The Economic Way of Thinking
2 c h a p t e r
KNOW A FEW PRINCIPLES WELL
Most of economics is really knowing certain principles well and knowing when and how to apply them. This chapter presents some important tools that will help you understand the economic way of thinking. These few basic ideas will repeatedly occur throughout the text. If you develop a good understanding of these principles and master the problem-solving skills inherent in them, they will serve you well for the rest of your life.
SCARCITY
Economics is concerned primarily with scarcity— how we satisfy our unlimited wants in a world of limited resources. We may want “essential” items like food, clothing, schooling, and health care. We may want many other items, like vacations, cars, computers, and concert tickets. We may want more friendship, love, knowledge, and so on. We also may have many goals—perhaps an A in this class, a college education, and a great job. Unfortunately, people are not able to fulfill all their wants—material desires and nonmaterial desires. And as long as human wants exceed available resources, scarcity will exist.
SCARCITY AND RESOURCES
The scarce resources used in the production of goods and services can be grouped into four categories: labor, land, capital, and entrepreneurship.
Labor is the total of both physical and mental effort expended by people in the production of goods and services.
Land includes the “gifts of nature” or the natural resources used in the production of goods and services.
Economists consider “land” to include trees, animals, water, minerals, and so on, along with the physical space we normally think of as land.
Capital is the equipment and structures used to produce goods and services. Office buildings, tools, machines, and factories are all considered capital goods. When we invest in factories, machines, research and development, or education, we increase the potential to create more goods and services in the future. Capital also includes human capital— the productive knowledge and skill people receive from education and on-the-job training.
Entrepreneurship is the process of combining labor, land, and capital to produce goods and services.
Entrepreneurs make the tough and risky decisions about what and how to produce goods and services. Entrepreneurs are always looking for new ways to improve production techniques or to create new products. They are lured by the chance to make a profit. It is this opportunity to make a profit that leads entrepreneurs to take risks.
However, not every entrepreneur is a Bill Gates (Microsoft) or a Henry Ford (Ford Motor Company).
In some sense, we are all entrepreneurs when we try new products or when we find better ways to manage our households or our study time.
Rather than money, then, our profits might take the form of greater enjoyment, additional time for recreation, or better grades.
GOODS AND SERVICES
Goods are the items that we value or desire. Goods tend to be tangible—objects that can be seen, held,
Scarcity
s e c t i o n
2.1
_ What are goods and services?
_ What are tangible and intangible goods?
_ What are economic goods?
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All the things you see here— flowers, trees, rocks, animals—are considered land to economists.
heard, tasted, or smelled. But there are also goods that we cannot reach out and touch, called intangible goods. Intangible goods include fairness for all, friendship, knowledge, security, and health. While some intangible goods have no price tags, a USA Today poll showed that the wealthy would be willing to pay top dollar, if they could, for a place in heaven ($640,000), true love ($487,000), and a great intellect ($407,000). There’s even a price for some people’s sweat. At a charity auction in China, a bathrobe “still bearing the stink of [soccer star] David Beckham’s sweat sold for $350.”
Services are intangible acts for which people are willing to pay, such as legal counsel, medical care, and education. Services are intangible because they are less overtly visible, but they are certainly no less valuable than goods.
All goods and services, whether tangible or intangible, are produced from scarce resources and can be subjected to economic analysis. Scarce goods created from scarce resources are called economic goods. If there are not enough economic goods for all of us, we will have to compete for those scarce goods. That is, scarcity ultimately leads to competition for the available goods and services, a subject we will return to often in the text.
ARE THOSE WHO WANT MORE GREEDY?
We all want more tangible and intangible goods and services. In economics, we assume that more goods lead to greater satisfaction. However, just because economics assumes that we want more goods does not mean that economics also assumes that we are selfish and greedy. Many people give much of their income and time to charitable or religious organizations.
The ways people allocate their income and time reveal their preferences. The fact that people are willing to give up their money and time for what they believe to be important causes reveals quite conclusively that charitable endeavors are a desirable good. Clearly, then, many desires, like building new friendships or helping charities, can hardly be defined as selfish, yet these are desires that many people share. In other words, self-interest is not the same as selfishness or greed.
EVERYONE FACES SCARCITY
We all face scarcity because we cannot have all the goods and services we desire. However, because we all have different wants and desires, scarcity affects everyone differently. For example, a child in a developing country may face a scarcity of food and clean drinking water, while a rich man may face a scarcity of garage space for his growing antique car collection. Likewise, a harried middle-class working mother may find time for exercise particularly scarce, while a pharmaceutical company may be concerned with the scarcity of the natural resources it uses in its production process. While its effects vary, no one can escape scarcity.
Scarcity 27 Providing charity is a desire or want—many people want to help others. In this ad, we see a picture of an exhausted young child who has a life-threatening illness.
Through the generosity of Make-a-Wish contributors, John has just had batting instruction and lunch with all-star baseball players Sammy Sosa and Cal Ripken.
Courtesy of MAKE-A-WISH Foundation. Phoenix, AZ www.wish.org The New Yorker Collection 1991 Jack Ziegler from Cartoonbank.com. All rights reserved.
EVEN THE RICH FACE SCARCITY
We often hear it said of rich people that “He has everything” or “She can buy anything she wants.” Actually, even the richest person must live with scarcity and must, at some point, choose one want or desire over another. And of course, we all have only 24 hours in a day! The problem is that as we get more affluent, we learn of new luxuries to provide us with satisfaction. Wealth, then, creates a new set of wants to be satisfied. There is no evidence that people would not find a valuable use for additional income, no matter how rich they became.
Even the wealthy individual who decides to donate all her money to charity faces the constraints of scarcity. If she had greater resources, she could do still more for others. As Johnny Carson (Jay Leno’s Tonight Show predecessor) reportedly once said, “Having more money does not mean having fewer problems; the problems just have more zeros after the dollar sign.”
SCARCITY AND GROWING EXPECTATIONS
It is probably clear by now that scarcity never has and never will be eradicated. The same creativity that permits new methods to produce goods and services in greater quantities also reveals new wants. Fashions are always changing. Clothes and shoes that are “in” one year will surely be “out” the next. New wants quickly replace old ones.
Thus, a small black-and-white television set, which provided so much enjoyment for viewers raised on radio, is an inadequate form of entertainment for most people now. Two generations ago, only the well-to-do had telephones; today telephones are provided to some welfare recipients on the grounds that they are a “necessity.” Moreover, although people seem to be happier when they can buy more goods and services, it is likely that over a period of time, a rising quantity of goods and services will not increase human happiness. Why? There are several possibilities, but it is very possible that our wants grow as fast, if not faster, than our ability to meet those wants, so we still feel scarcity as much or more than we did before.
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Not even millionaire lottery winners can escape scarcity. The problem is that as we get more affluent, we learn of new luxuries to provide us with satisfaction.
Even lottery winners may become less content as the excitement wears off and they begin looking for new satisfactions.
Reuters New Media/CORBIS © The New Yorker Collection 1999 William Hamilton from cartoonbank.com. All Rights Reserved.
SCARCITY AND CHOICES
Each of us may want a nice home, two luxury cars, wholesome and good-tasting food, a personal trainer, and a therapist, all enjoyed in a pristine environment with zero pollution. If we had unlimited resources, and thus an ability to produce all the goods and services everyone wants, we would not have to choose among those desires. If we did not have to make meaningful economic choices, the study of economics would not be necessary. The essence of economics is to understand fully the implications that scarcity has for wise decision making.
This suggests another way to define economics:
Economics is the study of the choices we make among our many wants and desires.
TO CHOOSE IS TO LOSE
We are all faced with scarcity, and as a consequence, we must make choices. Because none of us can “afford” to buy everything we want, each time we do decide to buy one good or service, we reduce our ability to buy other things we would also like to have.
If you buy a new car this year, you may not be able to afford your next best choice—the vacation you’ve been planning. You must choose. The cost of the car to you is the value of the vacation that must be forgone.
The highest or best forgone opportunity resulting from a decision is called the opportunity cost. Another way to put this is that “to choose is to lose” or “an opportunity cost is an opportunity lost.” To get more of anything that is desirable, you must accept
Opportunity Cost 29
1. We all have many wants and goods.
2. Scarcity exists when our wants exceed the available resources.
3. Scarce resources can be categorized as: land (all of our natural resources), labor (the physical and mental efforts expended in the production of goods and services), capital (the equipment and structures used to produce goods and services, and the productive knowledge and skill people receive from education and on-the-job training) and entrepreneurship (the process of combining land, labor, and capital into production of goods and services).
4. Goods and services are things that we value.
5. Goods can be tangible (physical) or intangible (love, compassion, and intelligence).
6. Economic goods are goods created from limited resources.
7. We all face scarcity—rich and poor alike.
8. Our wants grow over time, so scarcity will never be eliminated.
1. What must be true for something to be an economic good?
2. Does wanting more tangible and intangible goods and services make us selfish?
3. Why does scarcity affect everyone?
4. How and why does scarcity affect each of us differently?
5. Why do you think economists often refer to training that increases the quality of workers’ skills as “adding to human capital”?
6. What are some ways that students act as entrepreneurs as they seek higher grades?
7. Why might sunshine be scarce in Seattle but not in Tucson?
8. Why can’t a country become so technologically advanced that its citizens won’t have to choose?
s e c t i o n c h e c k
Opportunity Cost
2.2
_ Why do we have to make choices?
_ What do we give up when we have to choose?
_ Why are “free” lunches not free?
less of something else that you also value. For example, time spent running costs time that could have been spent doing something else that is valuable— perhaps relaxing with friends or studying for an upcoming exam.
THE OPPORTUNITY COST OF GOING TO COLLEGE OR HAVING A CHILD
The average person often does not correctly consider opportunity costs when thinking about costs. For example, the cost of going to college is includes not just the direct expenses of tuition and books. It also includes the opportunity cost of your time, which for many people is the greatest expense. Specifically, the time spent going to school is time that could have been spent on a job earning, say, $25,000 a year. And how often do people consider the cost of raising a child to age 18? There are the obvious costs: food, visits to the doctor, clothes, piano lessons, time spent at soccer practices, and so on. According to the Department of Agriculture, a family with a child born in 2000 can expect to spend about $230,000 for food, shelter, and other necessities to raise that child over the next 17 years. But there are also other substantial opportunity costs incurred in rearing a child. Consider the opportunity cost of one parent choosing to give up his or her job to stay at home. For a parent who makes that choice, the time spent in child rearing is time that could have been used making money and pursuing a career.
IS THAT REALLY A FREE LUNCH, A FREEWAY, OR A FREE BEACH?
The expression “there’s no such thing as a free lunch” clarifies the relationship between scarcity and opportunity cost. Suppose the school cafeteria is offering “free” lunches today. Although the lunch is free to you, is it really free from society’s perspective?
The answer is no, because some of society’s scarce resources will have been used in the preparation of the lunch. The issue is whether the resources that went into creating that lunch could have been used to produce something else of value. Clearly, the scarce resources that went into the production of the lunch— the labor and materials (food service workers, lettuce, meat, plows, tractors, fertilizer, and so forth)—could have been used in other ways. They had an opportunity cost and thus were not free.
Do not confuse free with a zero monetary price.
A number of goods—freeways, free beaches, and free libraries, for instance—do not cost consumers money, but they are still scarce. Very few things are free in the sense that they use none of society’s scarce resources.
So what does a free lunch really mean? It is, technically speaking, a “subsidized” lunch—a lunch using society’s scarce resources, but one that the person receiving it does not have to pay for personally.
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Is air free? How about clean air? Clean air is desirable but limited in cities—that is, it is a scarce good. How about air to a scuba diver? Or how about air to a climbing expedition on Mount Everest? What if you want to fill your tires at this gas station but you didn’t buy gas?
So in many situations, air is not free; it is scarce.
As we all know, change is not always bad. Perhaps this Hershey ad should read “Choices Have Costs.”
Hershey Foods Corporation
Opportunity Cost 31
In a series of early morning raids across the Central Valley and Central Coast on Wednesday, state wildlife agents arrested 11 men accused of illegally killing hundreds of black bears, sometimes “shooting anything they could,” including deer, bobcats and mountain lions, according to officials. . . .
Officials said they are still investigating whether any of the suspects were selling bear parts on the black market. In much of Asia, bear parts—particularly the feet and gall bladders— are used in homemade medicines and potions as cures and aphrodisiacs.
Frederick Cole, Fish and Game’s assistant chief of special operations, said one of the suspects boasted to agents that he had shot 68 bears out of season. . . .
“You have to look at poaching as sly, sneaking and nefarious,” said Cole. He said poachers often eavesdropped on agency game warden radio communications to figure out the best places to hunt and not be caught. . . .
Galindo is charged with felony conspiracy for hunting bears out of season. He could face 3 1.2 to six years in state prison and a fine of up to $10,000 if convicted, officials said. . . .
California law requires all bear hunters to buy a license for the three-month hunting season during the fall and early winter. A hunter is permitted to kill only one adult bear during the season.
The investigation leading to the arrests had been going on for the last 13 months and grew out of a tip to the Fish and Game Department from hunters over a telephone hotline that the agency maintains for citizens to report poaching activities.
As part of the investigation, two undercover Fish and Game agents paid to go on an illegal hunting trip with one of the suspects and killed two bears.
“It was a hard thing to do, but we have to do that to get evidence,” Cole said.
SOURCE: Steve Hyman, “11 Are Accused of Killing Hundreds of Black Bears”, Los Angeles Times, January 23, 2003, pp. B1, B12.
LAWS AND ENFORCEMENT COSTS
In The NEWS
CONSIDER THIS:
In a world of scarcity, we have to make choices about how to enforce laws, too. Sometimes it is less expensive to establish tougher statutes and fines than it is to increase state or federal budgets to enforce laws more vigorously. An alternative to charging higher fines would be to add additional rangers, game wardens, and the like. But this might prove to be prohibitively expensive because costly scarce resources would have to be used to comb the vast wilderness, which is not easily patrolled. Because the probability of being detected is lower, the higher fine should deter some from illegal hunting and fishing activities without adding costly wildlife personnel. That is, substituting fines for monitoring is a relatively inexpensive method for deterring illegal behavior. For example, if the fine for illegally killing a black bear were raised to $500,000 and a five-year mandatory prison sentence, we would expect that the Department of Fish and Game could deter many illegal hunters without increasing monitoring costs. This line of reasoning can be used in other areas of public policy. For example, a lower blood-alcohol level requirement on drinking and driving (or boating) could be substituted for more costly choices like sobriety checkpoints and increasing the number of police officers.
SOURCE: Steve Moore, Universal Press Syndicate, May 19, 1998. Also see http://www.uexpress.com/.
Are laws against fishing without a license tough to enforce?
© Tom Fitzharris/Masterfile
CHOICES ARE PRIMARILY MARGINAL— NOT ALL OR NOTHING
Most choices involve how much of something to do rather than whether or not to do something. It is not whether you eat but how much you eat. Your instructors hope that the question is not whether
you study this semester but how much you study.
You might think to yourself, “If I studied a little more, I might be able to improve my grade,” or “If I had a little better concentration when I was studying, I could improve my grade.” These examples reflect what economists call marginal thinking because the focus is on the additional, or marginal, choices available to you. Marginal choices involve the effects of adding or subtracting from the current situation. In short, they are the small (or large) incremental changes to a plan of action.
You can find examples of marginal thinking everywhere. If I hire another worker for my snowboard company, how many more snowboards will be produced? If national income increases by $1 billion, how much will consumer income increase?
If I decide to go to college, how much will my lifetime income increase?
Always watch out for the difference between average and marginal costs. Suppose an airline had 10 unoccupied seats on a flight from Los Angeles to New York, and the average cost was $400 per seat (the total cost divided by the number of seats— $100,000/250). If there are 10 people on standby, each willing to pay $300, should the airline sell them the tickets? Yes! The unoccupied seats earn nothing for the airline. What are the additional (marginal) costs of a few more passengers? The marginal costs are minimal—slight wear and tear on the airplane, handling some extra baggage, and 10 extra in-flight meals. In this case, thinking at the margin can increase total profits, even if it means selling at less than the average cost of production.
Another good example of marginal thinking is an auction. Prices are bid up marginally as the auctioneer calls out one price after another. When bidders view the new price (the marginal cost) to be greater than the value they place on the good (the marginal benefit), they withdraw from further bidding.
In trying to make themselves better off, people alter their behavior if the expected marginal benefits from doing so outweigh the expected marginal costs—this is the rule of rational choice. Economic theory is often called marginal analysis because it assumes that people are always weighing the expected marginal benefits against the expected mar-
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1. Scarcity means we all have to make choices.
2. When we are forced to choose, we give up the next highest-valued alternative.
3. Opportunity cost is what you give up when you make a choice.
1. Would we have to make choices if we had unlimited resources?
2. What is given up when we make a choice?
3. What do we mean by opportunity cost?
4. Why is there no such thing as a free lunch?
5. Why was the opportunity cost of staying in college higher for Tiger Woods than for most undergraduates?
6. Why is the opportunity cost of time spent getting an MBA typically lower for a 22-year-old straight out of college than for a 45-year-old experienced manager?
Marginal Thinking
2.3
_ What do we mean by marginal thinking?
_ What is the rule of rational choice?
_ Why do we use the word “expected” with marginal benefits and costs?
ginal costs. The term expected is used with marginal benefits and marginal costs because the world is uncertain in many important respects, so the actual result of changing behavior may not always make people better off—but on average it will.
However, as a matter of rationality, people are assumed to engage only in behavior that they think ahead of time will make them better off. That is, individuals will only pursue an activity if expected marginal benefits are greater than the expected marginal costs, or E(MB) > E(MC).
This fairly unrestrictive and realistic view of individuals seeking self-betterment can be used to analyze a variety of social phenomena.
Suppose that you have to get up for an 8 am class but have been up very late. When the alarm goes off at 7 AM you are weighing the marginal benefits and marginal costs of an extra 15 minutes of sleep. If you perceive the marginal benefits of 15 additional minutes of sleep to be greater than the marginal costs of those extra minutes, you may choose to hit the snooze alarm. Or perhaps you may decide to blow off class completely. But it’s unlikely that you will choose that action if it’s the day of the final exam—because it is now likely that the
net benefits (the difference between the expected marginal benefits and the expected marginal costs) of skipping class have changed.
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