..s, v|c|.tc.s c.r be ce.t.|r t|ey .||| be c|teJ || t|ey |grc.e .
.eJ ||g|t. ArJ .eJuc|rg t|e runbe. c| pecp|e .urr|rg .eJ ||g|ts c|e..|y s.ves ||ves.
.oo·ce ^.·e· |o·||o· o·J |·oce .oce·Jo|e ¯|e |e·¡o··e o| ´·|·|·o|· o·J |o·´·|·|·o|· |o ||·e·' .oo··o| o| |o. o·J |co·o·|c·. 4.¹ (^¡·|| 2004:
¹¹.
A N S W £ R S 7 O 7 R Y I 7 ! P R O 8 L £ M S
1. ¯|e .bsc|ute v.|ue c| p.|ce e|.st|c|ty c| Jen.rJ terJs tc be g.e.te. .|er nc.e t|ne |s .||c.eJ |c.
ccrsune.s tc .espcrJ. Ove. t|ne, .|Je.s c| t|e ccnnute. ..|| systen c.r c.g.r|.e c.. pcc|s, ncve, c.
ct|e..|se .J¦ust tc t|e |..e |rc.e.se.
2. |s|rg t|e |c.nu|. |c. p.|ce e|.st|c|ty c| Jen.rJ .rJ p|ugg|rg |r v.|ues |c. t|e est|n.te c| p.|ce e|.st|c|ty
(0.5) .rJ t|e pe.cert.ge c|.rge |r p.|ce (5) .rJ t|er .e....rg|rg te.ns, .e c.r sc|ve |c. t|e
pe.cert.ge c|.rge |r ,u.rt|ty Jen.rJeJ .s. e
|
/ |r (// |r |, 0.5 / |r (/5, (0.5)(5) /
|r ( 2.5. ||Je.s||p |.||s by 2.5 |r t|e |.st |e. ncrt|s.
3. |s|rg t|e |c.nu|. |c. p.|ce e|.st|c|ty c| Jen.rJ .rJ p|ugg|rg |r v.|ues |c. t|e est|n.te c| p.|ce e|.st|c|ty
cve. . |e. ye..s (1.5) .rJ t|e pe.cert.ge c|.rge |r p.|ce (5), .e c.r sc|ve |c. t|e pe.cert.ge c|.rge
|r ,u.rt|ty Jen.rJeJ .s e
|
/ |r (// |r | , 1.5 / |r (/5, (1.5)(5) / |r ( .5.
||Je.s||p |.||s by .5 cve. . |e. ye..s.
4. ¯ct.| .everue .|ses |nneJ|.te|y .|te. t|e |..e |rc.e.se, s|rce Jen.rJ cve. t|e |nneJ|.te pe.|cJ |s p.|ce
|re|.st|c. ¯ct.| .everue |.||s .|te. . |e. ye..s, s|rce Jen.rJ c|.rges .rJ beccnes p.|ce e|.st|c.
2. RESPONSIVENESS OF DEMAND TO OTHER FACTORS
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. £xpIain the concept of income eIasticity of demand and its caIcuIation.
2. CIassify goods as normaI or inferior depending on their income eIasticity of demand.
3. £xpIain the concept of cross price eIasticity of demand and its caIcuIation.
4. CIassify goods as substitutes or compIements depending on their cross price eIasticity of
demand.
Although the iesponse of quantity demanded to changes in piice is the most widely used measuie of
elasticity, economists aie inteiested in the iesponse to changes in the demand shifteis as well. Two of
the most impoitant measuies show how demand iesponds to changes in income and to changes in the
piices of ielated goods and seivices.
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 123
income eIasticity of
demand
¯|e pe.cert.ge c|.rge |r
,u.rt|ty Jen.rJeJ .t .
spec||c p.|ce J|v|JeJ by t|e
pe.cert.ge c|.rge |r
|rccne t|.t p.cJuceJ t|e
Jen.rJ c|.rge, .|| ct|e.
t||rgs urc|.rgeJ.
2.1 Income Elasticity of Demand
We saw in the chaptei that intioduced the model of demand and supply that the demand foi a good oi
seivice is afected by income. We measuie the income elasticity of demand, e
Y
, as the peicentage
change in quantity demanded at a specifc price divided by the peicentage change in income that pio-
duced the demand change, all othei things unchanged:
£QUA7I ON 5. 4
e
Y
=
° change in quantity demanded
° change in income
The symbol Y is often used in economics to iepiesent income. Because income elasticity of de-
mand iepoits the iesponsiveness of quantity demanded to a change in income, all othei things un-
changed (including the piice of the good), it iefects a shift in the demand cuive at a given piice. Re-
membei that piice elasticity of demand iefects movements along a demand cuive in iesponse to a
change in piice.
A positive income elasticity of demand means that income and demand move in the same diiec-
tion-an inciease in income incieases demand, and a ieduction in income ieduces demand. As we
leained, a good whose demand iises as income iises is called a noimal good.
Studies show that most goods and seivices aie noimal, and thus theii income elasticities aie posit-
ive. Goods and seivices foi which demand is likely to move in the same diiection as income include
housing, seafood, iock conceits, and medical seivices.
If a good oi seivice is infeiioi, then an inciease in income ieduces demand foi the good. That im-
plies a negative income elasticity of demand. Goods and seivices foi which the income elasticity of de-
mand is likely to be negative include used clothing, beans, and uiban public tiansit. Foi example, the
studies we have alieady cited conceining the demands foi uiban public tiansit in Fiance and in Madiid
found the long-iun income elasticities of demand to be negative (÷0.23 in Fiance and ÷0.23 in Mad-
iid).
[3]
II GUR£ 5. 7
When we compute the income elasticity of demand, we aie looking at the change in the quantity de-
manded at a specifc piice. We aie thus dealing with a change that shifts the demand cuive. An inciease
in income shifts the demand foi a noimal good to the iight; it shifts the demand foi an infeiioi good to
the left.
124 PRINCIPL£S OI £CONOMICS
cross price eIasticity of
demand
|t e,u.|s t|e pe.cert.ge
c|.rge |r t|e ,u.rt|ty
Jen.rJeJ c| cre gccJ c.
se.v|ce .t . spec||c p.|ce
J|v|JeJ by t|e pe.cert.ge
c|.rge |r t|e p.|ce c| .
.e|.teJ gccJ c. se.v|ce.
2.2 Cioss Piice Elasticity of Demand
The demand foi a good oi seivice is afected by the piices of ielated goods oi seivices. A ieduction in
the piice of salsa, foi example, would inciease the demand foi chips, suggesting that salsa is a comple-
ment of chips. A ieduction in the piice of chips, howevei, would ieduce the demand foi peanuts, sug-
gesting that chips aie a substitute foi peanuts.
The measuie economists use to desciibe the iesponsiveness of demand foi a good oi seivice to a
change in the piice of anothei good oi seivice is called the cross price elasticity of demand, e
A, B
. It
equals the peicentage change in the quantity demanded of one good oi seivice at a specifc price di-
vided by the peicentage change in the piice of a ielated good oi seivice. We aie vaiying the piice of a
ielated good when we considei the cioss piice elasticity of demand, so the iesponse of quantity deman-
ded is shown as a shift in the demand cuive.
The cioss piice elasticity of the demand foi good A with iespect to the piice of good B is given by:
£QUA7I ON 5. 5
e
A, B
=
° change in quantity demanded of good A
° change in piice of good B
Cioss piice elasticities of demand defne whethei two goods aie substitutes, complements, oi unie-
lated. If two goods aie substitutes, an inciease in the piice of one will lead to an inciease in the demand
foi the othei-the cioss piice elasticity of demand is positive. If two goods aie complements, an in-
ciease in the piice of one will lead to a ieduction in the demand foi the othei-the cioss piice elasticity
of demand is negative. If two goods aie unielated, a change in the piice of one will not afect the de-
mand foi the othei-the cioss piice elasticity of demand is zeio.
II GUR£ 5. 8
An examination of the demand foi local television adveitising with iespect to the piice of local iadio
adveitising ievealed that the two goods aie cleaily substitutes. A 10 pei cent inciease in the piice of loc-
al iadio adveitising led to a 10 pei cent inciease in demand foi local television adveitising, so that the
cioss piice elasticity of demand foi local television adveitising with iespect to changes in the piice of
iadio adveitising was 1.0.
[4]
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 125
Heads Up!
|ct|ce t|.t .|t| |rccne e|.st|c|ty c| Jen.rJ .rJ c.css p.|ce e|.st|c|ty c| Jen.rJ .e ..e p.|n..||y ccrce.reJ
.|t| .|et|e. t|e ne.su.eJ v.|ue c| t|ese e|.st|c|t|es |s pcs|t|ve c. reg.t|ve. |r t|e c.se c| |rccne e|.st|c|ty c|
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n.rJ |t te||s us .|et|e. t.c gccJs ..e subst|tutes c. ccnp|enerts. \|t| p.|ce e|.st|c|ty c| Jen.rJ .e .e.e
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1, bec.use t||s g.ve us |r|c.n.t|cr .bcut .|.t |.ppers tc tct.| .everue .s p.|ce c|.rges. ¯|e te.ns e|.st|c
.rJ |re|.st|c .pp|y tc p.|ce e|.st|c|ty c| Jen.rJ. ¯|ey ..e rct useJ tc Jesc.|be |rccne e|.st|c|ty c| Jen.rJ c.
c.css p.|ce e|.st|c|ty c| Jen.rJ.
k £ Y 7 A k £ A W A Y S
< ¯|e |rccne e|.st|c|ty c| Jen.rJ .e|ects t|e .espcrs|veress c| Jen.rJ tc c|.rges |r |rccne. |t |s t|e
pe.cert.ge c|.rge |r ,u.rt|ty Jen.rJeJ o| o ·¡ec||c ¡·|ce J|v|JeJ by t|e pe.cert.ge c|.rge |r |rccne,
cete.|s p..|bus.
< |rccne e|.st|c|ty |s pcs|t|ve |c. rc.n.| gccJs .rJ reg.t|ve |c. |r|e.|c. gccJs.
< ¯|e c.css p.|ce e|.st|c|ty c| Jen.rJ ne.su.es t|e ..y Jen.rJ |c. cre gccJ c. se.v|ce .espcrJs tc
c|.rges |r t|e p.|ce c| .rct|e.. |t |s t|e pe.cert.ge c|.rge |r t|e ,u.rt|ty Jen.rJeJ c| cre gccJ c.
se.v|ce o| o ·¡ec||c ¡·|ce J|v|JeJ by t|e pe.cert.ge c|.rge |r t|e p.|ce c| .rct|e. gccJ c. se.v|ce, .||
ct|e. t||rgs urc|.rgeJ.
< ´.css p.|ce e|.st|c|ty |s pcs|t|ve |c. subst|tutes, reg.t|ve |c. ccnp|enerts, .rJ .e.c |c. gccJs c. se.v|ces
.|cse Jen.rJs ..e ur.e|.teJ.
7 R Y I 7 !
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b.ge|s .rJ c.e.n c|eese ..e subst|tutes c. ccnp|enerts. ´.|cu|.te t|e |rccne e|.st|c|ty c| Jen.rJ .rJ te||
.|et|e. b.ge|s ..e rc.n.| c. |r|e.|c..
126 PRINCIPL£S OI £CONOMICS
Case in Point: 7een Smoking and £Iasticity
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3. PRICE ELASTICITY OF SUPPLY
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. £xpIain the concept of eIasticity of suppIy and its caIcuIation.
2. £xpIain what it means for suppIy to be price ineIastic, unit price eIastic, price eIastic, perfectIy
price ineIastic, and perfectIy price eIastic.
3. £xpIain why time is an important determinant of price eIasticity of suppIy.
4. AppIy the concept of price eIasticity of suppIy to the Iabor suppIy curve.
The elasticity measuies encounteied so fai in this chaptei all ielate to the demand side of the maiket. It
is also useful to know how iesponsive quantity supplied is to a change in piice.
Suppose the demand foi apaitments iises. Theie will be a shoitage of apaitments at the old level of
apaitment ients and piessuie on ients to iise. All othei things unchanged, the moie iesponsive the
quantity of apaitments supplied is to changes in monthly ients, the lowei the inciease in ient iequiied
to eliminate the shoitage and to biing the maiket back to equilibiium. Conveisely, if quantity supplied
is less iesponsive to piice changes, piice will have to iise moie to eliminate a shoitage caused by an in-
ciease in demand.
This is illustiated in Figuie 3.10. Suppose the ient foi a typical apaitment had been R
0
and the
quantity Q
0
when the demand cuive was D
1
and the supply cuive was eithei S
1
(a supply cuive in
which quantity supplied is less iesponsive to piice changes) oi S
2
(a supply cuive in which quantity
supplied is moie iesponsive to piice changes). Note that with eithei supply cuive, equilibiium piice
and quantity aie initially the same. Now suppose that demand incieases to D
2
, peihaps due to popula-
tion giowth. With supply cuive S
1
, the piice (ient in this case) will iise to R
1
and the quantity of apait-
ments will iise to Q
1
. If, howevei, the supply cuive had been S
2
, the ient would only have to iise to R
2
to biing the maiket back to equilibiium. In addition, the new equilibiium numbei of apaitments would
be highei at Q
2
. Supply cuive S
2
shows gieatei iesponsiveness of quantity supplied to piice change
than does supply cuive S
1
.
128 PRINCIPL£S OI £CONOMICS
II GUR£ 5. 10 Increase in Apartment
Rents Depends on How Responsive SuppIy
Is
¯|e nc.e .espcrs|ve t|e supp|y c| .p..tnerts
|s tc c|.rges |r p.|ce (.ert |r t||s c.se), t|e |ess
.erts .|se .|er t|e Jen.rJ |c. .p..tnerts
|rc.e.ses.
price eIasticity of suppIy
¯|e ..t|c c| t|e pe.cert.ge
c|.rge |r ,u.rt|ty supp||eJ
c| . gccJ c. se.v|ce tc t|e
pe.cert.ge c|.rge |r |ts
p.|ce, .|| ct|e. t||rgs
urc|.rgeJ.
We measuie the price elasticity of supply (e
S
) as the iatio of the peicentage
change in quantity supplied of a good oi seivice to the peicentage change in its piice,
all othei things unchanged:
£QUA7I ON 5. 6
e
S
=
° change in quantity supplied
° change in piice
Because piice and quantity supplied usually move in the same diiection, the piice
elasticity of supply is usually positive. The laigei the piice elasticity of supply, the moie
iesponsive the fims that supply the good oi seivice aie to a piice change.
Supply is piice elastic if the piice elasticity of supply is gieatei than 1, unit piice
elastic if it is equal to 1, and piice inelastic if it is less than 1. A veitical supply cuive, as
shown in Panel (a) of Figuie 3.11, is peifectly inelastic; its piice elasticity of supply is
zeio. The supply of Beatles' songs is peifectly inelastic because the band no longei ex-
ists. A hoiizontal supply cuive, as shown in Panel (b) of Figuie 3.11, is peifectly elastic;
its piice elasticity of supply is infnite. It means that supplieis aie willing to supply any
amount at a ceitain piice.
II GUR£ 5. 11 SuppIy Curves and 7heir Price £Iasticities
¯|e supp|y cu.ve |r |.re| (.) |s pe.|ect|y |re|.st|c. |r |.re| (b), t|e supp|y cu.ve |s pe.|ect|y e|.st|c.
3.1 Time: An Impoitant Deteiminant of the Elasticity of Supply
Time plays a veiy impoitant iole in the deteimination of the piice elasticity of supply. Look again at
the efect of ient incieases on the supply of apaitments. Suppose apaitment ients in a city iise. If we aie
looking at a supply cuive of apaitments ovei a peiiod of a few months, the ient inciease is likely to in-
duce apaitment owneis to ient out a ielatively small numbei of additional apaitments. With the highei
ients, apaitment owneis may be moie vigoious in ieducing theii vacancy iates, and, indeed, with moie
people looking foi apaitments to ient, this should be faiily easy to accomplish. Attics and basements
aie easy to ienovate and ient out as additional units. In a shoit peiiod of time, howevei, the supply ie-
sponse is likely to be faiily modest, implying that the piice elasticity of supply is faiily low. A supply
cuive coiiesponding to a shoit peiiod of time would look like S
1
in Figuie 3.10. It is duiing such peii-
ods that theie may be calls foi ient contiols.
If the peiiod of time undei consideiation is a few yeais iathei than a few months, the supply cuive
is likely to be much moie piice elastic. Ovei time, buildings can be conveited fiom othei uses and new
apaitment complexes can be built. A supply cuive coiiesponding to a longei peiiod of time would look
like S
2
in Figuie 3.10.
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 129
3.2 Elasticity of Laboi Supply: A Special Application
The concept of piice elasticity of supply can be applied to laboi to show how the quantity of laboi sup-
plied iesponds to changes in wages oi salaiies. What makes this case inteiesting is that it has some-
times been found that the measuied elasticity is negative, that is, that an inciease in the wage iate is as-
sociated with a ieduction in the quantity of laboi supplied.
In most cases, laboi supply cuives have theii noimal upwaid slope: highei wages induce people to
woik moie. Foi them, having the additional income fiom woiking moie is piefeiable to having moie
leisuie time. Howevei, wage incieases may lead some people in veiy highly paid jobs to cut back on the
numbei of houis they woik because theii incomes aie alieady high and they would iathei have moie
time foi leisuie activities. In this case, the laboi supply cuive would have a negative slope. The ieasons
foi this phenomenon aie explained moie fully in a latei chaptei.
This chaptei has coveied a vaiiety of elasticity measuies. All iepoit the degiee to which a depend-
ent vaiiable iesponds to a change in an independent vaiiable. As we have seen, the degiee of this ie-
sponse can play a ciitically impoitant iole in deteimining the outcomes of a wide iange of economic
events. Table 3.2
[3]
piovides examples of some estimates of elasticities.
130 PRINCIPL£S OI £CONOMICS
7A8L£ 5. 2 SeIected £Iasticity £stimates
Product £Iasticity Product £Iasticity Product £Iasticity
Price £Iasticity
of Demand
Cross Price £Iasticity of
Demand
Income £Iasticity of
Demand
´.uJe c|| (|.S.)¯ 0.06 A|cc|c| .|t| .espect tc p.|ce c|
|e.c|r
0.05 SpeeJ|rg c|t.t|crs 0.26 tc
0.33
C.sc||re 0.1 |ue| .|t| .espect tc p.|ce c|
t..rspc.t
0.48 |.b.r |ub||c ¯.ust |r
|..rce .rJ V.J.|J
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0.23,
0.26
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|ccJ
0.16 C.curJ bee| 0.19
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c| |e.c|r (s|n||.. |c. ccc.|re)
0.01 |ctte.y |rst.rt g.ne
s.|es |r ´c|c..Jc
0.06
´cc.|re (t.c
est|n.tes)
0.28,
1.0
bee. .|t| .espect tc p.|ce c|
.|re J|st|||eJ ||,uc. (ycurg
J.|rke.s)
0.0 |e.c|r 0.00
A|cc|c| 0.30 bee. .|t| .espect tc p.|ce c|
J|st|||eJ ||,uc. (ycurg J.|rke.s)
0.0 V..¡u.r., .|cc|c|,
ccc.|re
+0.00
|e.c|es 0.38 |c.k .|t| .espect tc p.|ce c|
pcu|t.y
0.06 |ct.tces 0.15
V..¡u.r. 0.4 |c.k .|t| .espect tc p.|ce c|
g.curJ bee|
0.23 |ccJ¯¯ 0.2
´|g..ettes (.||
sncke.s, t.c
est|n.tes)
0.4,
0.32
C.curJ bee| .|t| .espect tc
p.|ce c| pcu|t.y
0.24 ´|ct||rg¯¯¯ 0.3
´.uJe c|| (|.S.)¯¯ 0.45 C.curJ bee| .|t| .espect tc
p.|ce c| pc.k
0.35 bee. 0.4
V||k (t.c
est|n.tes)
0.49,
0.63
´cke .|t| .espect tc p.|ce c|
|eps|
0.61 |ggs 0.5
C.sc||re
(|rte.neJ|.te
te.n)
0.5 |eps| .|t| .espect tc p.|ce c|
´cke
0.80 ´cke 0.60
Sc|t J.|rks 0.55 |cc.| te|ev|s|cr .Jve.t|s|rg .|t|
.espect tc p.|ce c| ..J|c
.Jve.t|s|rg
1.0 S|e|te.¯¯ 0.
¯..rspc.t.t|cr¯ 0.6 Sncke|ess tcb.ccc .|t| .espect
tc p.|ce c| c|g..ettes (ycurg
n.|es)
1.2 bee| (t.b|e cutsrct
g.curJ)
0.81
|ccJ 0. Price £Iasticity of SuppIy O..rges 0.83
bee. 0. tc
0.9
||ys|c|.rs (Spec|.||st) 0.3 App|es 1.32
´|g..ettes
(teer.ge.s, t.c
est|n.tes)
0.9 tc
1.5
||ys|c|.rs (|.|n..y ´..e) 0.0 |e|su.e¯¯ 1.4
|e.c|r 0.94 ||ys|c|.rs (+curg n.|e) 0.2 |e.c|es 1.43
C.curJ bee| 1.0 ||ys|c|.rs (+curg |en.|e) 0.5 |e.|t| c..e¯¯ 1.6
´ctt.ge c|eese 1.1 V||k¯ 0.36 ||g|e. eJuc.t|cr 1.6
C.sc||re¯¯ 1.5 V||k¯¯ 0.5
´cke 1.1 ´|||J c..e |.bc. 2
¯..rspc.t.t|cr 1.9
|eps| 2.08
|.es| tcn.tces 2.22
|ccJ¯¯ 2.3
|ettuce 2.58
Note: "=short-run, ""=Iong-run
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 131
k £ Y 7 A k £ A W A Y S
< ¯|e p.|ce e|.st|c|ty c| supp|y ne.su.es t|e .espcrs|veress c| ,u.rt|ty supp||eJ tc c|.rges |r p.|ce. |t |s t|e
pe.cert.ge c|.rge |r ,u.rt|ty supp||eJ J|v|JeJ by t|e pe.cert.ge c|.rge |r p.|ce. |t |s usu.||y pcs|t|ve.
< Supp|y |s p.|ce |re|.st|c || t|e p.|ce e|.st|c|ty c| supp|y |s |ess t|.r 1, |t |s ur|t p.|ce e|.st|c || t|e p.|ce
e|.st|c|ty c| supp|y |s e,u.| tc 1, .rJ |t |s p.|ce e|.st|c || t|e p.|ce e|.st|c|ty c| supp|y |s g.e.te. t|.r 1. A
ve.t|c.| supp|y cu.ve |s s.|J tc be pe.|ect|y |re|.st|c. A |c.|.crt.| supp|y cu.ve |s s.|J tc be pe.|ect|y e|.st|c.
< ¯|e p.|ce e|.st|c|ty c| supp|y |s g.e.te. .|er t|e |ergt| c| t|ne urJe. ccrs|Je..t|cr |s |crge. bec.use
cve. t|ne p.cJuce.s |.ve nc.e cpt|crs |c. .J¦ust|rg tc t|e c|.rge |r p.|ce.
< \|er .pp||eJ tc |.bc. supp|y, t|e p.|ce e|.st|c|ty c| supp|y |s usu.||y pcs|t|ve but c.r be reg.t|ve. || ||g|e.
..ges |rJuce pecp|e tc .c.k nc.e, t|e |.bc. supp|y cu.ve |s up...J s|cp|rg .rJ t|e p.|ce e|.st|c|ty c|
supp|y |s pcs|t|ve. |r scne ve.y ||g|p.y|rg p.c|ess|crs, t|e |.bc. supp|y cu.ve n.y |.ve . reg.t|ve s|cpe,
.||c| |e.Js tc . reg.t|ve p.|ce e|.st|c|ty c| supp|y.
7 R Y I 7 !
|r t|e |.te 1990s, |t ..s .epc.teJ cr t|e re.s t|.t t|e ||g|tec| |rJust.y ..s .c..|eJ .bcut be|rg .b|e tc
|rJ ercug| .c.ke.s .|t| ccnpute..e|.teJ expe.t|se. 'cb c|e.s |c. .ecert cc||ege g..Ju.tes .|t| Jeg.ees |r
ccnpute. sc|erce .ert .|t| ||g| s.|..|es. |t ..s .|sc .epc.teJ t|.t nc.e urJe.g..Ju.tes t|.r eve. .e.e n.
¦c.|rg |r ccnpute. sc|erce. ´cnp..e t|e p.|ce e|.st|c|ty c| supp|y c| ccnpute. sc|ert|sts .t t|.t pc|rt |r t|ne
tc t|e p.|ce e|.st|c|ty c| supp|y c| ccnpute. sc|ert|sts cve. . |crge. pe.|cJ c|, s.y, 1999 tc 2009.
Case in Point: A Variety of Labor SuppIy £Iasticities
÷ 2010 jupiterimages Corporation
StuJ|es suppc.t t|e |Je. t|.t |.bc. supp|y |s |ess e|.st|c |r ||g|p.y|rg ¦cbs t|.r |r |c.e.p.y|rg cres.
|c. ex.np|e, |.v|J V. b|.u est|n.teJ t|e |.bc. supp|y c| c|||Jc..e .c.ke.s tc be ve.y p.|ce e|.st|c, .|t| es
t|n.teJ p.|ce e|.st|c|ty c| |.bc. supp|y c| .bcut 2.0. ¯||s ne.rs t|.t . 10 |rc.e.se |r ..ges |e.Js tc . 20 |r
c.e.se |r t|e ,u.rt|ty c| |.bc. supp||eJ. 'c|r bu.kett est|n.teJ t|e |.bc. supp|y c| bct| ru.s|rg .ss|st.rts
.rJ ru.ses tc be p.|ce e|.st|c, .|t| t|.t c| ru.s|rg .ss|st.rts tc be 1.9 (ve.y c|cse tc t|.t c| c|||Jc..e .c.ke.s)
.rJ c| ru.ses tc be 1.1. |cte t|.t t|e p.|ce e|.st|c|ty c| |.bc. supp|y c| t|e ||g|e.p.|J ru.ses |s . b|t |c.e.
t|.r t|.t c| |c.e.p.|J ru.s|rg .ss|st.rts.
132 PRINCIPL£S OI £CONOMICS
|r ccrt..st, 'c|r ||..c .rJ |.v|J b|unert|.| est|n.teJ t|e p.|ce e|.st|c|ty c| |.bc. supp|y |c. ycurg p|ys|
c|.rs (urJe. t|e .ge c| 40) tc be .bcut 0.3. ¯||s ne.rs t|.t . 10 |rc.e.se |r ..ges |e.Js tc .r |rc.e.se |r
t|e ,u.rt|ty c| |.bc. supp||eJ c| cr|y .bcut 3. |r .JJ|t|cr, .|er ||..c .rJ b|unert|.| |cckeJ .t |.bc. sup
p|y e|.st|c|t|es by gerJe., t|ey |curJ t|e |en.|e p|ys|c|.rs |.bc. supp|y p.|ce e|.st|c|ty tc be . b|t ||g|e. (.t
.bcut 0.5) t|.r t|.t c| t|e n.|es (.t .bcut 0.2) |r t|e s.np|e. bec.use e..r|rgs c| |en.|e p|ys|c|.rs |r t|e
s.np|e .e.e |c.e. t|.r e..r|rgs c| t|e n.|e p|ys|c|.rs |r t|e s.np|e, t||s J||e.erce |r |.bc. supp|y e|.st|c|t
|es ..s expecteJ. Vc.ecve., s|rce t|e s.np|e ccrs|steJ c| p|ys|c|.rs |r t|e e..|y p|.ses c| t|e|. c..ee.s, t|e
pcs|t|ve, t|cug| sn.||, p.|ce e|.st|c|t|es .e.e .|sc expecteJ. V.ry c| t|e |rJ|v|Ju.|s |r t|e s.np|e .|sc |.J
||g| Jebt |eve|s, c|ter |.cn eJuc.t|cr.| |c.rs. ¯|us, t|e c|.rce tc e..r nc.e by .c.k|rg nc.e |s .r cppc.
tur|ty tc .ep.y eJuc.t|cr.| .rJ ct|e. |c.rs.
|r .rct|e. stuJy c| p|ys|c|.rs |.bc. supp|y t|.t ..s rct .est.|cteJ tc ycurg p|ys|c|.rs, |cug|.s V. b.c.r
|curJ t|e |.bc. supp|y p.|ce e|.st|c|ty |c. p.|n..y c..e p|ys|c|.rs tc be c|cse tc .e.c .rJ t|.t c| spec|.||sts tc
be reg.t|ve, .t .bcut 0.3. ¯|us, |c. t||s s.np|e c| p|ys|c|.rs, |rc.e.ses |r ..ges |.ve ||tt|e c. rc e|ect cr t|e
.ncurt t|e p.|n..y c..e Jcctc.s .c.k, .|||e . 10 |rc.e.se |r ..ges |c. spec|.||sts ·eJoce· t|e|. ,u.rt|ty c|
|.bc. supp||eJ by .bcut 3. bec.use t|e e..r|rgs c| spec|.||sts exceeJ t|cse c| p.|n..y c..e Jcctc.s, t||s
e|.st|c|ty J||e.ert|.| .|sc n.kes serse.
.oo·ce· |o.|J / ||oo. ¯|e .o¡¡|, o| ´|||J ´o·e |o·o·.' .oo··o| o| |o·o· |co·o·|c· ¹¹2 (^¡·|| ¹993: 32434.. |o.|J / |·o.·. ¯|e ||·|·¸ ´o·| o|
||,·|c|o·· .e·.|ce· ^ ´o··ec||o· o·J ||e··|o· o· .o¡¡|,.' |e.|e. o| |co·o·|c· o·J .|o||·||c· .6 (2: (/o, ¹994: 3S9393. .o|· | |o·|e||. ¯|e |o·o·
.o¡¡|, o| |o··e· o·J |o··|·¸ ^··|·|o·|· |· ||e |·||eJ .|o|e·.' |o·|e·· |co·o·|c .oo··o| 3¹(4: (|o|| 2005: 5S5599. .o|· ^ ||o o·J |oo| ||o·e·||o|
||,·|c|o· |o·o· .o¡¡|, |o |·co·e ||ec|· /o||e·.' .oo··o| o| |eo||| |co·o·|c· ¹34 (|ece··e· ¹994: 433453
A N S W £ R 7 O 7 R Y I 7 ! P R O 8 L £ M
\|||e .t . pc|rt |r t|ne t|e supp|y c| pecp|e .|t| Jeg.ees |r ccnpute. sc|erce |s ve.y p.|ce |re|.st|c, cve.
t|ne t|e e|.st|c|ty s|cu|J .|se. ¯|.t nc.e stuJerts .e.e n.¦c.|rg |r ccnpute. sc|erce |erJs c.eJerce tc t||s
p.eJ|ct|cr. As supp|y beccnes nc.e p.|ce e|.st|c, s.|..|es |r t||s |e|J s|cu|J .|se nc.e s|c.|y.
4. REVIEW AND PRACTICE
Summary
¯||s c|.pte. |rt.cJuceJ . re. tcc|. t|e ccrcept c| e|.st|c|ty. ||.st|c|ty |s . ne.su.e c| t|e Jeg.ee tc .||c| .
JeperJert v..|.b|e .espcrJs tc . c|.rge |r .r |rJeperJert v..|.b|e. |t |s t|e pe.cert.ge c|.rge |r t|e Je
perJert v..|.b|e J|v|JeJ by t|e pe.cert.ge c|.rge |r t|e |rJeperJert v..|.b|e, .|| ct|e. t||rgs urc|.rgeJ.
¯|e ncst .|Je|y useJ e|.st|c|ty ne.su.e |s t|e p.|ce e|.st|c|ty c| Jen.rJ, .||c| .e|ects t|e .espcrs|veress c|
,u.rt|ty Jen.rJeJ tc c|.rges |r p.|ce. |en.rJ |s s.|J tc be p.|ce e|.st|c || t|e .bsc|ute v.|ue c| t|e p.|ce
e|.st|c|ty c| Jen.rJ |s g.e.te. t|.r 1, ur|t p.|ce e|.st|c || |t |s e,u.| tc 1, .rJ p.|ce |re|.st|c || |t |s |ess t|.r 1.
¯|e p.|ce e|.st|c|ty c| Jen.rJ |s use|u| |r |c.ec.st|rg t|e .espcrse c| ,u.rt|ty Jen.rJeJ tc p.|ce c|.rges, |t
|s .|sc use|u| |c. p.eJ|ct|rg t|e |np.ct . p.|ce c|.rge .||| |.ve cr tct.| .everue. ¯ct.| .everue ncves |r t|e
J|.ect|cr c| t|e ,u.rt|ty c|.rge || Jen.rJ |s p.|ce e|.st|c, |t ncves |r t|e J|.ect|cr c| t|e p.|ce c|.rge || Je
n.rJ |s p.|ce |re|.st|c, .rJ |t Jces rct c|.rge || Jen.rJ |s ur|t p.|ce e|.st|c. ¯|e ncst |npc.t.rt Jete.n|r
.rts c| t|e p.|ce e|.st|c|ty c| Jen.rJ ..e t|e .v.||.b|||ty c| subst|tutes, t|e |npc.t.rce c| t|e |ten |r |cuse
|c|J buJgets, .rJ t|ne.
¯.c ct|e. e|.st|c|ty ne.su.es ccnncr|y useJ |r ccr¦urct|cr .|t| Jen.rJ ..e |rccne e|.st|c|ty .rJ c.css
p.|ce e|.st|c|ty. ¯|e s|grs c| t|ese e|.st|c|ty ne.su.es p|.y |npc.t.rt .c|es. A pcs|t|ve |rccne e|.st|c|ty te||s us
t|.t . gccJ |s rc.n.|, . reg.t|ve |rccne e|.st|c|ty te||s us t|e gccJ |s |r|e.|c.. A pcs|t|ve c.css p.|ce e|.st|c|ty
te||s us t|.t t.c gccJs ..e subst|tutes, . reg.t|ve c.css p.|ce e|.st|c|ty te||s us t|ey ..e ccnp|enerts.
||.st|c|ty c| supp|y ne.su.es t|e .espcrs|veress c| ,u.rt|ty supp||eJ tc c|.rges |r p.|ce. ¯|e v.|ue c| p.|ce
e|.st|c|ty c| supp|y |s gere..||y pcs|t|ve. Supp|y |s c|.ss||eJ .s be|rg p.|ce e|.st|c, ur|t p.|ce e|.st|c, c. p.|ce |r
e|.st|c || p.|ce e|.st|c|ty |s g.e.te. t|.r 1, e,u.| tc 1, c. |ess t|.r 1, .espect|ve|y. ¯|e |ergt| c| t|ne cve. .||c|
supp|y |s be|rg ccrs|Je.eJ |s .r |npc.t.rt Jete.n|r.rt c| t|e p.|ce e|.st|c|ty c| supp|y.
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 133
C O N C £ P 7 P R O 8 L £ M S
1. |xp|.|r .|y t|e p.|ce e|.st|c|ty c| Jen.rJ |s gere..||y . reg.t|ve runbe., except |r t|e c.ses .|e.e t|e
Jen.rJ cu.ve |s pe.|ect|y e|.st|c c. pe.|ect|y |re|.st|c. \|.t .cu|J be |np||eJ by . pcs|t|ve p.|ce e|.st|c|ty
c| Jen.rJ`
2. |xp|.|r .|y t|e s|gr (pcs|t|ve c. reg.t|ve) c| t|e c.css p.|ce e|.st|c|ty c| Jen.rJ |s |npc.t.rt.
3. |xp|.|r .|y t|e s|gr (pcs|t|ve c. reg.t|ve) c| t|e |rccne e|.st|c|ty c| Jen.rJ |s |npc.t.rt.
4. |ccrcn|sts |.|e |e|er .rJ ´.t|y |c|e|n \esse||s |curJ t|.t t|e p.|ce e|.st|c|ty c| Jen.rJ |c. |.es| n||k
|s 0.63 .rJ t|e p.|ce e|.st|c|ty c| Jen.rJ |c. cctt.ge c|eese |s 1.1.
¦6¦
\|y Jc ycu t||rk t|e e|.st|c|ty
est|n.tes J||e.`
5. ¯|e p.|ce e|.st|c|ty c| Jen.rJ |c. |e.|t| c..e |.s beer est|n.teJ tc be 0.2. ´|...cte.|.e t||s Jen.rJ .s
p.|ce e|.st|c, ur|t p.|ce e|.st|c, c. p.|ce |re|.st|c. ¯|e text ..gues t|.t t|e g.e.te. t|e |npc.t.rce c| .r |ten
|r ccrsune. buJgets, t|e g.e.te. |ts e|.st|c|ty. |e.|t|c..e ccsts .cccurt |c. . .e|.t|ve|y |..ge s|..e c|
|cuse|c|J buJgets. |c. ccu|J t|e p.|ce e|.st|c|ty c| Jen.rJ |c. |e.|t| c..e be suc| . sn.|| runbe.`
6. Suppcse ycu ..e .b|e tc c.g.r|.e .r .|||.rce t|.t |rc|uJes .|| |..ne.s. ¯|ey .g.ee tc |c||c. t|e g.cups
|rst.uct|crs .|t| .espect tc t|e ,u.rt|ty c| .g.|cu|tu..| p.cJucts t|ey p.cJuce. \|.t n|g|t t|e g.cup
seek tc Jc` \|y`
. Suppcse ycu ..e t|e c||e| execut|ve c|ce. c| . |.n, .rJ ycu |.ve beer p|.rr|rg tc .eJuce ycu. p.|ces.
+cu. n..ket|rg n.r.ge. .epc.ts t|.t t|e p.|ce e|.st|c|ty c| Jen.rJ |c. ycu. p.cJuct |s 0.65. |c. .||| t||s
re.s .|ect ycu. p|.rs`
8. Suppcse t|e |rccne e|.st|c|ty c| t|e Jen.rJ |c. be.rs |s 0.8. |rte.p.et t||s runbe..
9. ¯..rspc.t.t|cr eccrcn|sts gere..||y .g.ee t|.t t|e c.css p.|ce e|.st|c|ty c| Jen.rJ |c. .utcncb||e use
.|t| .espect tc t|e p.|ce c| bus |..es |s .bcut 0. |xp|.|r .|.t t||s runbe. ne.rs.
10. Suppcse t|e p.|ce e|.st|c|ty c| supp|y c| tcn.tces .s ne.su.eJ cr . g|ver J.y |r 'u|y |s 0. |rte.p.et t||s
runbe..
11. ¯|e p.|ce e|.st|c|ty c| supp|y |c. c|||Jc..e .c.ke.s ..s .epc.teJ tc be ,u|te ||g|, .bcut 2. \|.t .|||
|.pper tc t|e ..ges c| c|||Jc..e .c.ke.s .s Jen.rJ |c. t|en |rc.e.ses, ccnp..eJ tc .|.t .cu|J
|.pper || t|e ne.su.eJ p.|ce e|.st|c|ty c| supp|y .e.e |c.e.`
12. ¯|e ´.se |r |c|rt cr c|g..ette t.xes .rJ teer snck|rg suggests t|.t . ||g|e. t.x cr c|g..ettes .cu|J
.eJuce teer snck|rg .rJ p.en.tu.e Je.t|s. S|cu|J c|g..ette t.xes t|e.e|c.e be ..|seJ`
134 PRINCIPL£S OI £CONOMICS
N U M £ R I C A L P R O 8 L £ M S
1. |ccrcn|st |.v|J |cne. |curJ t|.t |r |rt.cJuctc.y eccrcn|cs c|.sses . 10 |rc.e.se |r c|.ss .tterJ.rce
|s .sscc|.teJ .|t| . 4 |rc.e.se |r ccu.se g..Je.
¦¦
\|.t |s t|e e|.st|c|ty c| ccu.se g..Je .|t| .espect tc
c|.ss .tterJ.rce`
2. |e|e. tc ||gu.e 5.2 .rJ
.. |s|rg t|e ..c e|.st|c|ty c| Jen.rJ |c.nu|., ccnpute t|e p.|ce e|.st|c|ty c| Jen.rJ bet.eer
pc|rts b .rJ ´.
b. |s|rg t|e ..c e|.st|c|ty c| Jen.rJ |c.nu|., ccnpute t|e p.|ce e|.st|c|ty c| Jen.rJ bet.eer
pc|rts | .rJ |.
c. |c. Jc t|e v.|ues c| p.|ce e|.st|c|ty c| Jen.rJ ccnp..e` \|y ..e t|ey t|e s.ne c. J||e.ert`
J. ´cnpute t|e s|cpe c| t|e Jen.rJ cu.ve bet.eer pc|rts b .rJ ´.
e. ´cnpute. t|e s|cpe c| t|e Jen.rJ cu.ve bet.eer pc|rts | .rJ |.
|. |c. Jc t|e s|cpes ccnp..e` \|y ..e t|ey t|e s.ne c. J||e.ert`
3. ´crs|Je. t|e |c||c.|rg ,ucte |.cn ¯|e /o|| .|·ee| .oo··o| ´A bunpe. c.cp c| c..rges |r ||c.|J. |.st ye..
J.cve Jc.r c..rge p.|ces. As ¦u|ce n..kete.s ccsts |e||, t|ey cut p.|ces by .s nuc| .s 15. ¯|.t ..s
ercug| tc tenpt scne v.|uec.|erteJ custcne.s. ur|t vc|une c| |.c.er ¦u|ces .ctu.||y .cse .bcut 6
Ju.|rg t|e ,u..te..´
.. C|ver t|ese runbe.s, .rJ .ssun|rg t|e.e .e.e rc c|.rges |r Jen.rJ s|||te.s |c. |.c.er c..rge
¦u|ce, .|.t ..s t|e p.|ce e|.st|c|ty c| Jen.rJ |c. |.c.er c..rge ¦u|ce`
b. \|.t Jc ycu t||rk |.ppereJ tc tct.| sperJ|rg cr |.c.er c..rge ¦u|ce` \|y`
4. Suppcse ycu ..e t|e n.r.ge. c| . .est.u..rt t|.t se.ves .r .ve..ge c| 400 ne.|s pe. J.y .t .r .ve..ge
p.|ce pe. ne.| c| ´20. Or t|e b.s|s c| . su.vey, ycu |.ve Jete.n|reJ t|.t .eJuc|rg t|e p.|ce c| .r .ve..ge
ne.| tc ´18 .cu|J |rc.e.se t|e ,u.rt|ty Jen.rJeJ tc 450 pe. J.y.
.. ´cnpute t|e p.|ce e|.st|c|ty c| Jen.rJ bet.eer t|ese t.c pc|rts.
b. \cu|J ycu expect tct.| .everues tc .|se c. |.||` |xp|.|r.
c. Suppcse ycu |.ve .eJuceJ t|e .ve..ge p.|ce c| . ne.| tc ´18 .rJ ..e ccrs|Je.|rg . |u.t|e.
.eJuct|cr tc ´16. Arct|e. su.vey s|c.s t|.t t|e ,u.rt|ty Jen.rJeJ c| ne.|s .||| |rc.e.se |.cn
450 tc 500 pe. J.y. ´cnpute t|e p.|ce e|.st|c|ty c| Jen.rJ bet.eer t|ese t.c pc|rts.
J. \cu|J ycu expect tct.| .everue tc .|se c. |.|| .s . .esu|t c| t||s seccrJ p.|ce .eJuct|cr` |xp|.|r.
e. ´cnpute tct.| .everue .t t|e t|.ee ne.| p.|ces. |c t|ese tct.|s ccr|.n ycu. .rs.e.s |r (b) .rJ
(J) .bcve`
5. ¯|e text rctes t|.t, |c. .ry ||re.. Jen.rJ cu.ve, Jen.rJ |s p.|ce e|.st|c |r t|e uppe. |.|| .rJ p.|ce
|re|.st|c |r t|e |c.e. |.||. ´crs|Je. t|e |c||c.|rg Jen.rJ cu.ves.
¯|e t.b|e g|ves t|e p.|ces .rJ ,u.rt|t|es cc..espcrJ|rg tc e.c| c| t|e pc|rts s|c.r cr t|e t.c Jen.rJ
cu.ves.
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 135
Demand curve |
1
[PaneI (a)] Demand curve |
2
[PaneI (b)]
Price Quantity Price Quantity
A 80 2 | 8 20
b 0 3 | 30
´ 30 C 3 0
| 20 8 | 2 80
.. ´cnpute t|e p.|ce e|.st|c|ty c| Jen.rJ bet.eer pc|rts A .rJ b .rJ bet.eer pc|rts ´ .rJ | cr
Jen.rJ cu.ve |
1
|r |.re| (.). A.e ycu. .esu|ts ccrs|stert .|t| t|e rct|cr t|.t . ||re.. Jen.rJ
cu.ve |s p.|ce e|.st|c |r |ts uppe. |.|| .rJ p.|ce |re|.st|c |r |ts |c.e. |.||`
b. ´cnpute t|e p.|ce e|.st|c|ty c| Jen.rJ bet.eer pc|rts | .rJ | .rJ bet.eer pc|rts C .rJ | cr
Jen.rJ cu.ve |
2
|r |.re| (b). A.e ycu. .esu|ts ccrs|stert .|t| t|e rct|cr t|.t . ||re.. Jen.rJ
cu.ve |s p.|ce e|.st|c |r |ts uppe. |.|| .rJ p.|ce |re|.st|c |r |ts |c.e. |.||`
c. ´cnp..e tct.| sperJ|rg .t pc|rts A .rJ b cr |
1
|r |.re| (.). |s ycu. .esu|t ccrs|stert .|t| ycu.
|rJ|rg .bcut t|e p.|ce e|.st|c|ty c| Jen.rJ bet.eer t|cse t.c pc|rts`
J. ´cnp..e tct.| sperJ|rg .t pc|rts ´ .rJ | cr |
1
|r |.re| (.). |s ycu. .esu|t ccrs|stert .|t| ycu.
|rJ|rg .bcut t|e p.|ce e|.st|c|ty c| Jen.rJ bet.eer t|cse t.c pc|rts`
e. ´cnp..e tct.| sperJ|rg .t pc|rts | .rJ | cr |
2
|r |.re| (b). |s ycu. .esu|t ccrs|stert .|t| ycu.
|rJ|rg .bcut t|e p.|ce e|.st|c|ty c| Jen.rJ bet.eer t|cse t.c pc|rts`
|. ´cnp..e tct.| sperJ|rg .t pc|rts C .rJ | cr |
2
|r |.re| (b). |s ycu. .esu|t ccrs|stert .|t| ycu.
|rJ|rg .bcut t|e p.|ce e|.st|c|ty c| Jen.rJ bet.eer t|cse t.c pc|rts`
6. Suppcse '.r|ce buys t|e |c||c.|rg .ncurts c| v..|cus |ccJ |tens JeperJ|rg cr |e. .eek|y |rccne.
WeekIy Income Hamburgers Pizza Ice Cream Sundaes
´500 3 3 2
´50 4 2 2
.. ´cnpute '.r|ces |rccne e|.st|c|ty c| Jen.rJ |c. |.nbu.ge.s.
b. ´cnpute '.r|ces |rccne e|.st|c|ty c| Jen.rJ |c. p|....
c. ´cnpute '.r|ces |rccne e|.st|c|ty c| Jen.rJ |c. |ce c.e.n surJ.es.
J. ´|.ss||y e.c| gccJ .s rc.n.| c. |r|e.|c..
. Suppcse t|e |c||c.|rg t.b|e Jesc.|bes 'cce|yrs .eek|y sr.ck pu.c|.ses, .||c| v..y JeperJ|rg cr t|e
p.|ce c| . b.g c| c||ps.
Price of bag of chips 8ags of chips Containers of saIsa 8ags of pretzeIs Cans of soda
´1.00 2 3 1 4
´1.50 1 2 2 4
.. ´cnpute t|e c.css p.|ce e|.st|c|ty c| s.|s. .|t| .espect tc t|e p.|ce c| . b.g c| c||ps.
b. ´cnpute t|e c.css p.|ce e|.st|c|ty c| p.et.e|s .|t| .espect tc t|e p.|ce c| . b.g c| c||ps.
c. ´cnpute t|e c.css p.|ce e|.st|c|ty c| scJ. .|t| .espect tc t|e p.|ce c| . b.g c| c||ps.
J. A.e c||ps .rJ s.|s. subst|tutes c. ccnp|enerts` |c. Jc ycu krc.`
e. A.e c||ps .rJ p.et.e|s subst|tutes c. ccnp|enerts` |c. Jc ycu krc.`
|. A.e c||ps .rJ scJ. subst|tutes c. ccnp|enerts` |c. Jc ycu krc.`
8. ¯|e t.b|e be|c. Jesc.|bes t|e supp|y cu.ve |c. ||g|t bu|bs.
Price per Iight buIb Quantity suppIied per day
´1.00 500
1.50 3,000
2.00 4,000
2.50 4,500
3.00 4,500
136 PRINCIPL£S OI £CONOMICS
´cnpute t|e p.|ce e|.st|c|ty c| supp|y .rJ Jete.n|re .|et|e. supp|y |s p.|ce e|.st|c, p.|ce |re|.st|c,
pe.|ect|y e|.st|c, pe.|ect|y |re|.st|c, c. ur|t e|.st|c.
.. .|er t|e p.|ce c| . ||g|t bu|b |rc.e.ses |.cn ´1.00 tc ´1.50.
b. .|er t|e p.|ce c| . ||g|t bu|b |rc.e.ses |.cn ´1.50 tc ´2.00.
c. .|er t|e p.|ce c| . ||g|t bu|b |rc.e.ses |.cn ´2.00 tc ´2.50.
J. .|er t|e p.|ce c| . ||g|t bu|b |rc.e.ses |.cn ´2.50 tc ´3.00.
CHAP7£R 5 £LAS7ICI7Y: A M£ASUR£ OI R£SPONS£ 137
1.
2.
3.
4.
5.
6.
.
ENDNOTES
|ct|ce t|.t s|rce t|e runbe. c| ur|ts sc|J c| . gccJ |s t|e s.ne .s t|e runbe. c|
ur|ts bcug|t, t|e Je|r|t|cr |c. tct.| .everue ccu|J .|sc be useJ tc Je|re tct.|
sperJ|rg. \||c| te.n .e use JeperJs cr t|e ,uest|cr .t |.rJ. || .e ..e t.y|rg tc
Jete.n|re .|.t |.ppers tc .everues c| se||e.s, t|er .e ..e .sk|rg .bcut tct.| .ev
erue. || .e ..e t.y|rg tc Jete.n|re |c. nuc| ccrsune.s sperJ, t|er .e ..e .sk|rg
.bcut tct.| sperJ|rg.
||v|s|cr by .e.c .esu|ts |r .r urJe|reJ sc|ut|cr. S.y|rg t|.t t|e p.|ce e|.st|c|ty c|
Jen.rJ |s |r|r|te .e,u|.es t|.t .e s.y t|e Jercn|r.tc. ´.pp.c.c|es´ .e.c.
See Cec.ges b.esscr, 'cyce |..g.y, 'e.r|cup V.J.e, .rJ A|.|r ||.ctte, ´|ccrcn|c
.rJ St.uctu..| |ete.n|r.rts c| t|e |en.rJ |c. |.erc| ¯..rspc.t. Ar Ar.|ys|s cr .
|.re| c| |.erc| |.b.r A.e.s |s|rg S|.|rk.ge |st|n.tc.s.´ ¯·o··¡o·|o||o· |e·eo·c|
|o·| ^ 38. 4 (V.y 2004). 269285. See .|sc Arr. V.t.s. ´|en.rJ .rJ |everue |n
p||c.t|crs c| .r |rteg..teJ ¯..rspc.t |c||cy. ¯|e ´.se c| V.J.|J.´ ¯·o··¡o·| |e.|e.·
24.2 (V..c| 2004). 19521.
|cbe.t b. |ke|urJ, S. |c.J, .rJ 'c|r |. '.ckscr. ´A.e |cc.| ¯\ V..kets Sep...te V..
kets`´ |·|e··o||o·o| .oo··o| o| ||e |co·o·|c· o| |o·|·e·· .1 (2000). 99.
A|t|cug| c|cse tc .e.c |r .|| c.ses, t|e s|gr||c.rt .rJ pcs|t|ve s|grs c| |rccne e|.st|
c|ty |c. n..¡u.r., .|cc|c|, .rJ ccc.|re suggest t|.t t|ey ..e rc.n.| gccJs, but s|g
r||c.rt .rJ reg.t|ve s|grs, |r t|e c.se c| |e.c|r, suggest t|.t |e.c|r |s .r |r|e.|c.
gccJ, S.|e. .rJ ´|.|cupk. (c|teJ be|c.) suggest t|e e|ects c| |rccne |c. .|| |cu.
subst.rces n|g|t be .|ecteJ by eJuc.t|cr.
Scu.ces. 'c|r A. ¯.u..s. ´|ub||c |c||cy .rJ Snck|rg ´ess.t|cr .ncrg +curg
AJu|ts |r t|e |r|teJ St.tes,´ |eo||| |o||c,, 68.3 ('ure 2004). 321332. Cec.ges
b.esscr, 'cyce |..g.y, 'e.r|cup V.J.e, .rJ A|.|r ||.ctte, ´|ccrcn|c .rJ St.uctu..|
|ete.n|r.rts c| t|e |en.rJ |c. |.erc| ¯..rspc.t. Ar Ar.|ys|s cr . |.re| c| |.erc|
|.b.r A.e.s |s|rg S|.|rk.ge |st|n.tc.s,´ ¯·o··¡o·|o||o· |e·eo·c| |o·| ^ 38.4 (V.y
2004). 269285, Avre. b..||.r .rJ b.uce S.ce.Jcte, ´¯|e |espcrse c| ´.|n|r.|s .rJ
|cr´.|n|r.|s tc ||res,´ .oo··o| o| |o. o·J |co·o·|c·, 4.1 (Ap.|| 2004). 11, |.r.
|css .rJ |..rk '. ´|.|cupk., ´¯|e ||ect c| |ub||c |c||c|es .rJ |.|ces cr +cut|
Snck|rg,´ .oo||e·· |co·o·|c .oo··o| 0.4 (Ap.|| 2004). 96815, Arr. V.t.s,
´|en.rJ .rJ |everue |np||c.t|crs c| .r |rteg..teJ ¯..rspc.t |c||cy. ¯|e ´.se c|
V.J.|J,´ ¯·o··¡o·| |e.|e.·, 24.2 (V..c| 2004). 19521, V.tt|e. ´. |...e||y, ¯e..y |.
|ec|.cek, .rJ |..rk '. ´|.|cupk., ´¯|e |np.ct c| ¯cb.ccc ´crt.c| |.cg..n |x
perJ|tu.es cr Agg.eg.te ´|g..ette S.|es. 19812000,´ .oo··o| o| |eo||| |co·o·|c·
22.5 (Septenbe. 2003). 843859, |cbe.t b. |ke|urJ, S. |c.J, .rJ 'c|r |. '.ckscr. ´A.e
|cc.| ¯\ V..kets Sep...te V..kets`´ |·|e··o||o·o| .oo··o| o| ||e |co·o·|c· o| |o·|·e··
.1 (2000). 99, |er.y S.|e. .rJ |..rk ´|.|cupk., ´¯|e |en.rJ |c. ||||c|t |.ugs,´
|co·o·|c |·¸o|·, 3(3) ('u|y, 1999). 401411, |cbe.t \. |cge|, ´´.tc||rg |p \|t| t|e
|ccrcny,´ ^·e·|co· |co·o·|c |e.|e. 89(1) (V..c|, 1999).121, V|c|.e| C.cssn.r,
´A Su.vey c| |ccrcn|c VcJe|s c| AJJ|ct|ve be|.v|c.,´ .oo··o| o| |·o¸ |··oe· 28.3
(Sunne. 1998).631643, S.r¦|b b|uy.r .rJ ||gcbe.tc A. |cpe., ´O||gcpc|y |c.e. |r
t|e |ccJ .rJ ¯cb.ccc |rJust.|es,´ ^·e·|co· .oo··o| o| ^¸·|co||o·o| |co·o·|c· 9
(August 199).10351043, V|c|.e| C.cssn.r, ´´|g..ette ¯.xes,´ |o·||c |eo||| |e¡o·|·
112.4 ('u|y/August 199). 29029, Arr |.rser, ´¯|e ¯.x |rc|Jerce c| t|e ´c|c..Jc
St.te |ctte.y |rst.rt C.ne,´ |o·||c ||·o·ce (oo·|e·|, 23(3) ('u|y, 1995).385398,
|.r|e| b. Su|ts, ´Ag.|cu|tu.e,´ |r \.|te. AJ.ns .rJ '.nes b.cck, eJs., ¯|e .|·oc|o·e o|
^·e·|co· |·Jo·|·,, 9
t|
eJ. (|rg|e.ccJ ´|||s. |.ert|ce |.||, , 1995), pp. 133, |erret|
C. ||.|rg., ´bee.,´ |r \.|te. AJ.ns .rJ '.nes b.cck, eJs., ¯|e .|·oc|o·e o| ^·e·|co· |·
Jo·|·,, 9
t|
eJ. (|rg|e.ccJ ´|||s. |.ert|ce |.||, 1995), pp. 119151, 'c|r A. ||..c .rJ
|.v|J b|unert|.|, ´||ys|c|.r |.bc. Supp|y. |c |rccne ||ects V.tte.`´ .oo··o| o|
|eo||| |co·o·|c· 13(4) (|ecenbe. 1994).433453, |cug|.s V. b.c.r, ´¯|e ||s|rg
|.|ce c| ||ys|c|.rs Se.v|ces. A ´c..ect|cr .rJ |xters|cr cr Supp|y,´ |e.|e. o| |co
·o·|c· o·J .|o||·||c· 6(2) (V.y 1994).389393, Cec.ge ´. |.v|s .rJ V|c|.e| |. \c||
ger.rt, ´|en.rJ ||.st|c|t|es |.cn . ||sc.ete ´|c|ce VcJe|. ¯|e |.tu..| ´|.|stn.s
¯.ee V..ket,´ .oo··o| o| ^¸·|co||o·o| |co·o·|c· 5(3) (August 1993).3038, |.v|J V.
b|.u, ´¯|e Supp|y c| ´|||J ´..e |.bc.,´ .oo··o| o| |o·o· |co·o·|c· 2(11) (Ap.||
1993).32434, ||c|..J b|urJe|| e| o|., ´\|.t |c \e |e..r Abcut ´crsune. |en.rJ
|.tte.rs |.cn V|c.c |.t.`´, ^·e·|co· |co·o·|c |e.|e. 83(3) ('ure 1993).5059, |.
C.sn|, e| o|., ´|ccrcnet.|c Ar.|ys|s c| ´c||us|ve be|.v|c. |r . Sc|t|.|rk V..ket,´
.oo··o| o| |co·o·|c· o·J /o·o¸e·e·| .|·o|e¸, (Sunne. 1992), pp. 2311, V.|.
b.ye, |.\. '.rser, .rJ '.\. |ee, ´AJve.t|s|rg ||ects |r ´cnp|ete |en.rJ Systens,´
^¡¡||eJ |co·o·|c· 24 (1992).1081096, C..y \. b.este. .rJ V|c|.e| |. \c||ger.rt,
´|st|n.t|rg |rte..e|.teJ |en.rJs |c. Ve.ts |s|rg |e. Ve.su.es |c. C.curJ .rJ
¯.b|e ´ut bee|,´ ^·e·|co· .oo··o| o| ^¸·|co||o·o| |co·o·|c· 3 (|cvenbe.
1991).11821194, AJesc¦|, O. AJe|.¦., ´|.|ce ´|.rges, Supp|y ||.st|c|t|es, |rJust.y O.
g.r|..t|cr, .rJ |.|.y Output ||st.|but|cr,´ ^·e·|co· .oo··o| o| ^¸·|co||o·o| |co·o·|c·
3.1 (|eb.u..y 1991).89102, V..k A. |. ||e|rn.r, /o·¸oo·o ´o·|· o| ^·o·e. ´o·|· o|
´o·|·o| (|+.C.eer.ccJ |.ess, 1989), 'u|es V. |ev|re, e| o|., ´¯|e |en.rJ |c. ||g|e.
|Juc.t|cr |r ¯|.ee V|JAt|.rt|c St.tes,´ |e. `o·| |co·o·|c |e.|e. 18 (|.||
1988).320, |.|e |e|er .rJ ´.t|y |c|e|n \esse||s, ´¯|e |en.rJ |c. |.|.y |.cJucts.
St.uctu.e, |.eJ|ct|cr, .rJ |eccnpcs|t|cr,´ ^·e·|co· .oo··o| o| ^¸·|co||o·e |co·o·|c·
(V.y 1988).219228, V|c|.e| C.cssn.r .rJ |er.y S.|e., ´bee. ¯.xes, t|e |eg.|
|.|rk|rg Age, .rJ +cut| Vctc. \e||c|e |.t.||t|es,´ .oo··o| o| |e¸o| .|oJ|e· 16(2) ('ure
198).35134, '.nes V. C.||r .rJ |er.y b. Stee|e, |·e·¸, |co·o·|c· o·J |o||c,
(|e. +c.k. Ac.Jen|c |.ess, 1980), p. 232.
|.|e V. |e|er .rJ ´.t|y |c|e|n \esse|s, ´¯|e |en.rJ |c. |.|.y |.cJucts. St.uc
tu.e, |.eJ|ct|cr, .rJ |eccnpcs|t|cr,´ ^·e·|co· .oo··o| o| ^¸·|co||o·o| |co·o·|c· 0.2
(V.y 1988). 219228.
|.v|J |cne., ´|c StuJerts Cc tc ´|.ss` S|cu|J ¯|ey`´ .oo··o| o| |co·o·|c |e··¡ec|
|.e· .3 (Sunne. 1993). 1614.
138 PRINCIPL£S OI £CONOMICS
´ | A | ¯ | | 6
Markets, Maximizers, and
Efficiency
S7AR7 UP: A DRIV£ IN 7H£ COUN7RY
Suppcse ycu Jec|Je tc t.ke . J.|ve. |c. pu.pcses c| t||s ex.np|e, .e .||| .ssune t|.t ycu |.ve . c.. .v.||.b|e, t|.t
t|e .e.t|e. |s p|e.s.rt, .rJ t|.t t|e.e |s .r ..e. re..by t|.t .||| be pe.|ect |c. ycu. J.|ve.
+cu. Jec|s|cr tc t.ke t||s J.|ve |s . c|c|ce. S|rce eccrcn|cs Je.|s .|t| c|c|ces, .e c.r put eccrcn|cs tc .c.k
|r t||rk|rg .bcut |t. |ccrcn|sts .ssune t|.t pecp|e n.ke c|c|ces t|.t n.x|n|.e t|e v.|ue c| scne cb¦ect|ve. +cu
..e . ccrsune., .e .ssune t|.t t.k|rg . J.|ve |s . c|c|ce t|.t n.x|n|.es ycu. ut|||tyt|e s.t|s|.ct|cr ycu cbt.|r
|.cn ycu. use c| gccJs .rJ se.v|ces .rJ |.cn t|e .ct|v|t|es ycu pu.sue.
+cu ce.t.|r|y p|.r tc er¦cy t|e J.|ve, t|.t er¦cynert |s t|e bere|t ycu expect |.cn |t. but ycu .||| g|ve up
scne t||rgs .s .e||. +cu. J.|ve .||| t.ke scne t|ne, t|ne ycu ccu|J |.ve spert Jc|rg scnet||rg e|se. |t .||| t.ke
scne g.sc||re, .|.t ycu sperJ |c. t|e g.sc||re ccu|J |.ve beer useJ |c. scnet||rg e|se. ¯|e J.|ve .||| .|sc ger
e..te scne .e.. .rJ te.. cr ycu. c... ¯|.t .||| ccst ycu t|e p.|ce c| .ep.|. .rJ n.|rter.rce .rJ .eJuceJ .es.|e
v.|ue c| ycu. c... ¯|e cppc.tur|ty ccst c| ycu. J.|ve .||| t|us |rc|uJe t|e v.|ue c| t|e best ct|e. use c| ycu. t|ne
.rJ t|e v.|ue c| t|e best ct|e. use c| t|e |urJs ycu. J.|ve .||| .e,u|.e. ¯c n.x|n|.e ut|||ty ycu .||| .e|g| t|e be
re|ts c| t|e J.|ve .g.|rst t|e ccst c| t|e J.|ve .rJ n.x|n|.e t|e J||e.erce bet.eer t|cse bere|ts .rJ ccsts.
¯||s c|.pte. |rt.cJuces t|e net|cJ t|.cug| .||c| n.x|n|.|rg c|c|ces c.r be n.Je. ¯||s net|cJ .pp||es rct
¦ust tc ycu. Jec|s|cr tc t.ke . J.|ve, but .|sc tc \.|V..ts Jec|s|cr tc ||.e ext.. .c.ke.s .rJ tc |S` ´c.pc..t|crs
tc p.cJuce ext.. stee|. ¯|e net|cJ .e .||| |e..r c.r be .pp||eJ tc t|e .r.|ys|s c| .ry c|c|ce, .e .||| use |t
t|.cug|cut cu. |rvest|g.t|cr c| n|c.ceccrcn|cs.
\e .||| .|sc see |c. n.x|n|.|rg c|c|ces by |rJ|v|Ju.|s .rJ by |.ns c.r |e.J tc .r .||cc.t|cr c| .escu.ces t|.t
gere..tes t|e g.e.test g.|rs pcss|b|e |c. t|e eccrcny .s . .|c|e. |r t||s .r.|ys|s, .e .||| put . re. |ten |r cu.
tcc|k|t, t|e net|cJ t|.cug| .||c| |rJ|v|Ju.|s .rJ |.ns n.x|n|.e, tcget|e. .|t| Jen.rJ .rJ supp|y .r.|ys|s, tc
see |c. t|e n..ketp|.ce c.r gu|Je .escu.ces tc t|e|. best uses.
\e .||| .|sc ex.n|re c.ses |r .||c| n.x|n|.|rg c|c|ces Jc rct gu|Je .escu.ces tc t|e|. best uses. ¯|.t pcss|b
|||ty |s suggesteJ by .rct|e. .spect c| ycu. c|c|ce tc t.ke . J.|ve. |r .JJ|t|cr tc t|e ccsts ycu .||| ccrs|Je., t|e.e
.||| be ccsts |npcseJ cr ct|e.s. +cu. J.|ve .||| pc||ute t|e .|., sc p..t c| t|e cppc.tur|ty ccst c| t|e J.|ve .||| be
t|e v.|ue c| t|e s||g|t|y c|e.re. .|. pecp|e |r ycu. ..e. n|g|t |.ve |.J. |escu.ces suc| .s t|e .|. .e b.e.t|e .||| .|
ncst ce.t.|r|y be n|s.||cc.teJ .s t|e .esu|t c| n.x|n|.|rg c|c|ces. \e .||| see ¦ust |c. n|s.||cc.t|cr c| .r ecc
rcnys .escu.ces c.r cccu. .rJ |c. t||s n|s.||cc.t|cr ccu|J be |xeJ.
economic proñt
¯|e J||e.erce bet.eer tct.|
.everue .rJ tct.| ccst.
net beneñt
¯|e tct.| bere|t c| .r .ct|v|ty
n|rus |ts cppc.tur|ty ccst.
marginaI beneñt
¯|e .ncurt by .||c| .r
.JJ|t|cr.| ur|t c| .r .ct|v|ty
|rc.e.ses |ts tct.| bere|t.
marginaI cost
¯|e .ncurt by .||c| .r
.JJ|t|cr.| ur|t c| .r .ct|v|ty
|rc.e.ses |ts tct.| ccst.
marginaI decision ruIe
|| t|e n..g|r.| bere|t c| .r
.JJ|t|cr.| ur|t c| .r .ct|v|ty
exceeJs t|e n..g|r.| ccst,
t|e ,u.rt|ty c| t|e .ct|v|ty
s|cu|J be |rc.e.seJ. || t|e
n..g|r.| bere|t |s |ess t|.r
t|e n..g|r.| ccst, t|e
,u.rt|ty s|cu|J be .eJuceJ.
1. THE LOGIC OF MAXIMIZING BEHAVIOR
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. £xpIain the maximization assumption that economists make in expIaining the behavior of con-
sumers and ñrms.
2. £xpIain and iIIustrate the concepts of marginaI beneñt and marginaI cost and appIy them to
understanding the marginaI decision ruIe.
To say that individuals maximize is to say that they pick some objective and then seek to maximize its
value. A spiintei might want to maximize his oi hei speed; a politician might want to maximize the
piobability that he oi she will win the next election. Economists pay special attention to two gioups of
maximizeis: consumeis and fims. We assume that consumeis seek to maximize utility and that fims
seek to maximize economic pront, which is the difeience between total ievenue and total cost. The
costs involved in this concept of economic pioft aie computed in the economic sense-as the oppoi-
tunity costs, oi value of the best oppoitunity foigone.
The assumption of maximizing behavioi lies at the heait of economic analysis. As we exploie its
implications, howevei, we must keep in mind the distinction between models and the ieal woild. Oui
model assumes that individuals make choices in a way that achieves a maximum value foi some cleaily
defned objective. In using such a model, economists do not assume that people actually go thiough the
calculations we will desciibe. What economists do aigue is that people's behavioi is bioadly consistent
with such a model. People may not consciously seek to maximize anything, but they behave as though
they do.
1.1 The Analysis of Maximizing Behavioi
The activities of consumeis and fims have benefts, and they also have oppoitunity costs. We assume
that given these benefts and costs, consumeis and fims will make choices that maximize the net be-
nent of each activity-the total beneft of the activity minus its oppoitunity cost. The specifc measuies
of beneft and cost vaiy with the kind of choice being made. In the case of a fim's choices in pioduc-
tion, foi example, the total beneft of pioduction is the ievenue a fim ieceives fiom selling the pioduct;
the total cost is the oppoitunity cost the fim incuis by pioducing it. The net beneft is thus total ieven-
ue minus total oppoitunity cost, oi economic pioft.
Economists maintain that in oidei to maximize net beneft, consumeis and fims evaluate each
activity at the maigin-they considei the additional beneft and the additional cost of anothei unit of
the activity. Should you ¨supeisize" youi oidei at McDonald's: Will the additional beveiage and the
additional fiench fiies be woith the extia cost: Should a fim hiie one moie woikei: Will the benefts
to the fim of hiiing this woikei be woith the additional cost of hiiing him oi hei:
The marginal benent is the amount by which an additional unit of an activity incieases its total
beneft. It is the amount by which the extia fiench fiies inciease youi satisfaction, oi the extia ievenue
the fim expects to biing in by hiiing anothei woikei. The marginal cost is the amount by which an
additional unit of an activity incieases its total cost. You will pay moie to supeisize youi McDonald's
oidei; the fim's laboi costs will iise when it hiies anothei woikei.
To deteimine the quantity of any activity that will maximize its net beneft, we apply the marginal
decision rule: If the maiginal beneft of an additional unit of an activity exceeds the maiginal cost, the
quantity of the activity should be incieased. If the maiginal beneft is less than the maiginal cost, the
quantity should be ieduced. Net beneft is maximized at the point at which maiginal beneft equals
maiginal cost. The maiginal decision iule is at the heait of the economic way of thinking. The iule ba-
sically says this: If the additional beneft of one moie unit exceeds the extia cost, do it; if not, do not.
This simple logic gives us a poweiful tool foi the analysis of choice. Peihaps moie than any othei iule
in economic analysis, the maiginal decision iule typifes the way in which economists analyze piob-
lems. We shall apply it in eveiy chaptei that follows in the micioeconomics poition of this text.
140 PRINCIPL£S OI £CONOMICS
constraint
A bcurJ..y t|.t ||n|ts t|e
..rge c| c|c|ces t|.t c.r be
n.Je.
Maximizing choices must be made within the paiameteis imposed by some constraint, which is a
boundaiy that limits the iange of choices that can be made. We assume that a consumei seeks the
gieatest satisfaction possible within the limits of his oi hei income oi budget. A fim cannot pioduce
beyond the limits of its pioduction capacity at a point in time.
The maiginal decision iule foims the foundation foi the stiuctuie economists use to analyze all
choices. At fist glance, it may seem that a consumei seeking satisfaction fiom, say, pizza has little in
common with an entiepieneui seeking pioft fiom the pioduction of custom-designed semiconduct-
ois. But maximizing choices always follow the maiginal decision iule-and that iule holds iegaidless of
what is being maximized oi who is doing the maximizing.
To see how the logic of maximizing choices woiks, we will examine a specifc pioblem. We will
then extend that pioblem to the geneial analysis of maximizing choices.
A ProbIem in Maximization
Suppose a college student, Lauiie Phan, faces two midteims tomoiiow, one in economics and anothei
in accounting. She has alieady decided to spend 3 houis studying foi the two examinations. This de-
cision imposes a constiaint on the pioblem. Suppose that Ms. Phan's goal is to allocate hei 3 houis of
study so that she incieases hei total scoie foi the two exams by as much as possible.
Ms. Phan expects the ielationship between the time she spends studying foi the economics exam
and the total gain in hei scoie to be as given by the second iow of the table in Panel (a) of Figuie 6.1.
We inteipiet the expected total gain in hei scoie as the total beneft of study. She expects that 1 houi of
study will iaise hei scoie by 18 points; 2 houis will iaise it by 32 points, and so on. These values aie
plotted in Panel (b). Notice that the total beneft cuive iises, but by smallei and smallei amounts, as she
studies moie and moie. The slope of the cuive, which in this case tells us the iate at which hei expected
scoie iises with incieased study time, falls as we tiavel up and to the iight along the cuive.
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 141
II GUR£ 6. 1 7he 8enefits of Studying £conomics
¯|e t.b|e |r |.re| (.) s|c.s t|e tct.| bere|t .rJ n..g|r.| bere|t c| t|e t|ne |.u.|e ||.r sperJs stuJy|rg |c. |e.
eccrcn|cs ex.n. |.re| (b) s|c.s t|e tct.| bere|t cu.ve. |.re| (c) s|c.s t|e n..g|r.| bere|t cu.ve, .||c| |s g|ver
by t|e s|cpe c| t|e tct.| bere|t cu.ve |r |.re| (b).
142 PRINCIPL£S OI £CONOMICS
II GUR£ 6. 2 7he MarginaI 8enefits of
Studying Accounting
¯|e n..g|r.| bere|t |.u.|e ||.r expects |.cn
stuJy|rg |c. |e. .cccurt|rg ex.n |s s|c.r by
t|e n..g|r.| bere|t cu.ve. ¯|e |.st |cu. c|
stuJy |rc.e.ses |e. expecteJ scc.e by 14
pc|rts, t|e seccrJ |cu. by 10 pc|rts, t|e t||.J
by 6 pc|rts, .rJ sc cr.
Now look at the thiid iow in the table in Panel (a). It tells us the amount by which each additional houi
of study incieases hei expected scoie; it gives the maiginal beneft of studying foi the economics exam.
Maiginal beneft equals the amount by which total beneft iises with each additional houi of study. Be-
cause these maiginal benefts aie given by the changes in total benefts fiom additional houis of study,
they equal the slope of the total beneft cuive. We see this in the ielationship between Panels (b) and (c)
of Figuie 6.1. The decieasing slope of the total beneft cuive in Panel (b) gives us the downwaid-slop-
ing maiginal beneft cuive in Panel (c).
The maiginal beneft cuive tells us what happens when we pass fiom one point to anothei on the
total beneft cuive, so we have plotted maiginal benefts at the midpoints of the houily inteivals in
Panel (c). Foi example, the total beneft cuive in Panel (b) tells us that, when Ms. Phan incieases hei
time studying foi the economics exam fiom 2 houis to 3 houis, hei total beneft iises fiom 32 points to
42 points. The inciease of 10 points is the maiginal beneft of incieasing study time foi the economics
exam fiom 2 houis to 3 houis. We maik the point foi a maiginal beneft of 10 points midway between
2 and 3 houis. Because maiginal values tell us what happens as we pass fiom one quantity to the next,
we shall always plot them at the midpoints of inteivals of the vaiiable on the hoiizontal axis.
We can peifoim the same kind of analysis to obtain the maiginal beneft cuive foi studying foi the
accounting exam. Figuie 6.2 piesents this cuive. Like the maiginal beneft cuive foi studying econom-
ics, it slopes downwaid. Once again, we have plotted maiginal values at the midpoints of the inteivals.
Incieasing study time in accounting fiom 0 to 1 houi incieases Ms. Phan's expected accounting scoie
by 14 points.
Ms. Phan's maiginal beneft cuives foi studying typify a geneial phenomenon in
economics. Maiginal beneft cuives foi viitually all activities, including the activities of
consumeis and of fims, slope downwaid. Think about youi own expeiience with
studying. On a given day, the fist houi spent studying a ceitain subject piobably genei-
ates a gieatei maiginal beneft than the second, and the second houi piobably geneiates
a gieatei maiginal beneft than the thiid. You may ieach a point at which an extia houi
of study is unlikely to yield any beneft at all. Of couise, oui example of Lauiie Phan's
expected exam scoies is a highly stylized one. One could haidly expect a student to
have a piecise set of numbeis to guide him oi hei in allocating study time. But it is cei-
tainly the case that students have a iough idea of the likely payof of study time in
difeient subjects. If you weie faced with exams in two subjects, it is likely that you
would set aside a ceitain amount of study time, just as Ms. Phan did in oui example.
And it is likely that youi own expeiience would seive as a guide in deteimining how to
allocate that time. Economists do not assume that people have numeiical scales in theii
heads with which to diaw maiginal beneft and maiginal cost cuives. They meiely as-
sume that people act as if they did.
The natuie of maiginal benefts can change with difeient applications. Foi a ies-
tauiant, the maiginal beneft of seiving one moie meal can be defned as the ievenue
that meal pioduces. Foi a consumei, the maiginal beneft of one moie slice of pizza can
be consideied in teims of the additional satisfaction the pizza will cieate. But whatevei
the natuie of the beneft, maiginal benefts geneially fall as quantities inciease.
Ms. Phan's falling maiginal beneft fiom houis spent studying accounting has spe-
cial signifcance foi oui analysis of hei choice conceining how many houis to devote to
economics. In oui pioblem, she had decided to devote 3 houis to studying the two sub-
jects. That means that the oppoitunity cost of an houi spent studying economics equals
the beneft she would have gotten spending that houi studying accounting.
Suppose, foi example, that she weie to considei spending all 3 houis studying ac-
counting. The maiginal beneft cuive foi studying foi hei accounting exam tells us that
she expects that the ffth houi will add nothing to hei scoie. Shifting that houi to economics would cost
nothing. We can say that the maiginal cost of the fist houi spent studying economics is zeio. We ob-
tained this value fiom the maiginal beneft cuive foi studying accounting in Figuie 6.2.
Similaily, we can fnd the maiginal cost of the second houi studying economics. That iequiies giv-
ing up the fouith houi spent on accounting. Figuie 6.2 tells us that the maiginal beneft of that houi
equals 2-that is the maiginal cost of spending the second houi studying economics.
Figuie 6.3 shows the maiginal cost cuive of studying economics. We see that at fist, time devoted
to studying economics has a low maiginal cost. As time spent studying economics incieases, howevei,
it iequiies hei to give up study time in accounting that she expects will be moie and moie pioductive.
The maiginal cost cuive foi studying economics can thus be deiived fiom the maiginal beneft cuive
foi studying accounting. Figuie 6.3 also shows the maiginal beneft cuive foi studying economics that
we deiived in Panel (b) of Figuie 6.1.
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 143
II GUR£ 6. 3 7he MarginaI 8enefits and
MarginaI Costs of Studying £conomics
¯|e n..g|r.| bere|t cu.ve |.cn |.re| (c) c|
||gu.e 6.1 |s s|c.r tcget|e. .|t| t|e n..g|r.|
ccsts c| stuJy|rg eccrcn|cs. ¯|e n..g|r.|
ccst cu.ve |s Je.|veJ |.cn t|e n..g|r.| bere|t
cu.ve |c. stuJy|rg .cccurt|rg s|c.r |r ||gu.e
6.2.
Just as maiginal beneft cuives geneially slope downwaid, maiginal cost cuives
geneially slope upwaid, as does the one in Figuie 6.3. In the case of allocating time, the
phenomenon of iising maiginal cost iesults fiom the simple fact that, the moie time a
peison devotes to one activity, the less time is available foi anothei. And the moie one
ieduces the second activity, the gieatei the foigone maiginal benefts aie likely to be.
That means the maiginal cost cuive foi that fist activity iises.
Because we now have maiginal beneft and maiginal cost cuives foi studying eco-
nomics, we can apply the maiginal decision iule. This iule says that, to maximize the
net beneft of an activity, a decision makei should inciease an activity up to the point at
which maiginal beneft equals maiginal cost. That occuis wheie the maiginal beneft
and maiginal cost cuives inteisect, with 3 houis spent studying economics and 2 houis
spent studying accounting.
Using MarginaI 8enefit and MarginaI Cost Curves to Iind Net 8enefits
We can use maiginal beneft and maiginal cost cuives to show the total beneft, the
total cost, and the net beneft of an activity. We will see that equating maiginal beneft
to maiginal cost does, indeed, maximize net beneft. We will also develop anothei tool
to use in inteipieting maiginal beneft and cost cuives.
Panel (a) of Figuie 6.4 shows the maiginal beneft cuive we deiived in Panel (c) of
Figuie 6.1. The coiiesponding point on the maiginal beneft cuive gives the maiginal
beneft of the fist houi of study foi the economics exam, 18 points. This same value
equals the aiea of the iectangle bounded by 0 and 1 houi of study and the maiginal be-
neft of 18. Similaily, the maiginal beneft of the second houi, 14 points, is shown by
the coiiesponding point on the maiginal beneft cuive and by the aiea of the shaded
iectangle bounded by 1 and 2 houis of study. The total beneft of 2 houis of study
equals the sum of the aieas of the fist two iectangles, 32 points. We continue this pio-
ceduie thiough the ffth houi of studying economics; the aieas foi each of the shaded
iectangles aie shown in the giaph.
II GUR£ 6. 4 7he 8enefits and Costs of Studying £conomics
|.re| (.) s|c.s t|e n..g|r.| bere|t cu.ve c| ||gu.e 6.1. ¯|e tct.| bere|t c| stuJy|rg eccrcn|cs .t .ry g|ver
,u.rt|ty c| stuJy t|ne |s g|ver .pp.cx|n.te|y by t|e s|.JeJ ..e. be|c. t|e n..g|r.| bere|t cu.ve up tc t|.t |eve|
c| stuJy. |.re| (b) s|c.s t|e n..g|r.| ccst cu.ve |.cn ||gu.e 6.3. ¯|e tct.| ccst c| stuJy|rg eccrcn|cs .t .ry g|ver
,u.rt|ty c| stuJy |s g|ver .pp.cx|n.te|y by t|e s|.JeJ ..e. be|c. t|e n..g|r.| ccst cu.ve up tc t|.t |eve| c| stuJy.
Two featuies of the cuive in Panel (a) of Figuie 6.4 aie paiticulaily impoitant. Fiist, note that the sum
of the aieas of the fve iectangles, 30 points, equals the total beneft of 3 houis of study given in the
table in Panel (a) of Figuie 6.1. Second, notice that the shaded aieas aie appioximately equal to the aiea
undei the maiginal beneft cuive between 0 and 3 houis of study. We can pick any quantity of study
time, and the total beneft of that quantity equals the sum of the shaded iectangles between zeio and
that quantity. Thus, the total beneft of 2 houis of study equals 32 points, the sum of the aieas of the
fist two iectangles.
144 PRINCIPL£S OI £CONOMICS
deadweight Ioss
¯|e |css |r ret bere|ts
.esu|t|rg |.cn . |.||u.e tc
c...y cut .r .ct|v|ty .t t|e
ncst e|c|ert |eve|.
Now considei the maiginal cost cuive in Panel (b) of Figuie 6.4. The aieas of the shaded iectangles
equal the values of maiginal cost. The maiginal cost of the fist houi of study equals zeio; theie is thus
no iectangle undei the cuive. The maiginal cost of the second houi of study equals 2 points; that is the
aiea of the iectangle bounded by 1 and 2 houis of study and a maiginal cost of 2. The maiginal cost of
the thiid houi of study is 6 points; this is the aiea of the shaded iectangle bounded by 2 and 3 houis of
study and a maiginal cost of 6.
Looking at the iectangles in Panel (b) ovei the iange of 0 to 3 houis of study, we see that the aieas
of the fve iectangles total 32, the total cost of spending all 3 houis studying economics. And looking at
the iectangles, we see that theii aiea is appioximately equal to the aiea undei the maiginal cost cuive
between 0 and 3 houis of study.
We have seen that the aieas of the iectangles diawn with Lauiie Phan's maiginal beneft and mai-
ginal cost cuives equal the total beneft and total cost of studying economics. We have also seen that
these aieas aie ioughly equal to the aieas undei the cuives themselves. We can make this last statement
much stiongei. Suppose, instead of thinking in inteivals of whole houis, we think in teims of smallei
inteivals, say, of 12 minutes. Then each iectangle would be only one-ffth as wide as the iectangles we
diew in Figuie 6.4. Theii aieas would still equal the total beneft and total cost of study, and the sum of
those aieas would be closei to the aiea undei the cuives. We have done this foi Ms. Phan's maiginal
beneft cuive in Figuie 6.3; notice that the aieas of the iectangles closely appioximate the aiea undei
the cuive. They still ¨stick out" fiom eithei side of the cuive as did the iectangles we diew in Figuie 6.4,
but you almost need a magnifying glass to see that. The smallei the inteival we choose, the closei the
aieas undei the maiginal beneft and maiginal cost cuives will be to total beneft and total cost. Foi
puiposes of oui model, we can imagine that the inteivals aie as small as we like. Ovei a paiticulai iange
of quantity, the aiea undei a maiginal beneft cuive equals the total beneft of that quantity, and the
aiea undei the maiginal cost cuive equals the total cost of that quantity.
II GUR£ 6. 5 7he MarginaI 8enefit Curve and 7otaI 8enefit
\|er t|e |rc.enerts useJ tc ne.su.e t|ne .||cc.teJ tc stuJy|rg eccrcn|cs ..e n.Je sn.||e., |r t||s c.se 12
n|rutes |rste.J c| .|c|e |cu.s, t|e ..e. urJe. t|e n..g|r.| bere|t cu.ve |s c|cse. tc t|e tct.| bere|t c| stuJy|rg
t|.t .ncurt c| t|ne.
Panel (a) of Figuie 6.6 shows maiginal beneft and maiginal cost cuives foi studying economics, this
time without numbeis. We have the usual downwaid-sloping maiginal beneft cuive and upwaid-slop-
ing maiginal cost cuive. The maiginal decision iule tells us to choose D houis studying economics, the
quantity at which maiginal beneft equals maiginal cost at point C. We know that the total beneft of
study equals the aiea undei the maiginal beneft cuive ovei the iange fiom A to D houis of study, the
aiea ABCD. Total cost equals the aiea undei the maiginal cost cuive ovei the same iange, oi ACD. The
difeience between total beneft and total cost equals the aiea between maiginal beneft and maiginal
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 145
cost between A and D houis of study; it is the gieen-shaded tiiangle ABC. This difeience is the net be-
neft of time spent studying economics. Panel (b) of Figuie 6.6 intioduces anothei impoitant concept.
If an activity is caiiied out at a level less than the emcient level, then net benefts aie foigone. The loss
in net benefts iesulting fiom a failuie to caiiy out an activity at the emcient level is called a dead-
weight loss.
II GUR£ 6. 6 Using MarginaI 8enefit and MarginaI Cost Curves to Determine Net 8enefit
|r |.re| (.) ret bere|ts ..e g|ver by t|e J||e.erce bet.eer tct.| bere|ts (.s ne.su.eJ by t|e ..e. urJe. t|e
n..g|r.| bere|t cu.ve up tc .ry g|ver |eve| c| .ct|v|ty) .rJ tct.| ccsts (.s ne.su.eJ by t|e ..e. urJe. t|e n..g|r.|
ccst cu.ve up tc .ry g|ver |eve| c| .ct|v|ty). V.x|nun ret bere|ts ..e |curJ .|e.e t|e n..g|r.| bere|t cu.ve
|rte.sects t|e n..g|r.| ccst cu.ve .t .ct|v|ty |eve| |. |.re| (b) s|c.s t|.t || t|e |eve| c| t|e .ct|v|ty |s .est.|cteJ tc
.ct|v|ty |eve| |, ret bere|ts ..e .eJuceJ |.cn t|e ||g|tg.eer s|.JeJ t.|.rg|e Ab´ |r |.re| (.) tc t|e sn.||e. ..e.
AbC|. ¯|e |c.gcre ret bere|ts, c. Je.J.e|g|t |css, |s g|ver by t|e pu.p|es|.JeJ ..e. |C´. || t|e .ct|v|ty |eve| |s
|rc.e.seJ |.cn | tc ', .s s|c.r |r |.re| (c), ret bere|ts Jec||reJ by t|e Je.J.e|g|t |css ne.su.eJ by t|e ..e.
´||.
Now suppose a peison incieases study time fiom D to J houis as shown in Panel (c). The aiea undei
the maiginal cost cuive between D and J gives the total cost of incieasing study time; it is DCHJ. The
total beneft of incieasing study time equals the aiea undei the maiginal beneft cuive between D and J;
it is DCL. The cost of incieasing study time in economics fiom D houis to J houis exceeds the beneft.
This gives us a deadweight loss of CHI. The net beneft of spending J houis studying economics equals
the net beneft of studying foi D houis less the deadweight loss, oi ABC minus CHI. Only by studying
up to the point at which maiginal beneft equals maiginal cost do we achieve the maximum net beneft
shown in Panel (a).
We can apply the maiginal decision iule to the pioblem in Figuie 6.6 in anothei way. In Panel (b),
a peison studies economics foi E houis. Reading up to the maiginal beneft cuive, we ieach point G.
Reading up to the maiginal cost cuive, we ieach point F. Maiginal beneft at G exceeds maiginal cost at
F; the maiginal decision iule says economics study should be incieased, which would take us towaid
the inteisection of the maiginal beneft and maiginal cost cuives. Spending J houis studying
146 PRINCIPL£S OI £CONOMICS
economics, as shown in Panel (c), is too much. Reading up to the maiginal beneft and maiginal cost
cuives, we see that maiginal cost exceeds maiginal beneft, suggesting that study time be ieduced.
This completes oui intioduction to the maiginal decision iule and the use of maiginal beneft and
maiginal cost cuives. We will spend the iemaindei of the chaptei applying the model.
Heads Up!
|t |s e.sy tc n.ke t|e n|st.ke c| .ssun|rg t|.t || .r .ct|v|ty |s c...|eJ cut up tc t|e pc|rt .|e.e n..g|r.| be
re|t e,u.|s n..g|r.| ccst, t|er ret bere|ts nust be .e.c. |enenbe. t|.t |c||c.|rg t|e n..g|r.| Jec|s|cr
.u|e .rJ e,u.t|rg n..g|r.| bere|ts .rJ ccsts ·o|·|e· ret bere|ts. |t n.kes t|e J||e·e·ce bet.eer tct.|
bere|ts .rJ tct.| ccst .s |..ge .s pcss|b|e.
k £ Y 7 A k £ A W A Y S
< |ccrcn|sts .ssune t|.t Jec|s|cr n.ke.s n.ke c|c|ces |r t|e ..y t|.t n.x|n|.es t|e v.|ue c| scne
cb¦ect|ve.
< V.x|n|..t|cr |rvc|ves Jete.n|r|rg t|e c|.rge |r tct.| bere|t .rJ t|e c|.rge |r tct.| ccst .sscc|.teJ
.|t| e.c| ur|t c| .r .ct|v|ty. ¯|ese c|.rges ..e c.||eJ n..g|r.| bere|t .rJ n..g|r.| ccst, .espect|ve|y.
< || t|e n..g|r.| bere|t c| .r .ct|v|ty exceeJs t|e n..g|r.| ccst, t|e Jec|s|cr n.ke. .||| g.|r by |rc.e.s|rg
t|e .ct|v|ty.
< || t|e n..g|r.| ccst c| .r .ct|v|ty exceeJs t|e n..g|r.| bere|t, t|e Jec|s|cr n.ke. .||| g.|r by .eJuc|rg
t|e .ct|v|ty.
< ¯|e ..e. urJe. t|e n..g|r.| bere|t cu.ve |c. .r .ct|v|ty g|ves |ts tct.| bere|t, t|e ..e. urJe. t|e n..g|r.|
ccst cu.ve g|ves t|e .ct|v|tys tct.| ccst. |et bere|t e,u.|s tct.| bere|t |ess tct.| ccst.
< ¯|e n..g|r.| bere|t .u|e te||s us t|.t .e c.r n.x|n|.e t|e ret bere|t c| .ry .ct|v|ty by c|ccs|rg t|e
,u.rt|ty .t .||c| n..g|r.| bere|t e,u.|s n..g|r.| ccst. At t||s ,u.rt|ty, t|e ret bere|t c| t|e .ct|v|ty |s
n.x|n|.eJ.
7 R Y I 7 !
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.JJ scne.|.t |ess tc |e. scc.e, .rJ s|e expects stuJy|rg .cccurt|rg .||| .JJ nc.e. ¯|e .esu|t |s t|e t.b|e
be|c. c| expecteJ tct.| bere|ts .rJ tct.| ccsts c| |cu.s spert stuJy|rg eccrcn|cs. |ct|ce t|.t seve..| v.|ues
|r t|e t.b|e |.ve beer cn|tteJ. |||| |r t|e n|ss|rg v.|ues |r t|e t.b|e. |c. n.ry |cu.s c| stuJy s|cu|J Vs.
||.r Jevcte tc eccrcn|cs tc n.x|n|.e |e. ret bere|t`
|cu.s stuJy|rg eccrcn|cs 0 1 2 3 4 5
¯ct.| bere|t 0 14 24 30 32
¯ct.| ccst 0 2 8 32 50
|et bere|t 0 12 12 0 18
|c. ccnpute t|e n..g|r.| bere|ts .rJ ccsts c| |cu.s JevcteJ tc stuJy|rg eccrcn|cs, ccnp|et|rg t|e t.b|e
be|c..
|... t|e n..g|r.| bere|t .rJ n..g|r.| ccst cu.ves |c. stuJy|rg eccrcn|cs (.enenbe. tc p|ct n..g|r.|
v.|ues .t t|e n|Jpc|rts c| t|e .espect|ve |cu.|y |rte.v.|s). |c ycu. cu.ves |rte.sect .t t|e ´.|g|t´ runbe. c|
|cu.s c| stuJyt|e runbe. t|.t n.x|n|.es t|e ret bere|t c| stuJy|rg eccrcn|cs`
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 147
Case in Point: Preventing OiI SpiIIs
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sp|||s be|c.e t|e ´c.st Cu..J beg.r |ts er|c.cenert, V.. ´c|er est|n.teJ t|.t t|e ´c.st Cu..J p.everteJ
1,159,352 g.||crs c| c|| |.cn be|rg sp|||eJ |r 1981.
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tenpteJ tc p.evert ever nc.e sp|||.ge` V.. ´c|er est|n.teJ t|.t t|e n..g|r.| bere|t c| p.evert|rg cre
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suggests t|.t bec.use t|e n..g|r.| bere|t c| nc.e v|gc.cus er|c.cenert exceeJeJ t|e n..g|r.| ccst, nc.e
v|gc.cus ´c.st Cu..J e|c.ts .cu|J |.ve beer ¦ust||eJ.
Vc.e v|gc.cus e|c.ts |.ve, |rJeeJ, beer pu.sueJ. |r 1989, t|e |xxcr c|| t.rke. |xxcr \.|Je. ..r .g.curJ,
sp||||rg 10.8 n||||cr g.||crs c| c|| c| t|e cc.st c| A|.sk.. ¯|e sp||| J.n.geJ t|e s|c.e||re c| . r.t|cr.| |c.est,
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..s tcc ||g| |r ccnp..|scr tc t|e ccnpers.tc.y J.n.ges |c. . c.se |r .||c| t|e .ct|crs c| t|e Je|erJ.rt,
|xxcr, .e.e ´.ep.e|ers|b|e´ but rct |rtert|cr.|.
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1990. |t |rc.e.seJ s||ppe. ||.b|||ty |.cn ´14 n||||cr tc ´100 n||||cr. |t .|sc .e,u|.eJ Jcub|e|u||eJ t.rke.s |c.
s||pp|rg c||.
¯|e |u.cpe.r |r|cr (||) |.s .|sc st.ergt|ereJ |ts st.rJ..Js |c. c|| t.rke.s. ¯|e 2002 b.e.kup c| t|e c|| t.rke.
|.est|ge c| t|e cc.st c| Sp.|r .esu|teJ |r t|e sp|||.ge c| 3.2 n||||cr g.||crs c| c||. ¯|e || |.J p|.rreJ tc b.r
s|rg|e|u||eJ t.rke.s, p|.s|rg |r t|e b.r bet.eer 2003 .rJ 2015. ¯|e s|rk|rg c| t|e |.est|ge |eJ t|e || tc
ncve up t|.t Je.J||re.
148 PRINCIPL£S OI £CONOMICS
Sp||| c.|ses |.ve |eJ bct| t|e |r|teJ St.tes .rJ t|e |u.cpe.r |r|cr tc t|g|ter up t|e|. .egu|.t|crs c| c||
t.rke.s. ¯|e .esu|t |.s beer . .eJuct|cr |r t|e ,u.rt|ty c| c|| sp|||eJ, .||c| ..s p.ec|se|y .|.t eccrcn|c .e
se..c| |.J ccrc|uJeJ ..s reeJeJ. by 2002, t|e .ncurt c| c|| sp|||eJ pe. b...e| s||ppeJ |.J |.||er 30 |.cn
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A N S W £ R 7 O 7 R Y I 7 ! P R O 8 L £ M
|e.e ..e t|e ccnp|eteJ J.t. t.b|e .rJ t|e t.b|e s|c.|rg tct.| .rJ n..g|r.| bere|t .rJ ccst.
Vs. ||.r n.x|n|.es |e. ret bere|t by .eJuc|rg |e. t|ne stuJy|rg eccrcn|cs tc 2 |cu.s. ¯|e c|.rge |r
|e. expect.t|crs .eJuceJ t|e bere|t .rJ |rc.e.seJ t|e ccst c| stuJy|rg eccrcn|cs. ¯|e ccnp|eteJ g..p| c|
n..g|r.| bere|t .rJ n..g|r.| ccst |s .t t|e |.. |e|t. |ct|ce t|.t .rs.e.|rg t|e ,uest|cr us|rg t|e n..g|r.| Je
c|s|cr .u|e g|ves t|e s.ne .rs.e..
2. MAXIMIZING IN THE MARKETPLACE
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. £xpIain what is meant by an emcient aIIocation of resources in an economy and describe the
market conditions that must exist to achieve this goaI.
2. Deñne consumer and producer surpIus.
3. Discuss the reIationship between emciency and equity.
In peihaps the most infuential book in economics evei wiitten, An Inquiry into the ^ature and Causes
of the Vealth of ^ations, published in 1776, Adam Smith aigued that the puisuit of self-inteiest in a
maiketplace would piomote the geneial inteiest. He said iesouices would be guided, as if by an
¨invisible hand," to theii best uses. That invisible hand was the maiketplace.
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 149
emcient
¯|e .||cc.t|cr c| .escu.ces
.|er t|e ret bere|ts c| .||
eccrcn|c .ct|v|t|es ..e
n.x|n|.eJ.
property rights
A set c| .u|es t|.t spec||y t|e
..ys |r .||c| .r c.re. c.r
use . .escu.ce.
excIusive property right
A p.cpe.ty .|g|t t|.t .||c.s
|ts c.re. tc p.evert ct|e.s
|.cn us|rg t|e .escu.ce.
transferabIe property right
A p.cpe.ty .|g|t t|.t .||c.s
t|e c.re. c| . .escu.ce tc
se|| c. |e.se |t tc scnecre
e|se.
Smith's idea was iadical foi its time; he saw that the seemingly haphazaid woikings of the maiket-
place could piomote the common good. In this section, we will use the tools we have developed thus
fai to see the powei of Smith's invisible hand. Efoits by individuals to maximize theii own net beneft
can maximize net beneft foi the economy as a whole.
When the net benefts of all economic activities aie maximized, economists say the allocation of
iesouices is emcient. This concept of emciency is bioadei than the notion of emcient pioduction that
we encounteied when discussing the pioduction possibilities cuive. Theie, we saw that the economy's
factois of pioduction would be emcient in production if they weie allocated accoiding to the piinciple
of compaiative advantage. That meant pioducing as much as possible with the factois of pioduction
available. The concept of an emcient allocation of iesouices incoipoiates pioduction, as in that discus-
sion, but it includes emciency in the consumption of goods and seivices as well.
2.1 Achieving Efficiency
Imagine youiself aiiiving at the stoie to puichase some food. In youi choice, you will weigh youi own
benefts and costs to maximize youi net beneft. The faimeis, the distiibutois, and the giocei have
sought to maximize theii net benefts as well. How can we expect that all those efoits will maximize
net benefts foi the economy as a whole: How can we expect the maiketplace to achieve an emcient al-
location of food, oi of anything else:
One condition that must be met if the maiket's allocation is to be emcient is that the maiketplace
must be competitive oi function as if it weie. We will have a gieat deal moie to say about competitive
maikets veisus less competitive ones in subsequent chapteis. Foi now, we can simply note that a com-
petitive maiket is one with many buyeis and selleis in each maiket and in which entiy and exit aie
faiily easy. No one contiols the piice; the foices of demand and supply deteimine piice.
The second condition that must hold if the maiket is to achieve an emcient allocation conceins
piopeity iights. We tuin to that topic in the next section.
7he RoIe of Property Rights
A smoothly functioning maiket iequiies that pioduceis possess piopeity iights to the goods and sei-
vices they pioduce and that consumeis possess piopeity iights to the goods and seivices they buy.
Property rights aie a set of iules that specify the ways in which an ownei can use a iesouice.
Considei the tomato maiket. Faimeis who giow tomatoes have cleaily defned iights to theii land
and to the tomatoes they pioduce and sell. Distiibutois who puichase tomatoes fiom faimeis and sell
them to gioceis have cleai iights to the tomatoes until they sell them to gioceis. The gioceis who pui-
chase the tomatoes ietain iights to them until they sell them to consumeis. When you buy a tomato,
you have the exclusive iight to its use.
A system of piopeity iights foims the basis foi all maiket exchange. Befoie exchange can begin,
theie must be a cleai specifcation of who owns what. The system of piopeity iights must also show
what puichaseis aie acquiiing when they buy iights to paiticulai iesouices. Because piopeity iights
must exist if exchange is to occui, and because exchange is the piocess thiough which economic em-
ciency is achieved, a system of piopeity iights is essential to the emcient allocation of iesouices.
Imagine what would happen in the maiket foi tomatoes if piopeity iights weie not cleaily defned.
Suppose, foi example, that gioceis could not legally pievent someone fiom simply giabbing some to-
matoes and leaving without paying foi them. If that weie the case, gioceis would not be likely to ofei
tomatoes foi sale. If it weie the case foi all gioceiy items, theie would not be gioceiy stoies at all.
Although piopeity iights vaiy foi difeient iesouices, two chaiacteiistics aie iequiied if the mai-
ketplace is to achieve an emcient allocation of iesouices:
1. Piopeity iights must be exclusive. An exclusive property right is one that allows its ownei to
pievent otheis fiom using the iesouice. The ownei of a house, foi example, has the iight to
exclude otheis fiom the use of the house. If this iight did not exist, owneiship would have little
value; it is not likely that the piopeity could be exchanged in a maiket. And the inability to sell
piopeity would limit the incentive of owneis to maintain it.
2. Piopeity iights must be tiansfeiable. A transferable property right is one that allows the
ownei of a iesouice to sell oi lease it to someone else. In the absence of tiansfeiability, no
exchange could occui.
150 PRINCIPL£S OI £CONOMICS
emcient
¯|e .||cc.t|cr c| .escu.ces
.|er t|e ret bere|ts c| .||
eccrcn|c .ct|v|t|es ..e
n.x|n|.eJ.
II GUR£ 6. 10 Demand and SuppIy and
the £fficiency Condition
|r . ccnpet|t|ve n..ket .|t| exc|us|ve .rJ
t..rs|e..b|e p.cpe.ty .|g|ts, suc| .s t|e n..ket
|c. tcn.tces, t|e e|c|ercy ccrJ|t|cr |s net.
buye.s .rJ se||e.s ..e |.ceJ .|t| .|| c| t|e
.e|ev.rt bere|ts .rJ ccsts, .rJ t|e
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scc|ety c| p.cJuc|rg t|.t gccJ, |e.e ´2.50 pe.
pcurJ. \e c.r |rte.p.et t|e n..ket Jen.rJ
.rJ supp|y cu.ve .s n..g|r.| bere|t .rJ
n..g|r.| ccst cu.ves, .espect|ve|y.
consumer surpIus
¯|e .ncurt by .||c| t|e
tct.| bere|ts tc ccrsune.s
|.cn ccrsun|rg . gccJ
exceeJ t|e|. tct.|
experJ|tu.es cr t|e gccJ.
Markets and the £fficiency Condition
A competitive maiket with well-defned and tiansfeiable piopeity iights satisfes the emciency condi-
tion. If met, we can assume that the maiket's allocation of iesouices will be emcient.
Considei again youi puichase of tomatoes. Suppose the cuives of demand and supply foi tomatoes
aie those given in Figuie 6.10; the equilibiium piice equals $1.30 pei pound. Suppose fuithei that the
maiket satisfes the emciency condition. With that assumption, we can ielate the model of demand and
supply to oui analysis of maiginal benefts and costs.
The demand cuive tells us that the last pound of tomatoes was woith $1.30; we can
think of that as the maiginal beneft of the last pound of tomatoes since that is how
much consumeis weie willing to pay. We can say that about any piice on a maiket de-
mand cuive; a demand cuive can be consideied as a maiginal beneft cuive. Similaily,
the supply cuive can be consideied the maiginal cost cuive. In the case of the tomato
maiket, foi example, the piice tells us that the maiginal cost of pioducing the last
pound of tomatoes is $1.30. This maiginal cost is consideied in the economic
sense-othei goods and seivices woith $1.30 weie not pioduced in oidei to make an
additional pound of tomatoes available.
On what basis can we piesume that the piice of a pound of tomatoes equals its
maiginal cost: The answei lies in oui maiginal decision iule. Pioft-maximizing tomato
pioduceis will pioduce moie tomatoes as long as theii maiginal beneft exceeds theii
maiginal cost. What is the maiginal beneft to a pioducei of an extia pound of toma-
toes: It is the piice that the pioducei will ieceive. What is the maiginal cost: It is the
value that must be given up to pioduce an extia pound of tomatoes.
Pioduceis maximize pioft by expanding theii pioduction up to the point at which
theii maiginal cost equals theii maiginal beneft, which is the maiket piice. The piice
of $1.30 thus iefects the maiginal cost to society of making an additional pound of to-
matoes available.
At the equilibiium piice and output of tomatoes, then, the maiginal beneft of to-
matoes to consumeis, as iefected by the piice they aie willing to pay, equals the mai-
ginal cost of pioducing tomatoes. Wheie maiginal beneft equals maiginal cost, net be-
neft is maximized. The equilibiium quantity of tomatoes, as deteimined by demand
and supply, is emcient.
2.2 Pioducei and Consumei Suiplus
Think about the last thing you puichased. You bought it because you expected that its
benefts would exceed its oppoitunity cost; you expected that the puichase would make
you bettei of. The sellei sold it to you because he oi she expected that the money you paid would be
woith moie than the value of keeping the item. The sellei expected to be bettei of as a iesult of the sale.
Exchanges in the maiketplace have a iemaikable piopeity: Both buyeis and selleis expect to emeige
fiom the tiansaction bettei of.
Panel (a) of Figuie 6.11 shows a maiket demand cuive foi a paiticulai good. Suppose the piice
equals OB and the quantity equals OE. The aiea undei the demand cuive ovei the iange of quantities
fiom the oiigin at O to the quantity at E equals the total beneft of consuming OE units of the good. It
is the aiea OCDE. Consumeis pay foi this beneft; theii total expendituies equal the iectangle OBDE,
which is the daik shaded iegion in the giaph. Because the total benefts exceed total expendituies, theie
is a consumei suiplus given by the tiiangle BCD. Consumer surplus is the amount by which the total
benefts to consumeis fiom consuming a good exceed theii total expendituies on the good.
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 151
producer surpIus
¯|e J||e.erce bet.eer t|e
tct.| .everue .ece|veJ by
se||e.s .rJ t|e|. tct.| ccst.
II GUR£ 6. 11 Consumer and Producer SurpIus
´crsune. su.p|us ¦|.re| (.)¦ ne.su.es t|e J||e.erce bet.eer tct.| bere|t c| ccrsun|rg . g|ver ,u.rt|ty c|
cutput .rJ t|e tct.| experJ|tu.es ccrsune.s p.y tc cbt.|r t|.t ,u.rt|ty. |e.e, tct.| bere|ts ..e g|ver by t|e
s|.JeJ ..e. O´||, tct.| experJ|tu.es ..e g|ver by t|e .ect.rg|e Ob||. ¯|e J||e.erce, s|c.r by t|e t.|.rg|e b´|,
|s ccrsune. su.p|us. |.cJuce. su.p|us ¦|.re| b)¦ ne.su.es t|e J||e.erce bet.eer tct.| .everue .ece|veJ by |.ns
.t . g|ver ,u.rt|ty c| cutput .rJ t|e tct.| ccst c| p.cJuc|rg |t. |e.e, tct.| .everue |s g|ver by t|e .ect.rg|e Ob||,
.rJ tct.| ccsts ..e g|ver by t|e ..e. OA||. ¯|e J||e.erce, s|c.r by t|e t.|.rg|e Ab| |s p.cJuce. su.p|us.
Now considei the selleis' side of tiansactions. Panel (b) of Figuie 6.11 shows a maiket supply cuive; ie-
call that it gives us maiginal cost. Suppose the maiket piice equals OB and quantity supplied is OE;
those aie the same values we had in Panel (a). The piice times the quantity equals the total ievenue ie-
ceived by selleis. It is shown as the shaded iectangle OBDE. The total ievenue ieceived by selleis equals
total expendituies by consumeis.
The total cost to selleis is the aiea undei the maiginal cost cuive; it is the aiea OADE. That cost is
less than ievenue. The difeience between the total ievenue ieceived by selleis and theii total cost is
called producer surplus. In Panel (b) it is the light-shaded tiiangle ABD.
II GUR£ 6. 12 Net 8enefit: 7he Sum of Consumer and Producer SurpIus
¯|e sun c| ccrsune. su.p|us .rJ p.cJuce. su.p|us ne.su.es t|e ret bere|t tc scc|ety c| .ry |eve| c| eccrcn|c
.ct|v|ty. |et bere|t |s n.x|n|.eJ .|er p.cJuct|cr .rJ ccrsunpt|cr ..e c...|eJ cut .t t|e |eve| .|e.e t|e
Jen.rJ .rJ supp|y cu.ves |rte.sect. |e.e, t|e ret bere|t tc scc|ety e,u.|s t|e ..e. A´|. |t |s t|e sun c| ccrsune.
su.p|us, b´|, .rJ p.cJuce. su.p|us, Ab|.
152 PRINCIPL£S OI £CONOMICS
We put the demand and supply cuives of Figuie 6.11 Panels (a) and (b) togethei in Figuie 6.12. The in-
teisection of the two cuives deteimines the equilibiium piice, OB, and the equilibiium quantity, OE.
The shaded iegions give us consumei and pioducei suiplus. The sum of these two suipluses is net be-
neft. This net beneft is maximized wheie the demand and supply cuives inteisect.
2.3 Efficiency and Equity
Consumei demands aie afected by incomes. Demand, aftei all, iefects ability as well as willingness to
pay foi goods and seivices. The maiket will be moie iesponsive to the piefeiences of people with high
incomes than to those of people with low incomes.
In a maiket that satisfes the emciency condition, an emcient allocation of iesouices will emeige
fiom any paiticulai distiibution of income. Difeient income distiibutions will iesult in difeient, but
still emcient, outcomes. Foi example, if 1° of the population contiols viitually all the income, then the
maiket will emciently allocate viitually all its pioduction to those same people.
What is a faii, oi equitable, distiibution of income: What is an unfaii distiibution: Should eveiy-
one have the same income: Is the cuiient distiibution faii: Should the iich have less and the pooi have
moie: Should the middle class have moie: Equity is veiy much in the mind of the obseivei. What may
seem equitable to one peison may seem inequitable to anothei. Theie is, howevei, no test we can apply
to deteimine whethei the distiibution of income is oi is not equitable. That question iequiies a noim-
ative judgment.
Deteimining whethei the allocation of iesouices is oi is not emcient is one pioblem. Deteimining
whethei the distiibution of income is faii is anothei. The goveinments of all nations act in some way to
iedistiibute income. That fact suggests that people geneially have concluded that leaving the distiibu-
tion of income solely to the maiket would not be faii and that some iedistiibution is desiiable. This
may take the foim of highei taxes foi people with highei incomes than foi those with lowei incomes. It
may take the foim of special piogiams, such as welfaie piogiams, foi low-income people.
Whatevei distiibution society chooses, an emcient allocation of iesouices is still piefeiied to an in-
emcient one. Because an emcient allocation maximizes net benefts, the gain in net benefts could be
distiibuted in a way that leaves all people bettei of than they would be at any inemcient allocation. If
an emcient allocation of iesouices seems unfaii, it must be because the distiibution of income is unfaii.
k £ Y 7 A k £ A W A Y S
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CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 153
Case in Point: Saving the £Iephant 7hrough Property Rights
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154 PRINCIPL£S OI £CONOMICS
market faiIure
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3. MARKET FAILURE
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. £xpIain what is meant by market faiIure and the conditions that may Iead to it.
2. Distinguish between private goods and pubIic goods and reIate them to the free rider probIem
and the roIe of government.
3. £xpIain the concepts of externaI costs and beneñts and the roIe of government intervention
when they are present.
4. £xpIain why a common property resource is unIikeIy to be aIIocated emcientIy in the
marketpIace.
Piivate decisions in the maiketplace may not be consistent with the maximization of the net beneft of
a paiticulai activity. The failuie of piivate decisions in the maiketplace to achieve an emcient allocation
of scaice iesouices is called market failure. Maikets will not geneiate an emcient allocation of ie-
souices if they aie not competitive oi if piopeity iights aie not well defned and fully tiansfeiable. Eith-
ei condition will mean that decision makeis aie not faced with the maiginal benefts and costs of theii
choices.
Think about the diive that we had you take at the beginning of this chaptei. You faced some, but
not all, of the oppoitunity costs involved in that choice. In paiticulai, youi choice to go foi a diive
would inciease aii pollution and might inciease tiamc congestion. That means that, in weighing the
maiginal benefts and maiginal costs of going foi a diive, not all of the costs would be counted. As a
iesult, the net beneft of the allocation of iesouices such as the aii might not be maximized.
3.1 Noncompetitive Maikets
The model of demand and supply assumes that maikets aie competitive. No one in these maikets has
any powei ovei the equilibiium piice; each consumei and pioducei takes the maiket piice as given and
iesponds to it. Undei such conditions, piice is deteimined by the inteisection of demand and supply.
In some maikets, howevei, individual buyeis oi selleis aie poweiful enough to infuence the mai-
ket piice. In subsequent chapteis, we will study cases in which pioduceis oi consumeis aie in a posi-
tion to afect the piices they chaige oi must pay, iespectively. We shall fnd that when individual fims
oi gioups of fims have maiket powei, which is the ability to change the maiket piice, the piice will be
distoited-it will not equal maiginal cost.
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 155
pubIic good
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3.2 Public Goods
Some goods aie unlikely to be pioduced and exchanged in a maiket because of special chaiacteiistics of
the goods themselves. The benefts of these goods aie such that exclusion is not feasible. Once they aie
pioduced, anyone can enjoy them; theie is no piactical way to exclude people who have not paid foi
them fiom consuming them. Fuitheimoie, the maiginal cost of adding one moie consumei is zeio. A
good foi which the cost of exclusion is piohibitive and foi which the maiginal cost of an additional
usei is zeio is a public good. A good foi which exclusion is possible and foi which the maiginal cost
of anothei usei is positive is a private good.
National defense is a public good. Once defense is piovided, it is not possible to exclude people
who have not paid foi it fiom its consumption. Fuithei, the cost of an additional usei is zeio-an aimy
does not cost any moie if theie is one moie peison to be piotected. Othei examples of public goods in-
clude law enfoicement, fie piotection, and efoits to pieseive species thieatened with extinction.
Iree Riders
Suppose a piivate fim, Teiioi Aleit, Inc., develops a completely ieliable system to identify and intei-
cept 98° of any would-be teiioiists that might attempt to entei the United States fiom anywheie in the
woild. This seivice is a public good. Once it is piovided, no one can be excluded fiom the system's pio-
tection on giounds that he oi she has not paid foi it, and the cost of adding one moie peison to the
gioup piotected is zeio. Suppose that the system, by eliminating a potential thieat to U.S. secuiity,
makes the aveiage peison in the United States bettei of; the beneft to each household fiom the added
secuiity is woith $40 pei month (about the same as an eaithquake insuiance piemium). Theie aie
ioughly 113 million households in the United States, so the total beneft of the system is $4.3 billion pei
month. Assume that it will cost Teiioi Aleit, Inc., $1 billion pei month to opeiate. The benefts of the
system fai outweigh the cost.
Suppose that Teiioi Aleit installs its system and sends a bill to each household foi $20 foi the fist
month of seivice-an amount equal to half of each household's beneft. If each household pays its bill,
Teiioi Aleit will enjoy a tidy pioft; it will ieceive ievenues of moie than $2.23 billion pei month.
But will each household pay: Once the system is in place, each household would iecognize that it
will beneft fiom the secuiity piovided by Teiioi Aleit whethei it pays its bill oi not. Although some
households will voluntaiily pay theii bills, it seems unlikely that veiy many will. Recognizing the op-
poitunity to consume the good without paying foi it, most would be fiee iideis. Free riders aie people
oi fims that consume a public good without paying foi it. Even though the total beneft of the system
is $4.3 billion, Teiioi Aleit will not be faced by the maiketplace with a signal that suggests that the sys-
tem is woithwhile. It is unlikely that it will iecovei its cost of $1 billion pei month. Teiioi Aleit is not
likely to get of the giound.
The bill foi $20 fiom Teiioi Aleit sends the wiong signal, too. An emcient maiket iequiies a piice
equal to maiginal cost. But the maiginal cost of piotecting one moie household is zeio; adding one
moie household adds nothing to the cost of the system. A household that decides not to pay Teiioi
Aleit anything foi its seivice is paying a piice equal to its maiginal cost. But doing that, being a fiee
iidei, is piecisely what pievents Teiioi Aleit fiom opeiating.
Because no household can be excluded and because the cost of an extia household is zeio, the em-
ciency condition will not be met in a piivate maiket. What is tiue of Teiioi Aleit, Inc., is tiue of public
goods in geneial: they simply do not lend themselves to piivate maiket piovision.
PubIic Goods and the Government
Because many individuals who beneft fiom public goods will not pay foi them, piivate fims will pio-
duce a smallei quantity of public goods than is emcient, if they pioduce them at all. In such cases, it
may be desiiable foi goveinment agencies to step in. Goveinment can supply a gieatei quantity of the
good by diiect piovision, by puichasing the public good fiom a piivate agency, oi by subsidizing con-
sumption. In any case, the cost is fnanced thiough taxation and thus avoids the fiee-iidei pioblem.
Most public goods aie piovided diiectly by goveinment agencies. Goveinments pioduce national
defense and law enfoicement, foi example. Piivate fims undei contiact with goveinment agencies pio-
duce some public goods. Paik maintenance and fie seivices aie public goods that aie sometimes pio-
duced by piivate fims. In othei cases, the goveinment piomotes the piivate consumption oi pioduc-
tion of public goods by subsidizing them. Piivate chaiitable contiibutions often suppoit activities that
aie public goods; fedeial and state goveinments subsidize these by allowing taxpayeis to ieduce theii
tax payments by a fiaction of the amount they contiibute.
156 PRINCIPL£S OI £CONOMICS
II GUR£ 6. 15 PubIic Goods and Market
IaiIure
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While the maiket will pioduce some level of public goods in the absence of gov-
einment inteivention, we do not expect that it will pioduce the quantity that maxim-
izes net beneft. Figuie 6.13 illustiates the pioblem. Suppose that piovision of a public
good such as national defense is left entiiely to piivate fims. It is likely that some de-
fense seivices would be pioduced; suppose that equals Q
1
units pei peiiod. This level of
national defense might be achieved thiough individual contiibutions. But it is veiy un-
likely that contiibutions would achieve the coiiect level of defense seivices. The em-
cient quantity occuis wheie the demand, oi maiginal beneft, cuive inteisects the mai-
ginal cost cuive, at Q¯. The deadweight loss is the shaded aiea ABC; we can think of
this as the net beneft of goveinment inteivention to inciease the pioduction of nation-
al defense fiom Q
1
up to the emcient quantity, Q¯.
Heads Up!
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3.3 Exteinal Costs and Benefits
Suppose that in the couise of pioduction, the fims in a paiticulai industiy geneiate aii
pollution. These fims thus impose costs on otheis, but they do so outside the context
of any maiket exchange-no agieement has been made between the fims and the
people afected by the pollution. The fims thus will not be faced with the costs of theii
action. A cost imposed on otheis outside of any maiket exchange is an external cost.
We saw an example of an exteinal cost in oui imaginaiy decision to go foi a diive.
Heie is anothei: violence on television, in the movies, and in video games. Many ciitics aigue that the
violence that peivades these media fosteis gieatei violence in the ieal woild. By the time a child who
spends the aveiage amount of time watching television fnishes elementaiy school, he oi she will have
seen 100,000 acts of violence, including 8,000 muideis, accoiding to the Ameiican Psychological Asso-
ciation. Thousands of studies of the ielationship between violence in the media and behavioi have con-
cluded that theie is a link between watching violence and violent behaviois. Video games aie a majoi
element of the pioblem, as young childien now spend houis each week playing them. Fifty peicent of
fouith-giade giadeis say that theii favoiite video games aie the ¨fist peison shootei" type.
[1]
Any tendency of incieased violence iesulting fiom incieased violence in the media constitutes an
exteinal cost of such media. The Ameiican Academy of Pediatiics iepoited in 2001 that homicides
weie the fouith leading cause of death among childien between the ages of 10 and 14 and the second
leading cause of death foi people aged 13 to 24 and has iecommended a ieduction in exposuie to me-
dia violence.
[2]
It seems ieasonable to assume that at least some of these acts of violence can be con-
sideied an exteinal cost of violence in the media.
An action taken by a peison oi fim can also cieate benefts foi otheis, again in the absence of any
maiket agieement; such a beneft is called an external benent. A fim that builds a beautiful building
geneiates benefts to eveiyone who admiies it; such benefts aie exteinal.
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 157
II GUR£ 6. 16 £xternaI Costs
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Je.J.e|g|t |css t|.t cccu.s .|er |.ns ..e
rct |.ceJ .|t| t|e |u|| ccsts c| t|e|. Jec|s|crs
|s s|c.r by t|e s|.JeJ ..e. |r t|e g..p|.
common property resource
|escu.ces |c. .||c| rc
p.cpe.ty .|g|ts |.ve beer
Je|reJ.
£xternaI Costs and £fficiency
The case of the polluting fims is illustiated in Figuie 6.16. The industiy supply cuive
S
1
iefects piivate maiginal costs, MC
p
. The maiket piice is P
p
foi a quantity Q
p
. This is
the solution that would occui if fims geneiating exteinal costs weie not foiced to pay
those costs. If the exteinal costs geneiated by the pollution weie added, the new supply
cuive S
2
would iefect highei maiginal costs, MC
e
. Faced with those costs, the maiket
would geneiate a lowei equilibiium quantity, Q
e
. That quantity would command a
highei piice, P
e
. The failuie to confiont pioduceis with the cost of theii pollution
means that consumeis do not pay the full cost of the good they aie puichasing. The
level of output and the level of pollution aie theiefoie highei than would be economic-
ally emcient. If a way could be found to confiont pioduceis with the full cost of theii
choices, then consumeis would be faced with a highei cost as well. Figuie 6.16 shows
that consumption would be ieduced to the emcient level, Q
e
, at which demand and the
full maiginal cost cuive (MC
e
) inteisect. The deadweight loss geneiated by allowing the
exteinal cost to be geneiated with an output of Q
p
is given as the shaded iegion in the
giaph.
£xternaI Costs and Government Intervention
If an activity geneiates exteinal costs, the decision makeis geneiating the activity will
not be faced with its full costs. Agents who impose these costs will caiiy out theii activ-
ities beyond the emcient level; those who consume them, facing too low a piice, will
consume too much. As a iesult, pioduceis and consumeis will caiiy out an excessive
quantity of the activity. In such cases, goveinment may tiy to inteivene to ieduce the
level of the activity towaid the emcient quantity. In the case shown in Figuie 6.16, foi
example, fims geneiating an exteinal cost have a supply cuive S
1
that iefects theii
piivate maiginal costs, MC
p
. A pei-unit pollution fee imposed on the fims would in-
ciease theii maiginal costs to MC
e
, thus shifting the supply cuive to S
2
, and the emcient
level of pioduction would emeige. Taxes oi othei iestiictions may be imposed on the
activity that geneiates the exteinal cost in an efoit to confiont decision makeis with
the costs that they aie imposing. In many aieas, fims and consumeis that pollute iiveis and lakes aie
iequiied to pay fees based on the amount they pollute. Fiims in many aieas aie iequiied to puichase
peimits in oidei to pollute the aii; the iequiiement that peimits be puichased seives to confiont the
fims with the costs of theii choices.
Anothei appioach to dealing with pioblems of exteinal costs is diiect iegulation. Foi example, a
fim may be oideied to ieduce its pollution. A peison who tuins his oi hei fiont yaid into a gaibage
dump may be oideied to clean it up. Paiticipants at a iaucous paity may be told to be quiet. Alteinative
ways of dealing with exteinal costs aie discussed latei in the text.
3.4 Common Piopeity Resouices
Common property resources
[3]
aie iesouices foi which no piopeity iights have been defned. The
dimculty with common piopeity iesouices is that individuals may not have adequate incentives to en-
gage in efoits to pieseive oi piotect them. Considei, foi example, the ielative fates of cattle and bufalo
in the United States in the nineteenth centuiy. Cattle populations incieased thioughout the centuiy,
while the bufalo neaily became extinct. The chief difeience between the two animals was that exclus-
ive piopeity iights existed foi cattle but not foi bufalo.
Owneis of cattle had an incentive to maintain heid sizes. A cattle ownei who slaughteied all of his
oi hei cattle without pioviding foi ieplacement of the heid would not have a souice of futuie income.
Cattle owneis not only maintained theii heids but also engaged in extensive efoits to bieed high-qual-
ity livestock. They invested time and efoit in the emcient management of the iesouice on which theii
livelihoods depended.
Bufalo hunteis suiely had similai conceins about the maintenance of bufalo heids, but they had
no individual stake in doing anything about them-the animals weie a common piopeity iesouice.
Thousands of individuals hunted bufalo foi a living. Anyone who cut back on hunting in oidei to help
to pieseive the heid would lose income-and face the likelihood that othei hunteis would go on hunt-
ing at the same iate as befoie.
Today, exclusive iights to bufalo have been widely established. The demand foi bufalo meat,
which is lowei in fat than beef, has been incieasing, but the numbei of bufalo in the United States is
iising iapidly. If bufalo weie still a common piopeity iesouice, that incieased demand, in the absence
of othei iestiictions on hunting of the animals, would suiely iesult in the elimination of the animal. Be-
cause theie aie exclusive, tiansfeiable piopeity iights in bufalo and because a competitive maiket
158 PRINCIPL£S OI £CONOMICS
biings buyeis and selleis of bufalo and bufalo pioducts togethei, we can be ieasonably confdent in
the emcient management of the animal.
When a species is thieatened with extinction, it is likely that no one has exclusive piopeity iights
to it. Whales, condois, giizzly beais, elephants in Cential Afiica-whatevei the animal that is
thieatened-aie common piopeity iesouices. In such cases a goveinment agency may impose limits on
the killing of the animal oi destiuction of its habitat. Such limits can pievent the excessive piivate use
of a common piopeity iesouice. Alteinatively, as was done in the case of the bufalo, piivate iights can
be established, giving iesouice owneis the task of pieseivation.
k £ Y 7 A k £ A W A Y S
< |ub||c sectc. |rte.vert|cr tc |rc.e.se t|e |eve| c| p.cv|s|cr c| pub||c gccJs n.y |np.cve t|e e|c|ercy c|
.escu.ce .||cc.t|cr by cve.ccn|rg t|e p.cb|en c| |.ee .|Je.s.
< Act|v|t|es t|.t gere..te exte.r.| ccsts ..e ||ke|y tc be c...|eJ cut .t |eve|s t|.t exceeJ t|cse t|.t .cu|J be
e|c|ert, t|e pub||c sectc. n.y seek tc |rte.vere tc ccr|.crt Jec|s|cr n.ke.s .|t| t|e |u|| ccsts c| t|e|.
c|c|ces.
< Scne p.|v.te .ct|v|t|es gere..te exte.r.| bere|ts.
< A ccnncr p.cpe.ty .escu.ce |s ur||ke|y tc be .||cc.teJ e|c|ert|y |r t|e n..ketp|.ce.
7 R Y I 7 !
¯|e n.ru|.ctu.e c| nenc.y c||ps |c. ccnpute.s gere..tes pc||ut.rts t|.t gere..||y erte. .|ve.s .rJ st.e.ns.
|se t|e ncJe| c| Jen.rJ .rJ supp|y tc s|c. t|e e,u|||b.|un p.|ce .rJ cutput c| c||ps. Assun|rg c||p n.r
u|.ctu.e.s Jc rct |.ve tc p.y t|e ccsts t|ese pc||ut.rts |npcse, .|.t c.r ycu s.y .bcut t|e e|c|ercy c| t|e
,u.rt|ty c| c||ps p.cJuceJ` S|c. t|e ..e. c| Je.J.e|g|t |css |npcseJ by t||s exte.r.| ccst. S|c. |c. . .e
,u|.enert t|.t |.ns p.y t|ese ccsts .s t|ey p.cJuce t|e c||ps .cu|J .|ect t|e e,u|||b.|un p.|ce .rJ cutput
c| c||ps. \cu|J suc| . .e,u|.enert |e|p tc s.t|s|y t|e e|c|ercy ccrJ|t|cr` |xp|.|r.
Case in Point: £xternaIities and Smoking
÷ 2010 jupiterimages Corporation
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 159
Sncke.s |npcse t.enerJcus ccsts cr t|ense|ves. b.seJ sc|e|y cr t|e Jeg.ee tc .||c| snck|rg s|c.ters
t|e|. |||e expect.rcy, .||c| |s by .bcut s|x ye..s, t|e ccst pe. p.ck |s ´35.64. ¯|.t ccst, c| ccu.se, |s . p.|v.te
ccst. |r .JJ|t|cr tc t|.t p.|v.te ccst, sncke.s |npcse ccsts cr ct|e.s. ¯|cse exte.r.| ccsts ccne |r t|.ee ..ys.
||.st, t|ey |rc.e.se |e.|t|c..e ccsts .rJ t|us |rc.e.se |e.|t| |rsu..rce p.en|uns. SeccrJ, snck|rg c.uses
|.es t|.t Jest.cy nc.e t|.r ´300 n||||cr .c.t| c| p.cpe.ty e.c| ye... ¯||.J, nc.e t|.r 2,000 pecp|e J|e e.c|
ye.. .s . .esu|t c| ´seccrJ|.rJ´ sncke. A 1989 stuJy by t|e |A|| ´c.pc..t|cr est|n.teJ t|ese ccsts .t ´0.53
pe. p.ck.
|r .r |npc.t.rt ..y, |c.eve., sncke.s .|sc gere..te exte.r.| bere|ts. ¯|ey ccrt.|bute tc .et|.enert p.c
g..ns .rJ tc Scc|.| Secu.|ty, t|er J|e sccre. t|.r rcrsncke.s. ¯|ey t|us subs|J|.e t|e .et|.enert p.cg..ns
c| t|e .est c| t|e pcpu|.t|cr. Accc.J|rg tc t|e |A|| stuJy, t|.t p.cJuces .r exte.r.| bere|t c| ´0.24 pe.
p.ck, |e.v|rg . ret exte.r.| ccst c| ´0.29 pe. p.ck. C|ver t|.t st.te .rJ |eJe..| exc|se t.xes .ve..geJ ´0.3 |r
1989, t|e |A|| .ese..c|e.s ccrc|uJeJ t|.t sncke.s nc.e t|.r p.|J t|e|. c.r ..y.
|ccrcn|sts 'cr.t|.r C.ube. c| t|e V.ss.c|usetts |rst|tute c| ¯ec|rc|cgy .rJ bctcrJ |cs.eg| c| t|e
|r|ve.s|ty c| ´.|||c.r|. .t be.ke|ey |.ve suggesteJ t|.t, |r t|e c.se c| pecp|e .|c ccrsune ´.JJ|ct|ve b.Js´
suc| .s c|g..ettes, .r exc|se t.x cr c|g..ettes c| .s nuc| .s ´4.6 pe. p.ck n.y |np.cve t|e .e||..e c|
sncke.s.
¯|ey b.se t|e|. ..gunert cr t|e ccrcept c| ´t|ne |rccrs|stercy,´ .||c| |s t|e t|ec.y t|.t sncke.s seek t|e
|nneJ|.te g..t||c.t|cr c| . c|g..ette .rJ t|er .eg.et t|e|. Jec|s|cr |.te.. |.c|essc.s C.ube. .rJ |cs.eg| ..gue
t|.t ||g|e. t.xes .cu|J se.ve tc .eJuce t|e ,u.rt|ty c| c|g..ettes Jen.rJeJ .rJ t|us .eJuce be|.v|c. t|.t
sncke.s .cu|J ct|e..|se .eg.et. ¯|e|. ..gunert |s t|.t sncke.s |npcse ´|rte.r.||t|es´ cr t|ense|ves .rJ t|.t
||g|e. t.xes .cu|J .eJuce t||s.
\|e.e Jces t||s |e.J us` || sncke.s ..e ´..t|cr.||y .JJ|cteJ´ tc snck|rg, |.e., t|ey |.ve .e|g|eJ t|e bere|ts
.rJ ccsts c| snck|rg .rJ |.ve c|cser tc sncke, t|er t|e cr|y p.cb|en |c. pub||c pc||cy |s tc .ssu.e t|.t
sncke.s ..e ccr|.crteJ .|t| t|e exte.r.| ccsts t|ey |npcse. |r t|.t c.se, t|e p.cb|en |s sc|veJ. t|.cug| ex
c|se t.xes, sncke.s nc.e t|.r p.y t|e|. c.r ..y. but, || t|e Jec|s|cr tc sncke |s .r |...t|cr.| cre, |t n.y be
|np.cveJ t|.cug| ||g|e. exc|se t.xes cr snck|rg.
.oo·ce· .o·o||o· O·o·e· o·J |o|o·J |o·e¸|. ^ ¯|eo·, o| Oo.e···e·| |e¸o|o||o· o| ^JJ|c||.e |oJ· ´¡||·o| ¯o |e.e|· o·J ¯o |·c|Je·ce |o·
´|¸o·e||e |c|·e ¯oo||o·.' |||| /o·||·¸ |o¡e· S.... |e··oo·, 2002. /|||o·J O /o··|·¸ e| o|. ¯|e ¯oe· o| .|· |o .·o|e·· o·J |·|·|e·· |o, ¯|e|·
/o,.' .oo··o| o| ||e ^·e·|co· /eJ|co| ^··oc|o||o·. 26¹ (/o·c| ¹.. ¹9S9: ¹604¹609
A N S W £ R 7 O 7 R Y I 7 ! P R O 8 L £ M
|r t|e .bserce c| .ry .egu|.t|cr, c||p p.cJuce.s ..e rct |.ceJ .|t| t|e ccsts c| t|e pc||ut|cr t|e|. cpe..t|crs
gere..te. ¯|e n..ket p.|ce |s t|us |
1
.rJ t|e ,u.rt|ty (
1
. ¯|e e|c|ercy ccrJ|t|cr |s rct net, t|e p.|ce |s
|c.e. .rJ t|e ,u.rt|ty g.e.te. t|.r .cu|J be e|c|ert. || p.cJuce.s .e.e |c.ceJ tc |.ce t|e ccst c| t|e|. pc||u
t|cr .s .e|| .s ct|e. p.cJuct|cr ccsts, t|e supp|y cu.ve .cu|J s|||t tc .
2
, t|e p.|ce .cu|J .|se tc |
2
, .rJ t|e
,u.rt|ty .cu|J |.|| tc (
2
. ¯|e re. sc|ut|cr s.t|s|es t|e e|c|ercy ccrJ|t|cr.
160 PRINCIPL£S OI £CONOMICS
4. REVIEW AND PRACTICE
Summary
|ccrcn|sts |rs|st t|.t |rJ|v|Ju.|s Jc rct n.ke c|c|ces .|||yr|||y. |.t|e., eccrcn|sts .ssune t|.t |rJ|v|Ju.|s
n.ke c|c|ces |r . pu.pcse|u| ..y, cre t|.t seeks t|e n.x|nun v.|ue |c. scne cb¦ect|ve. \e .ssune t|.t
ccrsune.s seek tc n.x|n|.e ut|||ty .rJ t|.t |.ns seek tc n.x|n|.e p.c|ts.
\|.teve. |s be|rg n.x|n|.eJ, c|c|ces ..e b.seJ cr t|e n..g|r.| Jec|s|cr .u|e. |c||c.|rg t||s .u|e .esu|ts |r .r
.||cc.t|cr t|.t .c||eves t|e g.e.test Jeg.ee c| ut|||ty c. p.c|t pcss|b|e.
|| ut|||ty .rJ p.c|tn.x|n|.|rg c|c|ces ..e n.Je |r t|e ccrtext c| . p.|ce systen t|.t ccr|.crts Jec|s|cr
n.ke.s .|t| .|| c| t|e ccsts .rJ .|| c| t|e bere|ts c| t|e|. c|c|ces, t|e .||cc.t|cr c| .escu.ces .||| be e|c|ert.
Ar e|c|ert .||cc.t|cr |s cre t|.t n.x|n|.es t|e ret bere|t c| eve.y .ct|v|ty. ¯|e ccrcepts c| ccrsune. .rJ
p.cJuce. su.p|us s|c. us |c. t||s ret bere|t |s s|..eJ. |,u|ty |s . sep...te |ssue, cre t|.t c.||s |c. . rc.n.t
|ve ev.|u.t|cr c| t|e |.|.ress c| t|e J|st.|but|cr c| |rccne.
¯|e .||cc.t|cr c| .escu.ces .||| be |re|c|ert |r t|e .bserce c| ccnpet|t|ve n..kets. |t .||| .|sc be |re|c|ert ||
p.cpe.ty .|g|ts ..e rct exc|us|ve .rJ t..rs|e..b|e. ¯|ese t.c ccrJ|t|crs b.e.k Jc.r .|er t|e.e ..e pub||c
gccJs, ccnncr p.cpe.ty .escu.ces, c. exte.r.| bere|ts c. ccsts. |r e.c| c| t|ese c.ses, pub||c sectc. |rte.
vert|cr n.y |np.cve t|e e|c|ercy c| .escu.ce .||cc.t|cr. \|er . n..ket |.||s tc .c||eve t|e e|c|ert sc|u
t|cr, ret bere|t |.||s s|c.t c| t|e n.x|nun pcss|b|e. |e.J.e|g|t |css |s t|e .ncurt by .||c| ret bere|t |.||s
be|c. t|e ret bere|t pcss|b|e .t t|e e|c|ert sc|ut|cr.
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 161
C O N C £ P 7 P R O 8 L £ M S
1. \|.t |s .c||eveJ by se|ect|rg t|e ,u.rt|ty c| .r .ct|v|ty .t .||c| n..g|r.| bere|t e,u.|s n..g|r.| ccst`
2. Suppcse t|e n..g|r.| bere|t c| .r .ct|v|ty exceeJs t|e n..g|r.| ccst. \|.t Jces t|e n..g|r.| Jec|s|cr
.u|e s.y . n.x|n|.|rg Jec|s|cr n.ke. .||| Jc`
3. Suppcse ycu ..e . J|scus |u.|e. .rJ ycu. gc.| |s tc n.x|n|.e t|e J|st.rce ycu .c||eve. +cu ´p.cJuce´
J|scus |u.|s by p..ct|c|rg. ¯|e tct.| bere|t c| p..ct|ce |s J|st.rce .c||eveJ, .rJ t|e |rput t|.t .c||eves
t||s J|st.rce |s |cu.s c| p..ct|ce. |esc.|be t|e tct.| bere|t cu.ve c| p..ct|ce. \|.t pc|rt cr t|e cu.ve
.cu|J ycu se|ect`
4. ¯||s c|.pte. ..gues t|.t ccrsune.s n.x|n|.e ut|||ty .rJ |.ns n.x|n|.e p.c|ts. \|.t Jc ycu suppcse
e.c| c| t|e |c||c.|rg n|g|t be p.esuneJ tc n.x|n|.e`
.. A n|r|ste. c. ..bb|
b. A |r|teJ St.tes Ser.tc.
c. ¯|e n.r.ge. c| . n.¦c. |e.gue b.seb.|| te.n
J. ¯|e c.re. c| . n.¦c. |e.gue b.seb.|| te.n
e. ¯|e J|.ectc. c| . c|..|t.b|e c.g.r|..t|cr
5. |c. e.c| c| t|e |c||c.|rg gccJs, |rJ|c.te .|et|e. exc|us|ve, t..rs|e..b|e p.cpe.ty .|g|ts ex|st .rJ .|et|e.
t|e gccJ pcses . p.cb|en |c. pub||c pc||cy. || |t Jces, Jces t|e p.cb|en .e|.te tc . p.cb|en c| p.cpe.ty
.|g|ts`
.. ´|e.r .|.
b. ¯cn.tces
c. |cus|rg
J. b|ue .|.|es
6. ¯|e J.yc|e.r|rg |rJust.y |s . n.¦c. scu.ce c| .|. pc||ut|cr. \|.t c.r ycu ccrc|uJe .bcut t|e p.|ce .rJ
cutput c| J.yc|e.r|rg se.v|ces`
. |ccrcn|sts c|ter .eccnnerJ t|.t pc||ute.s suc| .s J.yc|e.r|rg est.b||s|nerts be c|..geJ |ees |c. t|e
pc||ut|cr t|ey en|t. ´.|t|cs c| t||s |Je. .espcrJ t|.t t|e est.b||s|nerts .cu|J s|np|y .espcrJ by p.ss|rg
t|ese c|..ges cr tc t|e|. custcne.s, |e.v|rg t|e |eve| c| pc||ut|cr urc|.rgeJ. ´cnnert cr t||s
cb¦ect|cr.
8. Ccve.rnert .gerc|es c|ter .e,u|.e t|.t c|||J.er be |rccu|.teJ .g.|rst ccnnur|c.b|e J|se.ses suc| .s
pc||c .rJ ne.s|es. |.cn t|e st.rJpc|rt c| eccrcn|c e|c|ercy, |s t|e.e .ry ¦ust||c.t|cr |c. suc| .
.e,u|.enert`
9. \||c| c| t|e |c||c.|rg gccJs c. se.v|ces ..e pub||c` \|y c. .|y rct`
.. ||b...|es
b. ||.e p.ctect|cr
c. ¯e|ev|s|cr p.cg..ns
J. |e.|t| c..e
e. \.te. |c. |cuse|c|J ccrsunpt|cr
10. || . v|||.ge |r bcts..r. |s g..rteJ seve..| ||cerses tc k||| e|ep|.rts, |c. Jces t||s g|ve |t .r |rcert|ve tc
p.ese.ve e|ep|.rts .rJ |rc.e.se t|e s|.e c| t|e |e.J` |c. Jces t|e |rte.r.t|cr.| b.r cr |vc.y s.|es .|ect
t|e |rcert|ve |r bcts..r. tc p.ese.ve t|e e|ep|.rt`
11. ¯|e runbe. c| |s| c.ug|t |r t|e cce.r |.s |.||er |r .ecert ye..s p..t|y .s . .esu|t c| nc.e |rters|ve
|s||rg e|c.ts .rJ t|e use c| nc.e scp||st|c.teJ e,u|pnert. ||s| |r t|e cce.r ..e . ccnncr p.cpe.ty
.escu.ce. |c. n|g|t t||s |.ct be .e|.teJ tc Jec||r|rg |s| c.tc|es` |c. Jc ycu t||rk t||s J.cp |r t|e c.tc|
.|ects t|e p.|ce c| se.|ccJ`
162 PRINCIPL£S OI £CONOMICS
N U M £ R I C A L P R O 8 L £ M S
1. 'ce ||gg|rs |s t||rk|rg .bcut |c. nuc| t|ne tc sperJ stuJy|rg |c. . b|c|cgy ex.n tcnc..c.. |s|rg
´ut|||ty ur|ts´ |e ne.su.es t|e bere|ts .rJ ccsts c| stuJy, ||s c.|cu|.t|crs ..e s|c.r |r t|e |c||c.|rg
t.b|e.
.. |||| |r t|e |cu.t| .c. |c. ret bere|t |r t|e t.b|e. |se t|e n|Jpc|rt ccrvert|cr tc enp|.s|.e t|.t
t|e ret bere|t |s . n..g|r.| v.|ue s|c.|rg t|e g.|r .s |cu.s spert |rc.e.se by cre|cu.
|rc.enerts.
b. |s|rg . g..p| s|n||.. tc |.re| (.) c| ||gu.e 6.1 s|c. t|e n..g|r.| bere|t cu.ve .rJ ve.||y t|.t
t|e ..e. urJe. t|e cu.ve .t 3 |cu.s c| stuJy cc..espcrJs tc t|e tct.| bere|t c| t|.t nuc| stuJy.
(||rt. |enenbe. t|.t n..g|r.| v.|ues ..e p|ctteJ .t t|e n|Jpc|rts c| t|e cc..espcrJ|rg |rte.v.|s
cr t|e |c.|.crt.| .x|s.)
c. |se . g..p| s|n||.. tc |.re| (b) c| ||gu.e 6.1 tc s|c. t|e n..g|r.| ccst cu.ve .rJ ve.||y t|.t t|e
..e. urJe. t|e cu.ve .t 3 |cu.s c| stuJy cc..espcrJs tc t|e tct.| ccst c| t|.t nuc| stuJy.
J. |se . g..p| s|n||.. tc |.re| (.) c| ||gu.e 6.6 tc ccnb|re t|e n..g|r.| bere|t .rJ n..g|r.| ccst
cu.ves ycu J.e. |r p..ts (.) .rJ (b).
e. b.seJ cr t|e n..g|r.| Jec|s|cr .u|e, |c. n.ry |cu.s s|cu|J 'ce sperJ stuJy|rg |c. ||s b|c|cgy
ex.n`
2. |c. suppcse scne |.|erJs c| 'ces c.|| tc s.y t|ey ..e |.v|rg . p..ty tcr|g|t. 'ce c.|cu|.tes t|.t t|e p..ty
|s rc. ||s best .|te.r.t|ve tc stuJy, .rJ |e |rc.e.ses ||s est|n.te c| t|e ccst c| e.c| |cu. c| stuJy. Ore
|cu. c| stuJy rc. ccsts 0, t.c |cu.s ccst 140, t|.ee |cu.s 210, |cu. |cu.s 280, |ve |cu.s 350, .rJ s|x
|cu.s 40.
.. |... t|e re. n..g|r.| bere|t .rJ n..g|r.| ccst cu.ves .s |r |.cb|en 1, p..t (J).
b. b.seJ cr t|e n..g|r.| Jec|s|cr .u|e, |Jert||y t|e re. sc|ut|cr t|.t n.x|n|.es t|e ret bere|t c|
stuJy t|ne.
3. ¯|e |cc.| g.sc||re n..ket |r . p..t|cu|.. c|ty |.s Jen.rJ .rJ supp|y cu.ves g|ver by t|e |c||c.|rg J.t..
(A|| ,u.rt|t|es ..e |r n||||crs c| g.||crs pe. ncrt|.)
|.|ce pe. g.||cr ´1.00 ´1.50 ´2.00 ´2.50 ´3.00 ´3.50 ´4.00
¸u.rt|ty Jen.rJeJ 6 5 4 3 2 1 0
¸u.rt|ty supp||eJ 0 1 2 3 4 5 6
.. ||ct t|e Jen.rJ .rJ supp|y cu.ves, .rJ Jete.n|re t|e e,u|||b.|un p.|ce .rJ ,u.rt|ty.
b. S|c. t|e ..e.s c| ccrsune. .rJ p.cJuce. su.p|us.
c. |c. suppcse t|.t t|e ccnnur|ty Jete.n|res t|.t e.c| g.||cr c| g.sc||re ccrsuneJ |npcses
´0.50 |r pc||ut|cr ccsts. Accc.J|rg|y, . ´0.50pe.g.||cr t.x |s |npcseJ. ¯|e t.x |s |npcseJ cr
se||e.s c| g.sc||re, .rJ |t |.s t|e e|ect c| |rc.e.s|rg by ´0.50 t|e p.|ce .e,u|.eJ tc |rJuce t|e
,u.rt|t|es supp||eJ |r t|e t.b|e. |c. ex.np|e, . p.|ce c| ´2.00 |s rc. .e,u|.eJ |c. . ,u.rt|ty c| 1
n||||cr g.||crs tc be supp||eJ e.c| ncrt|. ||ct t|e re. supp|y cu.ve.
J. App.cx|n.te t|e re. e,u|||b.|un p.|ce .rJ cutput.
e. |ces t|e p.|ce |rc.e.se by t|e |u|| .ncurt c| t|e t.x` || rct, exp|.|r .|y.
|. \cu|J ycu. .rs.e. be J||e.ert || t|e Jen.rJ |c. g.sc||re .e.e pe.|ect|y |re|.st|c`
4. ¯|e |u v.cc|r.t|cr n..ket |.s t|e Jen.rJ .rJ supp|y cu.ves g|ver by t|e |c||c.|rg J.t.. (A|| ,u.rt|t|es
..e |r t|cus.rJs.)
|.|ce pe. v.cc|r.t|cr ´10 ´15 ´20 ´25 ´30
¸u.rt|ty Jen.rJeJ 90 80 0 60 50
¸u.rt|ty supp||eJ 50 60 0 80 90
.. ||ct t|e Jen.rJ .rJ supp|y cu.ves, .rJ Jete.n|re t|e e,u|||b.|un p.|ce .rJ ,u.rt|ty.
b. S|c. t|e ..e.s c| ccrsune. .rJ p.cJuce. su.p|us.
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 163
c. |c. suppcse t|.t e.c| v.cc|r.t|cr g|ver gere..tes .r exte.r.| bere|t, .s t|cse .|c Jc rct get
v.cc|r.teJ ..e |ess ||ke|y tc get t|e |u .|er ct|e.s Jc get v.cc|r.teJ. As . .esu|t, supp||e.s
.ece|ve . ´10 subs|Jy |.cn t|e gcve.rnert |c. e.c| v.cc|re. |c. ex.np|e, || ccrsune.s p.y ´10
pe. v.cc|r.t|cr, supp||e.s .ece|ve ´20, sc cr|y ´10 |.cn ccrsune.s |s .e,u|.eJ tc |rJuce supp||e.s
tc c|e. 0,000 v.cc|r.t|crs pe. ncrt|. ||ct t|e re. supp|y cu.ve.
J. |ete.n|re t|e re. e,u|||b.|un p.|ce .rJ ,u.rt|ty.
e. |ces t|e p.|ce |.|| by t|e |u|| .ncurt c| t|e subs|Jy` || rct, exp|.|r .|y.
|. \|.t |s t|e tct.| .ncurt t|.t ccrsune.s rc. p.y |c. t|e re. e,u|||b.|un ,u.rt|ty c|
v.cc|r.t|crs`
g. \|.t |s t|e tct.| subs|Jy t|.t supp||e.s .ece|ve |.cn t|e gcve.rnert .t t|e re. e,u|||b.|un
,u.rt|ty c| v.cc|r.t|crs`
5. C|ver t|e |c||c.|rg |r|c.n.t|cr .bcut t|e supp|y c| .rJ Jen.rJ |c. .pp|es.
Price per
pound
Quantity demanded (pounds per
month)
Quantity SuppIied (pounds per
month
´0.50 12,000 0
0.5 10,000 2,000
1.00 8,000 4,000
1.25 6,000 6,000
1.50 4,000 8,000
1.5 2,000 10,000
2.00 0 12,000
.. |... . g..p| s|n||.. tc ||gu.e 6.12
b. Assun|rg t|e n..ket |c. .pp|es neets t|e e|c|ercy ccrJ|t|cr, s|c. t|e e,u|||b.|un p.|ce .rJ
,u.rt|ty t|.t n.x|n|.es ret bere|t tc scc|ety.
c. |Jert||y t|e ..e. c| ccrsune. su.p|us .rJ t|e ..e. c| p.cJuce. su.p|us.
164 PRINCIPL£S OI £CONOMICS
1.
2.
3.
ENDNOTES
See |epc.t c| t|e ´cnn|ttee cr ´cnne.ce, Sc|erce, .rJ ¯..rspc.t.t|cr, ´|||J·e··
|·o|ec||o· |·o· v|o|e·| |·o¸·o··|·¸ ^c|, Ser.te |epc.t 106509 (Octcbe. 26, 2000),
\.s||rgtcr, |.´.. |.S. Ccve.rnert |.|rt|rg O|ce, 2000, .rJ V|c|.e| ||c|, ´\|c|ert
\|Jec C.nes ¯est|ncry,´ ´||c.gc ´|ty ´curc||, Octcbe. 30, 2000, .t
|ttp.//......p.c.g/.Jvcc.cy/.|c|v|Jecg.nev|c|erce.pJ|.
V..k |cserbe.g, ´Success|u| St.te St..teg|es,´ AJc|escert |e.|t| |e.Je.s||p |c.un,
|ecenbe. 6, 2003, .t |ttp.//......p.c.g/.Jvcc.cy/.|p.c¦ect/A||Success|u|
St.teSt..teg|esV|cserbe.g.pps.
´cnncr p.cpe.ty .escu.ces ..e scnet|nes .e|e..eJ tc .s cper .ccess .escu.ces.
CHAP7£R 6 MARk£7S, MAXIMI7£RS, AND £IIICI£NCY 165
166 PRINCIPL£S OI £CONOMICS
ñrms
O.g.r|..t|crs t|.t p.cJuce
gccJs .rJ se.v|ces.
´ | A | ¯ | | 8
Production and Cost
S7AR7 UP: S7R££7 CL£ANING AROUND 7H£ WORLD
|t |s J..r |r S|.rg|.|, ´||r.. A|.e.Jy t|cus.rJs c| ´||rese ..e cut c|e.r|rg t|e c|tys st.eets. ¯|ey ..e us|rg
b.ccns.
Or t|e ct|e. s|Je c| t|e .c.|J, r|g|t |.||s |r \.s||rgtcr, |.´., .|e.e t|e st.eets ..e .|sc be|rg c|e.reJby .
|.rJ|u| c| g|.rt st.eets.eep|rg n.c||res J.|ver by . |.rJ|u| c| .c.ke.s.
¯|e J||e.erce |r net|cJ |s rct t|e .esu|t c| . g.e.te. krc.|eJge c| ncJe.r tec|rc|cgy |r t|e |r|teJ
St.test|e ´||rese krc. pe.|ect|y .e|| |c. tc bu||J st.eets.eep|rg n.c||res. |t |s . p.cJuct|cr Jec|s|cr b.seJ
cr ccsts |r t|e t.c ccurt.|es. |r ´||r., .|e.e ..ges ..e .e|.t|ve|y |c., .r ..ny c| .c.ke.s ..neJ .|t| b.ccns |s
t|e |e.st expers|ve ..y tc p.cJuce c|e.r st.eets. |r \.s||rgtcr, .|e.e |.bc. ccsts ..e ||g|, |t n.kes serse tc use
nc.e n.c||re.y .rJ |ess |.bc..
A|| types c| p.cJuct|cr e|c.ts .e,u|.e c|c|ces |r t|e use c| |.ctc.s c| p.cJuct|cr. |r t||s c|.pte. .e ex.n|re
suc| c|c|ces. S|cu|J . gccJ c. se.v|ce be p.cJuceJ us|rg .e|.t|ve|y nc.e |.bc. .rJ |ess c.p|t.|` O. s|cu|J .e|.t
|ve|y nc.e c.p|t.| .rJ |ess |.bc. be useJ` \|.t .bcut t|e use c| r.tu..| .escu.ces`
|r t||s c|.pte. .e see .|y |.ns n.ke t|e p.cJuct|cr c|c|ces t|ey Jc .rJ |c. t|e|. ccsts .|ect t|e|. c|c|ces.
\e .||| .pp|y t|e n..g|r.| Jec|s|cr .u|e tc t|e p.cJuct|cr p.ccess .rJ see |c. t||s .u|e ersu.es t|.t p.cJuct|cr |s
c...|eJ cut .t t|e |c.est ccst pcss|b|e. \e ex.n|re t|e r.tu.e c| p.cJuct|cr .rJ ccsts |r c.Je. tc g.|r . bette. ur
Je.st.rJ|rg c| supp|y. \e t|us s|||t cu. |ccus tc ñrms, c.g.r|..t|crs t|.t p.cJuce gccJs .rJ se.v|ces. |r p.cJu
c|rg gccJs .rJ se.v|ces, |.ns ccnb|re t|e |.ctc.s c| p.cJuct|cr|.bc., c.p|t.|, .rJ r.tu..| .escu.cestc p.c
Juce v..|cus p.cJucts.
|ccrcn|sts .ssune t|.t |.ns erg.ge |r p.cJuct|cr |r c.Je. tc e..r . p.c|t .rJ t|.t t|ey seek tc n.ke t||s
p.c|t .s |..ge .s pcss|b|e. ¯|.t |s, eccrcn|sts .ssune t|.t |.ns .pp|y t|e n..g|r.| Jec|s|cr .u|e .s t|ey seek tc
n.x|n|.e t|e|. p.c|ts. \|et|e. .e ccrs|Je. t|e cpe..tc. c| . s|ces||re st.rJ .t .r .|.pc.t c. t|e |.n t|.t p.c
Juces .|.p|.res, .e .||| |rJ t|e.e ..e b.s|c .e|.t|crs||ps bet.eer t|e use c| |.ctc.s c| p.cJuct|cr .rJ cutput
|eve|s, .rJ bet.eer cutput |eve|s .rJ ccsts, t|.t .pp|y tc .|| p.cJuct|cr. ¯|e p.cJuct|cr c|c|ces c| |.ns .rJ t|e|.
.sscc|.teJ ccsts ..e .t t|e |curJ.t|cr c| supp|y.
short run
A p|.rr|rg pe.|cJ cve. .||c|
t|e n.r.ge.s c| . |.n nust
ccrs|Je. cre c. nc.e c| t|e|.
|.ctc.s c| p.cJuct|cr .s |xeJ
|r ,u.rt|ty.
ñxed factor of production
A |.ctc. c| p.cJuct|cr .|cse
,u.rt|ty c.rrct be c|.rgeJ
Ju.|rg . p..t|cu|.. pe.|cJ.
variabIe factor of
production
A |.ctc. c| p.cJuct|cr .|cse
,u.rt|ty c.r be c|.rgeJ
Ju.|rg . p..t|cu|.. pe.|cJ.
Iong run
¯|e p|.rr|rg pe.|cJ cve.
.||c| . |.n c.r ccrs|Je. .||
|.ctc.s c| p.cJuct|cr .s
v..|.b|e.
production function
¯|e .e|.t|crs||p bet.eer
|.ctc.s c| p.cJuct|cr .rJ t|e
cutput c| . |.n.
1. PRODUCTION CHOICES AND COSTS: THE SHORT
RUN
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. Understand the terms associated with the short-run production function÷totaI product, aver-
age product, and marginaI product÷and expIain and iIIustrate how they are reIated to each
other.
2. £xpIain the concepts of increasing, diminishing, and negative marginaI returns and expIain the
Iaw of diminishing marginaI returns.
3. Understand the terms associated with costs in the short run÷totaI variabIe cost, totaI ñxed
cost, totaI cost, average variabIe cost, average ñxed cost, average totaI cost, and marginaI
cost÷and expIain and iIIustrate how they are reIated to each other.
4. £xpIain and iIIustrate how the product and cost curves are reIated to each other and to determ-
ine in what ranges on these curves marginaI returns are increasing, diminishing, or negative.
Oui analysis of pioduction and cost begins with a peiiod economists call the shoit iun. The short run
in this micioeconomic context is a planning peiiod ovei which the manageis of a fim must considei
one oi moie of theii factois of pioduction as fxed in quantity. Foi example, a iestauiant may iegaid its
building as a fxed factoi ovei a peiiod of at least the next yeai. It would take at least that much time to
fnd a new building oi to expand oi ieduce the size of its piesent facility. Decisions conceining the op-
eiation of the iestauiant duiing the next yeai must assume the building will iemain unchanged. Othei
factois of pioduction could be changed duiing the yeai, but the size of the building must be iegaided
as a constant.
When the quantity of a factoi of pioduction cannot be changed duiing a paiticulai peiiod, it is
called a nxed factor of production. Foi the iestauiant, its building is a fxed factoi of pioduction foi
at least a yeai. A factoi of pioduction whose quantity can be changed duiing a paiticulai peiiod is
called a variable factor of production; factois such as laboi and food aie examples.
While the manageis of the iestauiant aie making choices conceining its opeiation ovei the next
yeai, they aie also planning foi longei peiiods. Ovei those peiiods, manageis may contemplate altein-
atives such as modifying the building, building a new facility, oi selling the building and leaving the
iestauiant business. The planning peiiod ovei which a fim can considei all factois of pioduction as
vaiiable is called the long run.
At any one time, a fim will be making both shoit-iun and long-iun choices. The manageis may be
planning what to do foi the next few weeks and foi the next few yeais. Theii decisions ovei the next
few weeks aie likely to be shoit-iun choices. Decisions that will afect opeiations ovei the next few
yeais may be long-iun choices, in which manageis can considei changing eveiy aspect of theii opeia-
tions. Oui analysis in this section focuses on the shoit iun. We examine long-iun choices latei in this
chaptei.
1.1 The Shoit-Run Pioduction Function
A fim uses factois of pioduction to pioduce a pioduct. The ielationship between factois of pioduction
and the output of a fim is called a production function Oui fist task is to exploie the natuie of the
pioduction function.
Considei a hypothetical fim, Acme Clothing, a shop that pioduces jackets. Suppose that Acme has
a lease on its building and equipment. Duiing the peiiod of the lease, Acme's capital is its fxed factoi
of pioduction. Acme's vaiiable factois of pioduction include things such as laboi, cloth, and electiicity.
In the analysis that follows, we shall simplify by assuming that laboi is Acme's only vaiiable factoi of
pioduction.
200 PRINCIPL£S OI £CONOMICS
totaI product curve
C..p| t|.t s|c.s t|e
,u.rt|t|es c| cutput t|.t c.r
be cbt.|reJ |.cn J||e.ert
.ncurts c| . v..|.b|e |.ctc.
c| p.cJuct|cr, .ssun|rg
ct|e. |.ctc.s c| p.cJuct|cr
..e |xeJ.
II GUR£ 8. 1 Acme CIothing's 7otaI
Product Curve
¯|e t.b|e g|ves cutput |eve|s pe. J.y |c. Acne
´|ct||rg ´cnp.ry .t v..|cus ,u.rt|t|es c|
|.bc. pe. J.y, .ssun|rg t|e |.ns c.p|t.| |s
|xeJ. ¯|ese v.|ues ..e t|er p|ctteJ g..p||c.||y
.s . tct.| p.cJuct cu.ve.
marginaI product
¯|e .ncurt by .||c| cutput
.|ses .|t| .r .JJ|t|cr.| ur|t
c| . v..|.b|e |.ctc..
marginaI product of Iabor
¯|e .ncurt by .||c| cutput
.|ses .|t| .r .JJ|t|cr.| ur|t
c| |.bc..
average product
¯|e cutput pe. ur|t c|
v..|.b|e |.ctc..
average product of Iabor
¯|e ..t|c c| cutput tc t|e
runbe. c| ur|ts c| |.bc. (¸/
|).
7otaI, MarginaI, and Average Products
Figuie 8.1 shows the numbei of jackets Acme can obtain with vaiying amounts of laboi (in this case,
tailois) and its given level of capital. A total product curve shows the quantities of output that can be
obtained fiom difeient amounts of a vaiiable factoi of pioduction, assuming othei factois of pioduc-
tion aie fxed.
Notice what happens to the slope of the total pioduct cuive in Figuie 8.1. Between
0 and 3 units of laboi pei day, the cuive becomes steepei. Between 3 and 7 woikeis, the
cuive continues to slope upwaid, but its slope diminishes. Beyond the seventh tailoi,
pioduction begins to decline and the cuive slopes downwaid.
We measuie the slope of any cuive as the veitical change between two points di-
vided by the hoiizontal change between the same two points. The slope of the total
pioduct cuive foi laboi equals the change in output (AQ) divided by the change in
units of laboi (AL):
Slope of the total pioduct cuive = AQ/ AL
The slope of a total pioduct cuive foi any vaiiable factoi is a measuie of the change in
output associated with a change in the amount of the vaiiable factoi, with the quantities
of all othei factois held constant. The amount by which output iises with an additional
unit of a vaiiable factoi is the marginal product of the vaiiable factoi. Mathematic-
ally, maiginal pioduct is the iatio of the change in output to the change in the amount
of a vaiiable factoi. The marginal product of labor (MP
L
), foi example, is the
amount by which output iises with an additional unit of laboi. It is thus the iatio of the
change in output to the change in the quantity of laboi (AQ/AL), all othei things un-
changed. It is measuied as the slope of the total pioduct cuive foi laboi.
£QUA7I ON 8. 1
MP
L
= AQ / AL
In addition we can defne the average product of a vaiiable factoi. It is the output
pei unit of vaiiable factoi. The average product of labor (AP
L
), foi example, is the
iatio of output to the numbei of units of laboi (Q/L).
£QUA7I ON 8. 2
AP
L
= Q / L
The concept of aveiage pioduct is often used foi compaiing pioductivity levels ovei time oi in
compaiing pioductivity levels among nations. When you iead in the newspapei that pioductivity is
iising oi falling, oi that pioductivity in the United States is nine times gieatei than pioductivity in Ch-
ina, the iepoit is piobably iefeiiing to some measuie of the aveiage pioduct of laboi.
The total pioduct cuive in Panel (a) of Figuie 8.2 is iepeated fiom Figuie 8.1. Panel (b) shows the
maiginal pioduct and aveiage pioduct cuives. Notice that maiginal pioduct is the slope of the total
pioduct cuive, and that maiginal pioduct iises as the slope of the total pioduct cuive incieases, falls as
the slope of the total pioduct cuive declines, ieaches zeio when the total pioduct cuive achieves its
maximum value, and becomes negative as the total pioduct cuive slopes downwaid. As in othei paits
of this text, maiginal values aie plotted at the midpoint of each inteival. The maiginal pioduct of the
ffth unit of laboi, foi example, is plotted between 4 and 3 units of laboi. Also notice that the maiginal
pioduct cuive inteisects the aveiage pioduct cuive at the maximum point on the aveiage pioduct
cuive. When maiginal pioduct is above aveiage pioduct, aveiage pioduct is iising. When maiginal
pioduct is below aveiage pioduct, aveiage pioduct is falling.
CHAP7£R 8 PRODUC7ION AND COS7 201
II GUR£ 8. 2 Irom 7otaI Product to the Average and MarginaI Product of Labor
¯|e |.st t.c .c.s c| t|e t.b|e g|ve t|e v.|ues |c. ,u.rt|t|es c| |.bc. .rJ tct.| p.cJuct |.cn ||gu.e 8.1. V..g|r.|
p.cJuct, g|ver |r t|e t||.J .c., |s t|e c|.rge |r cutput .esu|t|rg |.cn . creur|t |rc.e.se |r |.bc.. Ave..ge
p.cJuct, g|ver |r t|e |cu.t| .c., |s cutput pe. ur|t c| |.bc.. |.re| (.) s|c.s t|e tct.| p.cJuct cu.ve. ¯|e s|cpe c|
t|e tct.| p.cJuct cu.ve |s n..g|r.| p.cJuct, .||c| |s p|ctteJ |r |.re| (b). \.|ues |c. n..g|r.| p.cJuct ..e p|ctteJ .t
t|e n|Jpc|rts c| t|e |rte.v.|s. Ave..ge p.cJuct .|ses .rJ |.||s. \|e.e n..g|r.| p.cJuct |s .bcve .ve..ge p.cJuct,
.ve..ge p.cJuct .|ses. \|e.e n..g|r.| p.cJuct |s be|c. .ve..ge p.cJuct, .ve..ge p.cJuct |.||s. ¯|e n..g|r.|
p.cJuct cu.ve |rte.sects t|e .ve..ge p.cJuct cu.ve .t t|e n.x|nun pc|rt cr t|e .ve..ge p.cJuct cu.ve.
202 PRINCIPL£S OI £CONOMICS
increasing marginaI returns
¯|e ..rge cve. .||c| e.c|
.JJ|t|cr.| ur|t c| . v..|.b|e
|.ctc. .JJs nc.e tc tct.|
cutput t|.r t|e p.ev|cus
ur|t.
diminishing marginaI
returns
¯|e ..rge cve. .||c| e.c|
.JJ|t|cr.| ur|t c| . v..|.b|e
|.ctc. .JJs |ess tc tct.|
cutput t|.r t|e p.ev|cus
ur|t.
negative marginaI returns
¯|e ..rge cve. .||c|
.JJ|t|cr.| ur|ts c| . v..|.b|e
|.ctc. .eJuce tct.| cutput,
g|ver ccrst.rt ,u.rt|t|es c|
.|| ct|e. |.ctc.s.
As a student you can use youi own expeiience to undeistand the ielationship between maiginal and
aveiage values. Youi giade point aveiage (GPA) iepiesents the aveiage giade you have eained in all
youi couise woik so fai. When you take an additional couise, youi giade in that couise iepiesents the
maiginal giade. What happens to youi GPA when you get a giade that is highei than youi pievious av-
eiage: It iises. What happens to youi GPA when you get a giade that is lowei than youi pievious avei-
age: It falls. If youi GPA is a 3.0 and you eain one moie B, youi maiginal giade equals youi GPA and
youi GPA iemains unchanged.
The ielationship between aveiage pioduct and maiginal pioduct is similai. Howevei, unlike youi
couise giades, which may go up and down willy-nilly, maiginal pioduct always iises and then falls, foi
ieasons we will exploie shoitly. As soon as maiginal pioduct falls below aveiage pioduct, the aveiage
pioduct cuive slopes downwaid. While maiginal pioduct is above aveiage pioduct, whethei maiginal
pioduct is incieasing oi decieasing, the aveiage pioduct cuive slopes upwaid.
As we have leained, maximizing behavioi iequiies focusing on making decisions at the maigin.
Foi this ieason, we tuin oui attention now towaid incieasing oui undeistanding of maiginal pioduct.
Increasing, Diminishing, and Negative MarginaI Returns
Adding the fist woikei incieases Acme's output fiom 0 to 1 jacket pei day. The second tailoi adds 2
jackets to total output; the thiid adds 4. The maiginal pioduct goes up because when theie aie moie
woikeis, each one can specialize to a degiee. One woikei might cut the cloth, anothei might sew the
seams, and anothei might sew the buttonholes. Theii incieasing maiginal pioducts aie iefected by the
incieasing slope of the total pioduct cuive ovei the fist 3 units of laboi and by the upwaid slope of the
maiginal pioduct cuive ovei the same iange. The iange ovei which maiginal pioducts aie incieasing is
called the iange of increasing marginal returns. Incieasing maiginal ietuins exist in the context of a
total pioduct cuive foi laboi, so we aie holding the quantities of othei factois constant. Incieasing
maiginal ietuins may occui foi any vaiiable factoi.
The fouith woikei adds less to total output than the thiid; the maiginal pioduct of the fouith
woikei is 2 jackets. The data in Figuie 8.2 show that maiginal pioduct continues to decline aftei the
fouith woikei as moie and moie woikeis aie hiied. The additional woikeis allow even gieatei oppoi-
tunities foi specialization, but because they aie opeiating with a fxed amount of capital, each new
woikei adds less to total output. The ffth tailoi adds only a single jacket to total output. When each ad-
ditional unit of a vaiiable factoi adds less to total output, the fim is expeiiencing diminishing mar-
ginal returns. Ovei the iange of diminishing maiginal ietuins, the maiginal pioduct of the vaiiable
factoi is positive but falling. Once again, we assume that the quantities of all othei factois of pioduction
aie fxed. Diminishing maiginal ietuins may occui foi any vaiiable factoi. Panel (b) shows that Acme
expeiiences diminishing maiginal ietuins between the thiid and seventh woikeis, oi between 7 and 11
jackets pei day.
Aftei the seventh unit of laboi, Acme's fxed plant becomes so ciowded that adding anothei woik-
ei actually ieduces output. When additional units of a vaiiable factoi ieduce total output, given con-
stant quantities of all othei factois, the company expeiiences negative marginal returns. Now the
total pioduct cuive is downwaid sloping, and the maiginal pioduct cuive falls below zeio. Figuie 8.3
shows the ianges of incieasing, diminishing, and negative maiginal ietuins. Cleaily, a fim will nevei
intentionally add so much of a vaiiable factoi of pioduction that it enteis a iange of negative maiginal
ietuins.
CHAP7£R 8 PRODUC7ION AND COS7 203
II GUR£ 8. 3 Increasing MarginaI
Returns, Diminishing MarginaI Returns, and
Negative MarginaI Returns
¯||s g..p| s|c.s Acnes tct.| p.cJuct cu.ve
|.cn ||gu.e 8.1 .|t| t|e ..rges c| |rc.e.s|rg
n..g|r.| .etu.rs, J|n|r|s||rg n..g|r.| .etu.rs,
.rJ reg.t|ve n..g|r.| .etu.rs n..keJ. Acne
expe.|erces |rc.e.s|rg n..g|r.| .etu.rs
bet.eer 0 .rJ 3 ur|ts c| |.bc. pe. J.y,
J|n|r|s||rg n..g|r.| .etu.rs bet.eer 3 .rJ
ur|ts c| |.bc. pe. J.y, .rJ reg.t|ve n..g|r.|
.etu.rs beycrJ t|e t| ur|t c| |.bc..
Iaw of diminishing
marginaI returns
¯|e n..g|r.| p.cJuct c| .ry
v..|.b|e |.ctc. c| p.cJuct|cr
.||| evertu.||y Jec||re,
.ssun|rg t|e ,u.rt|t|es c|
ct|e. |.ctc.s c| p.cJuct|cr
..e urc|.rgeJ.
variabIe costs
¯|e ccsts .sscc|.teJ .|t| t|e
use c| v..|.b|e |.ctc.s c|
p.cJuct|cr.
ñxed costs
¯|e ccsts .sscc|.teJ .|t| t|e
use c| |xeJ |.ctc.s c|
p.cJuct|cr.
The idea that the maiginal pioduct of a vaiiable factoi declines ovei some iange is
impoitant enough, and geneial enough, that economists state it as a law. The law of
diminishing marginal returns holds that the maiginal pioduct of any vaiiable factoi
of pioduction will eventually decline, assuming the quantities of othei factois of pio-
duction aie unchanged.
Heads Up!
|t |s e.sy tc ccr|use t|e ccrcept c| J|n|r|s||rg n..g|r.| .etu.rs .|t| t|e |Je. c| reg.t|ve n..
g|r.| .etu.rs. ¯c s.y . |.n |s expe.|erc|rg J|n|r|s||rg n..g|r.| .etu.rs |s rct tc s.y |ts cutput
|s |.|||rg. ||n|r|s||rg n..g|r.| .etu.rs ne.r t|.t t|e n..g|r.| p.cJuct c| . v..|.b|e |.ctc. |s
Jec||r|rg. Output |s st||| |rc.e.s|rg .s t|e v..|.b|e |.ctc. |s |rc.e.seJ, but |t |s |rc.e.s|rg by
sn.||e. .rJ sn.||e. .ncurts. As .e s.. |r ||gu.e 8.2 .rJ ||gu.e 8.3, t|e ..rge c| J|n|r|s||rg
n..g|r.| .etu.rs ..s bet.eer t|e t||.J .rJ severt| .c.ke.s, cve. t||s ..rge c| .c.ke.s, cut
put .cse |.cn tc 11 ¦.ckets. |eg.t|ve n..g|r.| .etu.rs st..teJ .|te. t|e severt| .c.ke..
To see the logic of the law of diminishing maiginal ietuins, imagine a case in which it
does not hold. Say that you have a small plot of land foi a vegetable gaiden, 10 feet by
10 feet in size. The plot itself is a fxed factoi in the pioduction of vegetables. Suppose
you aie able to hold constant all othei factois-watei, sunshine, tempeiatuie, feitilizei,
and seed-and vaiy the amount of laboi devoted to the gaiden. How much food could
the gaiden pioduce: Suppose the maiginal pioduct of laboi kept incieasing oi was con-
stant. Then you could giow an unlimited quantity of food on youi small plot-enough
to feed the entiie woild! You could add an unlimited numbei of woikeis to youi plot
and still inciease output at a constant oi incieasing iate. If you did not get enough out-
put with, say, 300 woikeis, you could use 3 million; the fve-millionth woikei would
add at least as much to total output as the fist. If diminishing maiginal ietuins to laboi
did not occui, the total pioduct cuive would slope upwaid at a constant oi incieasing
iate.
The shape of the total pioduct cuive and the shape of the iesulting maiginal pioduct cuive diawn
in Figuie 8.2 aie typical of any fim foi the shoit iun. Given its fxed factois of pioduction, incieasing
the use of a vaiiable factoi will geneiate incieasing maiginal ietuins at fist; the total pioduct cuive foi
the vaiiable factoi becomes steepei and the maiginal pioduct iises. The oppoitunity to gain fiom in-
cieased specialization in the use of the vaiiable factoi accounts foi this iange of incieasing maiginal ie-
tuins. Eventually, though, diminishing ietuins will set in. The total pioduct cuive will become fattei,
and the maiginal pioduct cuive will fall.
1.2 Costs in the Shoit Run
A fim's costs of pioduction depend on the quantities and piices of its factois of pioduction. Because
we expect a fim's output to vaiy with the fim's use of laboi in a specifc way, we can also expect the
fim's costs to vaiy with its output in a specifc way. We shall put oui infoimation about Acme's
pioduct cuives to woik to discovei how a fim's costs vaiy with its level of output.
We distinguish between the costs associated with the use of vaiiable factois of pioduction, which
aie called variable costs, and the costs associated with the use of fxed factois of pioduction, which aie
called nxed costs. Foi most fims, vaiiable costs includes costs foi iaw mateiials, salaiies of pioduc-
tion woikeis, and utilities. The salaiies of top management may be fxed costs; any chaiges set by con-
tiact ovei a peiiod of time, such as Acme's one-yeai lease on its building and equipment, aie likely to
be fxed costs. A teim commonly used foi fxed costs is overhead. Notice that fxed costs exist only in
the shoit iun. In the long iun, the quantities of all factois of pioduction aie vaiiable, so that all long-
iun costs aie vaiiable.
204 PRINCIPL£S OI £CONOMICS
totaI variabIe cost
´cst t|.t v..|es .|t| t|e |eve|
c| cutput.
totaI ñxed cost
´cst t|.t Jces rct v..y .|t|
cutput.
totaI cost
¯|e sun c| tct.| v..|.b|e ccst
.rJ tct.| |xeJ ccst.
Total variable cost (TVC) is cost that vaiies with the level of output. Total nxed cost (TFC) is
cost that does not vaiy with output. Total cost (TC) is the sum of total vaiiable cost and total fxed
cost:
£QUA7I ON 8. 3
TVC + TFC = TC
Irom 7otaI Production to 7otaI Cost
Next we illustiate the ielationship between Acme's total pioduct cuive and its total costs. Acme can
vaiy the quantity of laboi it uses each day, so the cost of this laboi is a vaiiable cost. We assume capital
is a fxed factoi of pioduction in the shoit iun, so its cost is a fxed cost.
Suppose that Acme pays a wage of $100 pei woikei pei day. If laboi is the only vaiiable factoi,
Acme's total vaiiable costs pei day amount to $100 times the numbei of woikeis it employs. We can
use the infoimation given by the total pioduct cuive, togethei with the wage, to compute Acme's total
vaiiable costs.
We know fiom Figuie 8.1 that Acme iequiies 1 woikei woiking 1 day to pioduce 1 jacket. The
total vaiiable cost of a jacket thus equals $100. Thiee units of laboi pioduce 7 jackets pei day; the total
vaiiable cost of 7 jackets equals $300. Figuie 8.4 shows Acme's total vaiiable costs foi pioducing each
of the output levels given in Figuie 8.1
Figuie 8.4 gives us costs foi seveial quantities of jackets, but we need a bit moie detail. We know,
foi example, that 7 jackets have a total vaiiable cost of $300. What is the total vaiiable cost of 6 jackets:
II GUR£ 8. 4 Computing VariabIe Costs
¯|e pc|rts s|c.r g|ve t|e v..|.b|e ccsts c| p.cJuc|rg t|e ,u.rt|t|es c| ¦.ckets g|ver |r t|e tct.| p.cJuct cu.ve |r
||gu.e 8.1 .rJ ||gu.e 8.2. Suppcse Acnes .c.ke.s e..r ´100 pe. J.y. || Acne p.cJuces 0 ¦.ckets, |t .||| use rc
|.bc.|ts v..|.b|e ccst t|us e,u.|s ´0 (|c|rt A). |.cJuc|rg ¦.ckets .e,u|.es 3 ur|ts c| |.bc., Acnes v..|.b|e ccst
e,u.|s ´300 (|c|rt |).
We can estimate total vaiiable costs foi othei quantities of jackets by inspecting the total pioduct cuive
in Figuie 8.1. Reading ovei fiom a quantity of 6 jackets to the total pioduct cuive and then down sug-
gests that the Acme needs about 2.8 units of laboi to pioduce 6 jackets pei day. Acme needs 2 full-time
and 1 pait-time tailois to pioduce 6 jackets. Figuie 8.3 gives the piecise total vaiiable costs foi quantit-
ies of jackets ianging fiom 0 to 11 pei day. The numbeis in boldface type aie taken fiom Figuie 8.4; the
othei numbeis aie estimates we have assigned to pioduce a total vaiiable cost cuive that is consistent
CHAP7£R 8 PRODUC7ION AND COS7 205
with oui total pioduct cuive. You should, howevei, be ceitain that you undeistand how the numbeis in
boldface type weie found.
II GUR£ 8. 5 7he 7otaI VariabIe Cost Curve
¯ct.| v..|.b|e ccsts |c. cutput |eve|s s|c.r |r Acnes tct.| p.cJuct cu.ve .e.e s|c.r |r ||gu.e 8.4. ¯c ccnp|ete
t|e tct.| v..|.b|e ccst cu.ve, .e reeJ tc krc. t|e v..|.b|e ccst |c. e.c| |eve| c| cutput |.cn 0 tc 11 ¦.ckets pe.
J.y. ¯|e v..|.b|e ccsts .rJ ,u.rt|t|es c| |.bc. g|ver |r ||gu.e 8.4 ..e s|c.r |r bc|J|.ce |r t|e t.b|e |e.e .rJ .|t|
b|.ck Jcts |r t|e g..p|. ¯|e .en.|r|rg v.|ues .e.e est|n.teJ |.cn t|e tct.| p.cJuct cu.ve |r ||gu.e 8.1 .rJ ||gu.e
8.2. |c. ex.np|e, p.cJuc|rg 6 ¦.ckets .e,u|.es 2.8 .c.ke.s, |c. . v..|.b|e ccst c| ´280.
Suppose Acme's piesent plant, including the building and equipment, is the equivalent of 20 units of
capital. Acme has signed a long-teim lease foi these 20 units of capital at a cost of $200 pei day. In the
shoit iun, Acme cannot inciease oi deciease its quantity of capital-it must pay the $200 pei day no
mattei what it does. Even if the fim cuts pioduction to zeio, it must still pay $200 pei day in the shoit
iun.
Acme's total cost is its total fxed cost of $200 plus its total vaiiable cost. We add $200 to the total
vaiiable cost cuive in Figuie 8.3 to get the total cost cuive shown in Figuie 8.6.
206 PRINCIPL£S OI £CONOMICS
II GUR£ 8. 6 Irom VariabIe Cost to 7otaI Cost
\e .JJ tct.| |xeJ ccst tc t|e tct.| v..|.b|e ccst tc cbt.|r tct.| ccst. |r t||s c.se, Acnes tct.| |xeJ ccst e,u.|s ´200
pe. J.y.
Notice something impoitant about the shapes of the total cost and total vaiiable cost cuives in Figuie
8.6. The total cost cuive, foi example, staits at $200 when Acme pioduces 0 jackets-that is its total
fxed cost. The cuive iises, but at a decieasing iate, up to the seventh jacket. Beyond the seventh jacket,
the cuive becomes steepei and steepei. The slope of the total vaiiable cost cuive behaves in piecisely
the same way.
Recall that Acme expeiienced incieasing maiginal ietuins to laboi foi the fist thiee units of
laboi-oi the fist seven jackets. Up to the thiid woikei, each additional woikei added moie and moie
to Acme's output. Ovei the iange of incieasing maiginal ietuins, each additional jacket iequiies less
and less additional laboi. The fist jacket iequiied one tailoi; the second iequiied the addition of only a
pait-time tailoi; the thiid iequiied only that Acme boost that pait-time tailoi's houis to a full day. Up
to the seventh jacket, each additional jacket iequiies less and less additional laboi, and thus costs iise at
a decieasing iate; the total cost and total vaiiable cost cuives become fattei ovei the iange of incieasing
maiginal ietuins.
Acme expeiiences diminishing maiginal ietuins beyond the thiid unit of laboi-oi the seventh
jacket. Notice that the total cost and total vaiiable cost cuives become steepei and steepei beyond this
level of output. In the iange of diminishing maiginal ietuins, each additional unit of a factoi adds less
and less to total output. That means each additional unit of output iequiies laigei and laigei incieases
in the vaiiable factoi, and laigei and laigei incieases in costs.
CHAP7£R 8 PRODUC7ION AND COS7 207
average totaI cost
¯ct.| ccst J|v|JeJ by
,u.rt|ty, |t |s t|e |.ns tct.|
ccst pe. ur|t c| cutput.
average variabIe cost
¯ct.| v..|.b|e ccst J|v|JeJ by
,u.rt|ty, |t |s t|e |.ns tct.|
v..|.b|e ccst pe. ur|t c|
cutput.
average ñxed cost
¯ct.| |xeJ ccst J|v|JeJ by
,u.rt|ty.
MarginaI and Average Costs
Maiginal and aveiage cost cuives, which will play an impoitant iole in the analysis of the fim, can be
deiived fiom the total cost cuive. Marginal cost shows the additional cost of each additional unit of
output a fim pioduces. This is a specifc application of the geneial concept of maiginal cost piesented
eailiei. Given the maiginal decision iule's focus on evaluating choices at the maigin, the maiginal cost
cuive takes on enoimous impoitance in the analysis of a fim's choices. The second cuive we shall de-
iive shows the fim's aveiage total cost at each level of output. Average total cost (ATC) is total cost
divided by quantity; it is the fim's total cost pei unit of output:
£QUA7I ON 8. 4
ATC = TC/ Q
We shall also discuss average variable costs (AVC), which is the fim's vaiiable cost pei unit of
output; it is total vaiiable cost divided by quantity:
£QUA7I ON 8. 5
AVC = TVC/ Q
We aie still assessing the choices facing the fim in the shoit iun, so we assume that at least one
factoi of pioduction is fxed. Finally, we will discuss average nxed cost (AFC), which is total fxed
cost divided by quantity:
£QUA7I ON 8. 6
AFC = TFC/ Q
Maiginal cost (MC) is the amount by which total cost iises with an additional unit of output. It is
the iatio of the change in total cost to the change in the quantity of output:
£QUA7I ON 8. 7
MC = ATC/ AQ
It equals the slope of the total cost cuive. Figuie 8.7 shows the same total cost cuive that was
piesented in Figuie 8.6. This time the slopes of the total cost cuive aie shown; these slopes equal the
maiginal cost of each additional unit of output. Foi example, incieasing output fiom 6 to 7 units (
AQ = 1 ) incieases total cost fiom $480 to $300 (ATC = $20 ). The seventh unit thus has a maiginal
cost of $20 (ATC/ AQ = $20 / 1 = $20 ). Maiginal cost falls ovei the iange of incieasing maiginal ie-
tuins and iises ovei the iange of diminishing maiginal ietuins.
Heads Up!
|ct|ce t|.t t|e v..|cus ccst cu.ves ..e J...r .|t| t|e ,u.rt|ty c| cutput cr t|e |c.|.crt.| .x|s. ¯|e v..|cus
p.cJuct cu.ves ..e J...r .|t| ,u.rt|ty c| . |.ctc. c| p.cJuct|cr cr t|e |c.|.crt.| .x|s. ¯|e .e.scr |s t|.t t|e
t.c sets c| cu.ves ne.su.e J||e.ert .e|.t|crs||ps. |.cJuct cu.ves s|c. t|e .e|.t|crs||p bet.eer cutput .rJ
t|e ,u.rt|ty c| . |.ctc., t|ey t|e.e|c.e |.ve t|e |.ctc. ,u.rt|ty cr t|e |c.|.crt.| .x|s. ´cst cu.ves s|c. |c.
ccsts v..y .|t| cutput .rJ t|us |.ve cutput cr t|e |c.|.crt.| .x|s.
208 PRINCIPL£S OI £CONOMICS
II GUR£ 8. 7 7otaI Cost and MarginaI Cost
V..g|r.| ccst |r |.re| (b) |s t|e s|cpe c| t|e tct.| ccst cu.ve |r |.re| (.).
Figuie 8.8 shows the computation of Acme's shoit-iun aveiage total cost, aveiage vaiiable cost, and av-
eiage fxed cost and giaphs of these values. Notice that the cuives foi shoit-iun aveiage total cost and
aveiage vaiiable cost fall, then iise. We say that these cost cuives aie U-shaped. Aveiage fxed cost
keeps falling as output incieases. This is because the fxed costs aie spiead out moie and moie as
CHAP7£R 8 PRODUC7ION AND COS7 209
output expands; by defnition, they do not vaiy as laboi is added. Since aveiage total cost (ATC) is the
sum of aveiage vaiiable cost (AVC) and aveiage fxed cost (AFC), i.e.,
£QUA7I ON 8. 8
AVC + AFC = ATC
the distance between the ATC and AVC cuives keeps getting smallei and smallei as the fim
spieads its oveihead costs ovei moie and moie output.
II GUR£ 8. 8 MarginaI Cost, Average Iixed Cost, Average VariabIe Cost, and Average 7otaI Cost in the
Short Run
¯ct.| ccst |gu.es |c. Acne ´|ct||rg ..e t.ker |.cn ||gu.e 8.. ¯|e ct|e. v.|ues ..e Je.|veJ |.cn t|ese. Ave..ge
tct.| ccst (^¯´) e,u.|s tct.| ccst J|v|JeJ by ,u.rt|ty p.cJuceJ, |t .|sc e,u.|s t|e sun c| t|e .ve..ge |xeJ ccst
(^|´) .rJ .ve..ge v..|.b|e ccst (^v´) (except|crs |r t.b|e ..e Jue tc .curJ|rg tc t|e re..est Jc||..), .ve..ge
v..|.b|e ccst |s v..|.b|e ccst J|v|JeJ by ,u.rt|ty p.cJuceJ. ¯|e n..g|r.| ccst (/´) cu.ve (|.cn ||gu.e 8.) |rte.sects
t|e ^¯´ .rJ ^v´ cu.ves .t t|e |c.est pc|rts cr bct| cu.ves. ¯|e ^|´ cu.ve |.||s .s ,u.rt|ty |rc.e.ses.
Figuie 8.8 includes the maiginal cost data and the maiginal cost cuive fiom Figuie 8.7. The maiginal
cost cuive inteisects the aveiage total cost and aveiage vaiiable cost cuives at theii lowest points. When
maiginal cost is below aveiage total cost oi aveiage vaiiable cost, the aveiage total and aveiage vaiiable
cost cuives slope downwaid. When maiginal cost is gieatei than shoit-iun aveiage total cost oi aveiage
vaiiable cost, these aveiage cost cuives slope upwaid. The logic behind the ielationship between mai-
ginal cost and aveiage total and vaiiable costs is the same as it is foi the ielationship between maiginal
pioduct and aveiage pioduct.
We tuin next in this chaptei to an examination of pioduction and cost in the long iun, a planning
peiiod in which the fim can considei changing the quantities of any oi all factois.
210 PRINCIPL£S OI £CONOMICS
k £ Y 7 A k £ A W A Y S
< |r |.re| (.), t|e tct.| p.cJuct cu.ve |c. . v..|.b|e |.ctc. |r t|e s|c.t .ur s|c.s t|.t t|e |.n expe.|erces
|rc.e.s|rg n..g|r.| .etu.rs |.cn .e.c tc |
o
ur|ts c| t|e v..|.b|e |.ctc. (.e.c tc (
o
ur|ts c| cutput),
J|n|r|s||rg n..g|r.| .etu.rs |.cn |
o
tc |
·
((
o
tc (
·
ur|ts c| cutput), .rJ reg.t|ve n..g|r.| .etu.rs
beycrJ |
·
ur|ts c| t|e v..|.b|e |.ctc..
< |.re| (b) s|c.s t|.t n..g|r.| p.cJuct .|ses cve. t|e ..rge c| |rc.e.s|rg n..g|r.| .etu.rs, |.||s cve. t|e
..rge c| J|n|r|s||rg n..g|r.| .etu.rs, .rJ beccnes reg.t|ve cve. t|e ..rge c| reg.t|ve n..g|r.| .etu.rs.
Ave..ge p.cJuct .|ses .|er n..g|r.| p.cJuct |s .bcve |t .rJ |.||s .|er n..g|r.| p.cJuct |s be|c. |t.
< |r |.re| (c), tct.| ccst .|ses .t . Jec.e.s|rg ..te cve. t|e ..rge c| cutput |.cn .e.c tc (
o
¯||s ..s t|e
..rge c| cutput t|.t ..s s|c.r |r |.re| (.) tc ex||b|t |rc.e.s|rg n..g|r.| .etu.rs. beycrJ (
o
, t|e ..rge c|
J|n|r|s||rg n..g|r.| .etu.rs, tct.| ccst .|ses .t .r |rc.e.s|rg ..te. ¯|e tct.| ccst .t .e.c ur|ts c| cutput
(s|c.r .s t|e |rte.cept cr t|e ve.t|c.| .x|s) |s tct.| |xeJ ccst.
< |.re| (J) s|c.s t|.t n..g|r.| ccst |.||s cve. t|e ..rge c| |rc.e.s|rg n..g|r.| .etu.rs, t|er .|ses cve. t|e
..rge c| J|n|r|s||rg n..g|r.| .etu.rs. ¯|e n..g|r.| ccst cu.ve |rte.sects t|e .ve..ge tct.| ccst .rJ
.ve..ge v..|.b|e ccst cu.ves .t t|e|. |c.est pc|rts. Ave..ge |xeJ ccst |.||s .s cutput |rc.e.ses. |cte t|.t
.ve..ge tct.| ccst e,u.|s .ve..ge v..|.b|e ccst p|us .ve..ge |xeJ ccst.
< Assun|rg |.bc. |s t|e v..|.b|e |.ctc. c| p.cJuct|cr, t|e |c||c.|rg Je|r|t|crs .rJ .e|.t|crs Jesc.|be
p.cJuct|cr .rJ ccst |r t|e s|c.t .ur.
MP
L
= AQ / AL
AP
L
= Q / L
TVC + TFC = TC
ATC = TC/ Q
AVC = TVC/ Q
AFC = TFC/ Q
MC = ATC/ AQ
CHAP7£R 8 PRODUC7ION AND COS7 211
7 R Y I 7 !
1. Suppcse Acne gets scne re. e,u|pnert |c. p.cJuc|rg ¦.ckets. ¯|e t.b|e be|c. g|ves |ts re.
p.cJuct|cr |urct|cr. ´cnpute n..g|r.| p.cJuct .rJ .ve..ge p.cJuct .rJ ||| |r t|e bcttcn t.c .c.s c|
t|e t.b|e. |e|e..|rg tc ||gu.e 8.2, J... . g..p| s|c.|rg Acnes re. tct.| p.cJuct cu.ve. Or . seccrJ
g..p|, be|c. t|e cre s|c.|rg t|e tct.| p.cJuct cu.ve ycu J.e., sketc| t|e n..g|r.| .rJ .ve..ge
p.cJuct cu.ves. |enenbe. tc p|ct n..g|r.| p.cJuct .t t|e n|Jpc|rt bet.eer e.c| |rput |eve|. Or bct|
g..p|s, s|.Je t|e .eg|crs .|e.e Acne expe.|erces |rc.e.s|rg n..g|r.| .etu.rs, J|n|r|s||rg n..g|r.|
.etu.rs, .rJ reg.t|ve n..g|r.| .etu.rs.
2. |... t|e pc|rts s|c.|rg tct.| v..|.b|e ccst .t J.||y cutputs c| 0, 1, 3, , 9, 10, .rJ 11 ¦.ckets pe. J.y .|er
Acne |.ceJ . ..ge c| ´100 pe. J.y. (|se ||gu.e 8.5 .s . ncJe|.) Sketc| t|e tct.| v..|.b|e ccst cu.ve .s
s|c.r |r ||gu.e 8.4. |c. suppcse t|.t t|e ..ge .|ses tc ´125 pe. J.y. Or t|e s.ne g..p|, s|c. t|e re.
pc|rts .rJ sketc| t|e re. tct.| v..|.b|e ccst cu.ve. |xp|.|r .|.t |.s |.ppereJ. \|.t .||| |.pper tc
Acnes n..g|r.| ccst cu.ve` |ts .ve..ge tct.|, .ve..ge v..|.b|e, .rJ .ve..ge |xeJ ccst cu.ves` |xp|.|r.
Case in Point: 7he Production of Iitness
|c. nuc| s|cu|J .r .t||ete t..|r`
Spc.ts p|ys|c|cg|sts c|ter ne.su.e t|e ´tct.| p.cJuct´ c| t..|r|rg .s t|e |rc.e.se |r .r .t||etes .e.cb|c c.p.
c|tyt|e c.p.c|ty tc .bsc.b cxyger |rtc t|e b|ccJst.e.n. Ar .t||ete c.r be t|cug|t c| .s p.cJuc|rg .e.cb|c
c.p.c|ty us|rg . |xeJ |.ctc. (||s c. |e. r.tu..| c.p.c|ty) .rJ . v..|.b|e |rput (exe.c|se). ¯|e c|..t s|c.s |c.
t||s .e.cb|c c.p.c|ty v..|es .|t| t|e runbe. c| .c.kcuts pe. .eek. ¯|e cu.ve |.s . s|.pe ve.y nuc| ||ke .
tct.| p.cJuct cu.ve.||c|, .|te. .||, |s p.ec|se|y .|.t |t |s.
¯|e J.t. suggest t|.t .r .t||ete expe.|erces |rc.e.s|rg n..g|r.| .etu.rs |.cn exe.c|se |c. t|e |.st t|.ee J.ys
c| t..|r|rg e.c| .eek, |rJeeJ, cve. |.|| t|e tct.| g.|r |r .e.cb|c c.p.c|ty pcss|b|e |s .c||eveJ. A pe.scr c.r
beccne ever nc.e |t by exe.c|s|rg nc.e, but t|e g.|rs beccne sn.||e. .|t| e.c| .JJeJ J.y c| t..|r|rg. ¯|e
|.. c| J|n|r|s||rg n..g|r.| .etu.rs .pp||es tc t..|r|rg.
¯|e |rc.e.se |r |tress t|.t .esu|ts |.cn t|e s|xt| .rJ severt| .c.kcuts e.c| .eek |s sn.||. StuJ|es .|sc s|c.
t|.t t|e ccsts c| J.||y t..|r|rg, |r te.ns c| |rc.e.seJ ||ke|||ccJ c| |r¦u.y, ..e ||g|. V.ry t..|re.s .rJ cc.c|es
rc. .eccnnerJ t|.t .t||etes.t .|| |eve|s c| ccnpet|t|crt.ke . J.y c. t.c c| e.c| .eek.
.oo·ce .e| Oo||o.o,. Oo||o.o,· |oo| o· |o··|·¸ (|o||·o·. ´^ .|e||e· |o·||co||o··. 2002:. ¡ 56
212 PRINCIPL£S OI £CONOMICS
A N S W £ R S 7 O 7 R Y I 7 ! P R O 8 L £ M S
1. ¯|e |rc.e.seJ ..ge .||| s|||t t|e tct.| v..|.b|e ccst cu.ve up...J, t|e c|J .rJ re. pc|rts .rJ t|e
cc..espcrJ|rg cu.ves ..e s|c.r .t t|e .|g|t.
2. ¯|e tct.| v..|.b|e ccst cu.ve |.s s|||teJ up...J bec.use t|e ccst c| |.bc., Acnes v..|.b|e |.ctc., |.s
|rc.e.seJ. ¯|e n..g|r.| ccst cu.ve s|c.s t|e .JJ|t|cr.| ccst c| e.c| .JJ|t|cr.| ur|t c| cutput . |.n
p.cJuces. bec.use .r |rc.e.se |r cutput .e,u|.es nc.e |.bc., .rJ bec.use |.bc. rc. ccsts nc.e, t|e
n..g|r.| ccst cu.ve .||| s|||t up...J. ¯|e |rc.e.se |r tct.| v..|.b|e ccst .||| |rc.e.se tct.| ccst, .ve..ge
tct.| .rJ .ve..ge v..|.b|e ccsts .||| .|se .s .e||. Ave..ge |xeJ ccst .||| rct c|.rge.
CHAP7£R 8 PRODUC7ION AND COS7 213
2. PRODUCTION CHOICES AND COSTS: THE LONG RUN
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. AppIy the marginaI decision ruIe to expIain how a ñrm chooses its mix of factors of production
in the Iong run.
2. Deñne the Iong-run average cost curve and expIain how it reIates to economies and dis-
economies or scaIe.
In a long-iun planning peispective, a fim can considei changing the quantities of all its factois of pio-
duction. That gives the fim oppoitunities it does not have in the shoit iun. Fiist, the fim can select the
mix of factois it wishes to use. Should it choose a pioduction piocess with lots of laboi and not much
capital, like the stieet sweepeis in China: Oi should it select a piocess that uses a gieat deal of capital
and ielatively little laboi, like stieet sweepeis in the United States: The second thing the fim can select
is the scale (oi oveiall size) of its opeiations. In the shoit iun, a fim can inciease output only by in-
cieasing its use of a vaiiable factoi. But in the long iun, all factois aie vaiiable, so the fim can expand
the use of all of its factois of pioduction. The question facing the fim in the long iun is: How much of
an expansion oi contiaction in the scale of its opeiations should it undeitake: Alteinatively, it could
choose to go out of business.
In its long-iun planning, the fim not only iegaids all factois as vaiiable, but it iegaids all costs as
vaiiable as well. Theie aie no fxed costs in the long iun. Because all costs aie vaiiable, the stiuctuie of
costs in the long iun difeis somewhat fiom what we saw in the shoit iun.
2.1 Choosing the Factoi Mix
How shall a fim decide what mix of capital, laboi, and othei factois to use: We can apply the maiginal
decision iule to answei this question.
Suppose a fim uses capital and laboi to pioduce a paiticulai good. It must deteimine how to pio-
duce the good and the quantity it should pioduce. We addiess the question of how much the fim
should pioduce in subsequent chapteis, but ceitainly the fim will want to pioduce whatevei quantity it
chooses at as low a cost as possible. Anothei way of putting that goal is to say that the fim seeks the
maximum output possible at eveiy level of total cost.
At any level of total cost, the fim can vaiy its factoi mix. It could, foi example, substitute laboi foi
capital in a way that leaves its total cost unchanged. In teims of the maiginal decision iule, we can
think of the fim as consideiing whethei to spend an additional $1 on one factoi, hence $1 less on an-
othei. The maiginal decision iule says that a fim will shift spending among factois as long as the mai-
ginal beneft of such a shift exceeds the maiginal cost.
What is the maiginal beneft, say, of an additional $1 spent on capital: An additional unit of capital
pioduces the maiginal pioduct of capital. To deteimine the maiginal beneft of $1 spent on capital, we
divide capital's maiginal pioduct by its piice: MP
K
/P
K
. The piice of capital is the ¨ient" paid foi the use
of a unit of capital foi a given peiiod. If the fim alieady owns the capital, then this ient is an oppoitun-
ity cost; it iepiesents the ietuin the fim could get by ienting the capital to anothei usei oi by selling it
and eaining inteiest on the money thus gained.
If capital and laboi aie the only factois, then spending an additional $1 on capital while holding
total cost constant means taking $1 out of laboi. The cost of that action will be the output lost fiom
cutting back $1 woith of laboi. That cost equals the iatio of the maiginal pioduct of laboi to the piice
of laboi, MP
L
/P
L
, wheie the piice of laboi is the wage.
Suppose that a fim's maiginal pioduct of laboi is 13 and the piice of laboi is $3 pei unit; the fim
gains 3 units of output by spending an additional $1 on laboi. Suppose fuithei that the maiginal
pioduct of capital is 30 and the piice of capital is $30 pei unit, so the fim would lose 1 unit of output
by spending $1 less on capital.
MP
L
P
L
>
MP
K
P
K
13
3
>
30
30
The fim achieves a net gain of 2 units of output, without any change in cost, by tiansfeiiing $1 fiom
capital to laboi. It will continue to tiansfei funds fiom capital to laboi as long as it gains moie output
fiom the additional laboi than it loses in output by ieducing capital. As the fim shifts spending in this
214 PRINCIPL£S OI £CONOMICS
capitaI intensive
S|tu.t|cr |r .||c| . |.n |.s
. ||g| ..t|c c| c.p|t.| tc |.bc..
Iabor intensive
S|tu.t|cr |r .||c| . |.n |.s
. |c. ..t|c c| |.bc. tc c.p|t.|.
fashion, howevei, the maiginal pioduct of laboi will fall and the maiginal pioduct of capital will iise.
At some point, the iatios of maiginal pioduct to piice will be equal foi the two factois. At this point,
the fim will obtain the maximum output possible foi a given total cost:
£QUA7I ON 8. 9
MP
L
P
L
=
MP
K
P
K
Suppose that a fim that uses capital and laboi is satisfying Equation 8.9 when suddenly the piice
of laboi iises. At the cuiient usage levels of the factois, a highei piice of laboi (P
L
) loweis the iatio of
the maiginal pioduct of laboi to the piice of laboi:
MP
L
P
L
'
<
MP
K
P
K
The fim will shift funds out of laboi and into capital. It will continue to shift fiom laboi to capital until
the iatios of maiginal pioduct to piice aie equal foi the two factois. In geneial, a pioft-maximizing
fim will seek a combination of factois such that
£QUA7I ON 8. 10
MP
1
P
1
=
MP
2
P
2
= ... =
MP
n
P
n
When a fim satisfes the condition given in Equation 8.10 foi emcient use, it pioduces the gieatest
possible output foi a given cost. To put it anothei way, the fim achieves the lowest possible cost foi a
given level of output.
As the piice of laboi iises, the fim will shift to a factoi mix that uses ielatively moie capital and ie-
latively less laboi. As a fim incieases its iatio of capital to laboi, we say it is becoming moie capital
intensive. A lowei piice foi laboi will lead the fim to use ielatively moie laboi and less capital, iedu-
cing its iatio of capital to laboi. As a fim ieduces its iatio of capital to laboi, we say it is becoming
moie labor intensive. The notions of laboi-intensive and capital-intensive pioduction aie puiely iel-
ative; they imply only that a fim has a highei oi lowei iatio of capital to laboi.
Sometimes economists speak of laboi-intensive veisus capital-intensive countiies in the same
mannei. One implication of the maiginal decision iule foi factoi use is that fims in countiies wheie
laboi is ielatively expensive, such as the United States, will use capital-intensive pioduction methods.
Less developed countiies, wheie laboi is ielatively cheap, will use laboi-intensive methods.
Now that we undeistand how to apply the maiginal decision iule to the pioblem of choosing the
mix of factois, we can answei the question that began this chaptei: Why does the United States employ
a capital-intensive pioduction piocess to clean stieets while China chooses a laboi-intensive piocess:
Given that the same technology-know-how-is available, both countiies could, aftei all, use the same
pioduction piocess. Suppose foi a moment that the ielative piices of laboi and capital aie the same in
China and the United States. In that case, China and the United States can be expected to use the same
method to clean stieets. But the piice of laboi ielative to the piice of capital is, in fact, fai lowei in Ch-
ina than in the United States. A lowei ielative piice foi laboi incieases the iatio of the maiginal
pioduct of laboi to its piice, making it emcient to substitute laboi foi capital. China thus fnds it cheap-
ei to clean stieets with lots of people using biooms, while the United States fnds it emcient to clean
stieets with laige machines and ielatively less laboi.
Maquiladoras, plants in Mexico wheie piocessing is done using low-cost woikeis and laboi-in-
tensive methods, allow some U.S. fims to have it both ways. They complete pait of the pioduction pio-
cess in the United States, using capital-intensive methods. They then ship the unfnished goods to ma-
quiladoras. Foi example, many U.S. clothing manufactuieis pioduce cloth at U.S. plants on laige high-
speed looms. They then ship the cloth to Mexico, wheie it is fashioned into clothing by woikeis using
sewing machines. Anothei example is plastic injection molding, which iequiies highly skilled laboi and
is made in the U.S. The paits aie molded in Texas boidei towns and aie then shipped to maquiladoras
and used in cais and computeis. The iesulting items aie shipped back to the United States, labeled
¨Assembled in Mexico fiom U.S. mateiials." Oveiall maquiladoias impoit 97° of the components they
use, of which 80 to 83° come fiom the U.S.
The maquiladoras have been a boon to woikeis in Mexico, who enjoy a highei demand foi theii
seivices and ieceive highei wages as a iesult. The system also benefts the U.S. fims that paiticipate and
U.S. consumeis who obtain less expensive goods than they would otheiwise. It woiks because difeient
factoi piices imply difeient mixes of laboi and capital. Companies aie able to caiiy out the capital-in-
tensive side of the pioduction piocess in the United States and the laboi-intensive side in Mexico.
[1]
CHAP7£R 8 PRODUC7ION AND COS7 215
Iong-run average cost
curve
C..p| s|c.|rg t|e |.ns
|c.est ccst pe. ur|t .t e.c|
|eve| c| cutput, .ssun|rg t|.t
.|| |.ctc.s c| p.cJuct|cr ..e
v..|.b|e.
2.2 Costs in the Long Run
As in the shoit iun, costs in the long iun depend on the fim's level of output, the costs of factois, and
the quantities of factois needed foi each level of output. The chief difeience between long- and shoit-
iun costs is theie aie no fxed factois in the long iun. Theie aie thus no fxed costs. All costs aie vaii-
able, so we do not distinguish between total vaiiable cost and total cost in the long iun: total cost is
total vaiiable cost.
The long-run average cost (IRAC) curve shows the fim's lowest cost pei unit at each level of
output, assuming that all factois of pioduction aie vaiiable. The LRAC cuive assumes that the fim has
chosen the optimal factoi mix, as desciibed in the pievious section, foi pioducing any level of output.
The costs it shows aie theiefoie the lowest costs possible foi each level of output. It is impoitant to
note, howevei, that this does not mean that the minimum points of each shoit-iun ATC cuives lie on
the LRAC cuive. This ciitical point is explained in the next paiagiaph and expanded upon even fuithei
in the next section.
Figuie 8.14 shows how a fim's LRAC cuive is deiived. Suppose Lifetime Disc Co. pioduces com-
pact discs (CDs) using capital and laboi. We have alieady seen how a fim's aveiage total cost cuive can
be diawn in the shoit iun foi a given quantity of a paiticulai factoi of pioduction, such as capital. In
the shoit iun, Lifetime Disc might be limited to opeiating with a given amount of capital; it would face
one of the shoit-iun aveiage total cost cuives shown in Figuie 8.14. If it has 30 units of capital, foi ex-
ample, its aveiage total cost cuive is ATC
30
. In the long iun the fim can examine the aveiage total cost
cuives associated with vaiying levels of capital. Foui possible shoit-iun aveiage total cost cuives foi
Lifetime Disc aie shown in Figuie 8.14 foi quantities of capital of 20, 30, 40, and 30 units. The ielevant
cuives aie labeled ATC
20
, ATC
30
, ATC
40
, and ATC
30
iespectively. The LRAC cuive is deiived fiom this
set of shoit-iun cuives by fnding the lowest aveiage total cost associated with each level of output.
Again, notice that the U-shaped LRAC cuive is an envelope cuive that suiiounds the vaiious shoit-iun
ATC cuives. With the exception of ATC
40
, in this example, the lowest cost pei unit foi a paiticulai
level of output in the long iun is not the minimum point of the ielevant shoit-iun cuive.
II GUR£ 8. 14 ReIationship 8etween Short-Run and Long-Run Average 7otaI Costs
¯|e ||^´ cu.ve |s |curJ by t.k|rg t|e |c.est .ve..ge tct.| ccst cu.ve .t e.c| |eve| c| cutput. |e.e, .ve..ge tct.|
ccst cu.ves |c. ,u.rt|t|es c| c.p|t.| c| 20, 30, 40, .rJ 50 ur|ts ..e s|c.r |c. t|e |||et|ne ||sc ´c. At . p.cJuct|cr
|eve| c| 10,000 ´|s pe. .eek, |||et|ne n|r|n|.es |ts ccst pe. ´| by p.cJuc|rg .|t| 20 ur|ts c| c.p|t.| (pc|rt A). At
20,000 ´|s pe. .eek, .r exp.rs|cr tc . p|.rt s|.e .sscc|.teJ .|t| 30 ur|ts c| c.p|t.| n|r|n|.es ccst pe. ur|t (pc|rt
b). ¯|e |c.est ccst pe. ur|t |s .c||eveJ .|t| p.cJuct|cr c| 30,000 ´|s pe. .eek us|rg 40 ur|ts c| c.p|t.| (pc|rt ´). ||
|||et|ne c|ccses tc p.cJuce 40,000 ´|s pe. .eek, |t .||| Jc sc ncst c|e.p|y .|t| 50 ur|ts c| c.p|t.| (pc|rt |).
216 PRINCIPL£S OI £CONOMICS
economies of scaIe
S|tu.t|cr |r .||c| t|e
|crg.ur .ve..ge ccst
Jec||res .s t|e |.n exp.rJs
|ts cutput.
diseconomies of scaIe
S|tu.t|cr |r .||c| t|e
|crg.ur .ve..ge ccst
|rc.e.ses .s t|e |.n exp.rJs
|ts cutput.
constant returns to scaIe
S|tu.t|cr |r .||c| t|e
|crg.ur .ve..ge ccst st.ys
t|e s.ne cve. .r cutput
..rge.
II GUR£ 8. 15 £conomies and
Diseconomies of ScaIe and Long-Run
Average Cost
¯|e Jc.r...Js|cp|rg .eg|cr c| t|e |.ns
||^´ cu.ve |s .sscc|.teJ .|t| eccrcn|es c|
sc.|e. ¯|e.e n.y be . |c.|.crt.| ..rge
.sscc|.teJ .|t| ccrst.rt .etu.rs tc sc.|e. ¯|e
up...Js|cp|rg ..rge c| t|e cu.ve |np||es
J|seccrcn|es c| sc.|e.
£conomies and Diseconomies of ScaIe
Notice that the long-iun aveiage cost cuive in Figuie 8.14 fist slopes downwaid and then slopes up-
waid. The shape of this cuive tells us what is happening to aveiage cost as the fim changes its scale of
opeiations. A fim is said to expeiience economies of scale when long-iun aveiage cost declines as
the fim expands its output. A fim is said to expeiience diseconomies of scale when long-iun avei-
age cost incieases as the fim expands its output. Constant returns to scale occui when long-iun av-
eiage cost stays the same ovei an output iange.
Why would a fim expeiience economies of scale: One souice of economies of scale is gains fiom
specialization. As the scale of a fim's opeiation expands, it is able to use its factois in moie specialized
ways, incieasing theii pioductivity. Anothei souice of economies of scale lies in the economies that can
be gained fiom mass pioduction methods. As the scale of a fim's opeiation expands, the company can
begin to utilize laige-scale machines and pioduction systems that can substantially ieduce cost pei unit.
Why would a fim expeiience diseconomies of scale: At fist glance, it might seem that the answei
lies in the law of diminishing maiginal ietuins, but this is not the case. The law of diminishing maigin-
al ietuins, aftei all, tells us how output changes as a single factoi is incieased, with all othei factois of
pioduction held constant. In contiast, diseconomies of scale desciibe a situation of iising aveiage cost
even when the fim is fiee to vaiy any oi all of its factois as it wishes. Diseconomies of scale aie genei-
ally thought to be caused by management pioblems. As the scale of a fim's opeiations expands, it be-
comes haidei and haidei foi management to cooidinate and guide the activities of individual units of
the fim. Eventually, the diseconomies of management oveiwhelm any gains the fim might be achiev-
ing by opeiating with a laigei scale of plant, and long-iun aveiage costs begin iising. Fiims expeiience
constant ietuins to scale at output levels wheie theie aie neithei economies noi diseconomies of scale.
Foi the iange of output ovei which the fim expeiiences constant ietuins to scale, the long-iun aveiage
cost cuive is hoiizontal.
Fiims aie likely to expeiience all thiee situations, as shown in Figuie 8.13. At veiy
low levels of output, the fim is likely to expeiience economies of scale as it expands the
scale of its opeiations. Theie may follow a iange of output ovei which the fim expeii-
ences constant ietuins to scale-empiiical studies suggest that the iange ovei which
fims expeiience constant ietuins to scale is often veiy laige. And ceitainly theie must
be some iange of output ovei which diseconomies of scale occui; this phenomenon is
one factoi that limits the size of fims. A fim opeiating on the upwaid-sloping pait of
its LRAC cuive is likely to be undeicut in the maiket by smallei fims opeiating with
lowei costs pei unit of output.
7he Size Distribution of Iirms
Economies and diseconomies of scale have a poweiful efect on the sizes of fims that
will opeiate in any maiket. Suppose fims in a paiticulai industiy expeiience dis-
economies of scale at ielatively low levels of output. That industiy will be chaiacteiized
by a laige numbei of faiily small fims. The iestauiant maiket appeais to be such an in-
dustiy. Baibeis and beauticians aie anothei example.
If fims in an industiy expeiience economies of scale ovei a veiy wide iange of out-
put, fims that expand to take advantage of lowei cost will foice out smallei fims that
have highei costs. Such industiies aie likely to have a few laige fims instead of many
small ones. In the iefiigeiatoi industiy, foi example, the size of fim necessaiy to
achieve the lowest possible cost pei unit is laige enough to limit the maiket to only a
few fims. In most cities, economies of scale leave ioom foi only a single newspapei.
One factoi that can limit the achievement of economies of scale is the demand fa-
cing an individual fim. The scale of output iequiied to achieve the lowest unit costs possible may ie-
quiie sales that exceed the demand facing a fim. A gioceiy stoie, foi example, could minimize unit
costs with a laige stoie and a laige volume of sales. But the demand foi gioceiies in a small, isolated
community may not be able to sustain such a volume of sales. The fim is thus limited to a small scale
of opeiation even though this might involve highei unit costs.
CHAP7£R 8 PRODUC7ION AND COS7 217
k £ Y 7 A k £ A W A Y S
< A |.n c|ccses |ts |.ctc. n|x |r t|e |crg .ur cr t|e b.s|s c| t|e n..g|r.| Jec|s|cr .u|e, |t seeks tc e,u.te
t|e ..t|c c| n..g|r.| p.cJuct tc p.|ce |c. .|| |.ctc.s c| p.cJuct|cr. by Jc|rg sc, |t n|r|n|.es t|e ccst c|
p.cJuc|rg . g|ver |eve| c| cutput.
< ¯|e |crg.ur .ve..ge ccst (||^´ ) cu.ve |s Je.|veJ |.cn t|e .ve..ge tct.| ccst cu.ves .sscc|.teJ .|t|
J||e.ert ,u.rt|t|es c| t|e |.ctc. t|.t |s |xeJ |r t|e s|c.t .ur. ¯|e ||^´ cu.ve s|c.s t|e |c.est ccst pe.
ur|t .t .||c| e.c| ,u.rt|ty c.r be p.cJuceJ .|er .|| |.ctc.s c| p.cJuct|cr, |rc|uJ|rg c.p|t.|, ..e v..|.b|e.
< A |.n n.y expe.|erce eccrcn|es c| sc.|e, ccrst.rt .etu.rs tc sc.|e, c. J|seccrcn|es c| sc.|e. |ccrcn|es
c| sc.|e |np|y . Jc.r...Js|cp|rg |crg.ur .ve..ge ccst (||^´ ) cu.ve. ´crst.rt .etu.rs tc sc.|e |np|y .
|c.|.crt.| ||^´ cu.ve. ||seccrcn|es c| sc.|e |np|y .r up...Js|cp|rg ||^´ cu.ve.
< A |.ns .b|||ty tc exp|c|t eccrcn|es c| sc.|e |s ||n|teJ by t|e extert c| n..ket Jen.rJ |c. |ts p.cJucts.
< ¯|e ..rge c| cutput cve. .||c| |.ns expe.|erce eccrcn|es c| sc.|e, ccrst.rt .etu.r tc sc.|e, c.
J|seccrcn|es c| sc.|e |s .r |npc.t.rt Jete.n|r.rt c| |c. n.ry |.ns .||| su.v|ve |r . p..t|cu|.. n..ket.
7 R Y I 7 !
1. Suppcse Acne ´|ct||rg |s cpe..t|rg .|t| 20 ur|ts c| c.p|t.| .rJ p.cJuc|rg 9 ur|ts c| cutput .t .r
.ve..ge tct.| ccst c| ´6, .s s|c.r |r ||gu.e 8.8. |c. nuc| |.bc. |s |t us|rg`
2. Suppcse |t |rJs t|.t, .|t| t||s ccnb|r.t|cr c| c.p|t.| .rJ |.bc., /|
|
/|
|
> /|
|
/|
|
. \|.t .J¦ustnert .|||
t|e |.n n.ke |r t|e |crg .ur` \|y Jces |t rct n.ke t||s s.ne .J¦ustnert |r t|e s|c.t .ur`
Case in Point: 7eIecommunications £quipment, £conomies of ScaIe, and Outage
Risk
÷ 2010 jupiterimages Corporation
|c. b|g s|cu|J t|e c.|| s.|tc||rg e,u|pnert . n.¦c. te|eccnnur|c.t|crs ccnp.ry uses be` |.v|rg b|gge.
n.c||res .esu|ts |r eccrcn|es c| sc.|e but .|sc ..|ses t|e .|sk c| |..ge. cut.ges t|.t .||| .|ect nc.e
custcne.s.
\e.|.cr |.bc..tc.|es eccrcn|st |cr.|J |. Sn|t| ex.n|reJ bct| t|e eccrcn|es c| sc.|e .v.||.b|e |.cn |..ge.
e,u|pnert .rJ t|e g.e.te. J.rge. c| nc.e .|Jesp.e.J cut.ges. |e ccrc|uJeJ t|.t ccnp.r|es s|cu|J rct
use t|e |..gest n.c||res .v.||.b|e bec.use c| t|e cut.ge J.rge. .rJ t|.t t|ey s|cu|J rct use t|e sn.||est
s|.e bec.use t|.t .cu|J ne.r |c.gc|rg t|e pctert|.| g.|rs |.cn eccrcn|es c| sc.|e c| |..ge. s|.es.
218 PRINCIPL£S OI £CONOMICS
S.|tc||rg n.c||res, t|e |..ge ccnpute.s t|.t |.rJ|e c.||s |c. te|eccnnur|c.t|crs ccnp.r|es, ccne |r |cu.
b.s|c ´pc.t n.t.|x s|.es.´ ¯|ese ..e ne.su.eJ |r te.ns c| ||g|t.| ´.css´crrects (|´Ss). ¯|e |cu. |´S s|.es
.v.||.b|e ..e 6,000, 12,000, 24,000, .rJ 36,000 pc.ts. |||e.ert n.c||re s|.es ..e n.Je .|t| t|e s.ne ccnpcr
erts .rJ t|us |.ve essert|.||y t|e s.ne p.cb.b|||ty c| b.e.k|rg Jc.r. bec.use |..ge. n.c||res se.ve nc.e
custcne.s, |c.eve., . b.e.kJc.r |r . |..ge n.c||re |.s g.e.te. ccrse,uerces |c. t|e ccnp.ry.
¯|e ccsts c| .r cut.ge |.ve t|.ee e|enerts. ¯|e |.st |s |cst .everue |.cn c.||s t|.t .cu|J ct|e..|se |.ve
beer ccnp|eteJ. SeccrJ, t|e |´´ .e,u|.es ccnp.r|es tc p.cv|Je . c.eJ|t c| cre ncrt| c| |.ee se.v|ce .|te.
.ry cut.ge t|.t |.sts |crge. t|.r cre n|rute. ||r.||y, .r cut.ge J.n.ges . ccnp.rys .eput.t|cr .rJ |rev|t
.b|y .esu|ts |r J|ss.t|s|eJ custcne.sscne c| .|cn n.y s.|tc| tc ct|e. ccnp.r|es.
but, t|e.e ..e .Jv.rt.ges tc |..ge. n.c||res. A ccnp.ry |.s . ´pc.t|c||c´ c| s.|tc||rg n.c||res. |.v|rg |..
ge. n.c||res |c.e.s ccsts |r seve..| ..ys. ||.st, t|e |r|t|.| .c,u|s|t|cr c| t|e n.c||re gere..tes |c.e. ccst pe.
c.|| ccnp|eteJ t|e g.e.te. t|e s|.e c| t|e n.c||re. \|er t|e ccnp.ry nust n.ke upg..Jes tc t|e sc|t...e,
|.v|rg |e.e..rJ |..ge.n.c||res ne.rs |e.e. upg..Jes .rJ t|us |c.e. ccsts.
|r Jec|J|rg cr n.t.|x s|.e ccnp.r|es s|cu|J t|us ccnp..e t|e ccst .Jv.rt.ges c| . |..ge. n.t.|x .|t| t|e J|s
.Jv.rt.ges c| t|e ||g|e. cut.ge ccsts .sscc|.teJ .|t| t|cse |..ge. n.t.|xes.
V.. Sn|t| ccrc|uJeJ t|.t t|e eccrcn|es c| sc.|e cut.e|g| t|e cut.ge .|sks .s . ccnp.ry exp.rJs beycrJ
6,000 pc.ts but t|.t 36,000 pc.ts |s ´tcc b|g´ |r t|e serse t|.t t|e cut.ge ccsts cut.e|g| t|e .Jv.rt.ge c| t|e
eccrcn|es c| sc.|e. ¯|e ev|Jerce t|us suggests t|.t . n.t.|x s|.e |r t|e ..rge c| 12,000 tc 24,000 pc.ts |s
cpt|n.|.
.oo·ce |o·o|J | .·|||. |o. ||¸ |· ¯oo ||¸. ¯·oJ|·¸ ´| ||e |co·o·|e· o| .co|e o| |o·¸e· ¯e|eco··o·|co||o·· |e|.o·| ||e·e·|· ^¸o|··| ||e ||·| o|
|o·¸e· ´o|o¸e·.' |o·o¡eo· .oo··o| o| ´¡e·o||o·o| |e·eo·c|. ¹.3 (¹: (^o¸o·| 2006: 2993¹2
A N S W £ R S 7 O 7 R Y I 7 ! P R O 8 L £ M S
1. ¯c p.cJuce 9 ¦.ckets, Acne uses 4 ur|ts c| |.bc..
2. |r t|e |crg .ur, Acne .||| subst|tute c.p|t.| |c. |.bc.. |t c.rrct n.ke t||s .J¦ustnert |r t|e s|c.t .ur,
bec.use |ts c.p|t.| |s |xeJ |r t|e s|c.t .ur.
3. REVIEW AND PRACTICE
Summary
|r t||s c|.pte. .e |.ve ccrcert..teJ cr t|e p.cJuct|cr .rJ ccst .e|.t|crs||ps |.c|rg |.ns |r t|e s|c.t .ur
.rJ |r t|e |crg .ur.
|r t|e s|c.t .ur, . |.n |.s .t |e.st cre |.ctc. c| p.cJuct|cr t|.t |t c.rrct v..y. ¯||s |xeJ |.ctc. ||n|ts t|e |.ns
..rge c| |.ctc. c|c|ces. As . |.n uses nc.e .rJ nc.e c| . v..|.b|e |.ctc. (.|t| |xeJ ,u.rt|t|es c| ct|e. |.ctc.s
c| p.cJuct|cr), |t |s ||ke|y tc expe.|erce .t |.st |rc.e.s|rg, t|er J|n|r|s||rg, t|er reg.t|ve n..g|r.| .etu.rs.
¯|us, t|e s|c.t.ur tct.| ccst cu.ve |.s . pcs|t|ve v.|ue .t . .e.c |eve| c| cutput (t|e |.ns tct.| |xeJ ccst),
t|er s|cpes up...J .t . Jec.e.s|rg ..te (t|e ..rge c| |rc.e.s|rg n..g|r.| .etu.rs), .rJ t|er s|cpes up...J .t
.r |rc.e.s|rg ..te (t|e ..rge c| J|n|r|s||rg n..g|r.| .etu.rs).
|r .JJ|t|cr tc s|c.t.ur tct.| p.cJuct .rJ tct.| ccst cu.ves, .e Je.|veJ . |.ns n..g|r.| p.cJuct, .ve..ge
p.cJuct, .ve..ge tct.| ccst, .ve..ge v..|.b|e ccst, .ve..ge |xeJ ccst, .rJ n..g|r.| ccst cu.ves.
|| t|e |.n |s tc n.x|n|.e p.c|t |r t|e |crg .ur, |t nust se|ect t|e ccstn|r|n|.|rg ccnb|r.t|cr c| |.ctc.s |c. |ts
c|cser |eve| c| cutput. ¯|us, t|e |.n nust t.y tc use |.ctc.s c| p.cJuct|cr |r .ccc.J.rce .|t| t|e n..g|r.|
Jec|s|cr .u|e. ¯|.t |s, |t .||| use |.ctc.s sc t|.t t|e ..t|c c| n..g|r.| p.cJuct tc |.ctc. p.|ce |s e,u.| |c. .||
|.ctc.s c| p.cJuct|cr.
A |.ns |crg.ur .ve..ge ccst (||^´) cu.ve |rc|uJes . ..rge c| eccrcn|es c| sc.|e, cve. .||c| t|e cu.ve
s|cpes Jc.r...J, .rJ . ..rge c| J|seccrcn|es c| sc.|e, cve. .||c| t|e cu.ve s|cpes up...J. ¯|e.e n.y be
.r |rte.ver|rg ..rge c| cutput cve. .||c| t|e |.n expe.|erces ccrst.rt .etu.rs tc sc.|e, |ts ||^´ cu.ve .|||
be |c.|.crt.| cve. t||s ..rge. ¯|e s|.e c| cpe..t|crs recess..y tc .e.c| t|e |c.est pc|rt cr t|e ||^´ cu.ve |.s
. g.e.t Je.| tc Jc .|t| Jete.n|r|rg t|e .e|.t|ve s|.es c| |.ns |r .r |rJust.y.
CHAP7£R 8 PRODUC7ION AND COS7 219
¯||s c|.pte. |.s |ccuseJ cr t|e r.tu.e c| p.cJuct|cr p.ccesses .rJ t|e ccsts .sscc|.teJ .|t| t|en. ¯|ese
|Je.s .||| p.cve use|u| |r urJe.st.rJ|rg t|e be|.v|c. c| |.ns .rJ t|e Jec|s|crs t|ey n.ke ccrce.r|rg supp|y
c| gccJs .rJ se.v|ces.
C O N C £ P 7 P R O 8 L £ M S
1. \||c| c| t|e |c||c.|rg .cu|J be ccrs|Je.eJ |crg.ur c|c|ces` \||c| ..e s|c.t.ur c|c|ces`
.. A Jert|st ||.es . re. p..tt|ne Jert.| |yg|er|st.
b. ¯|e |cc.| c|| .e|re.y p|.rs . ccnp|ete .est.uctu.|rg c| |ts p.cJuct|cr p.ccesses, |rc|uJ|rg
.e|cc.t|rg t|e p|.rt.
c. A |..ne. |rc.e.ses t|e ,u.rt|ty c| ..te. .pp||eJ tc ||s c. |e. |e|Js.
J. A |.. p..tre.s||p s|grs . 3ye.. |e.se |c. .r c|ce ccnp|ex.
e. ¯|e ur|ve.s|ty ||.es . re. |cctb.|| cc.c| cr . 3ye.. ccrt..ct.
2. ´¯|e.e ..e rc |xeJ ccsts |r t|e |crg .ur.´ |xp|.|r.
3. bus|ress |s bccn|rg .t t|e |cc.| Vc|cr.|Js .est.u..rt. |t |s ccrtenp|.t|rg .JJ|rg . re. g.||| .rJ |.erc|
|.y n.c||re, but t|e J.y supe.v|sc. suggests s|np|y ||.|rg nc.e .c.ke.s. |c. s|cu|J t|e n.r.ge. Jec|Je
.||c| .|te.r.t|ve tc pu.sue`
4. Suppcse t|.t t|e .ve..ge .ge c| stuJerts |r ycu. eccrcn|cs c|.ss |s 23. ye..s. || . re. 19ye..c|J
stuJert er.c||s |r t|e c|.ss, .||| t|e .ve..ge .ge |r t|e c|.ss .|se c. |.||` |xp|.|r |c. t||s .e|.tes tc t|e
.e|.t|crs||p bet.eer .ve..ge .rJ n..g|r.| v.|ues.
5. b...y bcrJs c..ee. |cne .ur .ve..ge |r ||s |.st 15 ye..s |r n.¦c. |e.gue b.seb.|| (t|.cug| 199) ..s 33
|cne .urs pe. se.scr. |r 2001, |e ||t 3 |cne .urs. \|.t |.ppereJ tc ||s c..ee. |cne .ur .ve..ge`
\|.t e|ect J|J ||s pe.|c.n.rce |r 2001 |.ve cr ||s c..ee. |cne .ur .ve..ge` |xp|.|r |c. t||s .e|.tes tc
t|e .e|.t|crs||p bet.eer .ve..ge .rJ n..g|r.| v.|ues.
6. Suppcse . |.n |s cpe..t|rg .t t|e n|r|nun pc|rt c| |ts s|c.t.ur .ve..ge tct.| ccst cu.ve, sc t|.t
n..g|r.| ccst e,u.|s .ve..ge tct.| ccst. |rJe. .|.t c|.cunst.rces .cu|J |t c|ccse tc .|te. t|e s|.e c| |ts
p|.rt` |xp|.|r.
. \|.t |.ppers tc t|e J||e.erce bet.eer .ve..ge tct.| ccst .rJ .ve..ge v..|.b|e ccst .s . |.ns cutput
exp.rJs` |xp|.|r.
8. |c. .cu|J e.c| c| t|e |c||c.|rg .|ect .ve..ge tct.| ccst, .ve..ge v..|.b|e ccst, .rJ n..g|r.| ccst`
.. Ar |rc.e.se |r t|e ccst c| t|e |e.se c| t|e |.ns bu||J|rg
b. A .eJuct|cr |r t|e p.|ce c| e|ect.|c|ty
c. A .eJuct|cr |r ..ges
J. A c|.rge |r t|e s.|..y c| t|e p.es|Jert c| t|e ccnp.ry
9. ´crs|Je. t|e |c||c.|rg types c| |.ns. |c. e.c| cre, t|e |crg.ur .ve..ge ccst cu.ve evertu.||y ex||b|ts
J|seccrcn|es c| sc.|e. |c. .||c| |.ns .cu|J ycu expect J|seccrcn|es c| sc.|e tc set |r .t .e|.t|ve|y |c.
|eve|s c| cutput` \|y`
.. A ccpy s|cp
b. A |..J...e stc.e
c. A J.|.y
J. A re.sp.pe.
e. Ar .utcncb||e n.ru|.ctu.e.
|. A .est.u..rt
10. As c.. n.ru|.ctu.e.s |rcc.pc..te nc.e scp||st|c.teJ ccnpute. tec|rc|cgy |r t|e|. ve||c|es, .utc.ep.|.
s|cps .e,u|.e nc.e ccnpute.|.eJ test|rg e,u|pnert, .||c| |s ,u|te expers|ve, |r c.Je. tc .ep.|. re.e.
c..s. |c. |s t||s ||ke|y tc .|ect t|e s|.pe c| t|ese |.ns |crg.ur .ve..ge tct.| ccst cu.ves` |c. |s |t ||ke|y
tc .|ect t|e runbe. c| .utc.ep.|. |.ns |r .ry n..ket`
220 PRINCIPL£S OI £CONOMICS
N U M £ R I C A L P R O 8 L £ M S
1. ¯|e t.b|e be|c. s|c.s |c. t|e runbe. c| ur|ve.s|ty c|.ss.ccns c|e.reJ |r .r ever|rg v..|es .|t| t|e
runbe. c| ¦.r|tc.s.
'.r|tc.s pe. ever|rg 0 1 2 3 4 5 6
´|.ss.ccns c|e.reJ pe. ever|rg 0 3 12 16 1 1 16
.. \|.t |s t|e n..g|r.| p.cJuct c| t|e seccrJ ¦.r|tc.`
b. \|.t |s t|e .ve..ge p.cJuct c| |cu. ¦.r|tc.s`
c. |s t|e .JJ|t|cr c| t|e t||.J ¦.r|tc. .sscc|.teJ .|t| |rc.e.s|rg, J|n|r|s||rg, c. reg.t|ve n..g|r.|
.etu.rs` |xp|.|r.
J. |s t|e .JJ|t|cr c| t|e |cu.t| ¦.r|tc. .sscc|.teJ .|t| |rc.e.s|rg, J|n|r|s||rg, c. reg.t|ve n..g|r.|
.etu.rs` |xp|.|r.
e. |s t|e .JJ|t|cr c| t|e severt| ¦.r|tc. .sscc|.teJ .|t| |rc.e.s|rg, J|n|r|s||rg, c. reg.t|ve
n..g|r.| .etu.rs` |xp|.|r.
|. |... t|e tct.| p.cJuct, .ve..ge p.cJuct, .rJ n..g|r.| p.cJuct cu.ves .rJ s|.Je t|e .eg|crs
cc..espcrJ|rg tc |rc.e.s|rg n..g|r.| .etu.rs, Jec.e.s|rg n..g|r.| .etu.rs, .rJ reg.t|ve
n..g|r.| .etu.rs.
g. ´.|cu|.te t|e s|cpe c| t|e tct.| p.cJuct cu.ve .s e.c| ¦.r|tc. |s .JJeJ.
|. ´|...cte.|.e t|e r.tu.e c| n..g|r.| .etu.rs |r t|e .eg|cr .|e.e
1. ¯|e s|cpe c| t|e tct.| p.cJuct cu.ve |s pcs|t|ve .rJ |rc.e.s|rg.
2. ¯|e s|cpe c| t|e tct.| p.cJuct cu.ve |s pcs|t|ve .rJ Jec.e.s|rg.
3. ¯|e s|cpe c| t|e tct.| p.cJuct cu.ve |s reg.t|ve.
2. Suppcse . |.n |s p.cJuc|rg 1,000 ur|ts c| cutput. |ts .ve..ge |xeJ ccsts ..e ´100. |ts .ve..ge v..|.b|e
ccsts ..e ´50. \|.t |s t|e tct.| ccst c| p.cJuc|rg 1,000 ur|ts c| cutput`
3. ¯|e J|.ectc. c| . rcrp.c|t |curJ.t|cr t|.t spcrsc.s 8.eek sunne. |rst|tutes |c. g..Ju.te stuJerts
.r.|y.eJ t|e ccsts .rJ expecteJ .everues |c. t|e rext sunne. |rst|tute .rJ .eccnnerJeJ t|.t t|e
sess|cr be c.rce|eJ. |r |e. .r.|ys|s s|e |rc|uJeJ . s|..e c| t|e |curJ.t|crs cve.|e.Jt|e s.|..|es c| t|e
J|.ectc. .rJ st.| .rJ ccsts c| n.|rt.|r|rg t|e c|cetc t|e p.cg..n. S|e est|n.teJ ccsts .rJ .everues
.s |c||c.s.
|.c¦ecteJ .everues (|.cn tu|t|cr .rJ |ees) ´300,000
|·o,ec|eJ co·|·
Ove.|e.J ´ 50,000
|ccn .rJ bc..J |c. stuJerts ´100,000
´csts |c. |.cu|ty .rJ n|sce||.recus ´15,000
¯ct.| ccsts ´325,000
\|.t ..s t|e e..c. |r t|e J|.ectc.s .eccnnerJ.t|cr`
4. ¯|e t.b|e be|c. s|c.s t|e tct.| ccst c| c|e.r|rg c|.ss.ccns.
´|.ss.ccns c|e.reJ pe. ever|rg 0 3 12 16 1
¯ct.| ccst ´100 ´200 ´300 ´400 ´500 ´600
.. \|.t |s t|e .ve..ge |xeJ ccst c| c|e.r|rg t|.ee c|.ss.ccns`
b. \|.t |s t|e .ve..ge v..|.b|e ccst c| c|e.r|rg t|.ee c|.ss.ccns`
c. \|.t |s t|e .ve..ge |xeJ ccst c| c|e.r|rg sever c|.ss.ccns`
J. \|.t |s t|e .ve..ge v..|.b|e ccst c| c|e.r|rg sever c|.ss.ccns`
e. \|.t |s t|e n..g|r.| ccst c| c|e.r|rg t|e severteert| c|.ss.ccn`
|. \|.t |s t|e .ve..ge tct.| ccst c| c|e.r|rg t.e|ve c|.ss.ccns`
5. ¯|e .ve..ge tct.| ccst |c. p.|rt|rg 10,000 ccp|es c| .r |ssue c| . n.g..|re |s ´0.45 pe. ccpy. |c. 20,000
ccp|es, t|e .ve..ge tct.| ccst |s ´0.35 .p|ece, |c. 30,000, t|e .ve..ge tct.| ccst |s ´0.30 pe. ccpy. ¯|e
.ve..ge tct.| ccst ccrt|rues tc Jec||re s||g|t|y cve. eve.y |eve| c| cutput t|.t t|e pub||s|e.s c| t|e
n.g..|re |.ve ccrs|Je.eJ. Sketc| t|e .pp.cx|n.te s|.pes c| t|e .ve..ge .rJ n..g|r.| ccst cu.ves. \|.t
..e scne v..|.b|e ccsts c| pub||s||rg n.g..|res` Scne |xeJ ccsts`
6. ¯|e |r|c.n.t|cr |r t|e t.b|e exp|.|rs t|e p.cJuct|cr c| sccks. Assune t|.t t|e p.|ce pe. ur|t c| t|e
v..|.b|e |.ctc. c| p.cJuct|cr (|) |s ´20 .rJ t|e p.|ce pe. ur|t c| t|e |xeJ |.ctc. c| p.cJuct|cr (|) |s ´5.
CHAP7£R 8 PRODUC7ION AND COS7 221
Units of Iixed Iactor (|) Units of VariabIe Iactor (|) 7otaI Product (()
10 0 0
10 1 2
10 2 5
10 3 12
10 4 15
10 5 16
.. AJJ cc|unrs tc t|e t.b|e .rJ c.|cu|.te t|e v.|ues |c. . V..g|r.| |.cJuct c| |.bc. (/|
|
), ¯ct.|
\..|.b|e ´cst (¯v´), ¯ct.| ||xeJ ´cst (¯|´), ¯ct.| ´cst (¯´), Ave..ge \..|.b|e ´cst (^v´), Ave..ge
||xeJ ´cst (^|´), Ave..ge ¯ct.| ´cst (^¯´), .rJ V..g|r.| ´cst (/´).
b. Or t.c sets c| .xes, g..p| t|e ¯ct.| |.cJuct .rJ V..g|r.| |.cJuct cu.ves. be su.e tc |.be| cu.ves
.rJ .xes .rJ .enenbe. tc p|ct n..g|r.| p.cJuct us|rg t|e n|Jpc|rt ccrvert|cr. |rJ|c.te t|e
pc|rt cr e.c| g..p| .t .||c| J|n|r|s||rg n..g|r.| .etu.rs .ppe..s tc beg|r.
c. C..p| ¯ct.| \..|.b|e ´cst, ¯ct.| ||xeJ ´cst, .rJ ¯ct.| ´cst cr .rct|e. set c| .xes. |rJ|c.te t|e
pc|rt cr t|e g..p| .t .||c| J|n|r|s||rg n..g|r.| .etu.rs .ppe..s tc beg|r.
J. C..p| t|e Ave..ge ||xeJ ´cst, Ave..ge \..|.b|e ´cst, Ave..ge ¯ct.| ´cst, .rJ V..g|r.| ´cst
cu.ves cr .rct|e. set c| .xes. |rJ|c.te t|e pc|rt .t .||c| J|n|r|s||rg n..g|r.| .etu.rs .ppe..s
tc beg|r.
. ¯|e t.b|e be|c. s|c.s t|e |crg.ur .ve..ge ccst c| p.cJuc|rg kr|ves.
|r|ves pe. |cu. 1,000 2,000 3,000 4,000 5,000 6,000
´cst pe. kr||e ´2 ´1.50 ´1.00 ´1.00 ´1.20 ´1.30
.. |... t|e |crg.ur .ve..ge ccst cu.ve |c. kr|ves.
b. S|.Je t|e .eg|crs cc..espcrJ|rg tc eccrcn|es c| sc.|e, ccrst.rt .etu.rs tc sc.|e, .rJ
J|seccrcn|es c| sc.|e.
c. |r t|e .eg|cr c| t|e |crg.ur .ve..ge ccst cu.ve t|.t cc..espcrJs tc eccrcn|es c| sc.|e, .|.t |s
|.pper|rg tc t|e ccst pe. kr||e`
J. |r t|e .eg|cr c| t|e |crg.ur .ve..ge ccst cu.ve t|.t cc..espcrJs tc ccrst.rt .etu.rs tc sc.|e,
.|.t |s |.pper|rg tc t|e ccst pe. kr||e`
e. |r t|e .eg|cr c| t|e |crg.ur .ve..ge ccst cu.ve t|.t cc..espcrJs tc J|seccrcn|es c| sc.|e, .|.t
|s |.pper|rg tc t|e ccst pe. kr||e`
8. Suppcse . |.n |rJs t|.t t|e n..g|r.| p.cJuct c| c.p|t.| |s 60 .rJ t|e n..g|r.| p.cJuct c| |.bc. |s 20. ||
t|e p.|ce c| c.p|t.| |s ´6 .rJ t|e p.|ce c| |.bc. |s ´2.50, |c. s|cu|J t|e |.n .J¦ust |ts n|x c| c.p|t.| .rJ
|.bc.` \|.t .||| be t|e .esu|t`
9. A |.n n|r|n|.es |ts ccsts by us|rg |rputs suc| t|.t t|e n..g|r.| p.cJuct c| |.bc. |s 10 .rJ t|e n..g|r.|
p.cJuct c| c.p|t.| |s 20. ¯|e p.|ce c| c.p|t.| |s ´10 pe. ur|t. \|.t nust t|e p.|ce c| |.bc. be`
10. Suppcse t|.t t|e p.|ce c| |.bc. |s ´10 pe. ur|t .rJ t|e p.|ce c| c.p|t.| |s ´20 pe. ur|t.
.. Assun|rg t|e |.n |s n|r|n|.|rg |ts ccst, || t|e n..g|r.| p.cJuct c| |.bc. |s 50, .|.t nust t|e
n..g|r.| p.cJuct c| c.p|t.| be`
b. Suppcse t|e p.|ce c| c.p|t.| |rc.e.ses tc ´25 pe. ur|t, .|||e t|e p.|ce c| |.bc. st.ys t|e s.ne. ¯c
n|r|n|.e t|e ccst c| p.cJuc|rg t|e s.ne |eve| c| cutput, .cu|J t|e |.n beccne nc.e c.p|t.|
|rters|ve c. |.bc.|rters|ve` |xp|.|r.
222 PRINCIPL£S OI £CONOMICS
1.
ENDNOTES
|uc|rJ. \..g.s, ´V.,u||.Jc..s. |np.ct cr ¯ex.s bc.Je. ´|t|es,´ |r ¯|e |o·Je·
|co·o·,, |eJe..| |ese.ve b.rk c| |.||.s ('ure 2001). 2529, \||||.n ´. C.uber,
´|.ve Vex|ccs V.,u||.Jc..s bcttcneJ Out`´, Scut|.est |ccrcny, |eJe..| |ese.ve
b.rk c| |.||.s ('.ru..y/|eb.u..y, 2004), pp. 1415.
CHAP7£R 8 PRODUC7ION AND COS7 223
224 PRINCIPL£S OI £CONOMICS
´ | A | ¯ | | 9
Competitive Markets for
Goods and Services
S7AR7 UP: LII£ ON 7H£ IARM
¯|ey p.cJuce . ccnncJ|ty t|.t |s essert|.| tc cu. J.||y ||ves, cre |c. .||c| t|e Jen.rJ |s v|.tu.||y .ssu.eJ. ArJ
yet n.ryever .s |..n p.|ces ..e .e.c||rg .ecc.J ||g|sseen tc ||ve cr t|e n..g|r c| |.||u.e. ¯|cus.rJs ..e
J.|ver cut c| bus|ress e.c| ye... \e p.cv|Je b||||crs c| Jc||..s |r .|J |c. t|en, but st||| .e |e.. c| t|e |..Js||ps
n.ry c| t|en |.ce. ¯|ey ..e cu. r.t|crs |..ne.s.
\|.t |s |t .bcut |..ne.s, .rJ |..n|rg, t|.t ..cuses cu. ccrce.r` Vuc| c| t|e .rs.e. p.cb.b|y ||es |r cu. serse
t|.t |..n|rg |s |urJ.nert.| tc t|e Ane.|c.r ..y c| |||e. Ou. ccurt.y ..s bu||t, |r |..ge p..t, by |rJeperJert ner
.rJ .cner .|c n.Je t|e|. ||v|rg |.cn t|e sc||. V.ry c| us pe.ce|ve t|e|. p||g|t .s cu. p||g|t. but p..t c| t|e .r
s.e. ||es |r t|e |.ct t|.t |..ne.s Jc, |r |.ct, |.ce . J||cu|t eccrcn|c erv|.crnert. Vcst c| t|en cpe..te |r ||g||y
ccnpet|t|ve n..kets, n..kets t|.t tc|e..te |e. n|st.kes .rJ gere..||y c|e. sn.|| .e...Js. ||r.||y, pe.|.ps cu. ccr
ce.r |s st|..eJ by cu. .eccgr|t|cr t|.t t|e |..ne.s p||g|t |s cu. b|ess|rg. ¯|e |c. p.|ces t|.t n.ke |||e J||cu|t |c.
|..ne.s ..e t|e |c. p.|ces .e er¦cy .s ccrsune.s c| |ccJ.
\|.t keeps t|e .etu.rs tc |..n|rg .s |c. .s t|ey ..e` \|.t |c|Js n.ry |..ne.s |r . s|tu.t|cr |r .||c| t|ey .|
..ys seen tc be ¦ust gett|rg by` |r t||s c|.pte. .e s|.|| see t|.t p.|ces ¦ust ||g| ercug| tc |rJuce |.ns tc ccrt|r
ue tc p.cJuce ..e p.ec|se|y .|.t .e .cu|J expect tc p.ev.|| |r . ccnpet|t|ve n..ket. \e .||| ex.n|re . ncJe| c|
|c. ccnpet|t|ve n..kets .c.k. |ct cr|y Jces t||s ncJe| |e|p tc exp|.|r t|e s|tu.t|cr |.c|rg |..ne.s, but |t .||| .|sc
|e|p us tc urJe.st.rJ t|e Jete.n|r.t|cr c| p.|ce .rJ cutput |r . .|Je ..rge c| n..kets. A |..n |s . |.n, .rJ cu.
.r.|ys|s c| suc| . |.n |r . ccnpet|t|ve n..ket .||| g|ve us t|e tcc|s tc .r.|y.e t|e c|c|ces c| .|| |.ns cpe..t|rg |r
ccnpet|t|ve n..kets.
\e .||| put t|e ccrcepts c| n..g|r.| ccst, .ve..ge v..|.b|e ccst, .rJ .ve..ge tct.| ccst tc .c.k tc see |c.
|.ns |r . ccnpet|t|ve n..ket .espcrJ tc n..ket |c.ces. \e .||| see |c. |.ns .J¦ust tc c|.rges |r Jen.rJ .rJ
supp|y |r t|e s|c.t .ur .rJ |r t|e |crg .ur. |r .|| c| t||s, .e .||| be ex.n|r|rg |c. |.ns use t|e n..g|r.| Jec|s|cr
.u|e.
¯|e ccnpet|t|ve ncJe| |rt.cJuceJ |r t||s c|.pte. ||es .t cre erJ c| . spect.un c| n..ket
ncJe|s. At t|e ct|e. erJ |s t|e ncrcpc|y ncJe|. |t .ssunes . n..ket |r .||c| t|e.e |s rc ccn
pet|t|cr, . n..ket |r .||c| cr|y . s|rg|e |.n cpe..tes. ¯.c ncJe|s t|.t |.|| bet.eer t|e ex
t.enes c| pe.|ect ccnpet|t|cr .rJ ncrcpc|y ..e ncrcpc||st|c ccnpet|t|cr .rJ c||gcpc|y.
perfect competition
VcJe| c| t|e n..ket b.seJ
cr t|e .ssunpt|cr t|.t .
|..ge runbe. c| |.ns
p.cJuce |Jert|c.| gccJs
ccrsuneJ by . |..ge runbe.
c| buye.s.
price takers
|rJ|v|Ju.|s c. |.ns .|c nust
t.ke t|e n..ket p.|ce .s
g|ver.
1. PERFECT COMPETITION: A MODEL
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. £xpIain what economists mean by perfect competition.
2. Identify the basic assumptions of the modeI of perfect competition and expIain why they impIy
price-taking behavior.
Viitually all fims in a maiket economy face competition fiom othei fims. In this chaptei, we will be
woiking with a model of a highly idealized foim of competition called ¨peifect" by economists.
Perfect competition is a model of the maiket based on the assumption that a laige numbei of
fims pioduce identical goods consumed by a laige numbei of buyeis. The model of peifect competi-
tion also assumes that it is easy foi new fims to entei the maiket and foi existing ones to leave. And
fnally, it assumes that buyeis and selleis have complete infoimation about maiket conditions.
As we examine these assumptions in gieatei detail, we will see that they allow us to woik with the
model moie easily. No maiket fully meets the conditions set out in these assumptions. As is always the
case with models, oui puipose is to undeistand the way things woik, not to desciibe them. And the
model of peifect competition will piove enoimously useful in undeistanding the woild of maikets.
1.1 Assumptions of the Model
The assumptions of the model of peifect competition, taken togethei, imply that individual buyeis and
selleis in a peifectly competitive maiket accept the maiket piice as given. No one buyei oi sellei has
any infuence ovei that piice. Individuals oi fims who must take the maiket piice as given aie called
price takers. A consumei oi fim that takes the maiket piice as given has no ability to infuence that
piice. A piice-taking fim oi consumei is like an individual who is buying oi selling stocks. He oi she
looks up the maiket piice and buys oi sells at that piice. The piice is deteimined by demand and sup-
ply in the maiket-not by individual buyeis oi selleis. In a peifectly competitive maiket, each fim and
each consumei is a piice takei. A piice-taking consumei assumes that he oi she can puichase any
quantity at the maiket piice-without afecting that piice. Similaily, a piice-taking fim assumes it can
sell whatevei quantity it wishes at the maiket piice without afecting the piice.
You aie a piice takei when you go into a stoie. You obseive the piices listed and make a choice to
buy oi not. Youi choice will not afect that piice. Should you sell a textbook back to youi campus book-
stoie at the end of a couise, you aie a piice-taking sellei. You aie confionted by a maiket piice and you
decide whethei to sell oi not. Youi decision will not afect that piice.
To see how the assumptions of the model of peifect competition imply piice-taking behavioi, let
us examine each of them in tuin.
IdenticaI Goods
In a peifectly competitive maiket foi a good oi seivice, one unit of the good oi seivice cannot be difei-
entiated fiom any othei on any basis. A bushel of, say, haid wintei wheat is an example. A bushel pio-
duced by one faimei is identical to that pioduced by anothei. Theie aie no biand piefeiences oi con-
sumei loyalties.
The assumption that goods aie identical is necessaiy if fims aie to be piice takeis. If one faimei's
wheat weie peiceived as having special piopeities that distinguished it fiom othei wheat, then that
faimei would have some powei ovei its piice. By assuming that all goods and seivices pioduced by
fims in a peifectly competitive maiket aie identical, we establish a necessaiy condition foi piice-taking
behavioi. Economists sometimes say that the goods oi seivices in a peifectly competitive maiket aie
homogeneous, meaning that they aie all alike. Theie aie no biand difeiences in a peifectly competitive
maiket.
A Large Number of 8uyers and SeIIers
How many buyeis and selleis aie in oui maiket: The answei iests on oui piesumption of piice-taking
behavioi. Theie aie so many buyeis and selleis that none of them has any infuence on the maiket piice
iegaidless of how much any of them puichases oi sells. A fim in a peifectly competitive maiket can ie-
act to piices, but cannot afect the piices it pays foi the factois of pioduction oi the piices it ieceives foi
its output.
226 PRINCIPL£S OI £CONOMICS
£ase of £ntry and £xit
The assumption that it is easy foi othei fims to entei a peifectly competitive maiket implies an even
gieatei degiee of competition. Fiims in a maiket must deal not only with the laige numbei of compet-
ing fims but also with the possibility that still moie fims might entei the maiket.
Latei in this chaptei, we will see how ease of entiy is ielated to the sustainability of economic
piofts. If entiy is easy, then the piomise of high economic piofts will quickly attiact new fims. If
entiy is dimcult, it won't.
The model of peifect competition assumes easy exit as well as easy entiy. The assumption of easy
exit stiengthens the assumption of easy entiy. Suppose a fim is consideiing enteiing a paiticulai mai-
ket. Entiy may be easy, but suppose that getting out is dimcult. Foi example, supplieis of factois of pio-
duction to fims in the industiy might be happy to accommodate new fims but might iequiie that they
sign long-teim contiacts. Such contiacts could make leaving the maiket dimcult and costly. If that weie
the case, a fim might be hesitant to entei in the fist place. Easy exit helps make entiy easiei.
CompIete Information
We assume that all selleis have complete infoimation about piices, technology, and all othei know-
ledge ielevant to the opeiation of the maiket. No one sellei has any infoimation about pioduction
methods that is not available to all othei selleis. If one sellei had an advantage ovei othei selleis, pei-
haps special infoimation about a lowei-cost pioduction method, then that sellei could exeit some con-
tiol ovei maiket piice-the sellei would no longei be a piice takei.
We assume also that buyeis know the piices ofeied by eveiy sellei. If buyeis did not know about
piices ofeied by difeient fims in the maiket, then a fim might be able to sell a good oi seivice foi a
piice othei than the maiket piice and thus could avoid being a piice takei.
The availability of infoimation that is assumed in the model of peifect competition implies that in-
foimation can be obtained at low cost. If consumeis and fims can obtain infoimation at low cost, they
aie likely to do so. Infoimation about the maiketplace may come ovei the inteinet, ovei the aiiways in
a television commeicial, oi ovei a cup of cofee with a fiiend. Whatevei its souice, we assume that its
low cost ensuies that consumeis and fims have enough of it so that eveiyone buys oi sells goods and
seivices at maiket piices deteimined by the inteisection of demand and supply cuives.
The assumptions of the peifectly competitive model ensuie that each buyei oi sellei is a piice
takei. The maiket, not individual consumeis oi fims, deteimines piice in the model of peifect compet-
ition. No individual has enough powei in a peifectly competitive maiket to have any impact on that
piice.
1.2 Peifect Competition and the Real Woild
The assumptions of identical pioducts, a laige numbei of buyeis, easy entiy and exit, and peifect in-
foimation aie stiong assumptions. The notion that fims must sit back and let the maiket deteimine
piice seems to fy in the face of what we know about most ieal fims, which is that fims customaiily do
set piices. Yet this is the basis foi the model of demand and supply, the powei of which you have
alieady seen.
When we use the model of demand and supply, we assume that maiket foices deteimine piices. In
this model, buyeis and selleis iespond to the maiket piice. They aie piice takeis. The assumptions of
the model of peifect competition undeilie the assumption of piice-taking behavioi. Thus we aie using
the model of peifect competition whenevei we apply the model of demand and supply.
We can undeistand most maikets by applying the model of demand and supply. Even though
those maikets do not fulfll all the assumptions of the model of peifect competition, the model allows
us to undeistand some key featuies of these maikets.
Changes within youi lifetime have made many maikets moie competitive. Falling costs of tians-
poitation, togethei with diamatic advances in telecommunications, have opened the possibility of en-
teiing maikets to fims all ovei the woild. A company in South Koiea can compete in the maiket foi
steel in the United States. A fuinituie makei in New Mexico can compete in the maiket foi fuinituie in
Japan. A fim can entei the woild maiket simply by cieating a web page to adveitise its pioducts and to
take oideis.
In the iemaining sections of this chaptei, we will leain moie about the iesponse of fims to maiket
piices. We will see how fims iespond, in the shoit iun and in the long iun, to changes in demand and
to changes in pioduction costs. In shoit, we will be examining the foices that constitute the supply side
of the model of demand and supply.
We will also see how competitive maikets woik to seive consumei inteiests and how competition
acts to push economic piofts down, sometimes eliminating them entiiely. When we have fnished we
will have a bettei undeistanding of the maiket conditions facing faimeis and of the conditions that
pievail in any competitive industiy.
CHAP7£R 9 COMP£7I7IV£ MARk£7S IOR GOODS AND S£RVIC£S 227
k £ Y 7 A k £ A W A Y S
< ¯|e cert..| c|...cte.|st|c c| t|e ncJe| c| pe.|ect ccnpet|t|cr |s t|e |.ct t|.t p.|ce |s Jete.n|reJ by t|e
|rte..ct|cr c| Jen.rJ .rJ supp|y, buye.s .rJ se||e.s ..e p.|ce t.ke.s.
< ¯|e ncJe| .ssunes. . |..ge runbe. c| |.ns p.cJuc|rg |Jert|c.| (|cncgerecus) gccJs c. se.v|ces, . |..ge
runbe. c| buye.s .rJ se||e.s, e.sy ert.y .rJ ex|t |r t|e |rJust.y, .rJ ccnp|ete |r|c.n.t|cr .bcut p.|ces |r
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2. ´c.r
3. At||et|c s|ces
Case in Point: £ntering and £xiting the 8urkha Industry
÷ 2010 jupiterimages Corporation
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228 PRINCIPL£S OI £CONOMICS
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A N S W £ R S 7 O 7 R Y I 7 ! P R O 8 L £ M S
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2. OUTPUT DETERMINATION IN THE SHORT RUN
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. Show graphicaIIy how an individuaI ñrm in a perfectIy competitive market can use totaI reven-
ue and totaI cost curves or marginaI revenue and marginaI cost curves to determine the IeveI of
output that wiII maximize its economic proñt.
2. £xpIain when a ñrm wiII shut down in the short run and when it wiII operate even if it is incur-
ring economic Iosses.
3. Derive the ñrm's suppIy curve from the ñrm's marginaI cost curve and the industry suppIy
curve from the suppIy curves of individuaI ñrms.
Oui goal in this section is to see how a fim in a peifectly competitive maiket deteimines its output
level in the shoit iun-a planning peiiod in which at least one factoi of pioduction is fxed in quantity.
We shall see that the fim can maximize economic pioft by applying the maiginal decision iule and in-
cieasing output up to the point at which the maiginal beneft of an additional unit of output is just
equal to the maiginal cost. This fact has an impoitant implication: ovei a wide iange of output, the
fim's maiginal cost cuive is its supply cuive.
2.1 Piice and Revenue
Each fim in a peifectly competitive maiket is a piice takei; the equilibiium piice and industiy output
aie deteimined by demand and supply. Figuie 9.3 shows how demand and supply in the maiket foi
iadishes, which we shall assume aie pioduced undei conditions of peifect competition, deteimine total
output and piice. The equilibiium piice is $0.40 pei pound; the equilibiium quantity is 10 million
pounds pei month.
CHAP7£R 9 COMP£7I7IV£ MARk£7S IOR GOODS AND S£RVIC£S 229
II GUR£ 9. 3 7he Market for Radishes
|.|ce .rJ cutput |r . ccnpet|t|ve n..ket ..e
Jete.n|reJ by Jen.rJ .rJ supp|y. |r t|e
n..ket |c. ..J|s|es, t|e e,u|||b.|un p.|ce |s
´0.40 pe. pcurJ, 10 n||||cr pcurJs pe. ncrt|
..e p.cJuceJ .rJ pu.c|.seJ .t t||s p.|ce.
totaI revenue
A |.ns cutput nu|t|p||eJ by
t|e p.|ce .t .||c| |t se||s t|.t
cutput.
Because it is a piice takei, each fim in the iadish industiy assumes it can sell all the
iadishes it wants at a piice of $0.40 pei pound. No mattei how many oi how few
iadishes it pioduces, the fim expects to sell them all at the maiket piice.
The assumption that the fim expects to sell all the iadishes it wants at the maiket
piice is ciucial. If a fim did not expect to sell all of its iadishes at the maiket piice-if it
had to lowei the piice to sell some quantities-the fim would not be a piice takei. And
piice-taking behavioi is cential to the model of peifect competition.
Radish gioweis-and peifectly competitive fims in geneial-have no ieason to
chaige a piice lowei than the maiket piice. Because buyeis have complete infoimation
and because we assume each fim's pioduct is identical to that of its iivals, fims aie un-
able to chaige a piice highei than the maiket piice. Foi peifectly competitive fims, the
piice is veiy much like the weathei: they may complain about it, but in peifect competi-
tion theie is nothing any of them can do about it.
7otaI Revenue
While a fim in a peifectly competitive maiket has no infuence ovei its piice, it does
deteimine the output it will pioduce. In selecting the quantity of that output, one im-
poitant consideiation is the ievenue the fim will gain by pioducing it.
A fim's total revenue is found by multiplying its output by the piice at which it
sells that output. Foi a peifectly competitive fim, total ievenue (TR) is the maiket piice
(P) times the quantity the fim pioduces (Q), oi
£QUA7I ON 9. 1
TR = P × Q
The ielationship between maiket piice and the fim's total ievenue cuive is a ciucial one. Panel (a)
of Figuie 9.4 shows total ievenue cuives foi a iadish giowei at thiee possible maiket piices: $0.20,
$0.40, and $0.60 pei pound. Each total ievenue cuive is a lineai, upwaid-sloping cuive. At any piice,
the gieatei the quantity a peifectly competitive fim sells, the gieatei its total ievenue. Notice that the
gieatei the piice, the steepei the total ievenue cuive is.
II GUR£ 9. 4 7otaI Revenue, MarginaI Revenue, and Average Revenue
|.re| (.) s|c.s J||e.ert tct.| .everue cu.ves |c. t|.ee pcss|b|e n..ket p.|ces |r pe.|ect ccnpet|t|cr. A tct.|
.everue cu.ve |s . st..|g|t ||re ccn|rg cut c| t|e c.|g|r. ¯|e s|cpe c| . tct.| .everue cu.ve |s /|. |t e,u.|s t|e
n..ket p.|ce (|) .rJ ^| |r pe.|ect ccnpet|t|cr. V..g|r.| .everue .rJ .ve..ge .everue ..e t|us . s|rg|e |c.|.crt.|
||re .t t|e n..ket p.|ce, .s s|c.r |r |.re| (b). ¯|e.e |s . J||e.ert n..g|r.| .everue cu.ve |c. e.c| p.|ce.
230 PRINCIPL£S OI £CONOMICS
marginaI revenue
¯|e |rc.e.se |r tct.| .everue
|.cn . creur|t |rc.e.se |r
,u.rt|ty.
average revenue
¯ct.| .everue J|v|JeJ by
,u.rt|ty.
Price, MarginaI Revenue, and Average Revenue
The slope of a total ievenue cuive is paiticulaily impoitant. It equals the change in the veitical axis
(total ievenue) divided by the change in the hoiizontal axis (quantity) between any two points. The
slope measuies the iate at which total ievenue incieases as output incieases. We can think of it as the
inciease in total ievenue associated with a 1-unit inciease in output. The inciease in total ievenue fiom
a 1-unit inciease in quantity is marginal revenue. Thus maiginal ievenue (MR) equals the slope of
the total ievenue cuive.
How much additional ievenue does a iadish pioducei gain fiom selling one moie pound of
iadishes: The answei, of couise, is the maiket piice foi 1 pound. Maiginal ievenue equals the maiket
piice. Because the maiket piice is not afected by the output choice of a single fim, the maiginal ieven-
ue the fim gains by pioducing one moie unit is always the maiket piice. The maiginal ievenue cuive
shows the ielationship between maiginal ievenue and the quantity a fim pioduces. Foi a peifectly
competitive fim, the maiginal ievenue cuive is a hoiizontal line at the maiket piice. If the maiket
piice of a pound of iadishes is $0.40, then the maiginal ievenue is $0.40. Maiginal ievenue cuives foi
piices of $0.20, $0.40, and $0.60 aie given in Panel (b) of Figuie 9.4. In peifect competition, a fim's
maiginal ievenue cuive is a hoiizontal line at the maiket piice.
Piice also equals average revenue, which is total ievenue divided by quantity. Equation 9.1 gives
total ievenue, TR. To obtain aveiage ievenue (AR), we divide total ievenue by quantity, Q. Because
total ievenue equals piice (P) times quantity (Q), dividing by quantity leaves us with piice.
£QUA7I ON 9. 2
AR =
TR
Q
=
P × Q
Q
= P
The maiginal ievenue cuive is a hoiizontal line at the maiket piice, and aveiage ievenue equals the
maiket piice. The aveiage and maiginal ievenue cuives aie given by the same hoiizontal line. This is
consistent with what we have leained about the ielationship between maiginal and aveiage values.
When the maiginal value exceeds the aveiage value, the aveiage value will be iising. When the maigin-
al value is less than the aveiage value, the aveiage value will be falling. What happens when the aveiage
and maiginal values do not change, as in the hoiizontal cuives of Panel (b) of Figuie 9.4: The maiginal
value must equal the aveiage value; the two cuives coincide.
MarginaI Revenue, Price, and Demand for the PerfectIy Competitive Iirm
We have seen that a peifectly competitive fim's maiginal ievenue cuive is simply a hoiizontal line at
the maiket piice and that this same line is also the fim's aveiage ievenue cuive. Foi the peifectly com-
petitive fim, MR = P = AR . The maiginal ievenue cuive has anothei meaning as well. It is the de-
mand cuive facing a peifectly competitive fim.
Considei the case of a single iadish pioducei, Tony Goitaii. We assume that the iadish maiket is
peifectly competitive; Mi. Goitaii iuns a peifectly competitive fim. Suppose the maiket piice of
iadishes is $0.40 pei pound. How many pounds of iadishes can Mi. Goitaii sell at this piice: The an-
swei comes fiom oui assumption that he is a piice takei: He can sell any quantity he wishes at this
piice. How many pounds of iadishes will he sell if he chaiges a piice that exceeds the maiket piice:
None. His iadishes aie identical to those of eveiy othei fim in the maiket, and eveiyone in the maiket
has complete infoimation. That means the demand cuive facing Mi. Goitaii is a hoiizontal line at the
maiket piice as illustiated in Figuie 9.3. Notice that the cuive is labeled d to distinguish it fiom the
maiket demand cuive, D, in Figuie 9.3. The hoiizontal line in Figuie 9.3 is also Mi. Goitaii's maiginal
ievenue cuive, MR, and his aveiage ievenue cuive, AR. It is also the maiket piice, P.
Of couise, Mi. Goitaii could chaige a piice below the maiket piice, but why would he: We assume
he can sell all the iadishes he wants at the maiket piice; theie would be no ieason to chaige a lowei
piice. Mi. Goitaii faces a demand cuive that is a hoiizontal line at the maiket piice. In oui subsequent
analysis, we shall iefei to the hoiizontal line at the maiket piice simply as maiginal ievenue. We should
iemembei, howevei, that this same line gives us the maiket piice, aveiage ievenue, and the demand
cuive facing the fim.
CHAP7£R 9 COMP£7I7IV£ MARk£7S IOR GOODS AND S£RVIC£S 231
II GUR£ 9. 5 Price, MarginaI Revenue,
and Demand
A pe.|ect|y ccnpet|t|ve |.n |.ces . |c.|.crt.|
Jen.rJ cu.ve .t t|e n..ket p.|ce. |e.e, ..J|s|
g.c.e. ¯cry Cc.t..| |.ces Jen.rJ cu.ve J .t
t|e n..ket p.|ce c| ´0.40 pe. pcurJ. |e ccu|J
se|| ¸
1
c. ¸
2
c. .ry ct|e. ,u.rt|ty.t . p.|ce
c| ´0.40 pe. pcurJ.
Moie geneially, we can say that any peifectly competitive fim faces a hoiizontal
demand cuive at the maiket piice. We saw an example of a hoiizontal demand cuive in
the chaptei on elasticity. Such a cuive is peifectly elastic, meaning that any quantity is
demanded at a given piice.
2.2 Economic Piofit in the Shoit Run
A fim's economic pioft is the difeience between total ievenue and total cost. Recall
that total cost is the oppoitunity cost of pioducing a ceitain good oi seivice. When we
speak of economic pioft we aie speaking of a fim's total ievenue less the total oppoi-
tunity cost of its opeiations.
As we leained, a fim's total cost cuive in the shoit iun inteisects the veitical axis
at some positive value equal to the fim's total fxed costs. Total cost then iises at a de-
cieasing iate ovei the iange of incieasing maiginal ietuins to the fim's vaiiable factois.
It iises at an incieasing iate ovei the iange of diminishing maiginal ietuins. Figuie 9.6
shows the total cost cuive foi Mi. Goitaii, as well as the total ievenue cuive foi a piice
of $0.40 pei pound. Suppose that his total fxed cost is $400 pei month. Foi any given
level of output, Mi. Goitaii's economic pioft is the veitical distance between the total
ievenue cuive and the total cost cuive at that level.
II GUR£ 9. 6 7otaI Revenue, 7otaI Cost, and £conomic Profit
|ccrcn|c p.c|t |s t|e ve.t|c.| J|st.rce bet.eer t|e tct.| .everue .rJ tct.| ccst cu.ves (.everue
n|rus ccsts). |e.e, t|e n.x|nun p.c|t .tt.|r.b|e by ¯cry Cc.t..| |c. ||s ..J|s| p.cJuct|cr |s
´938 pe. ncrt| .t .r cutput c| 6,00 pcurJs.
Let us examine the total ievenue and total cost cuives in Figuie 9.6 moie caiefully. At zeio units of out-
put, Mi. Goitaii's total cost is $400 (his total fxed cost); total ievenue is zeio. Total cost continues to
exceed total ievenue up to an output of 1,300 pounds pei month, at which point the two cuives intei-
sect. At this point, economic pioft equals zeio. As Mi. Goitaii expands output above 1,300 pounds pei
month, total ievenue becomes gieatei than total cost. We see that at a quantity of 1,300 pounds pei
month, the total ievenue cuive is steepei than the total cost cuive. Because ievenues aie iising fastei
than costs, piofts iise with incieased output. As long as the total ievenue cuive is steepei than the total
cost cuive, pioft incieases as the fim incieases its output.
232 PRINCIPL£S OI £CONOMICS
economic proñt per unit
¯|e J||e.erce bet.eer p.|ce
.rJ .ve..ge tct.| ccst.
The total ievenue cuive's slope does not change as the fim incieases its output. But the total cost
cuive becomes steepei and steepei as diminishing maiginal ietuins set in. Eventually, the total cost and
total ievenue cuives will have the same slope. That happens in Figuie 9.6 at an output of 6,700 pounds
of iadishes pei month. Notice that a line diawn tangent to the total cost cuive at that quantity has the
same slope as the total ievenue cuive.
As output incieases beyond 6,700 pounds, the total cost cuive continues to become steepei. It be-
comes steepei than the total ievenue cuive, and piofts fall as costs iise fastei than ievenues. At an out-
put slightly above 8,000 pounds pei month, the total ievenue and cost cuives inteisect again, and eco-
nomic pioft equals zeio. Mi. Goitaii achieves the gieatest pioft possible by pioducing 6,700 pounds
of iadishes pei month, the quantity at which the total cost and total ievenue cuives have the same
slope. Moie geneially, we can conclude that a peifectly competitive fim maximizes economic pioft at
the output level at which the total ievenue cuive and the total cost cuive have the same slope.
2.3 Applying the Maiginal Decision Rule
The slope of the total ievenue cuive is maiginal ievenue; the slope of the total cost cuive is maiginal
cost. Economic pioft, the difeience between total ievenue and total cost, is maximized wheie maigin-
al ievenue equals maiginal cost. This is consistent with the maiginal decision iule, which holds that a
pioft-maximizing fim should inciease output until the maiginal beneft of an additional unit equals
the maiginal cost. The maiginal beneft of selling an additional unit is measuied as maiginal ievenue.
Finding the output at which maiginal ievenue equals maiginal cost is thus an application of oui mai-
ginal decision iule.
Figuie 9.7 shows how a fim can use the maiginal decision iule to deteimine its pioft-maximizing
output. Panel (a) shows the maiket foi iadishes; the maiket demand cuive (D), and supply cuive (S)
that we had in Figuie 9.3; the maiket piice is $0.40 pei pound. In Panel (b), the MR cuive is given by a
hoiizontal line at the maiket piice. The fim's maiginal cost cuive (MC) inteisects the maiginal ieven-
ue cuive at the point wheie pioft is maximized. Mi. Goitaii maximizes piofts by pioducing 6,700
pounds of iadishes pei month. That is, of couise, the iesult we obtained in Figuie 9.6, wheie we saw
that the fim's total ievenue and total cost cuives difei by the gieatest amount at the point at which the
slopes of the cuives, which equal maiginal ievenue and maiginal cost, iespectively, aie equal.
II GUR£ 9. 7 AppIying the MarginaI Decision RuIe
¯|e n..ket p.|ce |s Jete.n|reJ by t|e |rte.sect|cr c| Jen.rJ .rJ supp|y. As .|..ys, t|e |.n n.x|n|.es p.c|t by
.pp|y|rg t|e n..g|r.| Jec|s|cr .u|e. |t t.kes t|e n..ket p.|ce, ´0.40 pe. pcurJ, .s g|ver .rJ se|ects .r cutput .t
.||c| /| e,u.|s /´. |ccrcn|c p.c|t pe. ur|t |s t|e J||e.erce bet.eer ^¯´ .rJ p.|ce (|e.e, ´0.14 pe. pcurJ),
eccrcn|c p.c|t |s p.c|t pe. ur|t t|nes t|e ,u.rt|ty p.cJuceJ (´0.14×6,00´938).
CHAP7£R 9 COMP£7I7IV£ MARk£7S IOR GOODS AND S£RVIC£S 233
economic Ioss
¯|e .ncurt by .||c| . |.ns
tct.| ccst exceeJs |ts tct.|
.everue.
We can use the giaph in Figuie 9.7 to compute Mi. Goitaii's economic pioft. Economic pront per
unit is the difeience between piice and aveiage total cost. At the pioft-maximizing output of 6,700
pounds of iadishes pei month, aveiage total cost (ATC) is $0.26 pei pound, as shown in Panel (b).
Piice is $0.40 pei pound, so economic pioft pei unit is $0.14. Economic pioft is found by multiplying
economic pioft pei unit by the numbei of units pioduced; the fim's economic pioft is thus $938
($0.14 × 6,700). It is shown giaphically by the aiea of the shaded iectangle in Panel (b); this aiea equals
the veitical distance between maiginal ievenue (MR) and aveiage total cost (ATC) at an output of 6,700
pounds of iadishes times the numbei of pounds of iadishes pioduced, 6,700, in Figuie 9.7.
Heads Up!
|cck c..e|u||y .t t|e .ect.rg|e t|.t s|c.s eccrcn|c p.c|t |r |.re| (b) c| ||gu.e 9.. |t |s |curJ by t.k|rg t|e
p.c|tn.x|n|.|rg ,u.rt|ty, 6,00 pcurJs, t|er .e.J|rg up tc t|e ^¯´ cu.ve .rJ t|e |.ns Jen.rJ cu.ve .t
t|e n..ket p.|ce. |ccrcn|c p.c|t pe. ur|t e,u.|s p.|ce n|rus .ve..ge tct.| ccst (| ^¯´).
¯|e |.ns eccrcn|c p.c|t e,u.|s eccrcn|c p.c|t pe. ur|t t|nes t|e ,u.rt|ty p.cJuceJ. |t |s |curJ by exterJ
|rg |c.|.crt.| ||res |.cn t|e ^¯´ .rJ /| co·.e tc t|e ve.t|c.| .x|s .rJ t.k|rg t|e ..e. c| t|e .ect.rg|e |c.neJ.
¯|e.e |s rc .e.scr |c. t|e p.c|tn.x|n|.|rg ,u.rt|ty tc cc..espcrJ tc t|e |c.est pc|rt cr t|e ^¯´ cu.ve, |t
Jces rct |r t||s c.se. StuJerts scnet|nes n.ke t|e n|st.ke c| c.|cu|.t|rg eccrcn|c p.c|t .s t|e J||e.erce
bet.eer t|e p.|ce .rJ t|e |c.est pc|rt cr t|e ^¯´ cu.ve. ¯|.t g|ves us t|e n.x|nun eccrcn|c p.c|t pe.
ur|t, but .e .ssune t|.t |.ns n.x|n|.e eccrcn|c p.c|t, rct eccrcn|c p.c|t pe. ur|t. ¯|e |.ns eccrcn|c
p.c|t e,u.|s eccrcn|c p.c|t pe. ur|t t|nes ,u.rt|ty. ¯|e ,u.rt|ty t|.t n.x|n|.es eccrcn|c p.c|t |s Jete.n
|reJ by t|e |rte.sect|cr c| ^¯´ .rJ /|.
2.4 Economic Losses in the Shoit Run
In the shoit iun, a fim has one oi moie inputs whose quantities aie fxed. That means that in the shoit
iun the fim cannot leave its industiy. Even if it cannot covei all of its costs, including both its vaiiable
and fxed costs, going entiiely out of business is not an option in the shoit iun. The fim may close its
doois, but it must continue to pay its fxed costs. It is foiced to accept an economic loss, the amount
by which its total cost exceeds its total ievenue.
Suppose, foi example, that a manufactuiei has signed a 1-yeai lease on some equipment. It must
make payments foi this equipment duiing the teim of its lease, whethei it pioduces anything oi not.
Duiing the peiiod of the lease, the payments iepiesent a fxed cost foi the fim.
A fim that is expeiiencing economic losses-whose economic piofts have become negative-in
the shoit iun may eithei continue to pioduce oi shut down its opeiations, ieducing its output to zeio.
It will choose the option that minimizes its losses. The ciucial test of whethei to opeiate oi shut down
lies in the ielationship between piice and aveiage vaiiable cost.
Producing to Minimize £conomic Loss
Suppose the demand foi iadishes falls to D
2
, as shown in Panel (a) of Figuie 9.8. The maiket piice foi
iadishes plunges to $0.18 pei pound, which is below aveiage total cost. Consequently Mi. Goitaii ex-
peiiences negative economic piofts-a loss. Although the new maiket piice falls shoit of aveiage total
cost, it still exceeds aveiage vaiiable cost, shown in Panel (b) as AVC. Theiefoie, Mi. Goitaii should
continue to pioduce an output at which maiginal cost equals maiginal ievenue. These cuives (labeled
MC and MR
2
) inteisect in Panel (b) at an output of 4,444 pounds of iadishes pei month.
234 PRINCIPL£S OI £CONOMICS
shutdown point
¯|e n|r|nun |eve| c|
.ve..ge v..|.b|e ccst, .||c|
cccu.s .t t|e |rte.sect|cr c|
t|e n..g|r.| ccst cu.ve .rJ
t|e .ve..ge v..|.b|e ccst
cu.ve.
II GUR£ 9. 8 Suffering £conomic Losses in the Short Run
¯cry Cc.t..| expe.|erces . |css .|er p.|ce J.cps be|c. ^¯´, .s |t Jces |r |.re| (b) .s . .esu|t c| . .eJuct|cr |r
Jen.rJ. || p.|ce |s .bcve ^v´, |c.eve., |e c.r n|r|n|.e ||s |csses by p.cJuc|rg .|e.e /´ e,u.|s /|
2
. |e.e, t|.t
cccu.s .t .r cutput c| 4,444 pcurJs c| ..J|s|es pe. ncrt|. ¯|e p.|ce |s ´0.18 pe. pcurJ, .rJ .ve..ge tct.| ccst |s
´0.23 pe. pcurJ. |e |cses ´0.05 pe. pcurJ, c. ´222.20 pe. ncrt|.
When pioducing 4,444 pounds of iadishes pei month, Mi. Goitaii faces an aveiage total cost of $0.23
pei pound. At a piice of $0.18 pei pound, he loses a nickel on each pound pioduced. Total economic
losses at an output of 4,444 pounds pei month aie thus $222.20 pei month (=4,444×$0.03).
No pioducei likes a loss (that is, negative economic pioft), but the loss solution shown in Figuie
9.8 is the best Mi. Goitaii can attain. Any level of pioduction othei than the one at which maiginal cost
equals maiginal ievenue would pioduce even gieatei losses.
Suppose Mi. Goitaii weie to shut down and pioduce no iadishes. Ceasing pioduction would ie-
duce vaiiable costs to zeio, but he would still face fxed costs of $400 pei month (iecall that $400 was
the veitical inteicept of the total cost cuive in Figuie 9.6). By shutting down, Mi. Goitaii would lose
$400 pei month. By continuing to pioduce, he loses only $222.20.
Mi. Goitaii is bettei of pioducing wheie maiginal cost equals maiginal ievenue because at that
output piice exceeds aveiage vaiiable cost. Aveiage vaiiable cost is $0.14 pei pound, so by continuing
to pioduce he coveis his vaiiable costs, with $0.04 pei pound left ovei to apply to fxed costs. Whenevei
piice is gieatei than aveiage vaiiable cost, the fim maximizes economic pioft (oi minimizes economic
loss) by pioducing the output level at which maiginal ievenue and maiginal cost cuives inteisect.
Shutting Down to Minimize £conomic Loss
Suppose piice diops below a fim's aveiage vaiiable cost. Now the best stiategy foi the fim is to shut
down, ieducing its output to zeio. The minimum level of aveiage vaiiable cost, which occuis at the in-
teisection of the maiginal cost cuive and the aveiage vaiiable cost cuive, is called the shutdown
point. Any piice below the minimum value of aveiage vaiiable cost will cause the fim to shut down. If
the fim weie to continue pioducing, not only would it lose its fxed costs, but it would also face an ad-
ditional loss by not coveiing its vaiiable costs.
Figuie 9.9 shows a case wheie the piice of iadishes diops to $0.10 pei pound. Piice is less than av-
eiage vaiiable cost, so Mi. Goitaii not only would lose his fxed cost but would also incui additional
losses by pioducing. Suppose, foi example, he decided to opeiate wheie maiginal cost equals maiginal
ievenue, pioducing 1,700 pounds of iadishes pei month. Aveiage vaiiable cost equals $0.14 pei pound,
so he would lose $0.04 on each pound he pioduces ($68) plus his fxed cost of $400 pei month. He
would lose $468 pei month. If he shut down, he would lose only his fxed cost. Because the piice of
$0.10 falls below his aveiage vaiiable cost, his best couise would be to shut down.
CHAP7£R 9 COMP£7I7IV£ MARk£7S IOR GOODS AND S£RVIC£S 235
II GUR£ 9. 9 Shutting Down
¯|e n..ket p.|ce c| ..J|s|es J.cps tc ´0.10 pe.
pcurJ, sc /|
3
|s be|c. V.. Cc.t..|s ^v´. ¯|us
|e .cu|J su|e. . g.e.te. |css by ccrt|ru|rg tc
cpe..te t|.r by s|utt|rg Jc.r. \|ereve.
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.||| s|ut Jc.r, .eJuc|rg |ts p.cJuct|cr tc
.e.c.
Shutting down is not the same thing as going out of business. A fim shuts down
by closing its doois; it can ieopen them whenevei it expects to covei its vaiiable costs.
We can even think of a fim's decision to close at the end of the day as a kind of shut-
down point; the fim makes this choice because it does not anticipate that it will be able
to covei its vaiiable cost oveinight. It expects to covei those costs the next moining
when it ieopens its doois.
2.3 Maiginal Cost and Supply
In the model of peifect competition, we assume that a fim deteimines its output by
fnding the point wheie the maiginal ievenue and maiginal cost cuives inteisect.
Piovided that piice exceeds aveiage vaiiable cost, the fim pioduces the quantity de-
teimined by the inteisection of the two cuives.
A supply cuive tells us the quantity that will be pioduced at each piice, and that is
what the fim's maiginal cost cuive tells us. The fim's supply cuive in the shoit iun is
its maiginal cost cuive foi piices above the aveiage vaiiable cost. At piices below avei-
age vaiiable cost, the fim's output diops to zeio.
Panel (a) of Figuie 9.10 shows the aveiage vaiiable cost and maiginal cost cuives
foi a hypothetical astiologei, Madame LaFaige, who is in the business of pioviding as-
tiological consultations ovei the telephone. We shall assume that this industiy is pei-
fectly competitive. At any piice below $10 pei call, Madame LaFaige would shut down.
If the piice is $10 oi gieatei, howevei, she pioduces an output at which piice equals
maiginal cost. The maiginal cost cuive is thus hei supply cuive at all piices gieatei
than $10.
II GUR£ 9. 10 MarginaI Cost and SuppIy
¯|e supp|y cu.ve |c. . |.n |s t|.t pc.t|cr c| |ts /´ cu.ve t|.t ||es .bcve t|e ^v´ cu.ve, s|c.r |r
|.re| (.). ¯c cbt.|r t|e s|c.t.ur supp|y cu.ve |c. t|e |rJust.y, .e .JJ t|e cutputs c| e.c| |.n .t e.c| p.|ce. ¯|e
|rJust.y supp|y cu.ve |s g|ver |r |.re| (b).
Now suppose that the astiological foiecast industiy consists of Madame LaFaige and thousands of oth-
ei fims similai to heis. The maiket supply cuive is found by adding the outputs of each fim at each
piice, as shown in Panel (b) of Figuie 9.10. At a piice of $10 pei call, foi example, Madame LaFaige
supplies 14 calls pei day. Adding the quantities supplied by all the othei fims in the maiket, suppose
we get a quantity supplied of 280,000. Notice that the maiket supply cuive we have diawn is lineai;
thioughout the book we have made the assumption that maiket demand and supply cuives aie lineai
in oidei to simplify oui analysis.
Looking at Figuie 9.10, we see that pioft-maximizing choices by fims in a peifectly competitive
maiket will geneiate a maiket supply cuive that iefects maiginal cost. Piovided theie aie no exteinal
236 PRINCIPL£S OI £CONOMICS
benefts oi costs in pioducing a good oi seivice, a peifectly competitive maiket satisfes the emciency
condition.
k £ Y 7 A k £ A W A Y S
< |.|ce |r . pe.|ect|y ccnpet|t|ve |rJust.y |s Jete.n|reJ by t|e |rte..ct|cr c| Jen.rJ .rJ supp|y.
< |r . pe.|ect|y ccnpet|t|ve |rJust.y, . |.ns tct.| .everue cu.ve |s . st..|g|t, up...Js|cp|rg ||re .|cse
s|cpe |s t|e n..ket p.|ce. |ccrcn|c p.c|t |s n.x|n|.eJ .t t|e cutput |eve| .t .||c| t|e s|cpes c| t|e tct.|
.everue .rJ tct.| ccst cu.ves ..e e,u.|, p.cv|JeJ t|.t t|e |.n |s ccve.|rg |ts v..|.b|e ccst.
< ¯c use t|e n..g|r.| Jec|s|cr .u|e |r p.c|t n.x|n|..t|cr, t|e |.n p.cJuces t|e cutput .t .||c| n..g|r.|
ccst e,u.|s n..g|r.| .everue. |ccrcn|c p.c|t pe. ur|t |s p.|ce n|rus .ve..ge tct.| ccst, tct.| eccrcn|c
p.c|t e,u.|s eccrcn|c p.c|t pe. ur|t t|nes ,u.rt|ty.
< || p.|ce |.||s be|c. .ve..ge tct.| ccst, but .en.|rs .bcve .ve..ge v..|.b|e ccst, t|e |.n .||| ccrt|rue tc
cpe..te |r t|e s|c.t .ur, p.cJuc|rg t|e ,u.rt|ty .|e.e MR = MC Jc|rg sc n|r|n|.es |ts |csses.
< || p.|ce |.||s be|c. .ve..ge v..|.b|e ccst, t|e |.n .||| s|ut Jc.r |r t|e s|c.t .ur, .eJuc|rg cutput tc .e.c.
¯|e |c.est pc|rt cr t|e .ve..ge v..|.b|e ccst cu.ve |s c.||eJ t|e s|utJc.r pc|rt.
< ¯|e |.ns supp|y cu.ve |r t|e s|c.t .ur |s |ts n..g|r.| ccst cu.ve |c. p.|ces g.e.te. t|.r t|e n|r|nun
.ve..ge v..|.b|e ccst.
7 R Y I 7 !
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pe.|ect|y ccnpet|t|ve n..ket. Suppcse t|e Jen.rJ .rJ supp|y cu.ves |c. ¦.ckets |rte.sect .t . p.|ce c| ´81.
|c., us|rg t|e n..g|r.| ccst .rJ .ve..ge tct.| ccst cu.ves |c. Acne s|c.r |e.e.
|st|n.te Acnes p.c|tn.x|n|.|rg cutput pe. J.y (.ssune t|e |.n se|ects . .|c|e runbe.). \|.t ..e
Acnes eccrcn|c p.c|ts pe. J.y`
CHAP7£R 9 COMP£7I7IV£ MARk£7S IOR GOODS AND S£RVIC£S 237
Case in Point: Not Out of 8usiness '7iI 7hey IaII from the Sky
÷ 2010 jupiterimages Corporation
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238 PRINCIPL£S OI £CONOMICS
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p.c|t pe. J.y e,u.|s .bcut ´126.
3. PERFECT COMPETITION IN THE LONG RUN
L £ A R N I N G O 8 1 £ C 7 I V £ S
1. Distinguish between economic proñt and accounting proñt.
2. £xpIain why in Iong-run equiIibrium in a perfectIy competitive industry ñrms wiII earn zero eco-
nomic proñt.
3. Describe the three possibIe eñects on the costs of the factors of production that expansion or
contraction of a perfectIy competitive industry may have and iIIustrate the resuIting Iong-run
industry suppIy curve in each case.
4. £xpIain why under perfection competition output prices wiII change by Iess than the change in
production cost in the short run, but by the fuII amount of the change in production cost in the
Iong run.
5. £xpIain the eñect of a change in ñxed cost on price and output in the short run and in the Iong
run under perfect competition.
In the long iun, a fim is fiee to adjust all of its inputs. New fims can entei any maiket; existing fims
can leave theii maikets. We shall see in this section that the model of peifect competition piedicts that,
at a long-iun equilibiium, pioduction takes place at the lowest possible cost pei unit and that all eco-
nomic piofts and losses aie eliminated.
CHAP7£R 9 COMP£7I7IV£ MARk£7S IOR GOODS AND S£RVIC£S 239
expIicit costs
´|..ges t|.t nust be p.|J |c.
|.ctc.s c| p.cJuct|cr suc| .s
|.bc. .rJ c.p|t.|.
accounting proñt
|.c|t ccnputeJ us|rg cr|y
exp||c|t ccsts.
impIicit cost
A ccst t|.t |s |rc|uJeJ |r t|e
eccrcn|c ccrcept c|
cppc.tur|ty ccst but t|.t |s
rct .r exp||c|t ccst.
3.1 Economic Piofit and Economic Loss
Economic piofts and losses play a ciucial iole in the model of peifect competition. The existence of
economic piofts in a paiticulai industiy attiacts new fims to the industiy in the long iun. As new
fims entei, the supply cuive shifts to the iight, piice falls, and piofts fall. Fiims continue to entei the
industiy until economic piofts fall to zeio. If fims in an industiy aie expeiiencing economic losses,
some will leave. The supply cuive shifts to the left, incieasing piice and ieducing losses. Fiims continue
to leave until the iemaining fims aie no longei sufeiing losses-until economic piofts aie zeio.
Befoie examining the mechanism thiough which entiy and exit eliminate economic piofts and
losses, we shall examine an impoitant key to undeistanding it: the difeience between the accounting
and economic concepts of pioft and loss.
£conomic Versus Accounting Concepts of Profit and Loss
Economic pioft equals total ievenue minus total cost, wheie cost is measuied in the economic sense as
oppoitunity cost. An economic loss (negative economic pioft) is incuiied if total cost exceeds total
ievenue.
Accountants include only explicit costs in theii computation of total cost. Explicit costs include
chaiges that must be paid foi factois of pioduction such as laboi and capital, togethei with an estimate
of depieciation. Pioft computed using only explicit costs is called accounting pront. It is the meas-
uie of pioft fims typically iepoit; fims pay taxes on theii accounting piofts, and a coipoiation ie-
poiting its pioft foi a paiticulai peiiod iepoits its accounting piofts. To compute his accounting
piofts, Mi. Goitaii, the iadish faimei, would subtiact explicit costs, such as chaiges foi laboi, equip-
ment, and othei supplies, fiom the ievenue he ieceives.
Economists iecognize costs in addition to the explicit costs listed by accountants. If Mi. Goitaii
weie not giowing iadishes, he could be doing something else with the land and with his own efoits.
Suppose the most valuable alteinative use of his land would be to pioduce caiiots, fiom which Mi.
Goitaii could eain $230 pei month in accounting piofts. The income he foigoes by not pioducing cai-
iots is an oppoitunity cost of pioducing iadishes. This cost is not explicit; the ietuin Mi. Goitaii could
get fiom pioducing caiiots will not appeai on a conventional accounting statement of his accounting
pioft. A cost that is included in the economic concept of oppoitunity cost, but that is not an explicit
cost, is called an implicit cost.
7he Long Run and 7ero £conomic Profits
Given oui defnition of economic piofts, we can easily see why, in peifect competition, they must al-
ways equal zeio in the long iun. Suppose theie aie two industiies in the economy, and that fims in In-
dustiy A aie eaining economic piofts. By defnition, fims in Industiy A aie eaining a ietuin gieatei
than the ietuin available in Industiy B. That means that fims in Industiy B aie eaining less than they
could in Industiy A. Fiims in Industiy B aie expeiiencing economic losses.
Given easy entiy and exit, some fims in Industiy B will leave it and entei Industiy A to eain the
gieatei piofts available theie. As they do so, the supply cuive in Industiy B will shift to the left, in-
cieasing piices and piofts theie. As foimei Industiy B fims entei Industiy A, the supply cuive in In-
dustiy A will shift to the iight, loweiing piofts in A. The piocess of fims leaving Industiy B and entei-
ing A will continue until fims in both industiies aie eaining zeio economic pioft. That suggests an
impoitant long-iun iesult: Economic profts in a system of perfectly competitive markets will, in the long
run, be driven to zero in all industries.
£Iiminating £conomic Profit: 7he RoIe of £ntry
The piocess thiough which entiy will eliminate economic piofts in the long iun is illustiated in Figuie
9.14, which is based on the situation piesented in Figuie 9.7. The piice of iadishes is $0.40 pei pound.
Mi. Goitaii's aveiage total cost at an output of 6,700 pounds of iadishes pei month is $0.26 pei pound.
Pioft pei unit is $0.14 ($0.40 ÷ $0.26 ). Mi. Goitaii thus eains a pioft of $938 pei month (
= $0.14 × 6, 700 ).
240 PRINCIPL£S OI £CONOMICS
II GUR£ 9. 14 £Iiminating £conomic Profits in the Long Run
|| |.ns |r .r |rJust.y ..e n.k|rg .r eccrcn|c p.c|t, ert.y .||| cccu. |r t|e |crg .ur. |r |.re| (b), . s|rg|e |.ns
p.c|t |s s|c.r by t|e s|.JeJ ..e.. |rt.y ccrt|rues urt|| |.ns |r t|e |rJust.y ..e cpe..t|rg .t t|e |c.est pc|rt cr
t|e|. .espect|ve .ve..ge tct.| ccst cu.ves, .rJ eccrcn|c p.c|ts |.|| tc .e.c.
Piofts in the iadish industiy attiact entiy in the long iun. Panel (a) of Figuie 9.14 shows that as fims
entei, the supply cuive shifts to the iight and the piice of iadishes falls. New fims entei as long as theie
aie economic piofts to be made-as long as piice exceeds ATC in Panel (b). As piice falls, maiginal
ievenue falls to MR
2
and the fim ieduces the quantity it supplies, moving along the maiginal cost
(MC) cuive to the lowest point on the ATC cuive, at $0.22 pei pound and an output of 3,000 pounds
pei month. Although the output of individual fims falls in iesponse to falling piices, theie aie now
moie fims, so industiy output iises to 13 million pounds pei month in Panel (a).
£Iiminating Losses: 7he RoIe of £xit
Just as entiy eliminates economic piofts in the long iun, exit eliminates economic losses. In Figuie
9.13, Panel (a) shows the case of an industiy in which the maiket piice P
1
is below ATC. In Panel (b), at
piice P
1
a single fim pioduces a quantity q
1
, assuming it is at least coveiing its aveiage vaiiable cost.
The fim's losses aie shown by the shaded iectangle bounded by its aveiage total cost C
1
and piice P
1
and by output q
1
.
Because fims in the industiy aie losing money, some will exit. The supply cuive in Panel (a) shifts
to the left, and it continues shifting as long as fims aie sufeiing losses. Eventually the supply cuive
shifts all the way to S
2
, piice iises to P
2
, and economic piofts ietuin to zeio.
CHAP7£R 9 COMP£7I7IV£ MARk£7S IOR GOODS AND S£RVIC£S 241
constant-cost industry
|rJust.y |r .||c| exp.rs|cr
Jces rct .|ect t|e p.|ces c|
|.ctc.s c| p.cJuct|cr.
increasing-cost industry
|rJust.y |r .||c| t|e ert.y c|
re. |.ns b|Js up t|e p.|ces
c| |.ctc.s c| p.cJuct|cr .rJ
t|us |rc.e.ses p.cJuct|cr
ccsts.
decreasing-cost industry
|rJust.y |r .||c| p.cJuct|cr
ccsts |.|| |r t|e |crg .ur .s
|.ns erte..
II GUR£ 9. 15 £Iiminating £conomic Losses in the Long Run
|.re| (b) s|c.s t|.t .t t|e |r|t|.| p.|ce |
1
, |.ns |r t|e |rJust.y c.rrct ccve. .ve..ge tct.| ccst (/|
1
|s be|c. ^¯´).
¯|.t |rJuces scne |.ns tc |e.ve t|e |rJust.y, s|||t|rg t|e supp|y cu.ve |r |.re| (.) tc .
2
, .eJuc|rg |rJust.y cutput
tc (
2
.rJ ..|s|rg p.|ce tc |
2
. At t|.t p.|ce (/|
2
), |.ns e..r .e.c eccrcn|c p.c|t, .rJ ex|t |.cn t|e |rJust.y ce.ses.
|.re| (b) s|c.s t|.t t|e |.n |rc.e.ses cutput |.cn ¸
1
tc ¸
2
, tct.| cutput |r t|e n..ket |.||s |r |.re| (.) bec.use
t|e.e ..e |e.e. |.ns. |ct|ce t|.t |r |.re| (.) ,u.rt|ty |s Jes|gr.teJ by uppe.c.se (, .|||e |r |.re| (b) ,u.rt|ty |s
Jes|gr.teJ by |c.e.c.se ¸. ¯||s ccrvert|cr |s useJ t|.cug|cut t|e text tc J|st|rgu|s| bet.eer t|e ,u.rt|ty
supp||eJ |r t|e n..ket (() .rJ t|e ,u.rt|ty supp||eJ by . typ|c.| |.n (¸).
£ntry, £xit, and Production Costs
In oui examination of entiy and exit in iesponse to economic pioft oi loss in a peifectly competitive
industiy, we assumed that the ATC cuive of a single fim does not shift as new fims entei oi existing
fims leave the industiy. That is the case when expansion oi contiaction does not afect piices foi the
factois of pioduction used by fims in the industiy. When expansion of the industiy does not afect the
piices of factois of pioduction, it is a constant-cost industry. In some cases, howevei, the entiy of
new fims may afect input piices.
As new fims entei, they add to the demand foi the factois of pioduction used by the industiy. If
the industiy is a signifcant usei of those factois, the inciease in demand could push up the maiket
piice of factois of pioduction foi all fims in the industiy. If that occuis, then entiy into an industiy
will boost aveiage costs at the same time as it puts downwaid piessuie on piice. Long-iun equilibiium
will still occui at a zeio level of economic pioft and with fims opeiating on the lowest point on the
ATC cuive, but that cost cuive will be somewhat highei than befoie entiy occuiied. Suppose, foi ex-
ample, that an inciease in demand foi new houses diives piices highei and induces entiy. That will in-
ciease the demand foi woikeis in the constiuction industiy and is likely to iesult in highei wages in the
industiy, diiving up costs.
An industiy in which the entiy of new fims bids up the piices of factois of pioduction and thus
incieases pioduction costs is called an increasing-cost industry. As such an industiy expands in the
long iun, its piice will iise.
Some industiies may expeiience ieductions in input piices as they expand with the entiy of new
fims. That may occui because fims supplying the industiy expeiience economies of scale as they in-
ciease pioduction, thus diiving input piices down. Expansion may also induce technological changes
that lowei input costs. That is cleaily the case of the computei industiy, which has enjoyed falling input
costs as it has expanded. An industiy in which pioduction costs fall as fims entei in the long iun is a
decreasing-cost industry.
Just as industiies may expand with the entiy of new fims, they may contiact with the exit of exist-
ing fims. In a constant-cost industiy, exit will not afect the input piices of iemaining fims. In an
incieasing-cost industiy, exit will ieduce the input piices of iemaining fims. And, in a decieasing-cost
industiy, input piices may iise with the exit of existing fims.
242 PRINCIPL£S OI £CONOMICS
Iong-run industry suppIy
curve
A cu.ve t|.t .e|.tes t|e p.|ce
c| . gccJ c. se.v|ce tc t|e
,u.rt|ty p.cJuceJ .|te. .||
|crg.ur .J¦ustnerts tc .
p.|ce c|.rge |.ve beer
ccnp|eteJ.
The behavioi of pioduction costs as fims in an industiy expand oi ieduce theii output has im-
poitant implications foi the long-run industry supply curve, a cuive that ielates the piice of a good
oi seivice to the quantity pioduced aftei all long-iun adjustments to a piice change have been com-
pleted. Eveiy point on a long-iun supply cuive theiefoie shows a piice and quantity supplied at which
fims in the industiy aie eaining zeio economic pioft. Unlike the shoit-iun maiket supply cuive, the
long-iun industiy supply cuive does not hold factoi costs and the numbei of fims unchanged.
Figuie 9.16 shows thiee long-iun industiy supply cuives. In Panel (a), S
CC
is a long-iun supply
cuive foi a constant-cost industiy. It is hoiizontal. Neithei expansion noi contiaction by itself afects
maiket piice. In Panel (b), S
IC
is a long-iun supply cuive foi an incieasing-cost industiy. It iises as the
industiy expands. In Panel (c), S
DC
is a long-iun supply cuive foi a decieasing-cost industiy. Its down-
waid slope suggests a falling piice as the industiy expands.
II GUR£ 9. 16 Long-Run SuppIy Curves in Perfect Competition
¯|e |crg.ur supp|y cu.ve |c. . ccrst.rtccst, pe.|ect|y ccnpet|t|ve |rJust.y |s . |c.|.crt.| ||re, .
´´
, s|c.r |r
|.re| (.). ¯|e |crg.ur cu.ve |c. .r |rc.e.s|rgccst |rJust.y |s .r up...Js|cp|rg cu.ve, .

, .s |r |.re| (b). ¯|e
Jc.r...Js|cp|rg |crg.ur supp|y cu.ve, .

, |c. . Jec.e.s|rg ccst |rJust.y |s g|ver |r |.re| (c).
3.2 Changes in Demand and in Pioduction Cost
The piimaiy application of the model of peifect competition is in piedicting how fims will iespond to
changes in demand and in pioduction costs. To see how fims iespond to a paiticulai change, we de-
teimine how the change afects demand oi cost conditions and then see how the pioft-maximizing
solution is afected in the shoit iun and in the long iun. Having deteimined how the pioft-maximizing
fims of the model would iespond, we can then piedict fims' iesponses to similai changes in the ieal
woild.
In the examples that follow, we shall assume, foi simplicity, that entiy oi exit do not afect the in-
put piices facing fims in the industiy. That is, we assume a constant-cost industiy with a hoiizontal
long-iun industiy supply cuive similai to S
CC
in Figuie 9.16. We shall assume that fims aie coveiing
theii aveiage vaiiable costs, so we can ignoie the possibility of shutting down.
Changes in Demand
Changes in demand can occui foi a vaiiety of ieasons. Theie may be a change in piefeiences, incomes,
the piice of a ielated good, population, oi consumei expectations. A change in demand causes a change
in the maiket piice, thus shifting the maiginal ievenue cuives of fims in the industiy.
Let us considei the impact of a change in demand foi oats. Suppose new evidence suggests that
eating oats not only helps to pievent heait disease, but also pievents baldness in males. This will, of
couise, inciease the demand foi oats. To assess the impact of this change, we assume that the industiy
is peifectly competitive and that it is initially in long-iun equilibiium at a piice of $1.70 pei bushel.
Economic piofts equal zeio.
The initial situation is depicted in Figuie 9.17. Panel (a) shows that at a piice of $1.70, industiy
output is Q
1
(point A), while Panel (b) shows that the maiket piice constitutes the maiginal ievenue,
MR
1
, facing a single fim in the industiy. The fim iesponds to that piice by fnding the output level at
which the MC and MR
1
cuives inteisect. That implies a level of output q
1
at point A.
The new medical evidence causes demand to inciease to D
2
in Panel (a). That incieases the maiket
piice to $2.30 (point B), so the maiginal ievenue cuive foi a single fim iises to MR
2
in Panel (b). The
fim iesponds by incieasing its output to q
2
in the shoit iun (point B). Notice that the fim's aveiage
total cost is slightly highei than its oiiginal level of $1.70; that is because of the U shape of the cuive.
The fim is making an economic pioft shown by the shaded iectangle in Panel (b). Othei fims in the
industiy will eain an economic pioft as well, which, in the long iun, will attiact entiy by new fims.
CHAP7£R 9 COMP£7I7IV£ MARk£7S IOR GOODS AND S£RVIC£S 243
New entiy will shift the supply cuive to the iight; entiy will continue as long as fims aie making an
economic pioft. The supply cuive in Panel (a) shifts to S
2
, diiving the piice down in the long iun to
the oiiginal level of $1.70 pei bushel and ietuining economic piofts to zeio in long-iun equilibiium. A
single fim will ietuin to its oiiginal level of output, q
1
(point A) in Panel (b), but because theie aie
moie fims in the industiy, industiy output iises to Q
3
(point C) in Panel (a).
II GUR£ 9. 17 Short-Run and Long-Run Ad|ustments to an Increase in Demand
¯|e |r|t|.| e,u|||b.|un p.|ce .rJ cutput ..e Jete.n|reJ |r t|e n..ket |c. c.ts by t|e |rte.sect|cr c| Jen.rJ .rJ
supp|y .t pc|rt A |r |.re| (.). Ar |rc.e.se |r t|e n..ket Jen.rJ |c. c.ts, |.cn |
1
tc |
2
|r |.re| (.), s|||ts t|e
e,u|||b.|un sc|ut|cr tc pc|rt b. ¯|e p.|ce |rc.e.ses |r t|e s|c.t .ur |.cn ´1.0 pe. bus|e| tc ´2.30. |rJust.y cutput
.|ses tc (
2
. |c. . s|rg|e |.n, t|e |rc.e.se |r p.|ce ..|ses n..g|r.| .everue |.cn /|
1
tc /|
2
, t|e |.n .espcrJs |r t|e
s|c.t .ur by |rc.e.s|rg |ts cutput tc ¸
2
. |t e..rs .r eccrcn|c p.c|t g|ver by t|e s|.JeJ .ect.rg|e. |r t|e |crg .ur,
t|e cppc.tur|ty |c. p.c|t .tt..cts re. |.ns. |r . ccrst.rtccst |rJust.y, t|e s|c.t.ur supp|y cu.ve s|||ts tc .
2
,
n..ket e,u|||b.|un rc. ncves tc pc|rt ´ |r |.re| (.). ¯|e n..ket p.|ce |.||s b.ck tc ´1.0. ¯|e |.ns Jen.rJ cu.ve
.etu.rs tc /|
1
, .rJ |ts cutput |.||s b.ck tc t|e c.|g|r.| |eve|, ¸
1
. |rJust.y cutput |.s .|ser tc (
3
bec.use t|e.e ..e
nc.e |.ns.
A ieduction in demand would lead to a ieduction in piice, shifting each fim's maiginal ievenue cuive
downwaid. Fiims would expeiience economic losses, thus causing exit in the long iun and shifting the
supply cuive to the left. Eventually, the piice would iise back to its oiiginal level, assuming changes in
industiy output did not lead to changes in input piices. Theie would be fewei fims in the industiy, but
each fim would end up pioducing the same output as befoie.
Changes in Production Cost
A fim's costs change if the costs of its inputs change. They also change if the fim is able to take ad-
vantage of a change in technology. Changes in pioduction cost shift the ATC cuive. If a fim's vaiiable
costs aie afected, its maiginal cost cuives will shift as well. Any change in maiginal cost pioduces a
similai change in industiy supply, since it is found by adding up maiginal cost cuives foi individual
fims.
Suppose a ieduction in the piice of oil ieduces the cost of pioducing oil changes foi automobiles.
We shall assume that the oil-change industiy is peifectly competitive and that it is initially in long-iun
equilibiium at a piice of $27 pei oil change, as shown in Panel (a) of Figuie 9.18. Suppose that the ie-
duction in oil piices ieduces the cost of an oil change by $3.
244 PRINCIPL£S OI £CONOMICS
II GUR£ 9. 18 A Reduction in the Cost of Producing OiI Changes
¯|e |r|t|.| e,u|||b.|un p.|ce, ´2, .rJ ,u.rt|ty, (
1
, c| .utcncb||e c|| c|.rges ..e Jete.n|reJ by t|e |rte.sect|cr c|
n..ket Jen.rJ, |
1
, .rJ n..ket supp|y, .
1
|r |.re| (.). ¯|e |rJust.y |s |r |crg.ur e,u|||b.|un, . typ|c.| |.n, s|c.r
|r |.re| (b), e..rs .e.c eccrcn|c p.c|t. A .eJuct|cr |r c|| p.|ces .eJuces t|e n..g|r.| .rJ .ve..ge tct.| ccsts c|
p.cJuc|rg .r c|| c|.rge by ´3. ¯|e |.ns n..g|r.| ccst cu.ve s|||ts tc /´
2
, .rJ |ts .ve..ge tct.| ccst cu.ve s|||ts tc
^¯´
2
. ¯|e s|c.t.ur |rJust.y supp|y cu.ve s|||ts Jc.r by ´3 tc .
2
. ¯|e n..ket p.|ce |.||s tc ´26, t|e |.n |rc.e.ses |ts
cutput tc ¸
2
.rJ e..rs .r eccrcn|c p.c|t g|ver by t|e s|.JeJ .ect.rg|e. |r t|e |crg .ur, t|e cppc.tur|ty |c. p.c|t
s|||ts t|e |rJust.y supp|y cu.ve tc .
3
. ¯|e p.|ce |.||s tc ´24, .rJ t|e |.n .eJuces |ts cutput tc t|e c.|g|r.| |eve|, ¸
1
. |t
rc. e..rs .e.c eccrcn|c p.c|t crce .g.|r. |rJust.y cutput |r |.re| (.) .|ses tc (
3
bec.use t|e.e ..e nc.e |.ns,
p.|ce |.s |.||er by t|e |u|| .ncurt c| t|e .eJuct|cr |r p.cJuct|cr ccsts.
A ieduction in pioduction cost shifts the fim's cost cuives down. The fim's aveiage total cost and
maiginal cost cuives shift down, as shown in Panel (b