Chapter 1 Introduction: What Is Economics?

Economics: The study of choices when there is scarcity.

Scarcity: The resources we use to produce goods and services are limited.
The Five Factors of Production
Factors of Production: The resources used to produce goods and services; also known
as production inputs or resources.

1 Natural Resources: Resources provided by nature and used to produce goods and
services.

2 Labor: Human effort, including both physical and mental, used to produce goods and
services.

3 Physical Capital: The stock of equipment, machines, structures, and infrastructure that
is used to produce goods and services.

4 Human Capital: The knowledge and skills acquired by a worker through education
and experience and used to produce goods and services.

5 Entrepreneurship: The effort used to coordinate the factors of production—natural

resources, labor, physical capital, and human capital—to produce and sell products.
Ceteris Paribus: The Latin expression meaning that other variables are held fixed.
Positive relationship: A relationship in which two variables move in the same direction.
Negative relationship: A relationship in which two variables move in opposite
directions.
Demand schedule: A table that shows the relationship between the price of a product and
the quantity demanded, ceteris paribus.
Individual demand curve: A curve that shows the relationship between the price of a
good and quantity demanded by an individual consumer, ceteris paribus.
Economic model: A simplified representation of an economic environment, often
employing a graph.
Positive Analysis: Answers the question “What is?” or “What will be?”
Normative Analysis: Answers the question “What ought to be?”
Positive Questions Normative Questions
If the government increases the minimum Should the government increase the
wage, how many workers will lose their minimum wage?
jobs?
If two office-supply firms merge, will the Should the government block the merger
price of office supplies increase? of two office-supply firms?
How does a college education affect a Should the government subsidize a college
person’s productivity and earnings? education?
How do consumers respond to a cut in Should the government cut taxes to
income taxes? stimulate the economy?
If a nation restricts shoe imports, who Should the government restrict imports?
benefits and who bears the cost?

Variable: A measure of something that can take on different values.

Ceteris Paribus: The Latin expression meaning that other variables are held fixed.
Marginal Change: A small, one-unit change in value

Macroeconomics: The study of the nation’s economy as a whole; focuses on the issues
of inflation, unemployment, and economic growth.
Microeconomics: The study of the choices made by households, firms, and governments,
and how these choices affect the markets for goods and services.
Positive relationship: A relationship in which two variables move in the same direction.
Negative relationship: A relationship in which two variables move in opposite
directions.
Slope of a curve: The vertical difference between two points (the rise) divided by the
horizontal difference (the run).
Chapter 2 The Key Principles of Economics
Opportunity Cost: What you sacrifice to get something. “There is no such thing as a
free lunch”
Production possibilities curve: A curve that shows the possible combinations of
products that an economy can produce, given that its productive resources are fully
employed and efficiently used.
Marginal benefit: The additional benefit resulting from a small increase in some activity.
Marginal cost: The additional cost resulting from a small increase in some activity.
The marginal principle: Increase the level of an activity as long as its marginal benefit
exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal
cost.
The principle of voluntary exchange: A voluntary exchange between two people
makes both better off.
The principle of diminishing returns: Suppose output is produced with two or more
inputs, and we increase one input while holding the other input or inputs fixed. Beyond
some point—called the point of diminishing returns—output will increase at a decreasing
rate.
The real-nominal principle: What matters to people is the real value of money or
income—its purchasing power—not its face value.
Nominal value: The face value of an amount of money.
Real value: The value of an amount of money in terms of what it can buy.
Chapter 3 Demand, Supply, and Market Equilibrium
Perfectly competitive market: A market with many buyers and sellers of a
homogeneous product and no barriers to entry.
Quantity demanded: The amount of a product that consumers are willing and able to
buy.

The Individual Demand Curve

Demand schedule: A table that shows the relationship between the price of a product and
the quantity demanded, ceteris paribus.
Individual demand curve: A curve that shows the relationship between the price of a
good and quantity demanded by an individual consumer, ceteris paribus.
Law of demand: There is a negative relationship between price and quantity demanded,
ceteris paribus.
Change in quantity demanded: A change in the quantity consumers are willing and
able to buy when the price changes; represented graphically by movement along the
demand curve.
Market demand curve: A curve showing the relationship between price and quantity
demanded by all consumers, ceteris paribus.

The Individual Supply Curve

Supply schedule: A table that shows the relationship between the price of a product and
the quantity supplied, ceteris paribus.
Individual demand curve: A curve that shows the relationship between the price of a
good and quantity supplied by an individual firm, ceteris paribus.
Law of supply: There is a positive relationship between price and quantity supplied,
ceteris paribus.
Minimum supply price: The lowest price at which a product will be supplied.
Change in quantity supplied: A change in the quantity firms are willing and able to
sell when the price changes; represented graphically by movement along the supply curve.
Why Is the Market Supply Curve Positively Sloped?
There are two reasons why the market supply curve is positively sloped. As the market price
increases,

1. Individual firms increase output by purchasing more materials and hiring more
workers; and

2. New firms enter the market, encouraged by the higher price.

Market Equilibrium
Market equilibrium: A situation in which the quantity demanded equals the quantity
supplied at the prevailing market price.
Excess demand: A situation in which, at the prevailing price, the quantity demanded
exceeds the quantity supplied.
Excess supply: A situation in which the quantity supplied exceeds the quantity demanded
at the prevailing price.
Change in demand: A shift of the demand curve caused by a change in a variable other
than the price of the product.
An income change: Consumers buy more vacations and new cars when their income
increases. We call these normal goods. But consumers buy less of some goods (like
second-hand clothing, or ramen noodle packets) when their income increases: these are
inferior goods.
Normal good: A good for which an increase in income increases demand.
Inferior good: A good for which an increase in income decreases demand.
Substitutes: Two goods for which an increase in the price of one good increases the
demand for the other good.
Complements: Two goods for which a decrease in the price of one good increases the
demand for the other good.
Change in supply: A shift of the supply curve caused by a change in a variable other
than the price of the product.

Market Effects of Changes in Demand or Supply

Chapter 4 Elasticity: A Measure of Responsiveness
The Price Elasticity of Demand
Price elasticity of demand (Ed): A measure of the responsiveness of the quantity
demanded to changes in price; equal to the absolute value of the percentage change in
quantity demanded divided by the percentage change in price.

Elastic demand: The price elasticity of demand is greater than one, so the percentage
change in quantity exceeds the percentage change in price.
Example goods: restaurant meals, air travel, movies.

Inelastic demand: The price elasticity of demand is less than one, so the percentage
change in quantity is less than the percentage change in price.
Example goods: milk, salt, eggs, coffee, cigarettes.

Unit elastic demand: The price elasticity of demand is one, so the percentage change in
quantity equals the percentage change in price.
Example goods: housing, juice.

Perfectly inelastic demand: The price elasticity of demand is zero.

In this extreme case, the quantity demanded does not change when the price changes. This
could only happen if there were no possible substitutes for the good, say insulin for
diabetics.
Perfectly elastic demand: The price elasticity of demand is infinite.
In this extreme case, buyers will buy as much as sellers can offer at the given price. When a
seller provides a tiny fraction of output for the market, this may be a good assumption.

Using Price Elasticity

Total revenue: The money a firm generates from selling its product.
Total revenue = Price × Quantity sold
Good news: it gets more money for each product sold.
Bad news: it sells fewer products.

When elasticity is high, the “bad news” is large, and total revenue falls.

When elasticity is low, the “bad news” is small, and total revenue rises.

Income elasticity of demand: A measure of the responsiveness of demand to changes

in consumer income; equal to the percentage change in the quantity demanded divided by
the percentage change in income.

Cross-price elasticity of demand: A measure of the responsiveness of demand to

changes in the price of another good; equal to the percentage change in the quantity
demanded of one good (X) divided by the percentage change in the price of another good
(Y).

Price elasticity of supply: A measure of the responsiveness of the quantity supplied to

changes in price; equal to the percentage change in quantity supplied divided by the
percentage change in price.
Perfectly inelastic supply: The price elasticity of supply equals zero.
Perfectly elastic supply: The price elasticity of supply is equal to infinity.
Predicting Changes in Quantity Supplied
Chapter 5 Production Technology and Cost
Economic profit: Total revenue minus economic cost. economic profit = total revenue – economic cost
Economic cost: The opportunity cost of the inputs used in the production process; equal
to explicit cost plus implicit cost.
Explicit cost: A monetary payment.
Implicit cost: An opportunity cost that does not involve a monetary payment.
Accounting cost: The explicit costs of production.
Accounting profit: Total revenue minus accounting cost. Accounting profit = total revenue – accounting cost
Total-product curve: A curve showing the relationship between the quantity of labor
and the quantity of output produced, ceteris paribus.
Marginal product of labor: The change in output from one additional unit of labor.
Diminishing returns: As one input increases while the other inputs are held fixed,
output increases at a decreasing rate.

Short-Run Total Cost

Fixed cost (FC): Cost that does not vary with the quantity produced.
Variable cost (VC): Cost that varies with the quantity produced.
Short-run total cost (TC): The total cost of production when at least one input is fixed;
equal to fixed cost plus variable cost.
Average fixed cost (AFC): Fixed cost divided by the quantity produced.
Average variable cost (AVC): Variable cost divided by the quantity produced.
Short-run average total cost (ATC): Short-run total cost divided by the quantity
produced; equal to AFC plus AVC.
Short-run marginal cost (MC): The change in short-run total cost resulting from a
one-unit increase in output.
Long-run total cost (LTC): The total cost of production when a firm is perfectly
flexible in choosing its inputs.
Long-run average cost (LAC): The long-run cost divided by the quantity produced.
Constant returns to scale: A situation in which the long-run total cost (LTC) increases
proportionately with output, so average cost is constant.
Long-run marginal cost (LMC): The change in long-run cost resulting from a
one-unit increase in output.
Indivisible input: An input that cannot be scaled down to produce a smaller quantity of
output.
Economies of scale: A situation in which the long-run average cost (LAC) of production
decreases as output increases.
Minimum efficient scale: The output at which scale economies are exhausted.
Diseconomies of scale: A situation in which the long-run average cost (LAC) of
production increases as output increases.
Chapter 6 Perfect Competition
Perfectly competitive market: A market with many sellers and buyers of a
homogeneous product and no barriers to entry.
Price taker: A buyer or seller that takes the market price as given.
Features of a Perfectly Competitive Market
Here are the five features of a perfectly competitive market:
1. There are many sellers.
2. There are many buyers.
3. The product is homogeneous.
4. There are no barriers to market entry.
5. Both buyers and sellers are price takers.
Firm-specific demand curve: A curve showing the relationship between the price
charged by a specific firm and the quantity the firm can sell.

Characteristics of the Four Market Structures

Characteristics Perfect Monopolistic Oligopoly Monopoly
Competition Competition
Number of Many Many Few One
firms
Type of product Homogeneous Differentiated Homogeneous or Unique
differentiated
Firm-specific Demand is Demand is Demand is less Firm faces
Demand curve perfectly Elastic elastic but not elastic than market demand
perfectly elastic demand facing curve
monopolistically
competitive firm
Entry No barriers No barriers Large barriers Large barriers
conditions from economies from
of scale or economies of
government scale or
policies government
policies
Examples Corn, plain Toothbrushes, Air travel, Local phone
T-shirts music stores, automobiles, service,
groceries beverages, patented drugs
cigarettes, mobile
phone
economic profit: total revenue minus economic cost.
Marginal revenue: The change in total revenue from selling one more unit of output.
Break-even price: The price at which economic profit is zero; price equals average total
cost (ATC).
short-run decision: the firm has some fixed costs.

Shut-down price: The price at which the firm is indifferent between operating and
shutting down; equal to the minimum average variable cost.
Sunk cost: A cost that a firm has already paid or committed to pay, so it cannot be
recovered.
Short-run supply curve: A curve showing the relationship between the market price of
a product and the quantity of output supplied by a firm in the short run.
Short-run market supply curve: A curve showing the relationship between the
market price and quantity supplied in the short run.
Long-run market supply curve: A curve showing the relationship between the
market price and quantity supplied in the long run.
Increasing-cost industry: An industry in which the average cost of production
increases as the total output of the industry increases; the long-run supply curve is positively
sloped.
Increasing input price: As the industry grows, it competes with other industries for
scarce inputs, raising their price, and hence the break-even price in the industry.
Less productive inputs: A small industry uses only the most productive inputs, but as it
grows it will be forced to use less productive inputs.
Constant-cost industry: An industry in which the average cost of production is
constant; the long-run supply curve is horizontal.
Chapter 7 Monopoly and Price Discrimination
Monopoly: A market in which a single firm sells a product that does not have any close
substitutes.
Barrier to entry: Something that prevents firms from entering a profitable market.
Market power: The ability of a firm to affect the price of its product.
Barriers to Entry
Patent: The exclusive right to sell a new good for some period of time.
Network externalities: The value of a product to a consumer increases with the
number of other consumers who use it.
Natural monopoly: A market in which the economies of scale in production are so large
that only a single large firm can earn a profit.

Price discrimination: The practice of selling a good at different prices to different

consumers.

Conditions for Price Discrimination

1. Market power: The firm must have some control over its price.
2. Different consumer groups: Groups of consumers that differ in their willingness to
pay for the product, along with the ability to distinguish these groups.
In this context,
3. Resale is not possible: Otherwise a low-price consumer could resell to a high-price "circumventing" means
consumer, circumventing the price discrimination. finding a way to bypass or
avoid
How to Price Discriminate
• Discounts on airline tickets
• Discount coupons for groceries and restaurant meals
• Manufacturers’ rebates for appliances
• Senior citizen or student discounts
Chapter 8 Market Entry, Monopolistic Competition, and Oligopoly
Monopolistic competition: A market served by many firms that sell slightly different
products.

Entry Squeezes Profit From Three Sides

As the new firm enters the market:
1. The market price drops.
2. The quantity produced by the first firm decreases.
3. The first firm’s average cost of production increases.

Monopolistic Competition
Under the market structure of monopolistic competition, firms will continue to enter the
market until economic profit is zero.
The key features of monopolistic competition are:
• Many firms
• A differentiated product
• No artificial barriers to entry
Product differentiation: The process used by firms to distinguish their products from
the products of competing firms.

Trade-Offs with Entry and Monopolistic Competition

• The average cost is higher than minimum. Why? A larger firm could spread fixed costs out
more, reducing price.
• But we gain with increased variety: restaurants selling different types of food, apparel
firms selling different styles of clothes, etc.
• When firms differentiate by location, we gain through convenience: a shorter trip to the
store.
Oligopoly: A market served by a few firms.
Concentration ratio: The percentage of the market output produced by the largest
firms.
The main alternative measure of concentration is
Herfindahl Hirschman Index (HHI), obtained by summing the squares of the
percentage market shares of all firms in the market.
Why Do Oligopolies Exist?
1. Government barriers to entry: the government may limit the number of firms in
the market.
2. Economies of scale in production: similar to natural monopoly, but with smaller
scale economies that are not large enough to generate a natural monopoly.
3. Advertising campaigns: Breaking into some markets can be difficult without a very
large and expensive advertising campaign.

Monopoly Versus Duopoly

Duopoly: A market with two firms.
Cartel: A group of firms that act in unison, coordinating their price and quantity
decisions.
Price fixing: An arrangement in which firms conspire to fix prices.

Game tree: A graphical representation of the consequences of different actions in a

strategic setting.
Dominant strategy: An action that is the best choice for a player, no matter what the
other player does.
Duopolists’ dilemma: A situation in which both firms in a market would be better off
if both chose the high price, but each chooses the low price.
Nash equilibrium: An outcome of a game in which each player is doing the best he or
she can, given the action of the other players.
Low-price guarantee: A promise to match a lower price of a competitor.
Some Repeated Game Strategies (Essay)
1. A duopoly pricing strategy: Simply choose the duopoly price for the lifetime of
the firm. This is not very profitable, but avoids being underpriced.
2. A grim-trigger strategy: Committing to a mutually destructive low-price strategy.
3. A tit-for-tat strategy: Mimicking this period whatever the other firm did last period.

Grim-trigger strategy: A strategy where a firm responds to underpricing by choosing

a price so low that each firm makes zero economic profit.
Tit-for-tat strategy: A strategy where one firm chooses whatever price the other firm
chose in the preceding period.
Price leadership: A system under which one firm in an oligopoly takes the lead in
setting prices.
Limit pricing: The strategy of reducing the price to deter entry.
Limit price: The price that is just low enough to deter entry.
Contestable market: A market with low entry and exit costs.
Trust: An arrangement under which the owners of several companies transfer their
decision-making powers to a small group of trustees.
Merger: A process in which two or more firms combine their operations.
Regulating Business Practices
• Tie-in sales: A business practice under which a business requires a consumer of one
product to purchase another product.
• Cooperative agreements to limit advertising.
• Predatory pricing: A firm sells a product at a price below its production cost to drive
a rival out of business and then increases the price.
Chapter 9 Imperfect Information, External Benefits, and External Costs
Imperfect information: Either buyers or sellers do not know enough about the product
to make informed decisions.
External benefits: The benefits of a product are not confined to the person who pays for
it.
External costs: The cost of producing a product is not confined to the person who sells it.
Asymmetric information: A situation in which one side of the market—either buyers
or sellers—has better information than the other.
Mixed market: A market in which goods of different qualities are sold for the same
price.
Adverse-selection problem: A situation in which the uninformed side of the market
must choose from an undesirable or adverse selection of goods.
Thin market: A market in which some high-quality goods are sold but fewer than would
be sold in a market with perfect information.
Experience rating: A situation in which insurance companies charge different prices
for medical insurance to different firms depending on the past medical bills of a firm’s
employees.
Moral hazard: A situation in which one side of an economic relationship takes
undesirable or costly actions that the other side of the relationship cannot observe.
External benefit: A benefit from a good experienced by someone other than the person
who buys the good.
Public good: A good that is available for everyone to consume, regardless of who pays
and who doesn’t; a good that is nonrival in consumption and nonexcludable.
Free rider: A person who gets the benefit from a good but does not pay for it.
Private good: A good that is consumed by a single person or household; a good that is
rival in consumption and excludable.
Private cost of production: The production cost borne by a producer, which typically
includes the costs of labor, capital, and materials.
External cost of production: A cost incurred by someone other than the producer.
Social cost of production: Private cost plus external cost.
Pollution tax: A tax or charge equal to the external cost per unit of pollution.
Command and Control
Command-and-control policies specify maximum amounts of pollution and mandate
particular pollution reduction technologies.
Economists discourage command-and-control approaches:
• Requiring the same technology for all firms is unlikely to be efficient when firms differ in
their production technology.
• Even worse, there is no incentive to improve beyond the mandated technology.

Marketable pollution permits: sometimes called (pollution allowances). A system

under which the government picks a target pollution level for a particular area, issues just
enough pollution permits to meet the pollution target, and allows firms to buy and sell the
permits; also known as a cap-and-trade system.

Voluntary Exchange and Marketable Permits

Making pollution permits marketable is sensible because it allows mutually beneficial
exchanges between firms with different abatement costs.
• This is another illustration of the principle of voluntary exchange: A voluntary
exchange between two people makes both people better off.
A firm with a low cost of pollution abatement would sell its permits (i.e., abate more
pollution); a firm with a high cost of pollution abatement would buy those permits.
• This system uses market forces to discover which firms have the lowest cost of
pollution abatement
Chapter 10 The Labor Market and the Distribution of Income
Marginal product of labor: The change in output from one additional unit of labor.
Marginal-revenue product of labor (MRP): The extra revenue generated from
one additional unit of labor; MRP is equal to the price of output times the marginal
product of labor.
Short-run demand curve for labor: A curve showing the relationship between the
wage and the quantity of labor demanded over the short run, when the firm cannot change
its production facility.
Long-run demand curve for labor: A curve showing the relationship between the
wage and the quantity of labor demanded over the long run, when the number of firms in
the market can change and firms can modify their production facilities.

Labor Demand in the Long Run

The long-run demand curve for labor slopes downward for two reasons:
1. The output effect: when wages are higher, the price of output will be higher; less
output will be demanded, and hence fewer workers also.
2. The input-substitution effect: when wages are higher, firms can substitute
toward other inputs.
Output effect: The change in the quantity of labor demanded resulting from a change in
the quantity of output produced.
Input-substitution effect The change in the quantity of labor demanded resulting from
an increase in the price of labor relative to the price of other inputs.
Substitution effect for leisure demand: The change in leisure time resulting from a
change in the wage (the price of leisure) relative to the price of other goods.
Income effect for leisure demand: The change in leisure time resulting from a
change in real income caused by a change in the wage.

An Example of Income and Substitution Effects

Suppose each nurse in Florence initially works 36 hours per week at an hourly wage of
$10 and the wage increases to $12.
1. Lester works fewer hours. If Lester works 30 hours instead of 36 hours, he gets 6
hours of extra leisure time and still earns the same income per week
($360 = 30 hours × $12 per hour).
2. Sam works the same number of hours. If Sam continues to work 36 hours per week,
he gets an additional $72 of income ($2 per hour × 36 hours) and the same amount of
leisure time.
3. Maureen works more hours. If Maureen works 43 hours instead of 36 hours, she
sacrifices 7 hours of leisure time but earns a total of $516, compared to only $360 at a
wage of $10 per hour.
Market supply curve for labor: A curve showing the relationship between the wage
and the quantity of labor supplied.

The College Premium

Learning effect: The increase in a person’s wage resulting from the learning of skills
required for certain occupations.
Signaling effect: The information about a person’s work skills conveyed by
completing college.
Labor union: A group of workers organized to increase job security, improve working
conditions, and increase wages and fringe benefits.
Featherbedding: Work rules that increase the amount of labor required to produce a
given quantity of output; may actually decrease the demand for labor.
Means-tested program: A program that restricts eligibility to people or households
with less than a specified maximum wealth or income.