Chapter 2
Some Tools of the Economist
OUTLINE
I. What Shall We Give Up?
A. Opportunity Cost
1. Opportunity cost
2. The opportunity cost of college.
1. If the opportunity cost of college rises (e.g. tuition rises), then one will be
less likely to attend college.
II. Trade Creates Value
A. Voluntary Exchange
2. By channeling goods and resources to those who value them most, trade creates
B. Transactions Costs
1. Transactions costs: the time, effort, and other resources needed to search out,
negotiate, and consummate an exchange.
a. Transactions costs reduce our ability to produce gains from potential trades.
C. Middleman
1. Middleman: a person who buys and sells, or who arranges trades.
A middleman reduces transactions costs.
The Internet lowered transactions costs.
III. The Importance of Property Rights
A. Private Property Rights
2. Several features of private property rights.
a. They provide the right to exclusive use.
b. They provide legal protection against invaders.
c. They provide the right to transfer to another.
B. Private Property Rights Incentives
1. Private owners can gain by employing their resources in ways that are beneficial to
others and they bear the opportunity cost of ignoring the wishes of others
2. Private owners have a strong incentive to care for and properly manage what they
4. Private owners have an incentive to lower the chance that their property will cause
damage to the property of others.
a. Private ownership links responsibility with the right of control.
C. Private Property and Markets
1. When private property rights are protected and enforced, permission of the owner is
required for use of a resource.
2. Market prices provide a strong incentive for private owners to consider the desires
of others and to use and develop resources that are highly valued by others.
IV. Production Possibilities Curve
A. Shifting the Production Possibilities Curve Outward
1.
goods and services.
3. An improvement in the rules under which the economy functions can increase
output.
4. By working harder and giving up current leisure, we could increase our production
of goods and services.
V. Trade, Output, and Living Standards
A. Division of Labor
2. Division of labor increases output for three reasons:
a. Specialization permits individuals to take advantage of their existing skills.
b. Specialized workers become more skilled with time.
c. Permits adoption of mass-production technology.
B. Law of Comparative Advantage
1. Law of comparative advantage: total output is greatest when individuals specialize
in the production of goods that they produce at a low opportunity cost, and trade
those goods for goods that they are a high-opportunity-cost producer.
a. The principle of comparative advantage is universal as it applies across
individuals, firms, regions and countries.
VI. Human Ingenuity and the Creation of Wealth
A. Economic Pie
1. Economic goods are the result of human ingenuity and action; thus the size of the
economic pie is variable.
a. At any point in time, our ability to produce goods and services is constrained
Chapter 2/Some Tools of the Economist 27
b. With the passage of time, however, output can be expanded through investment
and the discovery of better ways of doing things.
VII. Economic Organization
A. Methods of Economic Organization
1. Market organization: A method or organization that allows unregulated prices and
2. Collective decision making is the method of organization that relies on public–
sector decision making to resolve basic issues.
a An economic system in which the government owns the income-producing
OBJECTIVES
In this chapter, we introduce the student to some basic economic tools opportunity cost, the
production possibilities curve, the law of comparative advantage, property rights, and the theory of
exchange. The basic description of these concepts, without applications, are often boring to the
student. Accordingly, it is vitally important that, as instructors, we present interesting and creative
examples to help the student to visualize and retain these concepts. Two alternative institutional
arrangements market and government planning are available to deal with economic issues. In
this chapter, basic tools are introduced and the stage is set for the following three chapters.
IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. Clearly, opportunity cost is the most vital and widely applicable concept in economics. From
-valued alternative
ith which students can readily identify
will help to reinforce the concept. What does the student give up when he studies economics
for an hour? When she works ten hours per week? When he owns a car and drives 50 miles a
week? In each case the answer is the highest-valued alternative that could have been chosen
2. The fact that trade creates value, the role of
of transactions costs are introduced. Later in the chapter, the myth that trade is a zero sum game
3. The section on property rights is important. Students need to understand how privately held
rights hold owners accountable, in an opportunity cost sense, for opportunities missed, and for
4. The concept of production possibilities provides the foundation for the constraints on aggregate
supply that will be discussed later. Resources can be used to produce alternative commodities.
However, when resources are being utilized efficiently, production of more of one good will
5. The law of comparative advantage is introduced here since it ties in nicely with both
opportunity cost
6. The myth dispelled in this chapter is the dangerous and increasingly popular misconception
7. It is difficult to overemphasize the importance of incentives and the broadness of this basic
8. The conclusion of Chapter two would be an excellent time to give a short quiz. Ample
9. Teachers are always looking for new examples illustrating the gains from specialization and
in 1-1/2 hours. Starting from this basic data, the normal conclusions can be drawn about
absolute advantage and comparative advantage, how comparative advantage is just another
10. Since this chapter is the main one dealing with the concept of opportunity cost, it needs to be
emphasized that costs are attached to choices, not goods. One effective way to do this in class
is
11. A way to integrate student understanding of how value is created and the crucial role of
entrepreneurship in the process is to show students that all forms of creating value involve one
or more of the following: resources are being moved from less– to more-valuable forms (what
importance of property rights under differing incentive structures that are faced by different
13. Games one to five described in the next section will help reinforce the material in chapter two.
14. first of several in the
15. This chapter includes
16. The addendum to the chapter gives a detailed numerical example of comparative advantage
GAMES
1. Getting Dressed in the Global Economy
Type: In-Class Assignment
Topics: Specialization, interdependence, self-interest, consumer choice,
international linkages
Textbook: Chapter 1 The Economic Approach
Chapter 2/Some Tools of the Economist 31
Instructions
Ask the class to answer the following questions. Give them time to write an answer to a question,
then discuss their answers before moving to the next question. The first question can be answered
with a brief phrase. The second question is the core of the assignment and takes several minutes.
Ask them to list as many categories of workers as possible. (Offering a dollar to the first student to
list 20 categories adds a competitive element.) Question three introduces demand concepts; most
of the determinants of demand can be introduced during its discussion. For the fourth question,
ask the class to look at the country-of-origin tags sewn in their garments.
1. Where did your clothes come from?
2. Who worked to produce your clothes?
3. What things do you consider when buying a garment?
4. Where were your clothes produced (what countries)?
Common answers and points for discussion
1. Where did your clothes come from?
–
2. Who worked to produce your clothes?
3. What things do you consider when buying a garment?
4. Where were your clothes produced (what countries)?
2. Screwdrivers and Bloody Marys
Type: In-Class demonstration
Topics: graphing, opportunity cost, choice
Textbook: Chapter 2 Some Tools of the Economist
Materials Needed: none
Time: 10 minutes
Class limitations: works in any size class
Purpose
This activity leads students from a simple graphing exercise to the concepts of scarcity,
opportunity cost and choice.
Instructions
Draw a graph with Bloody Marys on the horizontal axis and Screwdrivers on the vertical axis.
A Bloody Mary contains tomato juice and one shot of vodka. A Screwdriver contains orange juice
and one shot of vodka. Assume we have plenty of orange juice and tomato juice, but only one
small bottle of vodka, containing six shots.
How many Bloody Marys could we make, if we only made Bloody Marys?
How many Screwdrivers could we make if we only made Screwdrivers?
Could we make six of both drinks? Why not?
On your graph, show all the possible combinations of Bloody Marys and Screwdrivers that could
be made, given a small bottle of vodka.
Points for discussion
The combinations will make a continuous line, since we could pour half drinks, or quarter drinks,
or any fraction of either drink.
Several basic graphing techniques can be demonstrated: inverse relation, negative slope, linear
relation, etc.
The economic points are more interesting. We can produce any combination, on or inside the line.
If we produce inside the line, say two screwdrivers and two Bloody Marys, we are not fully using
our resources. This is inefficient.
3. Realism and Models: An Analogy
Type: In-Class demonstration
Topics: models
Textbook: Chapter two Some Tools of the Economist
Materials Needed: airplane kit, sheet of paper, whirl-a-gig wing toy (Note: the whirl-a-gig
wing toy is a helicopter wing on a stick; it is often sold in museum gift
shops, as well as toy stores.)
Time: 5 minutes
Class limitations: works in any size class
Purpose
Students frequently complain about the lack of realism in economic models. This demonstration
uses airplane toys to illustrate that simplicity can be an asset in modeling.
Instructions and points for discussion
Ask the class if a realistic model is better than an unrealistic model. Realism, of course, will be
favored.
Show them the airplane model kit. Describe some of the details included in the model (rivets,
canopy, struts, etc). Shake the box to rattle the large number of parts. This a fairly realistic model,
although obviously not a real airplane. Its complexity adds realism, but at a cost; assembling the
4. A Short Trip with Many Contributors
Type: In-Class Assignment
Topics: Specialization, interdependence, self-interest, international
linkages, role of government
Textbook: Chapter 2 Some Tools of the Economist
Materials Needed: none
Time: 20 minutes
Class limitations: works in any size class
Purpose
This assignment shows the advantages of specialization and division of labor, and global links. It
also introduces concepts of public and private financing.
Instructions
Ask the class to answer the following questions. Give them time to write an answer to a question,
then discuss their answers before moving to the next question.
1. Think of a recent trip you have taken. The distance traveled is unimportant, just choose
a specific trip. Where did this trip start and finish?
2. Who produced the goods and services that made your trip possible? (List as many types
3. How were the different elements of your trip financed? (e.g. the vehicle, the road
network, or the airport).
Common answers and points for discussion
Who produced the goods and services that made your trip possible?
The specific answers will vary depending on the mode of travel. The discussion below focuses on
automobiles but the ideas easily extend to airplanes, busses, trains, or boats.
Most students will include autoworkers, gas station attendants and, if they traveled through snow,
road maintenance crews. These answers touch on three important elements the vehicle, the fuel,
Chapter 2/Some Tools of the Economist 35
This can be repeated in a million directions for any individual component miners to extract ores,
cooks to feed the miners, farmers to supply the cooks. Of course a crowd of others are needed:
accountants, designers, managers, inventors, engineers, janitors, secretaries, computer operators,
communications technicians, chemists, and so on.
How were the different elements of your trip financed?
5. Lawless Transactions
Type: In-Class Demonstration
Topics: the legal system and property rights
Textbook: Chapter 2: Some Tools of the Economist
Materials Needed: a volunteer, a paper sack
Time: 15 minutes
Class limitations: works in any size class
Purpose
This example shows the importance of the legal system as part of the institutional framework of a
market system. It illustrates that even simple market transactions rely on an established body of
law. Four required elements for a legal system can be demonstrated. A legal system needs to: 1)
enforce contracts 2) define and protect property 3) prevent fraud 4) define and enforce liability.
Instructions
Explain that the transactions in this example are only hypothetical; no money or goods will
actually be exchanged.
Ask the volunteer how much he or she would be willing to pay for a backpack.
Agree to the offered price. This represents a typical market transaction, a good in exchange for a
36 Chapter 2/Some Tools of the Economist
enforcing contracts.
Now take a backpack from another student. Give it to the volunteer. In this case, both the buyer
and seller are satisfied. The volunteer gets a backpack, the professor gets paid. Ask the class if
anyone is unhappy?
Return the backpack to its owner.
Now give the volunteer a paper sack. Tell the volunteer you have a legally binding contract and
you expect full payment. The problem here is misrepresentation. Legal systems can prevent this
problem by stopping fraudulent contracts.
Finally tell the volunteer that you have a new backpack made of a high-tech material developed in
the
transaction and everyone is happy. A couple of weeks pass, and the volunteer is studying in the
library when the backpack bursts into flames and explodes. The new backpack material was
internally unstable. The entire library burns down. Who should pay?
Is the student responsible for the damages? Should the professor pay? Or should the Chemistry
department be responsible? Determining liability is another important role for the legal system.
Points for discussion
The transitional economies of Eastern Europe provide daily examples of the problems of markets
without established legal systems. Markets can be a very effective tool for allocation and
distribution, but they only work within a social framework.
Definition of property rights may be trivial for personal property like a backpack, but more
Environmental regulations (particularly those regarding wetlands or endangered species) and
intellectual property rights have been recent controversies over property definition.
Defining liability continues to be an important public issue.
Chapter 2/Some Tools of the Economist 37
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS
3. The rational decision-maker would choose the bus if the opportunity cost of his/her time was
4. The statement refl
private business can force customers to buy. Consumers purchase various goods and services
5. The major function of the middleman is to increase the value of resources by reducing
11. If consumer demand for beef fell, the profitability of cattle herding would fall as well. Many