HO3e ch01

Chapter 1: Economics: Foundations and Models
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 1 of 38
CHAPTER
1
Economics:
Foundations
and Models
Bill Gates, chairman of

Microsoft, testified
before Congress in
2008 that limiting the
number of foreign
technical workers
allowed into the United
States was resulting in
a “critical shortage of
scientific talent.” Prepared by:
Fernando Quijano
CHAPTER
1
Chapter Outline and
Learning Objectives
Economics: 1.1 Three Key Economic Ideas

Explain these three key economic ideas: People are
Foundations rational. People respond to incentives. Optimal
decisions are made at the margin.
and Models 1.2 The Economic Problem That Every Society
Must Solve
Discuss how an economy answers these questions:
What goods and services will be produced? How will
the goods and services be produced? Who will receive
the goods and services produced?
1.3 Economic Models
Understand the role of models in economic analysis.
1.4 Microeconomics and Macroeconomics

Distinguish between microeconomics and
macroeconomics.
1.5 A Preview of Important Economic Terms
Become familiar with important economic terms.
APPENDIX: Using Graphs and Formulas
Review the use of graphs and formulas.
Economics: Foundations and Models
In this book, we use economics to answer questions such as the

following:
• How are the prices of goods and services determined?
• How does pollution affect the economy, and how should

government policy deal with these effects?
• Why do firms engage in international trade, and how do

government policies affect international trade?
• Why does government control the prices of some goods

and services, and what are the effects of those controls?
Economics: Foundations and Models
4.1
Scarcity A situation in which unlimited wants

exceed the limited resources available to fulfill
those wants.
Economics The study of the choices people

make to attain their goals, given their scarce
resources.
Economic model A simplified version of

reality used to analyze real-world economic
situations.
1.1 LEARNING OBJECTIVE
Three Key Economic Ideas Explain these three key economic ideas:
People are rational. People respond to
incentives. Optimal decisions are made
at the margin.
Market A group of buyers and sellers of a

good or service and the institution or
arrangement by which they come together to
trade.
Throughout this book, as we study how people make choices
and interact in markets, we will return to three important ideas:
1. People are rational.
2. People respond to economic incentives.

3. Optimal decisions are made at the margin.
Marginal analysis Analysis that

involves comparing marginal
benefits and marginal costs.
Making Will Women Have More
Babies if the Government
Explain these three key economic ideas:
People are rational. People respond to
the Pays Them To? incentives. Optimal decisions are made
Connection at the margin.
More than 45 countries in

Europe and Asia have taken
steps to try to raise their
birthrates. These policies
suggest that people may
respond to economic
incentives even when
making the very personal

decision of how many
children to have.
YOUR TURN: Test your understanding by doing related problem 1.7 at the end of
this chapter.
Explain these three key economic ideas:
Solved Problem 1-1 People are rational. People respond to
incentives. Optimal decisions are made
Apple Computer Makes a at the margin.
Decision at the Margin
Should Apple produce an additional 1 million iPhones?
In solving the problem, consider the following:
• Optimal decisions are made at the margin.

• An activity should be continued to the point where
the marginal benefit is equal to the marginal cost.

• In this case, the correct decision requires
information about additional revenue and additional
cost.
YOUR TURN: For more practice, do related problems 1.4, 1.5, and 1.6 at the end
of this chapter.
The Economic Problem That Discuss how an economy answers
these questions: What goods and
Every Society Must Solve services will be produced? How will the
goods and services be produced? Who
will receive the goods and services
produced?
Trade-off The idea that because of scarcity,

producing more of one good or service means
producing less of another good or service.
Opportunity cost The highest-valued

alternative that must be given up to engage in
an activity.
Trade-offs force society to make choices when answering

the following three fundamental questions:
1. What goods and services will be produced?

2. How will the goods and services be produced?
3. Who will receive the goods and services produced?
Centrally Planned Economies will receive the goods and services
versus Market Economies produced?
Centrally planned economy An

economy in which the government
decides how economic resources will
be allocated.
Market economy An economy in

which the decisions of households
and firms interacting in markets
allocate economic resources.
The Modern “Mixed” Economy produced?
Mixed economy An economy in

which most economic decisions result
from the interaction of buyers and
sellers in markets but in which the
government plays a significant role in

the allocation of resources.
Efficiency and Equity produced?
Productive efficiency A situation in

which a good or service is produced
at the lowest possible cost.
Allocative efficiency A state of the

economy in which production is in
accordance with consumer

preferences; in particular, every good
or service is produced up to the point
where the last unit provides a
marginal benefit to society equal to
the marginal cost of producing it.
Efficiency and Equity produced?
Voluntary exchange A situation that

occurs in markets when both the
buyer and seller of a product are
made better off by the transaction.
Equity The fair distribution of

economic benefits.
Economic Models Understand the role of models

in economic analysis.
To develop a model, economists generally follow these steps:
1. Decide on the assumptions to use in developing the

model.
2. Formulate a testable hypothesis.
3. Use economic data to test the hypothesis.
4. Revise the model if it fails to explain well the economic
data.
5. Retain the revised model to help answer similar economic
questions in the future.

The Role of Assumptions in Economic Models
Economic models make behavioral

assumptions about the motives of consumers
and firms.
Forming and Testing Hypotheses in Economic Models

Economic variable Something measurable

that can have different values, such as the
wages of software programmers.

Normative and Positive Analysis
Positive analysis Analysis

concerned with what is.
Normative analysis Analysis

concerned with what ought to be.
Don’t Let This Happen to YOU!

Don’t Confuse Positive Analysis with Normative Analysis
YOUR TURN: Test your understanding by doing related problem 3.9 at the end of this
chapter.
Making Should the Federal Government Understand the role of models

the Have Increased Restrictions on
Connection the Immigration of Skilled Workers?
Like many other policy debates, the

debate over the immigration of skilled
workers has both positive and
normative elements.
The debate over the immigration of
skilled workers demonstrates that
economics is often at the center of

important policy issues.
Does restricting the immigration of skilled

workers affect the employment
opportunities of recent U.S. graduates?
YOUR TURN: Test your understanding by doing related problem 3.7 at the end of this
chapter.

Economics as a Social Science
Because economics studies the actions of

individuals, it is a social science. Economics is
therefore similar to other social science
disciplines, such as psychology, political
science, and sociology. As a social science,
economics considers human behavior—

particularly decision-making behavior—in
every context, not just in the context of
business.
Microeconomics and Distinguish between microeconomics
Macroeconomics and macroeconomics.
Microeconomics The study of how

households and firms make choices,
how they interact in markets, and how
the government attempts to influence
their choices.
Macroeconomics The study of the

economy as a whole, including topics
such as inflation, unemployment, and
economic growth.
A Preview of Important Become familiar with important
Economic Terms economic terms.
• Entrepreneur • Profit
• Innovation • Household
• Technology • Factors of production or
• Firm, company, or economic resources
business • Capital
• Goods • Human capital

• Services
• Revenue
AN INSIDE LOOK
at Policy >> Do Immigrants Displace or
Complement Domestic Workers?
Figure 1 Foreign-Born Scientists and Engineers as Figure 2 Foreign Recipients of U.S.

a Percentage of All Scientists and Engineers in the Science and Engineering Doctorates, 1985–
United States 2005
KEY TERMS
Allocative efficiency Microeconomics

Centrally planned economy Mixed economy
Economic model Normative analysis
Economic variable Opportunity cost
Economics Positive analysis
Equity Productive efficiency
Macroeconomics Scarcity
Marginal analysis Trade-off
Market Voluntary exchange
Market economy
LEARNING OBJECTIVE
Appendix Review the use of graphs
and formulas.
Using Graphs and Formulas
A graph is like a street

map—it is a simplified
version of reality.
LEARNING OBJECTIVE
and formulas.
Graphs of One Variable

FIGURE 1A-1
Bar Graphs and Pie Charts
Values for an economic variable are often displayed as a bar graph or as a pie chart.
In this case, panel (a) shows market share data for the U.S. automobile industry as a bar graph, where the
market share of each group of firms is represented by the height of its bar.
Panel (b) displays the same information as a pie chart, with the market share of each group of firms
represented by the size of its slice of the pie.
LEARNING OBJECTIVE
and formulas.
Graphs of One Variable

FIGURE 1A-2
Time-Series Graphs
Both panels present time-series graphs of Ford Motor Company’s worldwide sales during each year from
2001 to 2008. Panel (a) has a truncated scale on the vertical axis, and panel (b) does not.
As a result, the fluctuations in Ford’s sales appear smaller in panel (b) than in panel (a).
LEARNING OBJECTIVE
and formulas.
Graphs of Two Variables

FIGURE 1A-3
Plotting Price and Quantity
Points in a Graph
The figure shows a two-
dimensional grid on which we
measure the price of pizza along
the vertical axis (or y-axis) and
the quantity of pizza sold per
week along the horizontal axis (or
x-axis).
Each point on the grid represents
one of the price and quantity
combinations listed in the table.

By connecting the points with a
line, we can better illustrate the
relationship between the two
variables.
LEARNING OBJECTIVE
and formulas.

Slopes of Lines
FIGURE 1A-4
Calculating the Slope
of a Line
We can calculate the slope
of a line as the change in
the value of the variable on
the y-axis divided by the
change in the value of the
variable on the x-axis.
Because the slope of a
straight line is constant, we

can use any two points in
the figure to calculate the
slope of the line.
For example, when the price
of pizza decreases from $14
Change in value on the vertical axis Δy Rise
to $12, the quantity of pizza Slope   
demanded increases from
55 per week to 65 per week.
Change in value on the horizontal axis Δx Run
So, the slope of this line
equals –2 divided by 10, or
–0.2.
Δ Price of pizza ($12  $14) 2
Slope      0.2
Δ Quantity of pizza (65  55) 10
LEARNING OBJECTIVE
and formulas.

Taking into Account More Than Two Variables on a Graph
FIGURE 1A-5
Showing Three Variables on
a Graph
The demand curve for pizza shows the
relationship between the price of
pizzas and the quantity of pizzas
demanded, holding constant other
factors that might affect the willingness
of consumers to buy pizza.
If the price of pizza is $14 (point A), an

increase in the price of hamburgers
from $1.50 to $2.00 increases the
quantity of pizzas demanded from 55
to 60 per week (point B) and shifts us
to Demand curve2.
Or, if we start on Demand curve1 and
the price of pizza is $12 (point C), a
decrease in the price of hamburgers
from $1.50 to $1.00 decreases the
quantity of pizza demanded from 65 to
60 per week (point D) and shifts us to
Demand curve3.
LEARNING OBJECTIVE
and formulas.

Positive and Negative Relationships
FIGURE 1A-6
Graphing the Positive
Relationship between
Income and Consumption
In a positive relationship
between two economic
variables, as one variable
increases, the other variable
also increases. This figure
shows the positive relationship

between disposable personal
income and consumption
spending.
As disposable personal income
in the United States has
increased, so has consumption
spending.
LEARNING OBJECTIVE
and formulas.

Determining Cause and Effect
FIGURE 1A-7
Determining Cause and Effect
Using graphs to draw conclusions about cause and In panel (b), we see that more lawn mowers are
effect can be hazardous. In panel (a), we see that used in a neighborhood during times when the
there are fewer leaves on the trees in a neighborhood grass grows rapidly and fewer lawn mowers are
when many homes have fires burning in their fire used when the grass grows slowly. Concluding
places. We cannot draw the conclusion that the fires that using lawn mowers causes the grass to grow
cause the leaves to fall because we have an omitted faster would be making the error of reverse
variable—the season of the year. causality.
LEARNING OBJECTIVE
and formulas.

Are Graphs of Economic Relationships Always Straight Lines?
The graphs of relationships between two

economic variables that we have drawn so
far have been straight lines.
The relationship between two variables is

linear when it can be represented by a

straight line.
Few economic relationships are actually

linear.
LEARNING OBJECTIVE
and formulas.

Slopes of Nonlinear Curves
FIGURE 1A-8
The Slope of a Nonlinear Curve
The relationship between the quantity
of iPods produced and the total cost of
production is curved rather than linear.
In panel (a), in moving from point A to
point B, the quantity produced
increases by 1 million iPods, while the
total cost of production increases by
$50 million.
Farther up the curve, as we move from

point C to point D, the change in
quantity is the same—1 million iPods
—but the change in the total cost of
production is now much larger: $250
million.
Because the change in the y variable
has increased, while the change in the
x variable has remained the same, we
know that the slope has increased.
LEARNING OBJECTIVE
and formulas.

Slopes of Nonlinear Curves
FIGURE 1A-8 (continued)
The Slope of a Nonlinear Curve
In panel (b), we measure the slope of
the curve at a particular point by the
slope of the tangent line. The slope of
the tangent line at point B is 75, and
the slope of the tangent line at point C
is 150.
LEARNING OBJECTIVE
and formulas.
Formulas
Formula for a Percentage Change
One important formula is the percentage change.
The percentage change is the change in some economic

variable, usually from one period to the next, expressed as a
percentage.
 GDP2008  GDP2007 
  x 100
 GDP2007 
Value in the second period - Value in the first period

Percentage change  ( ) x 100
Value in the first period
LEARNING OBJECTIVE
and formulas.
Formulas
Formulas for the Areas of a Rectangle and a Triangle
Area of a rectangle  base x height
FIGURE 1A-9
Showing a Firm’s Total
Revenue on a Graph
The area of a rectangle is
equal to its base multiplied
by its height.
Total revenue is equal to
quantity multiplied by price.
Here, total revenue is equal

to the quantity of 125,000
bottles times the price of
$2.00 per bottle, or
$250,000.
The area of the green-
shaded rectangle shows the
firm’s total revenue.
LEARNING OBJECTIVE
and formulas.
Formulas
Formulas for the Areas of a Rectangle and a Triangle
Area of a triangle  1/2 x base x height
FIGURE 1A-10
The Area of a Triangle
The area of a triangle is equal
to 1⁄2 multiplied by its base
multiplied by its height.
The area of the blue-shaded
triangle has a base equal to

150,000 – 125,000, or
25,000, and a height equal to
$2.00 – $1.50, or $0.50.
Therefore, its area equals 1⁄2
× 25,000 × $0.50, or $6,250.
LEARNING OBJECTIVE
and formulas.
Formulas
Summary of Using Formulas
Whenever you must use a formula, you should follow these
steps:
1. Make sure you understand the economic concept

that the formula represents.
2. Make sure you are using the correct formula for the
problem you are solving.
3. Make sure that the number you calculate using the

formula is economically reasonable. For example, if
you are using a formula to calculate a firm’s revenue
and your answer is a negative number, you know you
made a mistake somewhere.

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Chapter 1: Economics: Foundations and Models

Bill Gates, chairman of

Economics: 1.1 Three Key Economic Ideas

Understand the role of models in economic analysis.

1.4 Microeconomics and Macroeconomics

In this book, we use economics to answer questions such as the

• How are the prices of goods and services determined?

• How does pollution affect the economy, and how should

• Why do firms engage in international trade, and how do

• Why does government control the prices of some goods

Scarcity A situation in which unlimited wants

Economics The study of the choices people

Economic model A simplified version of

Market A group of buyers and sellers of a

2. People respond to economic incentives.

Marginal analysis Analysis that

More than 45 countries in

making the very personal

Decision at the Margin

Should Apple produce an additional 1 million iPhones?

In solving the problem, consider the following:

• Optimal decisions are made at the margin.

the marginal benefit is equal to the marginal cost.

Trade-off The idea that because of scarcity,

Opportunity cost The highest-valued

Trade-offs force society to make choices when answering

1. What goods and services will be produced?

Centrally planned economy An

Market economy An economy in

Mixed economy An economy in

government plays a significant role in

Productive efficiency A situation in

Allocative efficiency A state of the

accordance with consumer

Voluntary exchange A situation that

Equity The fair distribution of

Economic Models Understand the role of models

To develop a model, economists generally follow these steps:

1. Decide on the assumptions to use in developing the

Economic Models Understand the role of models

The Role of Assumptions in Economic Models

Economic models make behavioral

Forming and Testing Hypotheses in Economic Models

Economic variable Something measurable

Economic Models Understand the role of models

Normative and Positive Analysis

Positive analysis Analysis

Normative analysis Analysis

Don’t Let This Happen to YOU!

Making Should the Federal Government Understand the role of models

Like many other policy debates, the

economics is often at the center of

Does restricting the immigration of skilled

Economic Models Understand the role of models

Economics as a Social Science

Because economics studies the actions of

economics considers human behavior—

Microeconomics The study of how