"we should support the market because it is efficient" is an example of:

1: Economics and Economic Reasoning

In my vacations, I visited the poorest quarters of several cities and walked through one street after another, looking at the faces of the poorest people. Next I resolved to make as thorough a study as I could of Political Economy.

—Alfred Marshall

What Economics Is

Economics is the study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society. One of the key words in the definition of the term “economics” is coordination. Coordination can mean many things. In the study of economics, coordination refers to how the three central problems facing any economy are solved. These central problems are

1. What, and how much, to produce.

2. How to produce it.

3. For whom to produce it.

Three central coordination problems any economy must solve are what to produce, how to produce it, and for whom to produce it.

How hard is it to make the three decisions? Imagine for a moment the problem of living in a family: the fights, arguments, and questions that come up. “Do I have to do the dishes?” “Why can't I have piano lessons?” “Bobby got a new sweater. How come I didn't?” “Mom likes you best.” Now multiply the size of the family by millions. The same fights, the same arguments, the same questions—only for society the questions are millions of times more complicated. In answering these questions, economies find that inevitably individuals want more than is available, given how much they're willing to work. That means that in our economy there is a problem of scarcity—the goods available are too few to satisfy individuals' desires.

The coordination questions faced by society are complicated.

Scarcity has two elements: our wants and our means of fulfilling those wants. These can be interrelated since wants are changeable and partially determined by society. The way we fulfill wants can affect those wants. For example, if you work on Wall Street, you will probably want upscale and trendy clothes. Up here in Vermont, I am quite happy wearing Levi's and flannel.

The quantity of goods, services, and usable resources depends on technology and human action.

The degree of scarcity is constantly changing. The quantity of goods, services, and usable resources depends on technology and human action, which underlie production. Individuals' imagination, innovativeness, and willingness to do what needs to be done can greatly increase available goods and resources. Who knows what technologies are in our future—nannites or micromachines that change atoms into whatever we want could conceivably eliminate scarcity of goods we currently consume. But they would not eliminate scarcity entirely since new wants are constantly developing.

So, how does an economy deal with scarcity? The answer is coercion. In all known economies, coordination has involved some type of coercion—limiting people's wants and increasing the amount of work individuals are willing to do to fulfill those wants. The reality is that many people would rather play than help solve society's problems. So the basic economic problem involves inspiring people to do things that other people want them to do, and not to do things that other people don't want them to do. Thus, an alternative definition of economics is that it is the study of how to get people to do things they're not wild about doing (such as studying) and not to do things they are wild about doing (such as eating all the lobster they like), so that the things some people want to do are consistent with the things other people want to do.

A Guide to Economic Reasoning

People trained in economics think in a certain way. They analyze everything critically; they compare the costs and the benefits of every issue and make decisions based on those costs and benefits. For example, say you're trying to decide whether a policy to eliminate terrorist attacks on airlines is a good idea. Economists are trained to put their emotions aside and ask: What are the costs of the policy, and what are the benefits? Thus, they are open to the argument that security measures, such as conducting body searches of every passenger or scanning all baggage with bomb-detecting machinery, might not be the appropriate policy because the costs might exceed the benefits. To think like an economist involves addressing almost all issues using a cost/benefit approach. Economic reasoning also involves abstracting from the “unimportant” elements of a question and focusing on the “important” ones by creating a simple model that captures the essence of the issue or problem. How do you know whether the model has captured the important elements? By collecting empirical evidence and “testing” the model—matching the predictions of the model with the empirical evidence—to see if it fits. Economic reasoning—how to think like an economist, making decisions on the basis of costs and benefits—is the most important lesson you'll learn from this book.

Economic reasoning is making decisions on the basis of costs and benefits.

The book Freakonomics gives examples of the economist's approach. It describes a number of studies by University of Chicago economist Steve Levitt that unlock seemingly mysterious observations with basic economic reasoning. For example, Levitt asks the question: Why do drug dealers on the street tend to live with their mothers? The answer he arrives at is that it is because they can't afford to live on their own; most earn less than $5 an hour. Why, then, are they dealing drugs and not working a legal job that, even for a minimum-wage job, pays over $6.00 an hour? The answer to that is determined through cost/benefit analysis. While their current income is low, their potential income as a drug dealer is much higher since, given their background and current U.S. institutions, they are more likely to move up to a high position in the local drug business (and Freakonomics describes how it is a business) and earn a six-figure income than they are to move up from working as a Taco Bell technician to an executive earning a six-figure income in corporate America. Levitt's model is a very simple one—people do what is in their best interest financially—and it assumes that people rely on a cost/benefit analysis to make decisions. Finally, he supports his argument through careful empirical work, collecting and organizing the data to see if they fit the model. His work is a good example of “thinking like an economist” in action.

Economic reasoning, once learned, is infectious. If you're susceptible, being exposed to it will change your life. It will influence your analysis of everything, including issues normally considered outside the scope of economics. For example, you will likely use economic reasoning to decide the possibility of getting a date for Saturday night, and who will pay for dinner. You will likely use it to decide whether to read this book, whether to attend class, whom to marry, and what kind of work to go into after you graduate. This is not to say that economic reasoning will provide all the answers. As you will see throughout this book, real-world questions are inevitably complicated, and economic reasoning simply provides a framework within which to approach a question. In the economic way of thinking, every choice has costs and benefits, and decisions are made by comparing them.

Marginal Costs and Marginal Benefits

The relevant costs and relevant benefits to economic reasoning are the expected incremental, or additional, costs incurred and the expected incremental benefits that result from a decision. Economists use the term marginal when referring to additional or incremental. Marginal costs and marginal benefits are key concepts.

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Web Note 1.1: Costs and Benefits

 Marginal Cost and Marginal Benefit

A marginal cost is the additional cost to you over and above the costs you have already incurred. That means not counting sunk costs—costs that have already been incurred and cannot be recovered—in the relevant costs when making a decision. Consider, for example, attending class. You've already paid your tuition; it is a sunk cost. So the marginal (or additional) cost of going to class does not include tuition.

Similarly with marginal benefit. A marginal benefit is the additional benefit above what you've already derived. The marginal benefit of reading this chapter is the additional knowledge you get from reading it. If you already knew everything in this chapter before you picked up the book, the marginal benefit of reading it now is zero. The marginal benefit is not zero if by reading the chapter you learn that you are prepared for class; before, you might only have suspected you were prepared.

 ADDED DIMENSION

Economic Knowledge in One Sentence: TANSTAAFL

Once upon a time, Tanstaafl was made king of all the lands. His first act was to call his economic advisers and tell them to write up all the economic knowledge the society possessed. After years of work, they presented their monumental effort: 25 volumes, each about 400 pages long. But in the interim, King Tanstaafl had become a very busy man, what with running a kingdom of all the lands and all. Looking at the lengthy volumes, he told his advisers to summarize their findings in one volume.

Despondently, the economists returned to their desks, wondering how they could summarize what they'd been so careful to spell out. After many more years of rewriting, they were finally satisfied with their one-volume effort, and tried to make an appointment to see the king. Unfortunately, affairs of state had become even more pressing than before, and the king couldn't take the time to see them. Instead he sent word to them that he couldn't be bothered with a whole volume, and ordered them, under threat of death (for he had become a tyrant), to reduce the work to one sentence.

The economists returned to their desks, shivering in their sandals and pondering their impossible task. Thinking about their fate if they were not successful, they decided to send out for one last meal. Unfortunately, when they were collecting money to pay for the meal, they discovered they were broke. The disgusted delivery man took the last meal back to the restaurant, and the economists started down the path to the beheading station. On the way, the delivery man's parting words echoed in their ears. They looked at each other and suddenly they realized the truth. “We're saved!” they screamed. “That's it! That's economic knowledge in one sentence!” They wrote the sentence down and presented it to the king, who thereafter fully understood all economic problems. (He also gave them a good meal.) The sentence?

There Ain't No Such Thing As A Free Lunch—TANSTAAFL

Comparing marginal (additional) costs with marginal (additional) benefits will often tell you how you should adjust your activities to be as well off as possible. Just follow the economic decision rule:

If the marginal benefits of doing something exceed the marginal costs, do it.

If the marginal costs of doing something exceed the marginal benefits, don't do it.

If the marginal benefits of doing something exceed the marginal costs, do it. If the marginal costs of doing something exceed the marginal benefits, don't do it.

As an example, let's consider a discussion I might have with a student who tells me that she is too busy to attend my classes. I respond, “Think about the tuition you've spent for this class—it works out to about $40 a lecture.” She answers that the book she reads for class is a book that I wrote, and that I wrote it so clearly she fully understands everything. She goes on:

I've already paid the tuition and whether I go to class or not, I can't get any of the tuition back, so the tuition is a sunk cost and doesn't enter into my decision. The marginal cost to me is what I could be doing with the hour instead of spending it in class. I value my time at $75 an hour [people who understand everything value their time highly], and even though I've heard that your lectures are super, I estimate that the marginal benefit of your class is only $50. The marginal cost, $75, exceeds the marginal benefit, $50, so I don't attend class.

I congratulate her on her diplomacy and her economic reasoning, but tell her that I give a quiz every week, that students who miss a quiz fail the quiz, that those who fail all the quizzes fail the course, and that those who fail the course do not graduate. In short, she is underestimating the marginal benefits of attending my classes. Correctly estimated, the marginal benefits of attending my class exceed the marginal costs. So she should attend my class.

Q-1

Say you bought a share of Sun Microsystems for $100 and a share of Cisco for $10. The price of each is currently $15. Assuming taxes are not an issue, which would you sell if you need $15?

Economics and Passion

Recognizing that everything has a cost is reasonable, but it's a reasonableness that many people don't like. It takes some of the passion out of life. It leads you to consider possibilities like these:

• Saving some people's lives with liver transplants might not be worth the additional cost. The money might be better spent on nutritional programs that would save 20 lives for every 2 lives you might save with transplants.

• Maybe we shouldn't try to eliminate all pollution, because the additional cost of doing so may be too high. To eliminate all pollution might be to forgo too much of some other worthwhile activity.

• Providing a guaranteed job for every person who wants one might not be a worthwhile policy goal if it means that doing so will reduce the ability of an economy to adapt to new technologies.

• It might make sense for the automobile industry to save $12 per car by not installing a safety device, even though without the safety device some people will be killed.

Economic reasoning is based on the premise that everything has a cost.

You get the idea. This kind of reasonableness is often criticized for being cold-hearted. But, not surprisingly, economists disagree; they argue that their reasoning leads to a better society for the majority of people.

Economists' reasonableness isn't universally appreciated. Businesses love the result; others aren't so sure, as I discovered some years back when my then-girlfriend told me she was leaving me. “Why?” I asked. “Because,” she responded, “you're so, so… reasonable.” It took me many years after she left to learn what she already knew: There are many types of reasonableness, and not everyone thinks an economist's reasonableness is a virtue. I'll discuss such issues later; for now, let me simply warn you that, for better or worse, studying economics will lead you to view questions in a cost/benefit framework.

Q-2

Can you think of a reason why a cost/benefit approach to a problem might be inappropriate? Can you give an example?

Opportunity Cost

Putting economists' cost/benefit rules into practice isn't easy. To do so, you have to be able to choose and measure the costs and benefits correctly. Economists have devised the concept of opportunity cost to help you do that. Opportunity cost is the benefit that you might have gained from choosing the next-best alternative. To obtain the benefit of something, you must give up (forgo) something else—namely, the next-best alternative. The opportunity cost is the value of that next-best alternative; that is a cost because in choosing one thing, you are precluding an alternative choice. The TANSTAAFL story in the box embodies the opportunity cost concept because it tells us that there is a cost to everything; that cost is the next-best forgone alternative.

Opportunity cost is the basis of cost/benefit economic reasoning; it is the benefit that you might have gained from choosing the next-best alternative.

Opportunity Cost

Let's consider some examples. The opportunity cost of going out once with Natalie (or Nathaniel), the most beautiful woman (attractive man) in the world, is the benefit you'd get from going out with your solid steady, Margo (Mike). The opportunity cost of cleaning up the environment might be a reduction in the money available to assist low-income individuals. The opportunity cost of having a child might be two boats, three cars, and a two-week vacation each year for five years, which are what you could have had if you hadn't had the child. (Kids really are this expensive.)

Examples are endless, but let's consider two that are particularly relevant to you: what courses to take and how much to study. Let's say you're a full-time student and at the beginning of the term you had to choose five courses. Taking one precludes taking some other, and the opportunity cost of taking an economics course may well be not taking a course on theater. Similarly with studying: You have a limited amount of time to spend studying economics, studying some other subject, sleeping, or partying. The more time you spend on one activity, the less time you have for another. That's opportunity cost.

Notice how neatly the opportunity cost concept takes into account costs and benefits of all other options, and converts these alternative benefits into costs of the decision you're now making.

The relevance of opportunity cost isn't limited to your individual decisions. Opportunity costs are also relevant to government's decisions, which affect everyone in society. A common example is what is called the guns-versus-butter debate. The resources that a society has are limited; therefore, its decision to use those resources to have more guns (more weapons) means that it will have less butter (fewer consumer goods). Thus, when society decides to spend $50 billion more on an improved health care system, the opportunity cost of that decision is $50 billion not spent on helping the homeless, paying off some of the national debt, or providing for national defense.

Opportunity costs have always made choice difficult, as we see in the early-19th-century engraving, “One or the Other.”

The opportunity cost concept has endless implications. It can even be turned upon itself. For instance, it takes time to think about alternatives; that means that there's a cost to being reasonable, so it's only reasonable to be somewhat unreasonable. If you followed that argument, you've caught the economic bug. If you didn't, don't worry. Just remember the opportunity cost concept for now; I'll infect you with economic thinking in the rest of the book.

Q-3

John, your study partner, has just said that the opportunity cost of studying this chapter is about 1/34 the price you paid for this book, since the chapter is about 1/34 of the book. Is he right? Why or why not?

Economic and Market Forces

The opportunity cost concept applies to all aspects of life and is fundamental to understanding how society reacts to scarcity. When goods are scarce, those goods must be rationed. That is, a mechanism must be chosen to determine who gets what.

Q-4

Ali, your study partner, states that rationing health care is immoral—that health care should be freely available to all individuals in society. How would you respond?

Let's consider some specific real-world rationing mechanisms. Dormitory rooms are often rationed by lottery, and permission to register in popular classes is often rationed by a first-come, first-registered rule. Food in the United States, however, is generally rationed by price. If price did not ration food, there wouldn't be enough food to go around. All scarce goods must be rationed in some fashion. These rationing mechanisms are examples of economic forces, the necessary reactions to scarcity.

When an economic force operates through the market, it becomes a market force.

One of the important choices that a society must make is whether to allow these economic forces to operate freely and openly or to try to rein them in. A market force is an economic force that is given relatively free rein by society to work through the market. Market forces ration by changing prices. When there's a shortage, the price goes up. When there's a surplus, the price goes down. Much of this book will be devoted to analyzing how the market works like an invisible hand, guiding economic forces to coordinate individual actions and allocate scarce resources. The invisible hand is the price mechanism, the rise and fall of prices that guides our actions in a market.

Economic reality is controlled by three forces:

Economic forces (the invisible hand).

Social and cultural forces.

Political and legal forces.

Societies can't choose whether or not to allow economic forces to operate—economic forces are always operating. However, societies can choose whether to allow market forces to predominate. Social, cultural, and political forces play a major role in deciding whether to let market forces operate. Economic reality is determined by a contest among these various forces.

ADDED DIMENSION

Economics in Perspective

All too often, students study economics out of context. They're presented with sterile analysis and boring facts to memorize, and are never shown how economics fits into the larger scheme of things. That's bad; it makes economics seem boring—but economics is not boring. Every so often throughout this book, sometimes in the appendixes and sometimes in these boxes, I'll step back and put the analysis in perspective, giving you an idea from whence the analysis sprang and its historical context. In educational jargon, this is called enrichment.

I begin here with economics itself.

First, its history: In the 1500s there were few universities. Those that existed taught religion, Latin, Greek, philosophy, history, and mathematics. No economics. Then came the Enlightenment (about 1700), in which reasoning replaced God as the explanation of why things were the way they were. Pre-Enlightenment thinkers would answer the question “Why am I poor?” with “Because God wills it.” Enlightenment scholars looked for a different explanation. “Because of the nature of land ownership” is one answer they found.

Such reasoned explanations required more knowledge of the way things were, and the amount of information expanded so rapidly that it had to be divided or categorized for an individual to have hope of knowing a subject. Soon philosophy was subdivided into science and philosophy. In the 1700s, the sciences were split into natural sciences and social sciences. The amount of knowledge kept increasing, and in the late 1800s and early 1900s social science itself split into subdivisions: economics, political science, history, geography, sociology, anthropology, and psychology. Many of the insights about how the economic system worked were codified in Adam Smith's The Wealth of Nations, written in 1776. Notice that this is before economics as a subdiscipline developed, and Adam Smith could also be classified as an anthropologist, a sociologist, a political scientist, and a social philosopher.

Throughout the 18th and 19th centuries, economists such as Adam Smith, Thomas Malthus, John Stuart Mill, David Ricardo, and Karl Marx were more than economists; they were social philosophers who covered all aspects of social science. These writers were subsequently called classical economists. Alfred Marshall continued in that classical tradition, and his book, Principles of Economics, published in the late 1800s, was written with the other social sciences much in evidence. But Marshall also changed the questions economists ask; he focused on those questions that could be asked in a graphical supply/demand framework.

This book falls solidly in the Marshallian tradition. It sees economics as a way of thinking—as an engine of analysis used to understand real-world phenomena.

Marshallian economics is primarily about policy, not theory. It sees institutions as well as political and social dimensions of reality as important, and it shows you how economics ties in to those dimensions.

Let's consider an example in which social forces prevent an economic force from becoming a market force: the problem of getting a date for Saturday night. If a school (or a society) has significantly more people of one gender than the other (let's say more men than women), some men may well find themselves without a date—that is, men will be in excess supply—and will have to find something else to do, say study or go to a movie by themselves. An “excess supply” person could solve the problem by paying someone to go out with him or her, but that would probably change the nature of the date in unacceptable ways. It would be revolting to the person who offered payment and to the person who was offered payment. That unacceptability is an example of the complex social and cultural norms that guide and limit our activities. People don't try to buy dates because social forces prevent them from doing so.

Social, cultural, and political forces can play a significant role in the economy.

Now let's consider another example in which political and legal influences stop economic forces from becoming market forces. Say you decide that you can make some money delivering mail in your neighborhood. You try to establish a small business, but suddenly you are confronted with the law. The U.S. Postal Service has a legal exclusive right to deliver regular mail, so you'll be prohibited from delivering regular mail in competition with the post office. Economic forces—the desire to make money—led you to want to enter the business, but in this case political forces squash the invisible hand.

Q-5

Your study partner, Joan, states that market forces are always operative. Is she right? Why or why not?

Often political and social forces work together against the invisible hand. For example, in the United States there aren't enough babies to satisfy all the couples who desire them. Babies born to particular sets of parents are rationed—by luck. Consider a group of parents, all of whom want babies. Those who can, have a baby; those who can't have one, but want one, try to adopt. Adoption agencies ration the available babies. Who gets a baby depends on whom people know at the adoption agency and on the desires of the birth mother, who can often specify the socioeconomic background (and many other characteristics) of the family in which she wants her baby to grow up. That's the economic force in action; it gives more power to the supplier of something that's in short supply.

If our society allowed individuals to buy and sell babies, that economic force would be translated into a market force. The invisible hand would see to it that the quantity of babies supplied would equal the quantity of babies demanded at some price. The market, not the adoption agencies, would do the rationing.2

Most people, including me, find the idea of selling babies repugnant. But why? It's the strength of social forces reinforced by political forces.

What is and isn't allowable differs from one society to another. For example, in Cuba and North Korea, many private businesses are against the law, so not many people start their own businesses. In the United States, until the 1970s, it was against the law to hold gold except in jewelry and for certain limited uses such as dental supplies, so most people refrained from holding gold. Ultimately a country's laws and social norms determine whether the invisible hand will be allowed to work.

Economic forces are always operative; society may allow market forces to operate.

Social and political forces are active in all parts of your life. You don't practice medicine without a license; you don't sell body parts or certain addictive drugs. These actions are against the law. But many people do sell alcohol; that's not against the law if you have a permit. You don't charge your friends interest to borrow money (you'd lose friends); you don't charge your children for their food (parents are supposed to feed their children); many sports and media stars don't sell their autographs (some do, but many consider the practice tacky); you don't lower the wage you'll accept in order to take a job away from someone else (you're no scab). The list is long. You cannot understand economics without understanding the limitations that political and social forces place on economic actions.

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Web Note 1.2: Society and Markets

In summary, what happens in a society can be seen as the reaction to, and interaction of, these three forces: economic forces, political and legal forces, and social and historical forces. Economics has a role to play in sociology, history, and politics, just as sociology, history, and politics have roles to play in economics.

What happens in society can be seen as a reaction to, and interaction of, economic forces, political forces, social forces, and historical forces.

Economic Terminology

Economic terminology needs little discussion. It simply needs learning. As terms come up, you'll begin to recognize them. Soon you'll begin to understand them, and finally you'll begin to feel comfortable using them. In this book, I'm trying to describe how economics works in the real world, so I introduce you to many of the terms that occur in business and in discussions of the economy. Whenever possible I'll integrate the introduction of new terms into the discussion so that learning them will seem painless. In fact I've already introduced you to a number of economic terms: opportunity cost, the invisible hand, market forces, economic forces, just to name a few. By the end of the book, I'll have introduced you to hundreds more.

Economic Insights

Economists have thought about the economy for a long time, so it's not surprising that they've developed some insights into the way it works.

These insights are often based on generalizations, called theories, about the workings of an abstract economy. Theories tie together economists' terminology and knowledge about economic institutions. Theories are inevitably too abstract to apply in specific cases, and thus a theory is often embodied in an economic model—a framework that places the generalized insights of the theory in a more specific contextual setting—or in an economic principle—a commonly held economic insight stated as a law or general assumption. To see the importance of principles, think back to when you learned to add. You didn't memorize the sum of 147 and 138; instead, you learned a principle of addition. The principle says that when adding 147 and 138, you first add 7 + 8, which you memorized was 15. You write down the 5 and carry the 1, which you add to 4 + 3 to get 8. Then add 1 + 1 = 2. So the answer is 285. When you know just one principle, you know how to add millions of combinations of numbers.

Theories, models, and principles are empirically tested (as best one can) to ensure that they correspond to reality. Because economics is an observational, not a laboratory, science, economists cannot test their models with controlled experiments. Instead, economists must carefully observe the economy and try to figure out what is affecting what. To do so they look for natural experiments, where something has changed in one place but has not changed somewhere else and compare the results in the two cases. An example of a natural experiment was when New Jersey raised its minimum wage and neighboring state Pennsylvania did not. But even in cases where there is a natural experiment, it is impossible to hold “other things constant,” as is done in laboratory experiments, and thus the empirical results in economics are often subject to dispute.

Theories, models, and principles must be combined with a knowledge of real-world economic institutions to arrive at specific policy recommendations.

While economic models and principles are less general than theories, they are still usually too general to apply in specific cases. Theories, models, and principles must be combined with a knowledge of real-world economic institutions to arrive at specific policy recommendations.

The Invisible Hand Theory

Knowing a theory gives you insight into a wide variety of economic phenomena even though you don't know the particulars of each phenomenon. For example, much of economic theory deals with the pricing mechanism and how the market operates to coordinate individuals' decisions. Economists have come to the following insights:

When the quantity supplied is greater than the quantity demanded, price has a tendency to fall.

When the quantity demanded is greater than the quantity supplied, price has a tendency to rise.

Q-6

There has been a superb growing season and the quantity of tomatoes supplied exceeds the quantity demanded. What is likely to happen to the price of tomatoes?

Using these generalized insights, economists have developed a theory of markets that leads to the further insight that, under certain conditions, markets are efficient. That is, the market will coordinate individuals' decisions, allocating scarce resources to their best possible use. Efficiency means achieving a goal as cheaply as possible. Economists call this insight the invisible hand theory—a market economy, through the price mechanism, will tend to allocate resources efficiently.

Theories, and the models used to represent them, are enormously efficient methods of conveying information, but they're also necessarily abstract. They rely on simplifying assumptions, and if you don't know the assumptions, you don't know the theory. The result of forgetting assumptions could be similar to what happens if you forget that you're supposed to add numbers in columns. Forgetting that, yet remembering all the steps, can lead to a wildly incorrect answer. For example,

Knowing the assumptions of theories and models allows you to progress beyond gut reaction and better understand the strengths and weaknesses of various economic theories and models. Let's consider a central economic assumption: the assumption that individuals behave rationally—that what they choose reflects what makes them happiest, given the constraints. If that assumption doesn't hold, the invisible hand theory doesn't hold.

Presenting the invisible hand theory in its full beauty is an important part of any economics course. Presenting the assumptions on which it is based and the limitations of the invisible hand is likewise an important part of the course. I'll do both throughout the book.

REAL-WORLD APPLICATION

Winston Churchill and Lady Astor

There are many stories about Nancy Astor, the first woman elected to Britain's Parliament. A vivacious, fearless American woman, she married into the English aristocracy and, during the 1930s and 1940s, became a bright light on the English social and political scenes, which were already quite bright.

One story told about Lady Astor is that she and Winston Churchill, the unorthodox genius who had a long and distinguished political career and who was Britain's prime minister during World War II, were sitting in a pub having a theoretical discussion about morality. Churchill suggested that as a thought experiment Lady Astor ponder the following question: If a man were to promise her a huge amount of money—say a million pounds—for the privilege, would she sleep with him? Lady Astor did ponder the question for a while and finally answered, yes, she would, if the money were guaranteed. Churchill then asked her if she would sleep with him for five pounds. Her response was sharp: “Of course not. What do you think I am—a prostitute?” Churchill responded, “We have already established that fact; we are now simply negotiating about price.”

One moral that economists might draw from this story is that economic incentives, if high enough, can have a powerful influence on behavior. But an equally important moral of the story is that noneconomic incentives also can be very strong. Why do most people feel it's wrong to sell sex for money, even if they might be willing to do so if the price were high enough? Keeping this second moral in mind will significantly increase your economic understanding of real-world events.

Economic Theory and Stories

Economic theory, and the models in which that theory is presented, often developed as a shorthand way of telling a story. These stories are important; they make the theory come alive and convey the insights that give economic theory its power. In this book I present plenty of theories and models, but they're accompanied by stories that provide the context that makes them relevant.

Theory is a shorthand way of telling a story.

At times, because there are many new terms, discussing theories takes up much of the presentation time and becomes a bit oppressive. That's the nature of the beast. As Albert Einstein said, “Theories should be as simple as possible, but not more so.” When a theory becomes oppressive, pause and think about the underlying story that the theory is meant to convey. That story should make sense and be concrete. If you can't translate the theory into a story, you don't understand the theory.

Microeconomics and Macroeconomics

Economic theory is divided into two parts: microeconomic theory and macroeconomic theory. Microeconomic theory considers economic reasoning from the viewpoint of individuals and firms and builds up to an analysis of the whole economy. Microeconomics is the study of individual choice, and how that choice is influenced by economic forces. Microeconomics studies such things as the pricing policies of firms, households' decisions on what to buy, and how markets allocate resources among alternative ends. Our discussion of opportunity cost was based on microeconomic theory. The invisible hand theory comes from microeconomics.

Microeconomics is the study of how individual choice is influenced by economic forces.

As we build up from microeconomic analysis to an analysis of the entire economy, everything gets rather complicated. Many economists try to uncomplicate matters by taking a different approach—a macroeconomic approach—first looking at the aggregate, or whole, and then breaking it down into components. Macroeconomics is the study of the economy as a whole. It considers the problems of inflation, unemployment, business cycles, and growth. Macroeconomics focuses on aggregate relationships such as how household consumption is related to income and how government policies can affect growth.

Macroeconomics is the study of the economy as a whole. It considers the problems of inflation, unemployment, business cycles, and growth.

Consider an analogy to the human body. A micro approach analyzes a person by looking first at each individual cell and then builds up. A macro approach starts with the person and then goes on to his or her components—arms, legs, fingernails, feelings, and so on. Put simply, microeconomics analyzes from the parts to the whole; macroeconomics analyzes from the whole to the parts.

Q-7

Classify the following topics as macroeconomic or microeconomic:

The impact of a tax increase on aggregate output.

The relationship between two competing firms' pricing behavior.

A farmer's decision to plant soy or wheat.

The effect of trade on economic growth.

Microeconomics and macroeconomics are very much interrelated. What happens in the economy as a whole is based on individual decisions, but individual decisions are made within an economy and can be understood only within that context. For example, whether a firm decides to expand production capacity will depend on what the owners expect will happen to the demand for their products. Those expectations are determined by macroeconomic conditions. Because microeconomics focuses on the individual and macroeconomics focuses on the whole economy, traditionally microeconomics and macroeconomics are taught separately, even though they are interrelated.

Economic Institutions

To know whether you can apply economic theory to reality, you must know about economic institutions—laws, common practices, and organizations in a society that affect the economy. Corporations, governments, and cultural norms are all examples of economic institutions. Many economic institutions have social, political, and religious dimensions. For example, your job often influences your social standing. In addition, many social institutions, such as the family, have economic functions. I include any institution that significantly affects economic decisions as an economic institution because you must understand that institution if you are to understand how the economy functions.

To apply economic theory to reality, you've got to have a sense of economic institutions.

Economic institutions differ significantly among countries. For example, in Germany banks are allowed to own companies; in the United States they cannot. This helps explain why investment decisions are made differently in Germany as compared to the United States. Alternatively, in the Netherlands workers are highly unionized, while in the United States they are not. Unions in the Netherlands therefore have the power to agree to keep wages lower in exchange for more jobs. This means that government policies to control inflation might differ in these two countries.

REAL-WORLD APPLICATION

Economists and Market Solutions

Economic reasoning is playing an increasing role in government policy. Consider the regulation of pollution. Pollution became a policy concern in the 1960s as books such as Rachel Carson's Silent Spring were published. In 1970, in response to concerns about the environment, the Clean Air Act was passed. It capped the amount of pollutants (such as sulfur dioxide, carbon monoxide, nitrogen dioxides, lead, and hydrocarbons) that firms could emit. This was a “command-and-control” approach to regulation, which brought about a reduction in pollution, but also brought about lots of complaints by firms that either found the limits costly to meet or couldn't afford to meet them and were forced to close.

Enter economists. They proposed an alternative approach, called cap-and-trade, that achieved the same overall reduction in pollution but at a lower overall cost. In the plan they proposed, government still set a pollution cap that firms had to meet, but it gave individual firms some flexibility. Firms that reduced emissions by less than the required limit could buy pollution permits from other firms that reduced their emissions by more than their limit. The price of the permits would be determined in an “emissions permit market.” Thus, firms that had a low cost of reducing pollution would have a strong incentive to reduce pollution by more than their limit in order to sell these permits, or rights to pollute, to firms that had a high cost of reducing pollution and therefore reduced their pollution by less than what was required. The net reduction was the same, but the reduction was achieved at a lower cost.

In 1990 Congress adopted economists' proposal and the Clean Air Act was amended to include tradable emissions permits. An active market in emissions permits developed and it is estimated that the tradable permit program has lowered the cost of reducing sulfur dioxide emissions by $1 billion a year. Economists used this same argument to promote an incentive-based solution to world pollution in an agreement among some countries to reduce world pollution known as the Kyoto Protocol. You can read more about the current state of tradable emissions at epa.gov/airmarkets.

Economic institutions sometimes seem to operate in ways quite different than economic theory predicts. For example, economic theory says that prices are determined by supply and demand. However, businesses say that they set prices by rules of thumb—often by what are called cost-plus-markup rules. That is, a firm determines what its costs are, multiplies by 1.4 or 1.5, and the result is the price it sets. Economic theory says that supply and demand determine who's hired; experience suggests that hiring is often done on the basis of whom you know, not by market forces.

These apparent contradictions have two complementary explanations. First, economic theory abstracts from many issues. These issues may account for the differences. Second, there's no contradiction; economic principles often affect decisions from behind the scenes. For instance, supply and demand pressures determine what the price markup over cost will be. In all cases, however, to apply economic theory to reality—to gain the full value of economic insights—you've got to have a sense of economic institutions.

Economic Policy Options

Economic policies are actions (or inaction) taken by government to influence economic actions. The final goal of the course is to present the economic policy options facing our society today. For example, should the government restrict mergers between firms? Should it run a budget deficit? Should it do something about the international trade deficit? Should it decrease taxes?

I saved this discussion for last because there's no sense talking about policy options unless you know some economic terminology, some economic theory, and something about economic institutions. Once you know something about them, you're in a position to consider the policy options available for dealing with the economic problems our society faces.

To carry out economic policy effectively, one must understand how institutions might change as a result of the economic policy.

Policies operate within institutions, but policies also can influence the institutions within which they operate. Let's consider an example: welfare policy and the institution of the two-parent family. In the 1960s, the United States developed a variety of policy initiatives designed to eliminate poverty. These initiatives provided income to single parents with children, and assumed that family structure would be unchanged by these policies. But family structure changed substantially, and, very likely, these policies played a role in increasing the number of single-parent families. The result was the programs failed to eliminate poverty. Now this is not to say that we should not have programs to eliminate poverty, nor that two-parent families are always preferable to one-parent families; it is only to say that we must build into our policies their effect on institutions.

Some policies are designed to change institutions directly. While these policies are much more difficult to implement than policies that don't, they also offer the largest potential for gain. Let's consider an example. In the 1990s, a number of Eastern European countries replaced central planning with market economies and private ownership. The result: Output in those countries fell enormously as the old institutions fell apart. While most Eastern European economies have rebounded from their initial losses, some countries of the former Soviet Union have yet to do so. The hardships these countries continue to experience show the enormous difficulty of implementing policies involving major institutional changes.

Q-8

True or false? Economists should focus their policy analysis on institutional changes because such policies offer the largest gains.

Objective Policy Analysis

Good economic policy analysis is objective; that is, it keeps the analyst's value judgments separate from the analysis. Objective analysis does not say, “This is the way things should be,” reflecting a goal established by the analyst. That would be subjective analysis because it would reflect the analyst's view of how things should be. Instead, objective analysis says, “This is the way the economy works, and if society (or the individual or firm for whom you're doing the analysis) wants to achieve a particular goal, this is how it might go about doing so.” Objective analysis keeps, or at least tries to keep, subjective views—value judgments—separate.

Q-9

John, your study partner, is a free market advocate. He argues that the invisible hand theory tells us that the government should not interfere with the economy. Do you agree? Why or why not?

Positive economics is the study of what is, and how the economy works.

To make clear the distinction between objective and subjective analysis, economists have divided economics into three categories: positive economics, normative economics, and the art of economics. Positive economics is the study of what is, and how the economy works. It asks such questions as: How does the market for hog bellies work? How do price restrictions affect market forces? These questions fall under the heading of economic theory. Normative economics is the study of what the goals of the economy should be. Normative economics asks such questions as: What should the distribution of income be? What should tax policy be designed to achieve? In discussing such questions, economists must carefully delineate whose goals they are discussing. One cannot simply assume that one's own goals for society are society's goals.

Normative economics is the study of what the goals of the economy should be.

The art of economics, also called political economy, is the application of the knowledge learned in positive economics to the achievement of the goals one has determined in normative economics. It looks at such questions as: To achieve a certain distribution of income, how would you go about it, given the way the economy works?3 Most policy discussions fall under the art of economics.

The art of economics is the application of the knowledge learned in positive economics to the achievement of the goals determined in normative economics.

REAL-WORLD APPLICATION

Economics and Global Warming

A good example of the central role that economics plays in policy debates is the debate about global warming. Almost all scientists are now convinced that global warming is occurring and that human activity such as the burning of fossil fuel is the cause. The policy question is what to do about it. To answer that question, most governments have turned to economists. The first part of the question that economists have considered is whether it is worth doing anything, and in a well-publicized report commissioned by the British government, economist Nicholas Stern argued that, based upon his cost/benefit analysis, yes it is worth doing something. The reason: because the costs of not doing anything would likely reduce output by 20 percent in the future, and that those costs (appropriately weighted for when they occur) are less than the benefits of policies that can be implemented.

The second part of the question is: what policies to implement? The policies he recommended were policies that changed incentives—specifically, policies that raised the costs of emitting greenhouse gases and decreased the cost of other forms of production. Those recommended policies reflected the economist's opportunity cost framework in action: if you want to change the result, change the incentives that individuals face.

There is considerable debate about Stern's analysis—both with the way he conducted the cost/benefit analysis and with his policy recommendations. Such debates are inevitable when the data are incomplete and numerous judgments need to be made. I suspect that these debates will continue over the coming years with economists on various sides of the debate. Economists are generally not united in their views about complicated policy issues since they differ in their normative views and in their assessment of the problem and of what politically can be achieved; that's because policy is part of the art of economics, not part of positive economics. But the framework of the policy debate about global warming is the economic framework. Thus, even though political forces will ultimately choose what policy is followed, you must understand the economic framework to take part in the debate.

In each of these three branches of economics, economists separate their own value judgments from their objective analysis as much as possible. The qualifier “as much as possible” is important, since some value judgments inevitably sneak in. We are products of our environment, and the questions we ask, the framework we use, and the way we interpret the evidence all involve value judgments and reflect our backgrounds.

Q-10

Tell whether the following five statements belong in positive economics, normative economics, or the art of economics.

1. We should support the market because it is efficient.

2. Given certain conditions, the market achieves efficient results.

3. Based on past experience and our understanding of markets, if one wants a reasonably efficient result, markets should probably be relied on.

4. The distribution of income should be left to markets.

5. Markets allocate income according to contributions of factors of production.

Maintaining objectivity is easiest in positive economics, where you are working with abstract models to understand how the economy works. Maintaining objectivity is harder in normative economics. You must always be objective about whose normative values you are using. It's easy to assume that all of society shares your values, but that assumption is often wrong.

It's hardest to maintain objectivity in the art of economics because it can suffer from the problems of both positive and normative economics. Because noneconomic forces affect policy, to practice the art of economics we must make judgments about how these noneconomic forces work. These judgments are likely to reflect our own value judgments. So we must be exceedingly careful to be as objective as possible in practicing the art of economics.

Policy and Social and Political Forces

When you think about the policy options facing society, you'll quickly discover that the choice of policy options depends on much more than economic theory. Politicians, not economists, determine economic policy. To understand what policies are chosen, you must take into account historical precedent plus social, cultural, and political forces. In an economics course, I don't have time to analyze these forces in as much depth as I'd like. That's one reason there are separate history, political science, sociology, and anthropology courses.

WWW

Web Note 1.3: The Art of Economics

While it is true that these other forces play significant roles in policy decisions, specialization is necessary. In economics, we focus the analysis on the invisible hand, and much of economic theory is devoted to considering how the economy would operate if the invisible hand were the only force operating. But as soon as we apply theory to reality and policy, we must take into account political and social forces as well.

An example will make my point more concrete. Most economists agree that holding down or eliminating tariffs (taxes on imports) and quotas (numerical limitations on imports) makes good economic sense. They strongly advise governments to follow a policy of free trade. Do governments follow free trade policies? Almost invariably they do not. Politics leads society in a different direction. If you're advising a policy maker, you need to point out that these other forces must be taken into account, and how other forces should (if they should) and can (if they can) be integrated with your recommendations.

Conclusion

There are tons more that could be said by way of introducing you to economics, but an introduction must remain an introduction. As it is, this chapter should have

1. Introduced you to economic reasoning.

2. Surveyed what we're going to cover in this book.

3. Given you an idea of my writing style and approach.

We'll be spending long hours together over the coming term, and before entering into such a commitment it's best to know your partner. While I won't know you, by the end of this book you'll know me. Maybe you won't love me as my mother does, but you'll know me.

This introduction was my opening line. I hope it also conveyed the importance and relevance that belong to economics. If it did, it has served its intended purpose. Economics is tough, but tough can be fun.

Summary

• The three coordination problems any economy must solve are what to produce, how to produce it, and for whom to produce it. In solving these problems, societies have found that there is a problem of scarcity.

• Economic reasoning structures all questions in a cost/ benefit framework: If the marginal benefits of doing something exceed the marginal costs, do it. If the marginal costs exceed the marginal benefits, don't do it.

• Sunk costs are not relevant in the economic decision rule.

• The opportunity cost of undertaking an activity is the benefit you might have gained from choosing the next-best alternative.

• “There ain't no such thing as a free lunch” (TANSTAAFL) embodies the opportunity cost concept.

• Economic forces, the forces of scarcity, are always working. Market forces, which ration by changing prices, are not always allowed to work.

• Economic reality is controlled and directed by three types of forces: economic forces, political forces, and social forces.

• Under certain conditions, the market, through its price mechanism, will allocate scarce resources efficiently.

• Economics can be divided into microeconomics and macroeconomics. Microeconomics is the study of individual choice and how that choice is influenced by economic forces. Macroeconomics is the study of the economy as a whole. It considers problems such as inflation, unemployment, business cycles, and growth.

• Economics can be subdivided into positive economics, normative economics, and the art of economics. Positive economics is the study of what is, normative economics is the study of what should be, and the art of economics relates positive to normative economics.

2: The Production Possibility Model, Trade, and Globalization

Economics is a science of thinking in terms of models, joined to the art of choosing models which are relevant to the contemporary world.

—J. M. Keynes

Every economy must solve three main coordination problems:

1. What, and how much, to produce.

2. How to produce it.

3. For whom to produce it.

In Chapter 1, I suggested that you can boil down all economic knowledge into the single phrase “There ain't no such thing as a free lunch.” There's obviously more to economics than that, but it's not a bad summary of the core of economic reasoning—it's relevant for an individual, for nonprofit organizations, for governments, and for nations. Oh, it's true that once in a while you can snitch a sandwich, but what economics tells you is that if you're offered something that approaches free-lunch status, you should also be on the lookout for some hidden cost.

A key element in getting people to recognize that lunches aren't free is the concept of opportunity cost—every decision has a cost in forgone opportunities—which I introduced you to in Chapter 1. Economists have a model, the production possibility model, that conveys the concept of opportunity costs both numerically and graphically. This model is important for understanding not only opportunity cost but also why people specialize in what they do and trade for the goods they need. Through specialization and trade, individuals, firms, and countries can achieve greater levels of production than they could otherwise achieve.

The Production Possibilities Model

The production possibilities model can be presented both in a table and in a graph. (Appendix A has a discussion of graphs in economics.) I'll start with the table and then move from that to the graph. Opportunity cost can be seen numerically with a production possibility table—a table that lists a choice's opportunity costs by summarizing what alternative outputs you can achieve with your inputs. An output is simply a result of an activity, and an input is what you put into a production process to achieve an output. For example, your grade in a course is an output and your study time is an input.

Q-1

In the graph below, what is the opportunity cost of producing an extra unit of good X in terms of good Y?

A Production Possibility Curve for an Individual

Let's consider the study-time/grades example. Say you have exactly 20 hours a week to devote to two courses: economics and history. (So maybe I'm a bit optimistic.) Grades are given numerically and you know that the following relationships exist: If you study 20 hours in economics, you'll get a grade of 100; 18 hours, 94; and so forth.1

Let's say that the best you can do in history is a 98 with 20 hours of study a week; 19 hours of study guarantees a 96, and so on. The production possibility table in Figure 2-1(a) shows the highest combination of grades you can get with various allocations of the 20 hours available for studying the two subjects. One possibility is getting 70 in economics and 78 in history.

Notice that the opportunity cost of studying one subject rather than the other is embodied in the production possibility table. The information in the table comes from experience: We are assuming that you've discovered that if you transfer an hour of study from economics to history, you'll lose 3 points on your grade in economics and gain 2 points in history. Thus, the opportunity cost of a 2-point rise in your history grade is a 3-point decrease in your economics grade.

The information in the production possibility table also can be presented graphically in a diagram called a production possibility curve. A production possibility curve (PPC) is a curve measuring the maximum combination of outputs that can be obtained from a given number of inputs. It is a graphical presentation of the opportunity cost concept.

The production possibility curve is a curve measuring the maximum combination of outputs that can be obtained from a given number of inputs.

A production possibility curve is created from a production possibility table by mapping the table in a two-dimensional graph. I've taken the information from the table in Figure 2-1(a) and mapped it into Figure 2-1(b). The history grade is mapped, or plotted, on the horizontal axis; the economics grade is on the vertical axis.

As you can see from the bottom row of Figure 2-1(a), if you study economics for all 20 hours and study history for 0 hours, you'll get grades of 100 in economics and 58 in history. Point A in Figure 2-1(b) represents that choice. If you study history for all 20 hours and study economics for 0 hours, you'll get a 98 in history and a 40 in economics. Point E represents that choice. Points B, C, and D represent three possible choices between these two extremes.

The slope of the production possibility curve tells you the opportunity cost of good X in terms of good Y. You have to give up 2Y to get 1X when you're around point A.

Notice that the production possibility curve slopes downward from left to right. That means that there is an inverse relationship (a trade-off) between grades in economics and grades in history. The better the grade in economics, the worse the grade in history, and vice versa. That downward slope represents the opportunity cost concept: you get more of one benefit only if you get less of another benefit.

The production possibility curve not only represents the opportunity cost concept but also measures the opportunity cost. For example, in Figure 2-1(b), say you want to raise your grade in history from a 94 to a 98 (move from point D to point E). The opportunity cost of that 4-point increase would be a 6-point decrease in your economics grade, from 46 to 40.

FIGURE 2-1 (A AND B): A Production Possibility Table and Curve for Grades in Economics and History

The production possibility table (a) shows the highest combination of grades you can get with only 20 hours available for studying economics and history. The information in the production possibility table in (a) can be plotted on a graph, as is done in (b). The grade received in economics is on the vertical axis, and the grade received in history is on the horizontal axis.

To summarize, the production possibility curve demonstrates that

1. There is a limit to what you can achieve, given the existing institutions, resources, and technology.

2. Every choice you make has an opportunity cost. You can get more of something only by giving up something else.

 Production Possibilities Curve

Increasing Marginal Opportunity Cost

In the study-time/grade example, the opportunity cost of trade remained constant; you could always trade two points on your history grade for three points on your economics grade. This assumption of an unchanging opportunity cost made the production possibility curve a straight line. Although this made the example easier, is it realistic? Probably not, especially if we are using the PPC to describe the choices that a society makes. For many of the choices society must make, opportunity costs tend to increase as we choose more and more of an item. Such a phenomenon is so common, in fact, that it has acquired a name: the principle of increasing marginal opportunity cost. That principle states:

In order to get more of something, one must give up ever-increasing quantities of something else

The principle of increasing marginal opportunity cost tells us that opportunity costs increase the more you concentrate on the activity.

In other words, initially the opportunity costs of an activity are low, but they increase the more we concentrate on that activity.

A production possibility curve that exhibits increasing marginal opportunity costs is bowed outward, as in Figure 2-2(b).

Why are production possibility curves typically bowed outward? Because some resources are better suited for the production of certain kinds of goods than other kinds of goods. To understand what that means, let's talk about the graph in Figure 2-2(b), which is derived from the table in Figure 2-2(a). This curve represents society's choice between defense spending (guns) and spending on domestic needs (butter).

Suppose society is producing only butter (point A). Giving up a little butter (1 pound) initially gains us a lot of guns (4), moving us to point B. The next 2 pounds of butter we give up gain us slightly fewer guns (point C). If we continue to trade butter for guns, we find that at point D we gain very few guns from giving up a pound of butter. The opportunity cost of choosing guns over butter increases as we increase the production of guns.

Comparative Advantage

The reason the opportunity cost of guns increases as we produce more guns is that some resources are relatively better suited to producing guns, while others are relatively better suited to producing butter. Put in economists' terminology, some resources have a comparative advantage over other resources—the ability to be better suited to the production of one good than to the production of another good. In this example, some resources have a comparative advantage over other resources in the production of butter, while other resources have a comparative advantage in the production of guns.

FIGURE 2-2 (A AND B): A Production Possibility Table and Curve

The table in (a) contains information on the trade-off between the production of guns and butter. This information has been plotted on the graph in (b). Notice in (b) that as we move along the production possibility curve from A to F, trading butter for guns, we get fewer and fewer guns for each pound of butter given up. That is, the opportunity cost of choosing guns over butter increases as we increase the production of guns. This concept is called the principle of increasing marginal opportunity cost. The phenomenon occurs because some resources are better suited for the production of butter than for the production of guns, and we use the better ones first.

A REMINDER

Production Possibility Curves

Q-2

If no resource had a comparative advantage in the production of any good, what would the shape of the production possibility curve be? Why?

Comparative Advantage

When making small amounts of guns and large amounts of butter, we first use the resources whose comparative advantage is in the production of guns to produce guns. All other resources are devoted to producing butter. Because the resources used in producing guns aren't good at producing butter, we're not giving up much butter to get those guns. As we produce more and more of a good, we must use resources whose comparative advantage is in the production of the other good—in this case, more suitable for producing butter than for producing guns. As we remove resources from the production of butter to get the same additional amount of guns, we must give up increasing amounts of butter. An alternative way of saying this is that the opportunity cost of producing guns becomes greater as the production of guns increases. As we continue to increase the production of guns, the opportunity cost of more guns becomes very high because we're using resources to produce guns that have a strong comparative advantage for producing butter.

Let's consider two more examples. Say the United States suddenly decides it needs more wheat. To get additional wheat, we must devote additional land to growing it. This land is less fertile than the land we're already using, so our additional output of wheat per acre of land devoted to wheat will be less. Alternatively, consider the use of relief pitchers in a baseball game. If only one relief pitcher is needed, the manager sends in the best; if he must send in a second one, then a third, and even a fourth, the likelihood of winning the game decreases.

Efficiency

We would like, if possible, to get as much output as possible from a given amount of inputs or resources. That's productive efficiency—achieving as much output as possible from a given amount of inputs or resources. We would like to be efficient. The production possibility curve helps us see what is meant by productive efficiency. Consider point A in Figure 2-3(a), which is inside the production possibility curve. If we are producing at point A, we are using all our resources to produce 6 guns and 4 pounds of butter. Point A represents inefficiency—getting less output from inputs that, if devoted to some other activity, would produce more output. That's because with the same inputs we could be getting either 8 guns and 4 pounds of butter (point B) or 6 pounds of butter and 6 guns (point C). As long as we prefer more to less, both points B and C represent efficiency—achieving a goal using as few inputs as possible. We always want to move our production out to a point on the production possibility curve.

ADDED DIMENSION

Choices in Context

The production possibility curve presents choices without regard to time and therefore makes opportunity costs clear-cut; there are two choices, one with a higher cost and one with a lower cost. The reality is that most choices are dependent on other choices; they are made sequentially. With sequential choices, you cannot simply reverse your decision. Once you have started on a path, to take another path you have to return to the beginning. Thus, following one path often lowers the costs of options along that path, but it raises the costs of options along another path.