CHAPTER 1 | Economics: Foundations
and Models
Brief Chapter Summary and Learning Objectives
1.1 Three Key Economic Ideas (pages 4–8)
Explain these three key economic ideas: People are rational; people respond to economic
1.2 The Economic Problem That Every Society Must Solve (pages 8–12)
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 (pages 12–17)
1.4 Microeconomics and Macroeconomics (page 17)
Distinguish between microeconomics and macroeconomics.
Key Terms
Allocative efficiency, p. 12. 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
Economic model, p. 4. A simplified version
of reality used to analyze real-world economic
situations.
2 CHAPTER 1 | Economics: Foundations and Models
Equity, p. 12. The fair distribution of economic
benefits.
Macroeconomics, p. 17. The study of the
Market economy, p. 10. An economy in which
the decisions of households and firms interacting
in markets allocate economic resources.
Microeconomics, p. 17. The study of how
households and firms make choices, how they
interact in markets, and how the government
attempts to influence their choices.
Normative analysis, p. 14. Analysis concerned
with what ought to be.
Opportunity cost, p. 8. The highest-valued
Scarcity, p. 4. A situation in which unlimited
wants exceed the limited resources available to
fulfill those wants.
Trade-off, p. 8. The idea that, because of
scarcity, producing more of one good or service
means producing less of another good or service.
Voluntary exchange, p. 12. A situation that
Chapter Outline
Will Smart Devices Revolutionize Health Care?
Scanadu, a California-based firm, developed a small disk that when pressed against someone’s head can
read the person’s blood pressure, heart rate and temperature. Apple and other firms also have developed
CHAPTER 1 | Economics: Foundations and Models 3
Teaching Tips
There are special features in the textbook:
1. The introduction, or chapter opener, uses a real-world business example to preview the economic
issues discussed in the chapter.
2. At the end of each of the first four textbook chapters is a feature titled An Inside Look that consists of
5. There are between two and four Making the Connection features in each chapter that provide real
world reinforcement of key concepts by citing news stories that focus on business and policy issues.
Extra Making the Connection features appear in the Instructor’s Manual.
6. Solved Problems use a step-by-step process for solving economic problems related to a chapter
learning objective. Extra Solved Problems are included in the Instructor’s Manual.
People must make choices as they try to attain their goals. The choices people make represent the trade-
offs made necessary by scarcity. Scarcity is a situation in which unlimited wants exceed the limited
resources available to fulfill those wants. Economics is the study of the choices people make to attain
their goals, given their scarce resources. An economic model is a simplified version of reality used to
analyze real-world economic situations.
Teaching Tips
Students will better understand what scarcity means if you give them examples of things that are not
1.1
Three Key Economic Ideas (pages 4–8)
Learning Objective: Explain these three key economic ideas: People are rational;
people respond to economic incentives; and optimal decisions are made at the margin.
A market is a group of buyers and sellers of a good or service and the institution or arrangement by
which they come together to trade.
4 CHAPTER 1 | Economics: Foundations and Models
B. People Respond to Economic Incentives
Economists emphasize that consumers and firms consistently respond to economic incentives.
C. Optimal Decisions Are Made at the Margin
Extra Solved Problem 1.1
A Doctor Makes a Decision at the Margin
A doctor receives complaints from patients that her office isn’t open enough hours. So the doctor asks her
office manager to analyze the effect of keeping her office open 9 hours per day rather than 8 hours. The
Solving the Problem
Step 1: Review the chapter material.
This problem is about making decisions, so you may want to review the section “Optimal
Decisions Are Made at the Margin,” which begins on page 7.
Step 2: Explain whether you agree with the office manager’s reasoning.
We have seen that any activity should be continued to the point where the marginal benefit is
Step 3: Explain what additional information you need.
To make a correct decision, you would need information on the marginal cost of remaining
open an extra hour per day. The marginal cost would include the additional salary to be paid
to the office staff, any additional medical supplies that would be used, as well as any
Teaching Tips
You don’t need to spend a lot of class time with explanations of the material in this section; subsequent
chapters will reinforce students’ understanding of markets and the “three key economic ideas.”
CHAPTER 1 | Economics: Foundations and Models 5
1.2
The Economic Problem That Every Society Must Solve (pages 8–12)
Learning Objective: 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?
Every society faces the economic problem that it has only a limited amount of economic resources, so it
can produce only a limited amount of goods and services. Society faces trade-offs. A trade-off is the idea
that, because of scarcity, producing more of one good or service means producing less of another good or
A. What Goods and Services Will Be Produced?
The answer to this question is determined by the choices consumers, firms, and the government make.
Each choice made comes with an opportunity cost.
B. How Will the Goods and Services Be Produced?
Firms choose how to produce the goods and services they sell. For example, firms often face trade-offs
between using more workers or more machines.
C. Who Will Receive the Goods and Services Produced?
In the United States, who receives the goods and services produced depends largely on how income is
D. Centrally Planned Economies versus Market Economies
Societies organize their economies in two main ways. A centrally planned economy is an economy in
which the government decides how economic resources will be allocated. A market economy is an
E. The Modern “Mixed” Economy
The high rates of unemployment and business bankruptcies during the Great Depression of the 1930s
caused a dramatic increase in government intervention in the economy in the United States and other
market economies. Some government intervention is designed to raise the incomes of the elderly, the sick,
6 CHAPTER 1 | Economics: Foundations and Models
F. Efficiency and Equity
Market economies tend to be more efficient than centrally planned economies. There are two types of
efficiency. Productive efficiency is a situation in which a good or service is produced at the lowest possible
cost. Allocative efficiency is a state of the economy in which production is in accordance with consumer
Teaching Tips
Ask students for examples of government regulation of private markets in the United States. Responses
may include: making the sale of cocaine and other addictive drugs illegal; minimum age requirements for
the purchase of alcoholic beverages and cigarettes; the prohibition of the sale of new drugs before their
effectiveness is demonstrated through government supervised tests. Ask students whether one of these
examples of government regulation promotes equity or fairness. The difficulty in defining equity will be
apparent.
To show how students may value equity less than they claim, an economics teacher at a college in
Extra Solved Problem 1.2
Advising New Government Leaders
Suppose that a country experiences a change in government leadership. Prior to this change, the country
had a centrally planned economy. The new leaders are willing to try a different system if they can be can
be convinced that it will yield better results. They hire an economist from a country with a market
CHAPTER 1 | Economics: Foundations and Models 7
Solving the Problem
Step 1: Review the chapter material.
The problem is about different types of economic systems, so you may want to review the section
“Centrally Planned Economies versus Market Economies” beginning on page 10 of the textbook.
Step 2: What will the economist suggest the leaders order their citizens to do?
Market economies allow members of households to select occupations and purchase goods
Step 3: Are there reasons why the leaders of this country might not accept the economist’s
suggestions?
Even democratically elected leaders may find it difficult to accept the new system. They may
wonder how self-interested individuals will produce and distribute goods and services so as to
1.3
Economic Models (pages 12–17)
Learning Objective: Describe the role of models in economic analysis.
Models are simplified versions of reality used to analyze real-world situations. To develop a model,
economists generally follow five steps.
1. Decide on the assumptions to use in developing the model.
2. Formulate a testable hypothesis.
A. The Role of Assumptions in Economic Models
Models are based on making assumptions because models must be simplified to be useful. When using
models economists make behavioral assumptions about the motives of consumers and firms. Economists
B. Forming and Testing Hypotheses in Economic Models
An economic variable is something measurable that can have different values, such as the incomes of
doctors. A hypothesis in an economic model is a statement that may be correct or incorrect about an
8 CHAPTER 1 | Economics: Foundations and Models
C. Positive and Normative Analysis
Positive analysis is analysis concerned with what is. Normative analysis is analysis concerned with what
D. Economics as a Social Science
Because economics studies the actions of individuals, it is a social science. Economics considers human
Extra Solved Problem 1.3
Sunspot Activity and the Market for Natural Gas
Sunspots are sites of strong magnetic fields that appear as dark regions on the surface of the sun. The
number of sunspots varies over an eleven-year cycle. Scientists have found that the Earth’s temperature
declines when the number of sunspots decreases, so when the number of sunspots declines there is an
expectation that a period of lower temperatures will follow. British economist William Stanley Jevons
How can we develop a model that tests the relationship between sunspot activity and the market for
natural gas?
Solving the Problem
Step 1: Review the chapter material.
The problem is about how to use models to analyze economic issues, so you may want to
review the section “Economic Models,” which begins on page 12 of the textbook.
Step 2: To develop and test a model of the relationship between sunspot activity and the
market for natural gas, follow these steps:
1. Decide on the assumptions to use in developing the model. Two assumptions of the
model are: (a) Changes in the earth’s temperature are related to changes in the amount of
CHAPTER 1 | Economics: Foundations and Models 9
3. Use economic data to test the hypothesis. Compare changes in sunspot activity with
changes in sales and the price of natural gas. Because sunspot activity varies in eleven-
4. Revise the model if it fails to explain the economic data well. The model could fail
because factors other than sunspot activity can have a significant effect the market for
5. Retain the revised model to help answer similar economic questions in the future. If the
data support the model, one can assume that there is a relationship between sunspot
1.4
Microeconomics and Macroeconomics (page 17)
Learning Objective: Distinguish between microeconomics and macroeconomics.
Microeconomics is the study of how households and firms make choices, how they interact in markets,
Extra Solved Problem 1.4
Microeconomic and Macroeconomic Views
Sports fans are used to watching events on television from different camera angles. For popular events
such as the Olympics, the World Series, and the Super Bowl, network coverage captures action from
ground level as well as higher locations. Blimps are frequently flown above the stadiums where the events
10 CHAPTER 1 | Economics: Foundations and Models
Solving the Problem
Step 1: Review the chapter material.
The problem concerns the differences between microeconomics and macroeconomics, so you
Step 2: Compare the focus of microeconomics with television coverage of a sports event.
Microeconomics focuses on how individual households and firms make choices, how they
Step 3: Compare the focus of macroeconomics with the television coverage of a sports event.
Macroeconomics is the study of the economy as a whole, including topics such as inflation,
Extra Making
the
Connection
Macroeconomic and Microeconomic Analysis
Economists separate the study of how households and firms make choices and interact in markets
(microeconomics) from the study of the economy as a whole (macroeconomics). But some issues can be
viewed from both perspectives. Labor productivity is one such issue.
Labor productivity—the quantity of goods and services that can be produced by one worker or by one
hour of work—is a microeconomic topic. Labor productivity increases when a firm invests in capital or
experiences an improvement in technology. Increased labor productivity allows a firm to earn higher
Some economists attribute the slowdown in productivity growth to a decline in investments in research by
U.S. firms from the high levels reached after 1995, which resulted in advancements in computer-related
applications. Other economists claim that many recent improvements in productivity escape
measurement. Google Inc.’s chief economist Hal Varian has argued that many innovations—such as apps
that can be used via cell phones to track locations or hailing taxis—lead to improvements in productivity
“But I doubt that gets measured anywhere.”
CHAPTER 1 | Economics: Foundations and Models 11
1.5
A Preview of Important Economic Terms (pages 17–19)
Learning Objective: Define important economic terms.
This section provides a brief definition and preview of terms students will see throughout the book: firm
Extra Economics in Your Life:
Is Cheating a Rational Decision?
In their best-selling book Freakonomics, Steven D. Levitt and Stephen J. Dubner stated: “Who cheats?
Well, just about anyone, if the stakes are right . . . . Cheating . . . is a prominent feature in just about every
human endeavor.” Evidence that some people cheat surfaced in the summer of 2011 when the
superintendent of the board of the Atlanta school district resigned after a report documented widespread
Sources: Steven D. Levitt and Stephen J. Dubner, Freakonomics New York: HarperCollins 2005, pages 24–25; Patrik Jonsson,
“America’s biggest teacher and principal cheating scandal unfolds in Atlanta,” Christian Science Monitor, July 5, 2011; Mary
Beth McCauley, “Atlanta school cheating: When teachers cheat, what do you tell the kids?” Christian Science Monitor,
September 5, 2013; and Valerie Strauss, “How and Why Convicted Teachers Cheated on Standardized Tests,” Washington Post,
April 1, 2015.
Question: For the sake of argument, let’s assume that you would never cheat. Under what circumstances
are students in general more or less likely to cheat on an economics examination?
Answer: Your economics instructor will be pleased if you would never cheat under any circumstances.
But cheating is more likely when: (a) the positive consequences of receiving a high grade are significant
Extra AN INSIDE LOOK News Article to Use in Class
12 CHAPTER 1 | Economics: Foundations and Models
Appendix
Using Graphs and Formulas (pages 27–38)
Learning Objective: Use graphs and formulas to analyze economic situations.
Graphs simplify economic ideas and make the ideas more concrete so they can be applied to real-world
problems.
Graphs of One Variable
Figure 1A.1 in the textbook displays examples of two common types of graphs: bar graphs and pie charts.
The height of the bars in the bar graph represents the market shares of automobile firms. The pie chart
Graphs of Two Variables
We often use graphs to show the relationship between two variables. Figure 1A.3 illustrates the graph of a
linear or straight-line demand curve where price is measured along the vertical axis and quantity is
measured along the horizontal axis.
A. Slopes of Lines
The slope of a straight line indicates how much the variable measured along the y–axis changes as the
variable measured along the x-axis changes. Slope can be measured between any two points on the
B. Taking into Account More Than Two Variables on a Graph
The demand curve in Figure 1A.4 shows the relationship between the price of pizza and the quantity of
pizza sold, but the quantity of any good sold depends on more than just the price of the good. Allowing
C. Positive and Negative Relationships
Sometimes the relationship between two variables is negative, as in the case with the price of pizza and