Chapter 2

THINKING LIKE AN
ECONOMIST

conomists have a distinctive way of thinking about issues, and the best way
to learn economics is to understand how to think like an economist. Thinking
like an economist involves focusing on trade-offs, incentives, exchange, information, and distributionthe five key concepts introduced in Chapter 1and more.
Economists focus on the choices individuals and business make when they are faced
with scarcity. These choices can involve a decision to eat at home rather than to go
to a restaurant, to go to college rather than take a job right out of high school, to
locate a plant overseas rather than in the United States, or any of a thousand other
alternatives. The choices made by individuals and business involve trade-offs and are
affected by the incentives they face, the opportunities for exchange that are available,
the information at hand, and the initial distribution of wealth. To understand choices,
economists start with a simple model of how individuals and firms interact with one
another in markets to carry out exchanges. This simple model is introduced in this
chapter and developed further in Part Two.

The Basic Competitive Model

Every day, millions of people take part in thousands of exchanges in hundreds of different markets. Somehow, out of all these exchanges, computers are produced and
end up in student dorm rooms, food is grown and ends up on the dinner tables of
households, and electricity is delivered to millions of homes and offices at a flick of
a switch. In an economy like that of the United States, markets play a critical role in
ensuring that workers find jobs, things get produced, and firms sell their products.
Exchange and the role of markets are important, but what makes them work? How
can you be sure that your local grocery store will have bread in the morning or that

25

your favorite caf will have milk and espresso for your morning latte? And how
can you be sure that the grocery store wont charge you $20 for that loaf of bread or
that your espresso wont cost $10?
The answer can be given in one wordcompetition. When firms compete
with one another for customers, they will offer customers the desired products
at the lowest possible price. Consumers also compete with one another. Only a
limited number of goods are available, and they come at a price. Consumers who
are willing to pay that price can enjoy the goods, but others are left empty-handed.
This picture of competitive markets, which economists call the basic competitive model, provides the point of departure for studying the economy. It consists
of three parts: assumptions about how consumers behave, assumptions about how
firms behave, and assumptions about the markets in which these consumers and
firms interact. Consumers are assumed to be rational, firms are assumed to be
profit maximizing, and the markets in which they interact are assumed to be highly
competitive. The model ignores the government, because we first need to see how
an economy without a government might function before we can understand the
role of the government.

RATIONAL CONSUMERS AND

PROFIT-MAXIMIZING FIRMS
Scarcity, which we encountered in Chapter 1, implies that individuals and firms face
trade-offs and must make choices. Underlying much of economic analysis is the
basic assumption of rational choice: that is, people weigh the costs and benefits of
each possibility whenever they must make a choice. This assumption, in turn, is
based on the expectation that individuals and firms will act consistently, with a reasonably well-defined notion of what they like and what their objectives are, and with
a reasonable understanding of how to attain those objectives.
In the case of individuals, the rationality assumption is taken to mean that they
make choices and decisions in pursuit of their own self-interest. Of course, different
people will have different goals and desires. Sarah may want to drive a Porsche, own
a yacht, and have a large house; to attain those objectives, she knows she needs
to work long hours and sacrifice time with her family. Andrew is willing to accept
a lower income in return for longer vacations and more leisure time throughout
the year.
Economists make no judgment about whether Sarahs preferences are better
or worse than Andrews. They do not even spend much time asking why different
individuals have different views on these matters, or why tastes change over time.
These are important issues, but they are more the province of psychology and sociology. Economists are concerned with the consequences of these different preferences.
What decisions can they expect Sarah and Andrew to make when each is rationally
pursuing her or his respective interests?
In the case of firms, the rationality assumption is taken to mean that firms
operate to maximize their profits.

26 CHAPTER 2 THINKING LIKE AN ECONOMIST

COMPETITIVE MARKETS
To complete the model, economists make assumptions about the places where selfinterested consumers and profit-maximizing firms meet: markets. Economists begin
by focusing on the case of many buyers and sellers, all buying and selling the same
thing. Picture a crowded farmers market with everyone buying and selling just one
good. Lets say we are in Florida, and the booths are full of oranges.
Each of the farmers would like to raise her prices. That way, if she can still sell
her oranges, her profits go up. Yet with a large number of sellers, each is forced to
charge close to the same price, since any farmer who charged much more would
lose business to the farmer next door. Profit-maximizing firms are in the same position. In an extreme case, if a firm charged any more than the going price, it would lose
all its sales. Economists label this case perfect competition. In perfect competition, each firm is a price taker, which simply means that it has no influence on the
market price. The firm takes the market price as given because it cannot raise its price
without losing all sales, and at the market price it can sell as much as it wishes. Even
a decision to sell ten times as much would have a negligible effect on the total quantity marketed or on the price prevailing in the market. Markets for agricultural
goods would be, in the absence of government intervention, perfectly competitive.
There are so many wheat farmers, for instance, that each farmer believes he
can grow and sell as much wheat as he wishes without affecting the price of wheat.

e-Insight

MARKETS, EXCHANGE, AND E-COMMERCE

In traditional societies, markets are places where people get
together to exchange goods. They are active, bustling places,
full of life. In the modern economy, goods and services are
being exchanged as if there were a well-defined marketplace.
The Internet has created a new kind of marketplace where
people all over the world can exchange goods and services
without ever getting together.
In traditional economies, prices for similar goods in different marketplaces could differ markedly. Traders would
buy goods in a marketplace where they were cheap and then
transport them to where the price was higher, making a
handsome profit in doing so. These merchants helped make
markets work better. Much of their high income could be
thought of as a return on their informationon knowing
where to buy cheap and sell dear. And by moving goods
from places where they were valued less to places where

they were valued more, the traders performed an important

social function.
The Internet has enabled all of this to be done far more
efficiently, at lower cost, with more complete information.
Markets all over the world can be joined instantaneously,
creating a global marketplace. Now any buyer (not just a
merchant) can find the place where the good is selling at the
lowest price, and any seller can find the place where the good
is selling at the highest price.
Some have worried that the role of the middleman, of merchants, will disappear. But there is more to trade than just
information about price. Many goods differ in a variety of
dimensions, such as quality and durability. E-markets work
best for well-defined goods, for which these issues are not
relevantgoods such as wheat or steel, or products like this
textbook.

THE BASIC COMPETITIVE MODEL

27

(Later in the book, we will encounter markets with limited or no competition, like
monopolies, in which firms can raise prices without losing all their sales.)
On the other side of our farmers market are rational individuals, each of whom
would like to pay as little as possible for oranges. But no consumer can pay less than
the going price, because the seller sees another buyer in the crowd who will pay it.
Thus, the consumers also have to compete against each other for the limited number
of oranges in the market, and as a result each takes the market price as given.
While a farmers market provides one illustration of what economists mean by
a market, most markets do not take this form. Today buyers and sellers are more
likely to interact over the Internet than at a farmers market. But the same basic
principles apply. When there are lots of buyers and sellers, each will take the price
as given in deciding how much to buy or sell.

EFFICIENCY AND DISTRIBUTION IN

THE BASIC COMPETITIVE MODEL
The basic competitive model, assuming it accurately represents actual markets,
has one very strong implication: the economy will be efficient. Scarce resources will
not be wasted. It will not be possible to produce more of one good without producing less of another, and it will not be possible to make any person better off without
making someone else worse off. These results are obtained in the absence of any
government activity.
Competitive markets also determine the distribution of goodswho gets to consume how much of the goods that are available. High levels of competition for the services of an individual with a rare and valuable skill will result in a very high income
for that individual. On the other hand, competition among suppliers of unskilled
labor may result in these workers earning very low wages, so low that even long
workdays fail to win them a decent standard of living. This disparity raises the question of the fairness of competitive distribution. Though efficiency is a desirable property of any economic system, fairness is a separate issue that must be considered.
Later in this book we will discuss how economists and policymakers approach the
inequalities that inevitably emerge from the workings of the competitive market.

THE BASIC COMPETITIVE

MODEL AS A BENCHMARK
Virtually all economists recognize that the competitive model is not a perfect representation of actual economies, but most economists still use it as a convenient
benchmarkas we will throughout this book. After all, as you learned in Chapter
1, an economic model is never a complete and accurate descriptionit is not meant
to bebut instead is designed to highlight critical aspects of the economy that provide insight and help us understand particular features of it. We will point out important differences between the predictions of the basic competitive model and observed
outcomes, and in Part Three, we will show how this model can be extended to offer

28 CHAPTER 2 THINKING LIKE AN ECONOMIST

new insights into markets and situations that the basic competitive model cannot fully
address. Differences between the predictions of the basic competitive model and
observed outcomes can help guide us to other models that provide a better understanding of particular markets and circumstances. While the basic competitive
model may not provide a perfect description of some markets, most economists
believe that it gives us tremendous insights into a wide range of economic issues;
for that reason, it is the foundation on which economists build.

Wrap-Up

INGREDIENTS IN THE BASIC COMPETITIVE

MODEL
1. Rational, self-interested consumers
2. Rational, profit-maximizing firms
3. Competitive markets with price-taking behavior

Incentives and Information:

Prices, Property Rights,
and Profits
For market economies to work efficiently, firms and individuals must be informed
and have incentives to act on available information. Indeed, incentives can be viewed
as at the heart of economics. Without incentives, why would individuals go to work
in the morning? Who would undertake the risks of bringing out new products?
Who would put aside savings for a rainy day? There is an old expression about the
importance of having someone mind the store. But without incentives, why would
anyone bother?
Market economies provide information and incentives through prices, profits,
and property rights. Prices provide information about the relative scarcity of different goods. The price system ensures that goods go to those individuals and firms that
are most willing and able to pay for them. Prices convey information to consumers
about scarcity, and consumers respond by adjusting their consumption. Similarly,
prices convey information to firms about how individuals value different goods.
The desire for profits motivates firms to respond to the information provided
by prices. By most efficiently producing what consumers want, in ways that least
use scarce resources, they increase their profits. Similarly, rational individuals pursuit of self-interest induces them to respond to prices: they buy goods that are more
expensivein a sense, relatively more scarceonly if those goods provide commensurately greater benefits. If a good such as oil becomes scarcer, its price rises. In
order to make rational decisions about how much heating oil to use, consumers do
not need to know why the price of oil has risen. Perhaps a particularly cold winter

INCENTIVES AND INFORMATION: PRICES, PROPERTY RIGHTS, AND PROFITS

29

has increased demand. Or perhaps troubles in the Middle East have decreased
supply. In either case, the higher price signals consumers to reduce their purchases
of oil products. If the price of home heating oil rises, that increase signals oil refineries to produce more heating oil. Prices provide the information that individuals and
firms need to make rational decisions.
For the profit motive to be effective, there must be private property, with its
attendant property rights. Under a system of private property, firms and individuals are able to own and use (or sell if they choose) factories, land, and buildings. Without private property, firms would not have an incentive to invest in new
factories or new technologies, hire employees, produce goods and services that
consumers want to buy, and earn profits. Even if the profits to be earned from
building a new factory are huge, no firm will begin construction without the confidence that the factory cannot just be taken away. Firms need to be able to keep
at least some of their profits to use as they see fit. Similarly, households need to be
able to keep at least some of the return on their investments. (The return on their
investment is simply what they receive back in excess of what they invested.)
Property rights include both the right of the owner to use property as she sees fit
and the right to sell it.
These two attributes of property rights give individuals the incentive to use
property under their control efficiently. The owner of a piece of land tries to figure
out the most profitable use of the landfor example, whether to build a store or
a restaurant. If he makes a mistake and opens a restaurant when he should have
opened a store, he bears the consequences: the loss in income. The profits he earns
if he makes the right decisionsand the losses he bears if he makes the wrong
onesgive him an incentive to think carefully about the decision and do the requisite research. The owner of a store tries to make sure that her customers get
the kind of merchandise and the quality of service they want. She has an incentive to establish a good reputation, which will enable her to do more business and
earn more profits.
The store owner will also want to maintain her propertynot just the land
but also the storebecause doing so will enable her to get a better price when the
time comes to sell her business to someone else. Similarly, the owner of a house
has an incentive to maintain his property, so that he can sell it for more when
he wishes to move. Again, the profit motive combines with private property to
provide incentives.

Wrap-Up

HOW THE PROFIT MOTIVE

DRIVES THE MARKET SYSTEM
In market economies, incentives are supplied to individuals and firms by prices,
profits, and property rights.

30 CHAPTER 2 THINKING LIKE AN ECONOMIST

INCENTIVES VERSUS EQUALITY

While incentives are at the heart of market economies, they come with a cost: inequality. Any system of incentives must tie compensation to performance. Whether through
variations in luck or ability, the performances of individuals will differ. In many cases,
the reason for high performance is unclear. The successful salesperson may point to
his superior skill and effort, while his colleague may view him as lucky.
If pay is tied to performance, inequalities are inevitable. And the more closely
compensation is tied to performance, the greater the inequality. The fact that greater
incentives lead to greater resulting inequality is called the incentive-equality tradeoff. If society provides greater incentives, total income is likely to be higher, but the
gap between incomes will also probably be greater.
Society thus faces a basic question: How much would incentives be diminished by
an increase in tax rates to finance a better welfare system and thus reduce inequality?
And what would be the results of those reduced incentives?

WHEN PROPERTY RIGHTS FAIL

Prices, profits, and property rights are the three essential ingredients of market
economies. Their importance is underscored by those cases in which property rights
and prices are interfered with. Each example below highlights a general point.
Whenever society fails to define the owner of its resources and does not allow the highest bidder to use them, inefficiencies result. Resources will be wasted or not used in
the most productive way.

Ill-Defined Property Rights: The Grand Banks Fish are a valuable

resource. Not long ago, the area between Newfoundland and Maine, called the Grand
Banks, was teeming with fish. Not surprisingly, it was also teeming with fishermen,
who saw scooping out the fish from the sea as an easy livelihood. Since there were
no property rights, everyone tried to catch as many fish as they could. A selfinterested fisherman would rationally reason that if he did not catch the fish, someone else would. The result was a tragedy: the Grand Banks was so badly overfished
that commercial fishing became unprofitable.
Overfishing is just one example of what is called the tragedy of the commons.
In the 1830s, an Oxford University economist named William Forster Lloyd
explained why the commonsthe pasture land in England that was not privately
ownedwas overgrazed. Because this land was freely available to all, each herder
had an incentive to increase the size of his herd. As a result, the commons was
overused until it was too damaged to support any grazing. When property rights
are difficult to define, the tragedy of the commons is often addressed through
international agreements. For example, Canada and the United States now have
a treaty limiting the amount of fish that their fisherman can take from the Grand
Banks, and in 1979 the Northwest Atlantic Fisheries Organization (NAFO) was
established to manage fish stocks.

INCENTIVES AND INFORMATION: PRICES, PROPERTY RIGHTS, AND PROFITS

31

Restricted Property Rights In California, the government allocates water

rights among various groups. Because water is scarce in California, these rights are
very valuable. But they come with a restriction: they are not transferable. Water
rights allow farmers to purchase water at much lower rates than the price charged
to nonfarm households. What thirsty urban consumers would be willing to pay for
additional water exceeds the profits from many of the crops the water is being used
to grow. If water rights were transferable, farmers would have a strong incentive to
sell them to California cities. Farmers could then switch away from water-intensive
crops such as rice to crops that need less water. By selling their water rights, the
farmers would be better offthe value of the water exceeds the value of the crops
they are growing; urban residents would also be better off, because lower-price
water would be available to them. A restriction on property rightsin this case, the
restriction on the farmers ability to sellhas led to inefficiencies.

Entitlements as Property Rights Property rights do not always entail full

ownership or control. A legal entitlement, such as the right to occupy an apartment
for life at a rent that is controlled, common in some large cities, is viewed by economists as a property right. Individuals do not own and thus cannot sell the apartment,
but under normal circumstances they cannot be evicted.
These partial and restricted property rights result in many inefficiencies. Because
someone in a rent-controlled apartment cannot (legally) sell the right to live in
her apartment, as she gets older she may have limited incentives to maintain its
condition, let alone improve it.
Incentives, prices, profits, and property rights are central features of any economy, and highlight an important area of consensus among economists: Providing
appropriate incentives is a fundamental economic problem. In modern market economies,
profits provide incentives for firms to produce the goods individuals want, and wages
provide incentives for individuals to work. Property rights also provide people with important incentives, not only to invest and to save but also to put their assets to the best
possible use.

Alternatives to the Price System

The price system is only one way of allocating resources, and a comparison with
other systems will help clarify the advantages of markets. When individuals get less
of a good than they would like at the terms being offered, the good is said to be
rationed. Different rationing systems are different ways of deciding who gets
societys scarce resources.

Rationing by Queues Rather than supplying goods to those willing and able
to pay the most for them, a society could give them instead to those most willing to
wait in line. This system is called rationing by queues, after the British term for lines.
Tickets are often allocated by queues, whether they are for movies, sporting events,
or rock concerts. A price is set, and it will not change no matter how many people

32 CHAPTER 2 THINKING LIKE AN ECONOMIST

line up to buy at that price. (The high price that scalpers can get for hot tickets is
a good indication of how much more than the ticket price (some) people would be
willing to pay.1)
Rationing by queues is thought by many to be a more desirable way of supplying
medical services than the price system. Why, it is argued, should the richwho are
most able to pay for medical servicesbe the ones to get better or more medical
care? Using this reasoning, Britain provides free medical care to everyone on its soil.
To see a doctor there, all you have to do is wait in line. Rationing medicine by queues
turns the allocation problem around: since the value of time for low-wage workers is
lower, they are more willing to wait, and therefore they get a disproportionate share
of (government-supplied) medical services.
In general, rationing by queues is an inefficient way of distributing resources,
because the time spent in line is a wasted resource. There are usually ways
of achieving the same goal within a price system that can make everyone better
off. To return to the medical example, if some individuals were allowed to pay for
doctors services instead of waiting in line, more doctors could be hired with
the proceeds, and the lines for those unable or unwilling to pay could actually
be reduced.

Rationing by Lotteries Lotteries allocate goods by a random process, such as

picking a name from a hat. University dormitory rooms are usually assigned by lottery. So are seats in popular courses; when more students want to enroll in a section
of a principles of economics course than the size of the section allows, there may be
a lottery to determine admission. Like queue systems, lotteries are thought to be
fair because everyone has an equal chance. However, they are also inefficient, because
the scarce resources do not go to the individual or firm who is willing and able to
pay (and therefore values them) the most.

Rationing by Coupons Most governments in wartime use coupon rationing.

People are allowed so many gallons of gasoline, so many pounds of sugar, and so
much flour each month. To get the good, consumers must pay the market price and
produce a coupon.
Coupon systems take two forms, depending on whether coupons are tradable or not. Coupons that are not tradable give rise to the same inefficiency that
occurs with most of the other nonprice systemsgoods do not in general go to
the individuals who are willing and able to pay the most. Moreover, the inability
to legally trade coupons creates strong incentives for the establishment of a
black market, an illegal market in which the goods or the coupons for goods
are traded.

1
So why are concert tickets rationed by queues rather than by price? The musicians and concert promoters
could increase their profits by raising the ticket price, but consider the situation of a popular musician who is
concerned with both concert income and income from CD sales. Allocating tickets by queue favors those with
the most free time and helps ensure that tickets go to the musicians core fansparticularly those who are
younger, who have less money to spend. These fans may be the most likely to buy CDs, and CD sales depend heavily on word-of-mouth advertising. So by ensuring that her core fans are not priced out of concerts, a musician
may actually end up increasing her profits.

ALTERNATIVES TO THE PRICE SYSTEM

33

Opportunity Sets and Trade-offs

Market economic systems leave to individuals and firms the question of what to
consume and what to produce. How are these decisions made?
For a rational individual or firm, the first step in the economic analysis of any
choice is to identify what is possiblewhat economists call the opportunity set,
which is simply the group of available options. If you want a sandwich and have only
tuna fish and cheese in the refrigerator, then your opportunity set consists of a tuna
fish sandwich, a cheese sandwich, a tuna and cheese sandwich, or no sandwich. A
ham sandwich is out of the question. Defining the limitations facing an individual
or firm is a critical step in any analysis of choice. You can spend time yearning after
the ham sandwich, or anything else outside the opportunity set, but when it comes
to making decisions, only what is within the opportunity set is relevant.
So the first step in analyzing choice is to identify what is within the opportunity set.

BUDGET AND TIME CONSTRAINTS

TABLE 2.1

MICHELLES
OPPORTUNITY SET
DVDs

CDs

6
5
4
3
2
1
0

0
2
4
6
8
10
12

Constraints limit choice and define the opportunity set. In most economic situations,
the constraints that limit a persons choicesthat is, those constraints that actually are relevantare time and money. Opportunity sets whose constraints are
imposed by money are referred to as budget constraints; opportunity sets whose
constraints are prescribed by time are called time constraints. A billionaire may feel
his choices are limited not by money but by time, while the limits for an unemployed
worker are set by lack of money rather than lack of time.
The budget constraint defines a typical opportunity set. Consider the budget
constraint of Michelle, who has decided to spend $120 on either CDs or DVDs. A CD
costs $10, a DVD $20. So Michelle can buy 12 CDs or 6 DVDs; or 8 CDs and 2 DVDs;
or 4 CDs and 4 DVDs. The various possibilities are set forth in Table 2.1. They are
also depicted graphically in Figure 2.1.2 Along the vertical axis, we measure the
number of CDs purchased, and along the horizontal axis, we measure the number
of DVDs. The line marked B1B2 is Michelles budget constraint. The extreme cases,
in which Michelle buys only DVDs or only CDs, are represented by the points B1 and
B2, respectively. The dots between these two points, along the budget constraint,
represent the other possible combinations. The cost of each combination of CDs
and DVDs must add up to $120. If Michelle decides to buy more DVDs, she will have
to settle for fewer CDs. The point actually chosen by Michelle is labeled E, where
she purchases 6 CDs (for $60) and 3 DVDs (for $60).
Michelles budget constraint is the line that defines the outer limits of her opportunity set. But the whole opportunity set is larger. It also includes all points below
the budget constraintin the figure, the shaded area. The budget constraint shows
the maximum number of DVDs Michelle can buy for each number of CDs purchased,
and vice versa. Michelle is always happiest when she chooses a point on her budget
constraint rather than below it. To see why, compare the points E and D. At point E,
2
See the chapter appendix for help in reading graphs. Economists have found graphs to be extremely useful and
they will be employed throughout this book. It is important that you learn to read and understand them.

34 CHAPTER 2 THINKING LIKE AN ECONOMIST

THE PRODUCTION POSSIBILITIES CURVE

Business firms and whole societies face constraints. They too must make
choices limited to opportunity sets. The amount of goods a firm or society can produce, given a fixed amount of land, labor, and other inputs, is
referred to as its production possibilities.
A commonly used example considers a society in which all economic
production is divided into two categories, military spending and civilian
spending. Of course, each of these two kinds of spending has many different elements, but for the moment, well focus only on the two broad categories. For the sake of simplicity, Figure 2.3 refers to military spending as
guns and civilian spending as butter. The production of guns is given
along the vertical axis, the production of butter along the horizontal. The
possible combinations of military and civilian spendingof guns and
butteris the opportunity set. Table 2.2 sets out some of the possible
combinationswhich 90 million guns and 40 million tons of butter, or 40
million guns and 90 million tons of butter. These possibilities are depicted
in the figure. In production decisions, the boundary of the opportunity
setthe maximum amount of guns that can be produced for each amount
of butter and vice versais called the production possibilities curve.
When we compare the individuals opportunity set and that of society,
we notice one major difference. The individuals budget constraint is a
straight line, while the production possibilities curve bows outward. There
is a good reason for this. An individual typically faces fixed trade-offs: if
Michelle spends $20 more on DVDs (that is, she buys one more DVD), she
has $20 less to spend on CDs (she can buy two fewer CDs).
In contrast, the trade-offs faced by society are not fixed. If a society
produces only a few guns, it will use those resourcesthe workers and
machinesthat are best equipped for gun making. But as society tries
to produce more and more guns, doing so becomes more difficult; it will
increasingly depend on resources that are less good at producing guns.

NUMBER OF CDs PURCHASED

14
12

B2

10
F

8
E

6
D

4
2

B1
1

NUMBER OF DVDs PURCHASED

Figure 2.1

MICHELLES BUDGET CONSTRAINT

The budget constraint identifies the limits of Michelles
opportunity set between CDs and DVDs. Points B1
and B2 are extreme options, where she chooses all of
one or the other. Her actual choice corresponds to
point E. Choices from the shaded area are possible
but less attractive than choices actually on the budget
constraint.

24
HOURS SPENT ON ALL OTHER ACTIVITIES

she has more of both goods than at point D. She would be even happier
at point F, where she has still more DVDs and CDs, but that point, by
definition, is unattainable.
Figure 2.2 depicts a time constraint. The most common time constraint simply says that the sum of what an individual spends her time
on each dayincluding sleepmust add up to 24 hours. The figure plots
the hours spent watching television on the horizontal axis and the hours
spent on all other activities on the vertical axis. Peopleno matter how
rich or poorhave only 24 hours a day to spend on different activities.
The time constraint is quite similar to the budget constraint. A person
cannot spend more than 24 hours or fewer than zero hours a day watching TV. The more time she spends watching television, the less time she
has available for all other activities. If she wants to watch more TV, she
must make a trade-off and reduce her time spent in some other activity.

20
16
Time constraint
12
8
4

12

16

24

20

HOURS SPENT WATCHING TV

Figure 2.2

AN OPPORTUNITY SET FOR WATCHING

TV AND OTHER ACTIVITIES
This opportunity set is limited by a time constraint,
which shows the trade-off a person faces between
spending time watching television and spending it on
other activities.

OPPORTUNITY SETS AND TRADE-OFFS

35

TABLE 2.2

PRODUCTION
POSSIBILITIES FOR THE
ECONOMY
Guns
(millions)

Butter
(millions of tons)

100
90
70
40
0

0
40
70
90
100

It will be drawing these resources out of the production of other goods, in this case,
butter. Thus, when the economy increases its production of guns from 40 million
a year (point A) to 70 million (B), butter production falls by 20 million tons,
from 90 million tons to 70 million tons. But if production of guns is increased further,
to 90 million (C), an increase of only 20 million, butter production has to decrease
by 30 million tons, to only 40 million tons. For each increase in the number of guns,
the reduction in the number of tons of butter produced gets larger. That is why the
production possibilities curve is curved.
In another example, assume that a firm owns land that can be used for growing
wheat but not corn, and land that can grow corn but not wheat. In this case, the only
way to increase wheat production is to move workers from the cornfields to
the wheat fields. As more and more workers are put into the wheat fields,
production of wheat goes up, but each successive worker increases production less.
The first workers might pick the largest and most destructive weeds. Additional
workers lead to better weeding, and better weeding leads to higher output. But the
additional weeds removed are smaller and less destructive, so output is increased
by a correspondingly smaller amount. This is an example of the general principle
of diminishing returns. Adding successive units of any input such as fertilizer,
labor, or machines to a fixed amount of other inputsseeds or landincreases the
output, or amount produced, but by less and less.

100
90

F
C

GUNS (MILLIONS)

80

Societys production
possibilities curve
B

70
60
50
40

Societys
opportunity
set

30
20
10
G
0

10 20 30 40 50 60 70 80 90 100
BUTTER (MILLIONS OF TONS)

Figure 2.3

THE GUNS AND BUTTER TRADE-OFF

A production possibilities curve can show societys opportunity set. This one describes
the trade-off between military spending (guns) and civilian spending (butter). Points
F and G show the extreme choices, where the economy produces all guns or all butter.
Notice that unlike the budget and time constraint lines, the production possibilities line
curves, reflecting diminishing returns.
36 CHAPTER 2 THINKING LIKE AN ECONOMIST

200,000

CORN (BUSHELS)

Diminishing returns is an important concept in economics. The

phenomenon occurs in many situations. You have probably discovered that you usually get more out of the first hour of studying than
the tenth, and that studying a few hours may bring big payoffs when
you are preparing for an exam; but if you stay up all night to cram,
your concentration is likely to decrease, and you may be so tired
in the morning that you actually do worse on the exam than if you
had quit studying sooner. Having one of your roommates help you
fix dinner cuts the preparation time; but if all your roommates try
to help, they may end up just getting in each others way. In Chapter 6, where we examine the factors that affect the costs of producing goods and services, the notion of diminishing returns will help
us understand why a rise in price is necessary to induce firms to
increase the amount they produce.
Table 2.3 shows the output of the corn- and wheat fields as labor
is increased in each. Assume the firm has 6,000 workers to divide
between wheat production and corn production. Thus, the second
and fourth columns together give the firms production possibilities,
which are depicted in Figure 2.4.

B
Firms production
possibilities curve
A

150,000

60,000

150,000

WHEAT (BUSHELS)

Figure 2.4

THE WHEAT AND CORN TRADE-OFF

This production possibilities curve shows that as wheat production increases, it becomes necessary to give up larger and
larger amounts of corn. Or to put the same point a different
way, as corn production falls, the resulting increase in wheat
production gets smaller.

Costs

Making trade-offs always involves weighing costs and benefits. What you gain is the
benefit; what you give up is the cost. Often, the benefits depend on an individuals personal preferencessome people would gladly skip a tennis game to go play golf, and
others would just as gladly make the opposite choice. Economists generally do not
try to explain why people have different preferences; instead, when it comes to
understanding the choices individuals make, economists focus on costs. An opportunity set, like the budget constraint, the time constraint, or the production possibilities curve, specifies the cost of one option in terms of another. If the individual,

TABLE 2.3

DIMINISHING RETURNS
Labor in cornfield
(no. of workers)

Corn
output
(bushels)

Labor in wheat field

(no. of workers)

Wheat
output
(bushels)

1,000
2,000
3,000
4,000
5,000

60,000
110,000
150,000
180,000
200,000

5,000
4,000
3,000
2,000
1,000

200,000
180,000
150,000
110,000
60,000

COSTS

37

the firm, or society is operating on the constraint or curve, then it is possible to get
more of one thing only by sacrificing some of another. The cost of one more unit
of one good is how much you have to give up of the other.
Economists think about costs in terms of trade-offs within opportunity sets.
Lets go back to Michelle choosing between CDs and DVDs in Figure 2.1. The
trade-off is given by the relative price, the ratio of the prices of CDs and DVDs.
In our example, a CD costs $10, and a DVD $20. The relative price is $20/$10 =
2. For every DVD Michelle gives up, she can buy 2 CDs. Likewise, societies and
firms face trade-offs along the production possibilities curve, like the one shown
in Figure 2.3. There, point A is the choice where 40 million guns and 90 million
tons of butter are produced. The trade-off can be calculated by comparing points
A and B. Society can have 30 million more guns by giving up 20 million tons
of butter.
Trade-offs are necessary because resources are scarce. If you want something,
you have to pay for ityou have to give up something. If you want to go to the library
tomorrow night, you have to give up going to the movies. If a sawmill wants to make
more two-by-four beams from its stock of wood, it will not be able to make as many
one-by-four boards.

OPPORTUNITY COSTS
If someone were to ask you right now what it costs to go to a movie, you would probably answer, Ten dollars, or whatever you last paid for a ticket. But the concept
of trade-offs suggests that a full answer is not that simple. To begin with, the cost is
not the $10 but what that $10 could otherwise buy. Furthermore, your time is a scarce
resource that must be figured into the calculation. Both the money and the
time represent opportunities forgone in favor of going to the movie, or what
economists refer to as the opportunity cost of the movie. To apply a resource to
one use means that it cannot be put to any other use. Thus, we should consider the
next-best, alternative use of any resource when we think about putting it to any particular use. This next-best use is the formal measurement of opportunity cost.
Some examples will help clarify the idea of opportunity cost. Consider a college student, Sarah, who works during the summer. She has a chance to go surfing in Costa Rica with friends, but to do so she has to quit her summer job two
weeks early. The friends have found a cheap airfare and place to stay, and they tell
Sarah the trip will cost only $1,000. To the economist, $1,000 is not the total cost
of the trip for Sarah. Since she would have continued working in her summer job
for an extra two weeks if she did not go to Costa Rica, the income she would have
earned is part of the opportunity cost of her time. This forgone income must be
added to the airfare and hotel costs in calculating the total economic cost of the
surfing trip.
Now consider a business firm that has bought a building for its headquarters
that is bigger than necessary. If the firm could receive $3 per month in rent for each
square foot of space that is not needed, then that is the opportunity cost of leaving
the space idle.

38 CHAPTER 2 THINKING LIKE AN ECONOMIST

Thinking Like an Economist

TRADE-OFFS
Whenever you see an opportunity set, a budget or time constraint, or a production possibilities curve, think trade-off. The
variables on the two axes identify the objects of the trade-offs,
whether those are CDs and DVDs, guns and butter, or something else. The line or curve drawn from one axis to the other
provides quantities for the trade-off. The opportunity set shows
the choices that are available. The budget constraint illustrates the trade-offs that must be made because of limited
money to spend, while the time constraint reflects the limited time we all have. The production possibilities curve gives
the trade-offs faced in deciding what to produce when the
amount of land, labor, and other inputs is limited. All three
focus attention on the necessity of making trade-offs.
Many people think economists study only situations that
involve money and budget constraints, but often time constraints are very important in defining trade-offs. Political
elections provide a good example of the importance of time
constraints. As the 2004 presidential election campaign
entered its final stages, each candidate faced tough choices
because of the time constraint. The election date was fixed
leaving only so much time available for campaigning. Ohio was
one of the critical states for both John Kerry and George W.
Bush, and both candidates visited it frequently in the months
leading up to the election. But time spent in Ohio was time
that could not be spent in the other toss-up states. Each candidate had to decide how best to allocate the time remaining
before the election.

President George W. Bush greets well-wishers.

Economists find it useful to distinguish between budget

constraints and time constraints, but often we study tradeoffs that involve both time and money. Choosing how to spend
your Saturday evening usually involves both. You might
decide to go to a movie that lasts for 2 hours and costs $10
or go to a concert that lasts 4 hours and costs $40. Both your
budget and time constraints are important for defining your
opportunity set.

The analysis can be applied to the government as well. The federal government
owns a vast amount of wilderness. In deciding whether it is worthwhile to convert
some of the land into a national park, the government needs to take into account
the opportunity cost of the land. The land might be used for growing timber or for
grazing sheep. Whatever the value of the land in its next-best use, this is the economic cost of the national park. The fact that the government does not have to buy
the land does not mean that the land should be treated as a free good.
Thus, in the economists view, when rational firms and individuals make
decisionswhether to undertake one investment project rather than another, whether
to buy one product rather than anotherthey take into account all of the costs (the
full opportunity costs), not just the direct expenditures.

COSTS

39

Internet Connection

INTERNET RESOURCES FOR ECONOMISTS

A guide to Internet resources for economists can be found
at http://rfe.wustl.edu. The American Economic Association
sponsors this guide. It lists more than 1,200 resources in

sixty-nine sections and subsections that are of interest to

professional economists as well as those simply interested
in economics.

Case in Point

THE OPPORTUNITY COST OF ATTENDING

COLLEGE
Opportunity cost is a key concept in economics. It is the correct measure of the cost
of everything we do. As a college student, what is your opportunity cost of attending
college? If you (or your parents) are asking how much your college costs, you probably think of the tuition, room and board, and books as major costs. But a consideration
of the opportunity cost suggests that such a list includes both too much and too little.
Since you would need a place to live, and you would certainly need to eat, even if
you were not in school, these costs do not represent part of the opportunity cost of
attending college. Only if your college charges higher rent than you would otherwise
pay would your dorm costs be part of your opportunity cost.
To correctly evaluate opportunity cost, you need to think about what you would be
doing if you had decided not to continue in school. The economists mind immediately
turns to the job you might have had if you had not enrolled in college and the income
you could have earned. That amount will vary from student to student; but in 2004,
eighteen- to twenty-four-year-olds with a high school diploma who were working fulltime earned just under $15,000 per year.3 This forgone income must be added to the
direct costs such as tuition to obtain the opportunity cost of attending school. For most
students, this forgone income is a major component of the opportunity cost of college.
Test your understanding: Use the concept of opportunity cost to explain why great
college basketball players often fail to complete four years of college.

Opportunity Cost and International Trade The concepts of opportunity

cost and exchange play a pivotal role in helping to understand why economists argue
that all countries can gain from international trade. Consider the case of two fictional countries, which we will call North and South. North is highly developed with
skilled workers and modern capital equipment. South is much poorer; its workers
are generally unskilled and have little capital equipment to aid them in production.
For simplicity, assume further that these two countries produce only two goods,
3
U.S. Census Bureau, Annual Demographic Survey, Table PINC-04, March 2004 (http://pubdb3.census.gov/
macro/032004/perinc/new04_001.htm).

40 CHAPTER 2 THINKING LIKE AN ECONOMIST

computers and textiles. The developed country is more productive than the lessdeveloped country at producing both computers and textiles. Despite the fact that
North can produce either good more efficiently than South can, economists argue
that it will still pay for the two countries to trade, and opportunity cost provides the
key to understanding why.
Lets make our example more concrete by assuming that in North, 100 hours of
labor can produce either 5 computers or 100 shirts. In South, 100 hours of labor can
produce only 1 computer or 50 shirts. These numbers reflect our assumption that
North is more productive in producing both computers and textiles (in this case,
shirts). These numbers are listed in the top half of Table 2.4. We describe this
situation by saying that North has an absolute advantage in producing both computers and textiles. But the key insight to understanding international trade is that
trade patterns are not based on absolute advantage. Instead, they are based on a
comparison of the opportunity cost in each country of producing the two goods. In
North, the opportunity cost of producing 100 shirts is 5 computers; shifting 100
hours of labor into textile production to produce the 100 extra shirts would reduce
computer production by 5 computers. In contrast, the opportunity cost of producing
100 shirts in South is only 2 computers; shifting 200 hours of labor into textile production to produce the extra 100 shirts would reduce computer production by 2 computers. The opportunity cost of producing more shirts is lower in South than it is in
North. We describe this by saying South has a comparative advantage in producing
textiles. South is relatively more efficient in producing shirts than North is.
While South has a comparative advantage in producing shirts, North has a comparative advantage in producing computers; it is relatively more efficient in producing computers. To see this, consider the opportunity cost in North of producing
1 more computer. To produce an additional computer, North must shift 20 hours of
labor out of textile production and into computer production, reducing shirt production by 20 shirts. The opportunity cost of the computer in North is 20 shirts. To
produce an additional computer, South must shift 100 hours of labor out of textile
production and into computer production, reducing shirt production by 50. The
opportunity cost of a computer is higher in South (50 shirts) than it is in North (20
shirts). North has a comparative advantage in computer production.
The bottom half of Table 2.4 shows the opportunity cost of producing computers (expressed in terms of shirts) and the opportunity cost of producing shirts
(expressed in terms of computers) for each country. While North has an absolute
advantage in producing both goods, its comparative advantage lies in producing
computers. Souths comparative advantage lies in producing shirts.
Because South has a comparative advantage in shirt production and North has
a comparative advantage in computer production, both countries can benefit by
trading. By shifting 100 hours of labor from computer production to shirt production, South produces 1 less computer and 50 more shirts. By shifting 20 hours of
labor from shirt production into computer production, North produces 1 more computer and 20 fewer shirts. By this move toward specialization in each country, total
computer production has remained unchanged (1 less produced in South, 1 more
produced in North), but total shirt production has risen by 30 shirts (50 more in
South, 20 fewer in North). These extra shirts represent (in our example), the gains
to specialization. Because the opportunity cost of a computer in North is 20 shirts,
COSTS

41

TABLE 2.4

LABOR PRODUCTIVITY IN PRODUCING

COMPUTERS AND SHIRTS
Computers produced with 100 hours of labor
Shirts produced with 100 hours of labor

North

South

5
100

1
50

OPPORTUNITY COST OF PRODUCING

COMPUTERS AND SHIRTS
Opportunity cost of a computer (in terms of shirts)
Opportunity cost of 100 shirts (in terms of computers)

North

South

20
5

50
2

North will be willing to accept no less than 20 shirts from South in exchange for 1 computer. If South were to offer fewer than 20 shirts for a computer, North would be
better off producing its own shirts. Because the opportunity cost of a computer in
South is 50 shirts, South will be willing to pay no more than 50 shirts to obtain a
computer from North. As long as the price for a computer lies between 20 and 50
shirts per computer, both countries can gain if North shifts labor into computer production, South shifts labor into textile production, and the two then engage in trade.
For example, if the price of a computer is 30 shirts, South can buy 1 computer from
North (leaving South with the same number of computers as it had previously) and
it will still have 20 shirts left over to better clothe its own residents. Meanwhile,
North reduced its own shirt production by 20 shirts, but was able to obtain 30 shirts
in exchange for the extra computer it produced. So North is also better off. North will
benefit by exporting computers to South, and South will benefit by exporting textiles
to North.
By recognizing the important role of opportunity cost, we can understand why
both North and South gain from specializing in production and engaging in international trade. Despite the economists argument that free trade can benefit both countries, many people oppose moves to promote international trade. Their arguments,
and the role of various government policies that affect international trade, will be the
subject of Chapter 19.

SUNK COSTS
Economic cost includes costs, as we have just seen, that noneconomists often exclude,
but it also ignores costs that noneconomists include. If an expenditure has already
been made and cannot be recovered no matter what choice is made, a rational person
would ignore it. Such expenditures are called sunk costs.
42 CHAPTER 2 THINKING LIKE AN ECONOMIST

To understand sunk costs, lets go back to the movies, assuming now that you
have spent $10 to buy a movie ticket. You were skeptical about whether the movie
was worth $10. Half an hour into the movie, your worst suspicions are realized: the
movie is a disaster. Should you leave the movie theater? In making that decision,
the $10 should be ignored. It is a sunk cost; your money is gone whether you stay or
leave. The only relevant choice now is how to spend the next 60 minutes of your
time: watch a terrible movie or go do something else.
Or assume you have just purchased a fancy laptop computer for $2,000. But the
next week, the manufacturer announces a new computer with twice the power for
$1,000; you can trade in your old computer for the new one by paying an additional
$400. You are angry. You feel you have just paid $2,000 for a computer that is now
almost worthless, and you have gotten little use out of it. You decide not to buy the
new computer for another year, until you have gotten at least some return for your
investment. Again, an economist would say that you are not approaching the question rationally. The past decision is a sunk cost. The only question you should ask yourself is whether the extra power of the fancier computer is worth the additional $400.
If it is, buy it. If not, dont.

MARGINAL COSTS
The third aspect of cost that economists emphasize is the extra costs of doing something,
what they call the marginal costs. These are weighed against the (additional) marginal benefits of doing it. The most difficult decisions we make are not whether to do
something or not. They are whether to do a little more or a little less of something. Few
of us waste much time deciding whether or not to work. We have to work; the decision
is whether to work a few more or a few less hours. A country does not consider whether
or not to have an army; it decides whether to have a larger or smaller army.
Polly is considering flying to Colorado for a ski weekend. She has three days off
from work. The airfare is $200, the hotel room costs $100 a night, and the ski ticket
costs $35 a day. Food costs the same as at home. She is trying to decide whether to
go for two or three days. The marginal cost of the third day is $135, the hotel cost
plus the cost of the ski ticket. There are no additional transportation costs involved
in staying the third day. She needs to compare the marginal cost with the additional
enjoyment she will have from the third day.

Internet Connection

THE ECONOMISTS' VOICE

One way to start thinking like an economist is to read what
economists have to say about current events. The Economists

Voice at www.bepress.com/ev/ provides articles about current

economic issues.
COSTS

43

People, consciously or not, think about the trade-offs at the margin in most of
their decisions. Economists, however, bring them into the foreground. Like opportunity costs and sunk costs, marginal analysis is one of the critical concepts that
enable economists to think systematically about the costs of alternative choices.
This kind of marginal analysis has come to play an increasingly important role
in policy discussions. For instance, the key issue in various environmental regulations and safety standards is not whether there should be such regulations, but
how tight they should be. Higher standards have both marginal benefits and
marginal costs. From an economic standpoint, justification of higher standards
hinges on whether the marginal benefits outweigh the marginal costs. Consider, for
instance, auto safety. For the past three decades, the government has taken an
active role in ensuring auto safety. It sets standards that all automobiles must
meet. For example, an automobile must be able to withstand a side collision of a
particular velocity. One of the most difficult problems the government faces
is deciding what those standards should be. It recently considered tightening
standards for withstanding side collisions on trucks. The government calculated
that the higher standards would result on average in 79 fewer deaths per year.
It calculated that meeting the higher standards would increase the cost of each
vehicle by $81. (In addition, the heavier trucks would use more fuel.) In deciding
whether to impose the higher standard, it used marginal analysis. It looked at the
additional lives saved and at the additional costs.

Wrap-Up

BASIC STEPS OF RATIONAL CHOICE

Identify the opportunity sets.
Define the trade-offs.
Calculate the costs correctly, ignoring sunk costs, taking into account opportunity
costs and marginal costs.

44 CHAPTER 2 THINKING LIKE AN ECONOMIST