CHAPTER 1

II. Why Study Economics? page 2

A. To Learn a Way of Thinking
Also described as a way to make decisions, the economic way of thinking
involves understading three fundamental concepts:
1. Opportunity Cost is the best alternative that we forgo, or give up, when we
make a choice or a decision. Every decision means giving up something.
Economists are fond of trade-offs as a way of thinking about decision
making. Taking one action usually means giving up something else. As
the text states, “The full cost of making a specific choice includes [the
value of] what we give up by not making the alternative choice.”
Opportunity costs arise because resources are scarce. Scarce means
limited. Resources are scarce because human wants exceed what we can
produce from our current resources.
2. Marginalism is the process of analyzing the additional or incremental costs
or benefits arising from a choice or decision. Marginal means a small
change. The text uses marginal cost, the cost of increasing production by
one unit. This can be illustrated by putting added miles on a car; the
change in the odometer reading is the marginal mileage.
3. Sunk Costs: “Sunk” means vanished. Sunk costs are costs that cannot be
avoided because they have already been incurred. Tthe time and money
have been spent and can’t be recovered. Sunk costs cannot be avoided,
regardless of what is done in the future, because they have already been
incurred. Therefore sunk costs are always irrelevant to decision making.
4. An efficient market is a market in which profit opportunities are
eliminated almost instantaneously. In efficient markets, profit
opportunities are eliminated rapidly by the actions of those seeking the
profits. Use the text’s example of checkout lines at a grocery store to make
the point that it is the people seeking the shortest line (express lines not
included!) whose actions result in all the lines being of about the same
length.
CHAPTER 3
SUPPLY AND DEMAND

Chapter Summary
On a long-ago episode of Saturday Night Live, a comedian (Don Novello, a.k.a. Father Guido Sarducci) got up
and gave a very brief lecture on economics. He held up one index finger and said “Supply.” He held up the other
index finger and said “Demand.” Then he brought them together to form an X and concluded “Supply and
Demand. That’s it.” And he was right; the two crossing curves, supply and demand, are the foundation of all
economics, and a powerful tool for understanding the real world.

The quantity demanded is the amount of a good that consumers want to buy at a given price, holding constant
all other factors that influence purchases. Other factors that influence purchases include tastes, information,
prices of other goods, income, and government rules and regulations.

The demand function shows the mathematical relationship between the quantity demanded , the price of the
product, and other factors that influence purchases. A demand curve plots the demand function, again holding
constant other factors. Demand curves are always graphed with the price per unit on the vertical axis and the
quantity (number of units per time period) on the horizontal axis. One of the most important finding of empirical
economics is the law of demand: consumers demand more of a product when the price is lower, holding all else
constant. The law of demand implies that demand curves slope downward, or that the derivative of quantity with
respect to price is negative.

The quantity supplied is the amount of a good that firms want to sell at a given price, holding constant all other
factors that influence firms’ supply decisions. Other factors that influence supply decisions include costs of
production, technology, and government rules and regulations.

The supply function shows the relationship between the quantity supplied, the price of the product, and other
factors that influence the number of units supplied. A supply curve shows the quantity supplied at each
possible price, again holding constant other factors that influence supply decisions. Like demand curves, supply
curves are graphed with the price per unit on the vertical axis and the quantity on the horizontal axis. Most
supply curves for goods and services slope upward—when the price is higher, firms are willing to sell more.

An equilibrium exists if no market participant wants to change its behavior. In a market, equilibrium occurs at
the price and quantity where the demand curve and the supply curve intersect. Market forces—actions of
consumers and firms—will drive the price and quantity to their equilibrium levels. If the price is initially lower
than the equilibrium price, there will be excess demand; consumers will want to buy more than suppliers want
to sell. Frustrated consumers will offer to pay firms more than the initial price and/or firms, noticing these
disappointed consumers, will raise their prices. Both actions will drive up the price toward the equilibrium. If
the price is initially above the equilibrium price, there will be excess supply—the consumers will want to buy
less than the suppliers want to sell. In order to sell all that they have made, firms will cut the price—rather than
paying storage costs, letting the product spoil, or having it remain unsold. At the equilibrium price, firms are
willing to sell exactly the quantity that consumers are willing to buy and no one has an incentive to pay more or
cut the price. The equilibrium price is often called the market clearing price, because at that price, there is
neither excess supply nor excess demand.

Once an equilibrium is reached, it can persist indefinitely, but if a change in some determinant of supply or
demand causes either (or both) curves to shift, the market will move to a new equilibrium. A shift of the demand
curve causes a movement along the supply curve. A shift of the supply curve causes a movement along the
demand curve.

Assuming that the demand curve slopes downward and that the supply curve slopes upward, the result of
demand or supply curve shifts is predictable. Analysis of how variables such as price and quantity react to
changes in environmental or exogenous variables is called comparative statics, comparing a static equilibrium
to the new (static) equilibrium that results from the change.
When demand rises (shifts outward), the equilibrium price and quantity will rise. When demand falls (shifts
inward), the equilibrium price and quantity fall. When supply falls (shifts inward), the equilibrium price will rise
and equilibrium quantity will fall. When supply rises (shifts outward), the equilibrium price will fall and
equilibrium quantity will rise. Both the size of the change in the environmental variable and the shape of supply
and demand curves have an impact on the magnitude of the changes.

Problems:
1. The following problem gives the supply and demand for Spam in two different markets. Calculate the
equilibrium price and quantity of Spam in each of the two markets, and graph the supply and demand
curves in each case.

Case 1: Base camp at the bottom of Mount Everest (the highest mountain in the world)

Qd  100  2 p
Qs  40  p
where quantity is measured in cases of Spam per week and p is the price of a case of Spam in dollars.

Case s: At the top of Mount Everest

Qd  100  2 p
Qs  80  p
Give an explanation for the difference between the two supply curves.

Case 1:
Step one: Find the equilibrium price at the base camp by remembering that equilibrium requires that the
price adjust to the point where quantity supplied, Qs, equals quantity demanded, Qd. Algebraically:
100  2 p  40  p or
60  3 p or
20  p
Step two: Find the equilibrium quantity by plugging the equilibrium price into the quantity supplied or the
quantity demanded equation. It is a good idea to plug the price into BOTH equations. The quantity will be
the same in both equations. If it is not, then you’ve made a mistake.
Qd  100  (2  20)  60
Qs  40  20  60
Step three: To graph a linear equation, find two points on the line and connect the dots. For a demand
curve, it is easiest to find the points along the vertical and horizontal axes. Along the horizontal axis the
price is zero. Putting a price of zero into the equation for quantity demanded reveals that consumers will
take 100 cases of Spam if the price is zero (i.e., they are giving Spam away for nothing). This is point A in
Figure 2.3. Along the vertical axis the quantity demanded is zero. Set Qd  0 and solve for p. This tells the
price at which consumers are no longer willing to buy Spam.
0  100  2 p, so

p  $50 where the demand curve hits the vertical axis. This is point B in Figure 2.3.

Graphing the supply curve is a bit more difficult because supply curves usually only hit one axis.

However, we know the point where the supply curve intersects the demand curve, so we can hook up these
two points.

Putting p  0 into the quantity supplied equation shows that the supply curve hits the horizontal axis at 40.
This is point C in Figure 2.3.

Finally, the supply and demand curves intersect where price is $20 and quantity is 60. This is point E in Figure
2.3.
 One important note about supply and demand curves: they are often estimated to be linear, but the estimates
are only reliable in the range of observation. These estimates are better in the range near where the market
is or has been in the past, but at extremely high or low prices these estimates are not always reliable. Since
no one has ever given Spam away for free or sold a case for $1, we don’t really know how much Spam
people would take or buy at these low prices. The bottom line is that the ends of both supply and demand
curves may not always tell us something that is economically meaningful. In this case, for example, it is
unlikely that suppliers would give away 40 cases of Spam per week if the price were zero.

3. In the following two cases, find and graph the market demand curve.

Case 1: There are 5 identical consumers with the following demand curve:
Qdi  100  2 p
Case 2: There are two consumers. Demand for the first consumer is:
Qd 1  100  2 p
Demand for the second consumer is:
Qd 2  200  p
Case 1:
Step one: To find a market demand curve, recall that you must add the quantity of each consumer at each
price. To do this, always be sure that the demand equation is arranged so that quantity is on the left
hand side.
Qdi  100  2 p
Step 2: Total market demand, Q, is equal to the sum of the individual demand curves. Since price must be
equal for all consumers, we can simply add the p variables together.

5 5 5 5
Q   Qdi   (100  2 p )   100   2 p  500  10 p
i 1 i 1 i 1 i 1

Q  500  10 p

2.The European Union has a policy of subsidizing farmers and then exporting the excess supply to poorer
countries. One report examined how these policies have affected the beef market in West Africa. In 1975,
cattle from the Sahel (the part of Africa just south of the Sahara) accounted for two-thirds of the beef
consumed in the Ivory Coast. By 1991, beef from the Sahel accounted for only one-quarter of the beef in
the Ivory Coast market. In 1991, the EC dumped tens of millions of tons of beef in West Africa. Assuming
that nothing else changed between 1975 and 1991, draw a graph showing how the EC’s beef exports
influenced the market in the Ivory Coast. (Source: “Overstuffing Africa,” The Economist, May 8, 1993.)
CHAPTER 4
II. The Price System: Rationing and Allocating Resources, pages 73-80
A. The price system performs two important and closely related functions.
1. It allocates goods and services when there is a shortage (price rationing).
2. It determines the allocation of resources among producers and hence the
final mix of outputs.
B. Price Rationing
1. Price rationing is the process by which the market system allocates goods
and services to consumers when quantity demanded exceeds quantity supplied.
2. Price rationing eliminates shortages and surpluses in free markets.
3. When there is a shortage or surplus the price will adjust in the direction of
equilibrium.
Unique Economics in Practice
For the 2008 fishing season, salmon fishing was banned off the coasts of
northern California and southern Oregon. At the same time bad weather
in Alaska limited the salmon catch from that source. According to the
Alaska Public Radio Network prices for wild salmon ranged from $9.77
to $10.25 per pound. The prized Copper River salmon carried a hefty
retail price of $45 to $50 per pound. Alaska Airlines had expected to ship
20,000 pounds of salmon. Their actual shipments were 7,500 pounds.
Sources:
http://aprn.org/2008/02/04/southeast-salmon-prices-at-record-highs/
http://www.seafoodsource.com/NST-3-50041552/Copper-River-Salmon-Prices-Reach-50-a-Pound.aspx
Question: Is there a shortage in this market? Explain your answer.
Answer: There is no shortage. The high price in this market simply
reflects increased scarcity. However the market is in equilibrium.
C. Constraints on the Market and Alternative Rationing Mechanisms
1. Governments and private firms sometimes decide to ration a particular
product using some nonprice mechanism.
2. The rationale given for this is usually “fairness” which includes:
a. price-gouging is “bad”;
b. income is distributed “unfairly”; and
c. some items are “necessities” and everyone should be able to buy
them at a “reasonable” price.

3. There are two key results.

a. Attempts to use non-price rationing are usually
more difficult and more costly than expected.
 b. Very often such attempts distribute costs and
benefits among households in unintended ways (the
law of unintended consequences again).
3. Oil, Gasoline, and OPEC
a. In 1973 and 1974 the OPEC oil embargo
reduced the quantity of gasoline available in the U.S.
i. If the market system had been allowed to
operate gasoline prices would have risen
dramatically. A good estimate was an
equilibrium price of $1.50 per gallon
(remember, this was the mid-1970s).
ii. Congress imposed a price ceiling of
$0.57 per gallon on gasoline.
b. A price ceiling is a maximum price that sellers
may charge for a good, usually set by government.
c. The “fairness” rationale was that the price ceiling would keep
gasoline from being so expensive that the poor could not afford it.
d. This did not resolve the problem of excess demand. Instead some
other mechanism was used to ration. The three most common
methods are queuing, favored customers, and ration coupons.
i. In 1974 the non-price rationing mechanism was queuing.
Queuing means waiting in line as a means of distributing
goods and services: a nonprice rationing mechanism.
ii. A second non-price rationing device was favored customers.
Favored customers are those who receive special treatment
from dealers during situations of excess demand. Some
gasoline stations only sold to favored customers. Some non-
favored customers tried to become favored by paying “side
payments” (bribes) to station owners.
iii. A ration coupon system requires two means of payment for a
product. One payment is money. The other (and limiting)
payment is ration coupons. This device was not used in the
U.S. during the 1970s. Ration coupons are tickets or coupons
that entitle individuals to purchase a certain amount of a
given product per month.
E. A price floor is a minimum price below which exchange is not permitted.
1. The result will be excess supply (a surplus).
2. The minimum wage is probably the most famous example of a price floor. A
minimum wage is a price floor set for the price of labor.
IV. Supply and Demand and Market Efficiency, pages 81-85
A. Price rationing is the key to understanding how markets allocate scarce goods and
services.
1. Supply and demand can also be used to measure market efficiency.
2. Economists use consumer surplus and producer surplus to measure
changes in market efficiency.
 B. Consumer Surplus
1. A demand curve reveals the maximum prices consumers would be willing
to pay for various quantities of a product.
2. In most markets, however, the product actually is sold at only one price.
3. Consumers who would have been willing to pay more for the product are
getting a good deal.
4. Consumer surplus is the difference between the maximum amount a
person is willing to pay for a good and its current market price.
5. Since we usually deal with market demand curves, we measure total
consumer surplus as the total amount consumers would have been willing to
spend. Total consumer surplus is the area between the demand curve and the
market price.
C. Producer Surplus
1. A supply curve reveals the minimum prices at which sellers would be
willing to sell various quantities of the product.
2. In most markets, however, the product actually is sold at only one price.
3. Producers who would have been willing to sell the product for less are
earning producer surplus.
4. Producer surplus is the difference between the current market price and
the full cost of production for the firm.
5. Since we usually deal with market supply curves, we measure total
producer surplus as the area between the supply curve and the market price.
D. Competitive Markets Maximize the Sum of Producer and Consumer Surplus
1. Total surplus is the sum of producer and consumer surplus.
2. In equilibrium a competitive market maximizes total surplus.
3. If either the price or quantity is restricted there will be a deadweight loss.
The deadweight loss is the total loss of producer and consumer surplus from
underproduction or overproduction.
E. Potential Causes of Deadweight Loss from Under- and Overproduction
1. Monopoly power.
2. Taxes and subsidies.
3. External costs or benefits.
4. Price ceilings and floors.
 Excess
P1
Supply

Excess
P2
Demand D
 º

III. Supply and Demand Analysis: An Oil Import Fee, pages 80-81
A. Should the U.S. impose a tariff on imported oil? By using the tools of supply and
demand we can see the preliminary results.
B. Imposing this fee would increase domestic oil production and reduce domestic
demand. U.S. oil imports would decrease.
C. This would have the benefits of reducing air pollution, U.S. dependency on foreign
oil, and the trade deficit. (The issues of “dependency” and the “trade deficit” are
normative economics.)
D. Will oil exporting countries retaliate with tariffs of their own?
 Practice

2. Your opportunity cost of attending college does not include

(a) the money you spend on meals while at college.
(b) your tuition.
(c) the money you spend on traveling between home and college.
(d) the income you could have earned if you’d been employed full-time.
ANSWER: (a) You would have bought food whether or not you were at college. All the
other expenses occur solely because of attending college.

3.            may be defined as the extra cost associated with an action.

(a) Marginal cost
(b) Operational cost
(c) Opportunity cost
(d) Action cost
ANSWER: (a) Refer to p. 2. Marginalism is a fundamental tool of economic analysis.

4. Jean owns a French restaurant—La Crème. Simply to operate this week, he must pay rent,
taxes, wages, food costs, and so on. This amounts to $1,000 per week. This evening, a diner
arrives and orders a bottle of Château Neuf du Pape wine to go with her meal. Jean has none
and sends out to Wine World for a bottle. It costs $20, and Jean charges his guest $30. Which
of the following is true for Jean?
(a) The marginal cost of the wine is $20.
(b) The marginal cost of the wine is $30.
(c) The efficiency cost of the meal is $1,020.
(d) The efficiency cost of the meal is $1,030.
ANSWER: (a) The up-front expense is $1,000. The extra cost that Jean bears for buying the
wine is $20. “Efficiency cost” is not a real term.
Practice
3. A decrease in the supply of American cars might be caused by
(a) an increase in the price of imported Japanese cars.
(b) an increase in the wages of U.S. car workers.
(c) an increase in demand that causes car prices to rise.
(d) a reduction in the cost of steel.
ANSWER: (b) The supply of American cars will decrease if input prices, such as the wages
of U.S. car workers, increase. Refer to p. 59.

4. Energizer batteries and Duracell’s Coppertop batteries are substitutes. The Energizer Bunny
cuts supply and increases the price of its batteries. Equilibrium price will            and quantity
exchanged will            in the market for Duracell.
(a) rise; rise
(b) fall; rise
(c) fall; fall
(d) rise; fall
ANSWER: (a) If Energizer increases the price of its batteries, consumers will switch over to
substitutes such as Duracell, increasing the demand for Duracell. This will
raise both equilibrium price and quantity.

5. Barney’s Bowling Balls and Fred’s Bowling Shoes are complements. Fred notices a decrease
in the quantity demanded of bowling shoes (a movement along his demand curve). This could
have been caused by
(a) a decrease in the income of Fred’s customers.
(b) an increase in the price of Fred’s Bowling Shoes.
 (c) an increase in the price of Barney’s Bowling Balls.
(d) an increased expectation that Fred will reduce the price of his bowling balls in the
near future.
ANSWER: (b) This is a change in quantity demanded, not a change in demand! The only
thing that can cause a change in quantity demanded is a change in price.
Refer to p. 53.

6. As the price of oranges increases, orange growers will

(a) use more-expensive methods of growing oranges.
(b) use less-expensive methods of growing oranges.
(c) increase the supply of oranges.
(d) decrease the supply of oranges.
ANSWER: (a) An increase in price results in an increase in quantity supplied. Suppliers are
able to produce more because, at the higher price, they can afford to hire
more-expensive resources. Refer to p. 59.

7. The supply of oranges to households will shift to the right if

(a) the price of oranges increases.
(b) oranges are rumored to have been treated with an insecticide that causes heart
disease.
(c) the Florida government requires that all orange workers be given more substantial
health benefits by employers.
(d) citrus growers see the price of grapefruits decreasing permanently.
ANSWER: (d) As the price of grapefruits falls, citrus farmers will switch over to another
production option—oranges. Refer to p. 59.
13. The demand curve diagram has
(a) “price” on the vertical axis, “quantity demanded per time period” on the horizontal
axis, and an upward sloping demand curve.
(b) “price” on the horizontal axis, “quantity demanded per time period” on the vertical
axis, and an upward sloping demand curve.
(c) “price” on the vertical axis, “quantity demanded per time period” on the horizontal
axis, and a downward sloping demand curve.
(d) “price” on the horizontal axis, “quantity demanded per time period” on the vertical
axis, and a downward sloping demand curve.
ANSWER: (c) Refer to p. 49.

14. We are trying to explain the law of demand. When the price of pretzels rises,
(a) the opportunity cost of pretzels increases along the demand curve.
(b) sellers switch production and increase the quantity supplied of pretzels.
(c) income rises for producers of pretzels.
(d) the opportunity cost of other goods increases.
ANSWER: (a) Refer to p. 50 for a full explanation of the negative relationship between price
and quantity demanded.
20. Equilibrium quantity will certainly decrease if
(a) demand and supply both increase.
(b) demand and supply both decrease.
(c) demand decreases and supply increases.
(d) demand increases and supply decreases.
ANSWER: (b) A decrease in demand will decrease equilibrium quantity. Similarly, a
decrease in supply will decrease equilibrium quantity.
21. The market for canned dog food is in equilibrium when
(a) the quantity demanded is less than the quantity supplied.
 (b) the demand curve is downward-sloping and the supply curve is upward-sloping.
(c) the quantity demanded and the quantity supplied are equal.
(d) all inputs producing canned dog food are employed.
ANSWER: (c) A market is in equilibrium when price has adjusted to make the quantity
demanded and the quantity supplied equal. Refer to p. 62.
22. In the market for broccoli, the price of broccoli will certainly increase if the supply of
broccoli
(a) increases and the demand for broccoli increases.
(b) increases and the demand for broccoli decreases.
(c) decreases and the demand for broccoli increases.
(d) decreases and the demand for broccoli decreases.
ANSWER: (c) An increase in demand will increase equilibrium price. Similarly, a decrease
in supply will increase equilibrium price.

23. In the market for mushrooms, the price of mushrooms will certainly increase if the supply
curve shifts
(a) right and the demand curve shifts right.
(b) right and the demand curve shifts left.
(c) left and the demand curve shifts right.
(d) left and the demand curve shifts left.
ANSWER: (c) When demand increases and supply decreases, both shifts are prompting a
price increase.

24. In the market for broccoli, the equilibrium quantity of broccoli will certainly increase if the
supply of broccoli            and the demand for broccoli            .
(a) increases; increases
(b) increases; decreases
(c) decreases; increases
(d) decreases; decreases
ANSWER: (a) An increase in supply will increase the quantity traded; similarly, an increase
in demand will increase the quantity traded.¾

Practice

1. In a market, either price must increase or nonprice rationing must occur when            exists.
(a) a shortage
(b) a surplus
(c) a horizontal demand curve
(d) a vertical supply curve
ANSWER: (a) Given a shortage, either price will increase (price rationing) or nonprice
rationing must be enforced.

2. In a free market, the rationing mechanism is

(a) price.
(b) quantity.
(c) demand.
(d) supply.
ANSWER: (a) Given an imbalance between quantity demanded and quantity supplied, a free
market will adjust price to achieve equilibrium.

6. Herman reduces the price of his Humongous Hoagie (a substitute for the Supreme
Submarine). At the Supreme Submarine’s initial equilibrium price, there will be an excess
 (a) demand of 100 units.
(b) demand of 200 units.
(c) supply of 100 units.
(d) supply of 200 units.
ANSWER: (c) Demand has decreased to D2. Supply has not changed. At a price of $5,
quantity demanded is 200 units and quantity supplied is 300 units.

7. Herman reduces the price of his Humongous Hoagie (a substitute for the Supreme
Submarine). Following any shifts in the curves, we would expect a(n)            in the Supreme
Submarine market.
(a) increase in quantity demanded and an increase in quantity supplied.
(b) increase in quantity demanded and a decrease in quantity supplied.
(c) decrease in quantity demanded and an increase in quantity supplied.
(d) decrease in quantity demanded and a decrease in quantity supplied.
ANSWER: (b) Demand has decreased to D2. Supply has not changed. There is an excess
supply which will cause Sam’s price to fall. A fall in price will increase
quantity demanded and decrease quantity supplied.¾
8. A price ceiling is set below the equilibrium price. We can predict that
(a) quantity demanded will decrease.
(b) quantity supplied will be greater than quantity demanded.
(c) demand will be less than supply.
(d) quantity supplied will decrease.
ANSWER: (d) Price will be reduced by the price ceiling. A decrease in price causes quantity
supplied to decrease (not a shift in the supply curve).

9. A price ceiling is set below the equilibrium price. We can predict that
(a) there will be a leftward shift in the demand curve.
(b) there will be a leftward shift in the supply curve.
(c) quantity demanded will be greater than quantity supplied.
(d) quantity supplied will be reduced to equal quantity demanded.
ANSWER: (c) A change in price does not cause the demand and/or supply curve to shift
position! If price is “too low,” a shortage (quantity demanded greater than
quantity supplied) will occur.

10. A price floor is set below the current equilibrium price. If supply increases, price would
(a) increase.
(b) decrease.
(c) not change.
(d) be indeterminate.
ANSWER: (b) Initially, the price floor will have no effect. As supply increases, there will
be a pressure for the market price to fall. If the price falls enough, then the
price floor will become effective.

11. Ticket scalping will be successful if

(a) the demand curve is fairly steep.
(b) the demand curve is fairly flat.
(c) the official price is below the equilibrium price.
(d) the official price is above the equilibrium price.
ANSWER: (c) The slope of the demand curve is irrelevant in this case. The important issue
is that a shortage of tickets exists because the official price has been set too
low.¾