Chapter 02 - The Market System and the Circular Flow
Chapter 2
ANSWERS TO END-OF-CHAPTER AND APPENDIX QUESTIONS
1-1
1-2
1-3
1-4
1-5
What is an opportunity cost? How does the idea relate to the definition of economics? Which of
the following decisions would entail the greatest opportunity cost: Allocating a square block in
the heart of New York City for a surface parking lot or allocating a square block at the edge of a
typical suburb for such a lot? Explain.
An opportunity cost is what was sacrificed to do or acquire something else. The condition of
scarcity creates opportunity cost. If there was no scarcity, there would be no need to sacrifice one
thing to acquire another.
The opportunity cost would be much higher in New York City as the alternative uses for that
square block are much more valuable than for a typical suburban city block.
What is meant by the term “utility” and how does it relate to purposeful behavior?
“Utility” refers to the pleasure, happiness, or satisfaction gained from engaging in an activity
(eating a meal, attending a ball game, etc.). It is an important component of purposeful behavior
because people will allocate their scarce time, energy, and money in an attempt to gain the most
utility possible.
(Key Question) Cite three examples of recent decisions that you made in which you, at least
implicitly, weighed marginal costs and marginal benefits.
Student answers will vary, but may include the decision to come to class, to skip breakfast to get
a few extra minutes of sleep, to attend college, or to make a purchase. Marginal benefits of
attending class may include the acquisition of knowledge, participation in discussion, and better
preparation for an upcoming examination. Marginal costs may include lost opportunities for
sleep, meals, or studying for other classes. In evaluating the discussion of marginal benefits and
marginal costs, be careful to watch for sunk costs offered as a rationale for marginal decisions.
What are the key elements of the scientific method and how does this method relate to economic
principles and laws?
The key elements include the gathering of data (observation), the formulation of possible
explanations (hypothesis), testing the hypothesis, determining the validity of the hypothesis, and
repeated testing of hypotheses that have appeared to be valid in prior tests.
The scientific method is the technique used by economists to determine economic laws or
principles. These laws or principles are formulated to explain and/or predict behavior of
individuals or institutions.
(Key Question) Indicate whether each of the following statements applies to microeconomics or
macroeconomics:
a. The unemployment rate in the United States was 4.9 percent in January 2008.
b. A U.S. software firm discharged 15 workers last month and transferred the work to India.
c. An unexpected freeze in central Florida reduced the citrus crop and caused the price of
oranges to rise.
d. U.S. output, adjusted for inflation, grew by 2.2 percent in 2007.
e. Last week Wells Fargo Bank lowered its interest rate on business loans by one-half of 1
percentage point.
f. The consumer price index rose by 2.8 percent in 2007.
Macroeconomics: (a), (d), and (f)
Microeconomics: (b), (c), and (e)
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Chapter 02 - The Market System and the Circular Flow
1-6
1-7
State (a) a positive economic statement of your choice, and then (b) a normative economic
statement relating to your first statement.
Student answers will vary. Example: (a) The unemployment rate is 4.8 percent; (b) the
unemployment rate is too high. In general we treat “what is” statements as positive, “what should
be” as normative, but keep an eye out for statements like “at full employment an increase in the
production of pizzas should come at the cost of less robots.” Some students may incorrectly
identify the statement as normative because of the term “should.”
(Key Question) Suppose you won $15 on a lotto ticket at the local 7-Eleven and decided to spend
all the winnings on candy bars and bags of peanuts. The price of candy bars is $.75 and the price
of peanuts is $1.50.
a. Construct a table showing the alternative combinations of the two products that are
available.
b. Plot the data in your able as a budget line in a graph. What is the slope of the budget
line? What is the opportunity cost of one more candy bar? Of one more bag of peanuts?
Do these opportunity costs rise, fall, or remain constant as each additional unit of the
product is purchased.
c. How, in general, would you decide which of the available combinations of candy bars
and bags of peanuts to buy?
d. Suppose that you had won $30 on your ticket, not $15. Show the $30 budget line in your
diagram. Why would this budget line be preferable to the old one?
(a)
Consumption alternatives
Goods
A
B
C
D
E
F
Candy bars
0
4
8
12
16
20
Bags of peanuts
10
8
6
4
2
0
(b)
Bags of
Peanuts
Slope 
 .75
  .5
1.5
10
20
2
Candy Bars
Chapter 02 - The Market System and the Circular Flow
The slope for the budget line above, with candy bars on the horizontal axis, is -0.5 (= Pcb/Pbp). Note that the figure could also be drawn with bags of peanuts on the horizontal axis.
The slope of that budget line would be -2.
The opportunity cost of one more candy bar is ½ of a bag of peanuts. The opportunity cost of
one more bag of peanuts is 2 candy bars. These opportunity costs are constant. They can be
found by comparing any two of the consumption alternatives for the two goods.
(c) The decision of how much of each to buy would involve weighing the marginal benefits and
marginal costs of the various alternatives. If, for example, the marginal benefits of moving
from alternative C to alternative D are greater than the marginal costs, then this consumer
should move to D (and then compare again with E, and so forth, until MB=MC is attained).
(d)
B ags of
P eanuts
Incom e = $ 15
20
Income = $30
10
20
1-8
1-9
40
Candy Bars
The budget line at $30 would be preferable because it would allow greater consumption of both
goods.
What are economic resources? What categories do economists use to classify them? Why are
resources also called factors of production? Why are they called inputs?
Economic resources are the natural, human, and manufactured inputs used to produce goods and
services. Economic resources fall into four main categories: labor, land (natural resources), real
capital (machines, factories, buildings, etc.,) and entrepreneurs. Economic resources are also
called factors of production because they are used to produce goods and services. They are
called inputs because they go in to a production process (like ingredients go into a bowl to make a
cake), with the resulting goods and services also being referred to as output.
Why isn’t money considered a capital resource in economics? Why is entrepreneurial ability
considered a category of economic resources, distinct from labor? What are the major functions
of the entrepreneur?
Money is not considered a capital resource because money is not productive – it provides access
to resources but itself does not directly contribute to the production of goods and services.
Additionally, the quantity of money in circulation does not determine an economy’s productive
capacity, while the amount of capital and other resources does. Doubling the amount of money in
circulation does not change the economy’s physical capacity to produce goods and services.
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Chapter 02 - The Market System and the Circular Flow
Money is, however, referred as a financial resource and financial capital, reflecting its ability to
acquire real economic resources.
Entrepreneurial ability and labor are both human resources, but they perform different functions
in the productive process. Entrepreneurial ability does not directly produce goods and services; it
organizes the resources that do. Labor refers to the human inputs that directly engage in
production.
Entrepreneurs are risk-takers: They coordinate the activities of the other three inputs for profit—
or loss, which is why they are called risk-takers. Entrepreneurs sometimes manage companies
that they own, but a manager who is not an owner is not necessarily an entrepreneur but may be
performing some of the entrepreneurial functions for the company. Entrepreneurs are also
innovators, or perhaps inventors, and profits help to motivate such activities.
1-10
(Key Question) Below is a production possibilities table for consumer goods (automobiles) and
capital goods (forklifts):
Type of Production
Automobiles
Forklifts
Production Alternatives
A
B
C
D
E
0
30
2
27
4
21
6
12
8
0
a. Show these data graphically. Upon what specific assumptions is this production possibilities
curve based?
b. If the economy is at point C, what is the cost of one more automobile? Of one more forklift?
Explain how the production possibilities curve reflects the law of increasing opportunity
costs.
c. If the economy characterized by this production possibilities table and curve were producing
3 automobiles and 20 fork lifts, what could you conclude about its use of available
resources?
d. What would production at a point outside the production possibilities curve indicate? What
must occur before the economy can attain such a level of production?
(a) See curve EDCBA. The assumptions are full employment, fixed supplies of resources, fixed
technology and two goods.
4
Chapter 02 - The Market System and the Circular Flow
Forklifts
(b) The opportunity cost of one more automobile is 9/2 = 4.5 forklifts. The opportunity cost of
one more forklift is 2/6 = 1/3 or .33 automobiles, as determined from the table. Increasing
opportunity costs are reflected in the concave-from-the-origin shape of the curve. This means
the economy must give up larger and larger amounts of forklifts to get constant added
amounts of automobiles—and vice versa.
(c) The economy is underutilizing its available resources. The assumption of full employment
has been violated.
(d) Production outside the curve cannot occur (consumption outside the curve could occur
through foreign trade). To produce beyond the current production possibilities curve this
economy must realize an increase in its available resources and/or technology.
1-11 (Key Question) Specify and explain the typical shapes of the marginal-benefit and marginal-cost
curves. How are these curves used to determine the optimal allocation of resources to a particular
product? If current output is such that marginal cost exceeds marginal benefit, should more or
fewer resources be allocated to this product? Explain.
The marginal benefit curve is downward sloping, MB falls as more of a product is consumed
because additional units of a good yield less satisfaction than previous units. The marginal cost
curve is upward sloping, MC increases as more of a product is produced since additional units
require the use of increasingly unsuitable resource. The optimal amount of a particular product
occurs where MB equals MC. If MC exceeds MB, fewer resources should be allocated to this
use. The resources are more valuable in some alternative use (as reflected in the higher MC) than
in this use (as reflected in the lower MB).
1-12 Explain how, if at all, each of the following affects the location of a country’s production
possibilities curve:
a. The quality of education increases.
b. The number of unemployed workers increases.
c. A new technique improves the efficiency of extracting copper from ore.
d. A devastating earthquake destroys numerous production facilities.
(a) Assuming better education translates into better work skills, then productivity should rise and
this would shift the curve outward.
(b) Should not affect location of curve. Production moves inward, away from the curve.
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Chapter 02 - The Market System and the Circular Flow
1-13
1-14
(c) The curve should shift outward as more production is possible with existing resources.
(d) The curve should shift inward with the destruction of resources (capital).
(Key Question) Referring to the table in question 10, suppose improvement occurs in the
technology of producing forklifts but not in the technology of producing automobiles. Draw the
new production possibilities curve. Now assume that a technological advance occurs in
producing automobiles but not in producing forklifts. Draw the new production possibilities
curve. Now draw a production possibilities curve that reflects technological improvement in the
production of both products.
See the graph for question 1-10. PPC1 shows improved forklift technology. PPC2 shows
improved auto technology. PPC3 shows improved technology in producing both products.
(Key Question) On average, households in China save 40 percent of their annual income each
year, whereas households in the United States save less than 5 percent. Production possibilities
are growing at roughly 9 percent annually in China and 3.5 percent in the United States. Use
graphical analysis of “present goods” versus “future goods” to explain the differences in growth
rates.
United States
China
Future
Goods
Future
Goods
B
A
1-15
1-16
Present
Present
Goods
Goods
Suppose that, on the basis of a nation’s production possibilities curve, an economy must sacrifice
10,000 pizzas domestically to get the 1 additional industrial robot it desires, but that it can get the
robot from another country in exchange for 9,000 pizzas. Relate this information to the following
statement: “Through international specialization and trade, a nation can reduce its opportunity
cost of obtaining goods and thus ‘move outside its production possibilities curve.’”
The message of the production possibilities curve is that an individual nation is limited to the
combinations of output indicated by its production possibilities curve.
International
specialization means directing domestic resources to output which a nation is highly efficient at
producing. International trade involves the exchange of these goods for goods produced abroad.
Specialization and trade have the same effect as having more and better resources or discovering
improved production techniques. The output gains from greater international specialization and
trade are the equivalent of economic growth.
(Last Word) Studies indicate that married men on average earn more income than unmarried men
of the same age and education level. Why must we be cautious in concluding that marriage is the
cause and higher income is the effect?
Correlation does not necessarily mean that there is causation. The relationship could be purely
coincidental or dependent on some other factor not included in the analysis. It is also possible
that higher income is the variable that “causes” marriage.
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Chapter 02 - The Market System and the Circular Flow
Chapter 1 - Appendix
1A-1
1A-2
1A-3
1A-4
Briefly explain the use of graphs as a way to present economic relationships. What is an inverse
relationship? How does it graph? What is a direct relationship? How does it graph? Graph and
explain the relationships you would expect to find between (a) the number of inches of rainfall
per month and the sale of umbrellas, (b) the amount of tuition and the level of enrollment at a
university, and (c) the popularity of an entertainer and the price of her concert tickets.
In each case cite and explain how variables other than those specifically mentioned might upset
the expected relationship. Is your graph in part b, above, consistent with the fact that,
historically, enrollments and tuition have both increased? If not, explain any difference.
Graphs can be used to illustrate the relationship between two sets of data. An inverse relationship
is when the two variables change in opposite directions. The line is downward sloping. A direct
relationship is when the two variables change in the same direction. The line is upward sloping.
Statements (a) and (c) illustrate direct relationships. Statement (b) illustrates an inverse
relationship. The inverse relationship is assuming that everything else remains equal.
(Key Appendix Question) Indicate how each of the following might affect the data shown in the
table and graph in Figure 2 of this appendix:
a. GSU’s athletic director schedules higher-quality opponents.
b. An NBA team locates in the city where GSU plays.
c. GSU contracts to have all its home games televised.
(a) More tickets are bought at each price; the line shifts to the right.
(b) Fewer tickets are bought at each price, the line shifts to the left.
(c) Fewer tickets are bought at each price, the line shifts to the left.
(Key Appendix Question) The following table contains data on the relationship between saving
and income. Rearrange these data into a meaningful order and graph them on the accompanying
grid. What is the slope of the line? The vertical intercept? Interpret the meaning of both the
slope and the intercept. Write the equation which represents this line. What would you predict
saving to be at the $12,500 level of income?
Income
(per year)`
Saving
(per year)
$15,000
0
10,000
5,000
20,000
$1,000
-500
500
0
1,500
Income column: $0; $5,000; $10,000, $15,000; $20,000. Saving column: $-500; 0; $500;
$1,000; $1,500. Slope = 0.1 (= $1,000 - $500)/($15,000 - $10,000). Vertical intercept = $-500.
The slope shows the amount saving will increase for every $1 increase in income; the intercept
shows the amount of saving (dissaving) occurring when income is zero. Equation: S = $-500 +
0.1Y (where S is saving and Y is income). Saving will be $750 at the $12,500 income level.
Construct a table from the following data shown on the accompanying graph. Which is the
dependent variable and which the independent variable? Summarize the data in equation form.
7
Chapter 02 - The Market System and the Circular Flow
Study time
(hours)
Exam
scores
0
2
4
6
8
9
10
30
50
70
90
100
The dependent variable (the effect) is the exam
score and the independent variable (the cause)
is the study time.
The equation is:
Exam score  10  50  30  / 4  2   Study time
 10  20 / 2  Study time
 10  10  Study time
1A-5
Proof:
Exam score when study time is 6 hours:
 10  10  6
 10  60
 70 as shown in the table above
Suppose that when the interest rate on loans is 16 percent, businesses find it unprofitable to invest
in machinery and equipment. However, when the interest rate is 14 percent, $5 billion worth of
investment is profitable. At 12 percent interest, a total of $10 billion of investment is profitable.
Similarly, total investment increases by $5 billion for each successive 2-percentage point decline
in the interest rate. Describe the relevant relationship between the interest rate and investment in
words, in a table, graphically, and as an equation. Put the interest rate on the vertical axis and
investment on the horizontal axis, and in your equation use the form i = a + bI, where i is the
interest rate, a is the vertical intercept, b is the slope of the line (which is negative), and I is the
level of investment. Comment on the advantages and disadvantages of the verbal, tabular,
graphic, and equation forms of description.
8
Chapter 02 - The Market System and the Circular Flow
Interest
rate
(in percent)
Amount of
investment
(billions of dollars)
16
14
12
10
8
6
4
2
0
$ 0
5
10
15
20
25
30
35
40
When the interest rate is 16%, investment spending will be zero. When the interest rate is 14%,
investment spending will be $5 billion. For each successive drop of 2 percentage points in the
interest rate, investment spending will increase by $5 billion.
Using equation i  a  bI
i  16  16  14  / 5  0  I
2
 16    I
5
Proof:
Substituting data from the table, when I is $25 billion, i = 16 -2/5(25) = 16 - 10 = 6 percent.
The verbal presentation can be made, but is hard to visualize. The tabular presentation is precise;
all the facts are there, neatly arrayed, and it is easier to visualize than the verbal one. The graphic
presentation shows at a glance the relationship between the variables and, moreover, is best for
showing large changes, that is, movements of a whole curve. However, the graph requires careful
drafting to ensure that it is as accurate as the table. The equation is as precise as the table and,
moreover, describes all the intermediate points not set out in the table. For most people, though,
the equation form is probably the hardest to visualize.
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Chapter 02 - The Market System and the Circular Flow
1A-6
Suppose that C = a + bY, where C = consumption, a = consumption at zero income, b= slope,
and Y = income.
a. Are C and Y positively related or are they negatively related?
b. If graphed, would the curve for this equation slope upward or downward?
c. Are the variables C and Y inversely related or directly related?
d. What is the value of C if a =10, b =.50, and Y = 200?
e. What is the value of Y if C = 100, a = 10, and b = .25?
(a) C and Y are positively related because the slope, b, is positive.
(b) The curve would slope upward because the slope is positive.
(c) C and Y are directly related because C and Y are positively related.
(d) C = 110.
(e) Y = 360.
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Chapter 02 - The Market System and the Circular Flow
1A-7
(Key Appendix Question) The accompanying graph shows curve XX and tangents at points A, B,
and C. Calculate the slope of the curve at these three points.
ANSWERS TO END-OF-CHAPTER QUESTIONS
2-1
2-2
2-3
2-4
Contrast how a market system and a command economy try to cope with economic scarcity.
A market system allows for the private ownership of resources and coordinates economic activity
through market prices. Participants act in their own self-interest and seek to maximize
satisfaction or profit through their own decisions regarding consumption or production. Goods
and services are produced and resources are supplied by whoever is willing to do so. The result is
competition and widely dispersed economic power.
The command economy is characterized by public ownership of nearly all property resources and
economic decisions are made through central planning. The planning board, appointed by the
government determines production goals for each enterprise. The division of output between
capital and consumer goods is centrally decided based on the board’s long-term priorities
How does self-interest help achieve society’s economic goals? Why is there such a wide variety
of desired goods and services in a market system? In what way are entrepreneurs and businesses
at the helm of the economy but commanded by consumers?
The motive of self-interest gives direction and consistency to the economy. The primary driving
force of the market system is self-interest. Entrepreneurs try to maximize their profits; property
owners want the highest price for their resources; workers choose the job with the best wages,
fringe benefits and working conditions. Consumers apportion their expenditures to maximize
their utility, while seeking the lowest possible prices. As individuals express their free choice, the
economy is directed to produce the most wanted goods at the lowest possible cost.
Each individual consumer will choose a variety of goods and services that in combination will
maximize his/her satisfaction (utility). There is a wide variety because individual wants are
diverse. To maximize profits, producers must respond to the desires of the individual consumer.
Although producers are free to choose what products they will produce, if the producers are to
maximize profits, these good and services must be what consumers desire. Entrepreneurs can
drive the economic ship where they want (at least for a while), but the ship will run aground
(businesses will fail) if entrepreneurs at the helm don’t listen to the consumers that command
them.
Why are private property, and the protection of property rights, so critical to the success of the
market system?
The ownership of private property and the protection of property rights encourages investment,
innovation, and, therefore, economic growth. Property rights encourage the maintaining of the
property and they facilitate the exchange of the property.
What are the advantages of using capital in the production process? What is meant by the term
“division of labor”? What are the advantages of specialization in the use of human and material
resources? Explain why exchange is the necessary consequence of specialization.
Capital goods enable producers to operate more efficiently and to produce more output.
“Division of labor” means that workers perform those tasks that are best suited to their individual
abilities and skills.
The advantages of specialization for workers are that they can choose work according to their
natural aptitudes, have the opportunity to perfect those skills, and save time in not having to shift
continually from one task to another. Material resources will be developed and adapted for a
specific use. On a regional basis, each region will produce those products for which it is best
suited. By specializing in its comparative advantage, each region or set of human and material
resources is being used to maximize efficiency.
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Chapter 02 - The Market System and the Circular Flow
2-5
2-6
2-7
When resources are specialized, they are no longer self-sufficient. To obtain the goods and
services one needs, exchange is necessary. Also, specialization will result in a surplus of a
specific good being produced. The surplus of one good will be exchanged for the surplus
production of other goods.
What problem does barter entail? Indicate the economic significance of money as a medium of
exchange. What is meant by the statement: “We want money only to part with it”?
Barter requires the “double coincidence of wants.” If someone wants something, he/she will have
to find someone who wishes to part with that good and at the same time wishes to exchange the
good for something that the first party wishes to part with.
With money as a medium of exchange, one knows the purchase price of the item to be purchased
and it relative price to other items. Money is a very convenient common denominator, a common
measure of value that is also used as a medium of exchange. Money also encourages
specialization. Without money, workers and other resources could not be paid except in the
output produced. All those who participated in the production of the good would have to
collectively exchange it for all the goods and service desired by the resource owners.
Money itself has value only in relation to the resources, goods, and services that can be obtained
with it. When people say that they want money, they really mean that they want the things that
money can buy. In this sense, money imparts value only when someone parts with it.
Evaluate and explain the following statements:
a. The market system is a profit-and-loss system.
b. Competition is the disciplinarian of the market economy.
(a) The quotation is accurate. In a market system, producer decisions are motivated by the
attempt to earn profits. Those products that enable a firm to earn at least a normal profit
(minimum compensation for the entrepreneur for his/her time and talents) will be produced.
If the product cannot be produced for a profit—in other words, if losses are involved in
production—the capitalist firm will respond by seeking lower cost production methods and
may halt the production of goods completely. Because profits and/or losses are the
motivation behind the fundamental decisions made in a market system, it could be called a
“profit and loss economy.”
(b) Competition provides discipline in two ways. First, it forces firms to seek the least-cost
production methods or face being driven out of business by their rivals. Second, it prevents
successful producers from charging whatever the market will bear. Competition keeps prices
at a level where total revenue will just cover the total cost of production including a normal
profit, but no more in the long run. If sellers try to charge a price that will earn them
economic profits, new firms will enter the industry, increasing supply, and lowering prices
until the economic profits are eliminated. Competition is indispensable in this role, because
otherwise some other method would have to be found to direct firms to use the least-cost
production technique and to charge a price that provides only a normal return. Where
competition does not exist, such as in natural monopolies like public utility companies,
regulators or publicly owned companies must assume the role of disciplinarian. Experience
has shown that this is a difficult process and does not achieve the same results as easily as a
competitive market situation.
In the 1990s thousands of “dot-com” companies emerged with great fanfare to take advantage of
the Internet and new information technologies. A few, like Yahoo, eBay, and Amazon, generally
thrived and prospered, but many others struggled and eventually failed. Explain these varied
outcomes in terms of how the market system answers the question “What goods and services will
be produced?”
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Chapter 02 - The Market System and the Circular Flow
2-8
2-9
The expectation of economic profits lured many new firms into the “dot-com” industries.
However, because of a lack of information and a market unable to sustain so many firms, many
failed to realize even a normal profit and failed. [Technically many of the early dot-coms were
not earning economic profits, but their shareholders were reaping huge windfalls from the stock
market speculation.] When these new firms found that they could not profitably produce in this
industry, they dropped out and the industry declined. The problem was not so much one of
consumer sovereignty – consumers demonstrated an interest in these services. The heavy
competition of so many firms trying to establish themselves in the market led to prices that were
insufficient to cover economic costs. In a few cases, most notably Napster (an internet company
that allowed uses to download music at little or no cost), government restrictions on activities
(copyright infringement in Napster’s case) led to firm failure (at least for a time).
(Key Question) With current technology, suppose a firm is producing 400 loaves of banana bread
daily. Also, assume that the least-cost combination of resources in producing those loaves is 5
units of labor, 7 units of land, 2 units of capital, and 1 unit of entrepreneurial ability, selling at
prices of $40, $60, $60, and $20, respectively. If the firm can sell these 400 units at $2 per
unit, will it continue to produce banana bread? If this firm’s situation is typical for the other
makers of banana bread, will resources flow to or away from this bakery good?
Total Profits = Total Cost – Total Revenue
Total Cost = Presource * Qresource and Total Revenue = Price * Qsold
Total Cost = ($40 * 5 units of labor) + ($60 * 7 units of land) + ($60 * 2 units of capital) + ($20 *
1 unit of entrepreneurial ability) = $200 + $420 + $120 + $20 = $760.
Total Revenue = $2 * 400 loaves of banana bread = $800.
Total Profits = $800 - $760 = $40. The firm will continue to produce as it is earning economic
profits. If this firm is typical of the banana bread industry, more resources will flow toward
banana bread as other potential firms are attracted to the economic profits in the industry.
(Key Question) Assume that a business firm finds that its profit it greatest when it produces $40
worth of product A. Suppose also that each of the three techniques shown in the table on page 43
will produce the desired output.
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Chapter 02 - The Market System and the Circular Flow
Resource Units Required
Resource
Labor
Land
Capital
Entrepreneurial
ability
2-10
2-11
Price per unit
of resource
Technique
1
$3
4
2
2
5
2
2
4
Technique
2
2
4
4
2
Technique
3
3
2
5
4
a. With the resource prices shown, which technique will the firm choose? Why? Will
production entail profit or losses? What will be the amount of profit or loss? Will the
industry expand or contract? When will that expansion end?
b. Assume now that a new technique, technique 4, is developed. It combines 2 units of labor, 2
of land, 6 of capital, and 3 of entrepreneurial ability. In view of the resource prices in the
table, will the firm adopt the new technique? Explain your answer.
c. Suppose that an increase in labor supply causes the price of labor to fall to $1.50 per unit, all
other resource prices being unchanged. Which technique will the producer now choose?
Explain.
d. “The market system causes the economy to conserve most in the use of those resources that
are particularly scarce in supply. Resources that are scarcest relative to the demand for them
have the highest prices. As a result, producers use these resources as sparingly as is
possible.” Evaluate this statement. Does your answer to part c, above, bear out this
contention? Explain.
(a) The firm will choose technique 2 because it produces the output at the least cost ($34
compared to $35 for techniques 1 and 3). Economic profit will be $6 (= $40 - $34), causing
the industry to expand. Expansion in this industry will continue until prices decline to where
total revenue equals total cost of $34 and no additional firms will want to enter the industry.
(b) The firm will adopt technique 4 because its cost is now lowest at $32.
(c) The firm will choose technique 1 because its cost is now lowest at $27.50.
(d) The statement is logical. Increasing scarcity of a resource causes its price to rise. Firms
ignoring higher resource prices will become high-cost producers. Firms switching to the less
expensive inputs become lower-cost producers and earn higher profits than high-cost
producers. The market system, therefore, forces producers to conserve on the use of highly
scarce resources. Question 9c confirms this: Technique 1 was adopted because labor had
become less expensive.
(Key Question) Some large hardware stores such as Home Depot boast of carrying as many as
20,000 different products in each store. What motivated the producers of those individuals to
make them and offer them for sale? How did producers decide on the best combinations of
resources to use? Who made these resources available, and why? Who decides whether these
particular hardware products should continue to be produced and offered for sale?
The quest for profit led firms to produce these goods. Producers looked for and found the leastcost combination of resources in producing their output. Resource suppliers, seeking income,
made these resources available. Consumers, through their dollar votes, ultimately decide on what
will continue to be produced.
What is meant by the term “creative destruction”? How does the emergence of MP3 (iPod)
technology relate to this idea?
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Chapter 02 - The Market System and the Circular Flow
2-12
2-13
2-14
2-15
Creative destruction refers to the process by which the creation of new products and production
techniques destroys the market positions of firms committed to producing only existing products
or using outdated methods. The ability to download and store a large number of songs, and the
superior quality of MP3 is causing a decline in the CD industry, just as CDs once replaced
cassette tapes, which had previously replaced phonographs (records).
In a sentence, describe the meaning of the phrase “invisible hand.”
Market prices act as an “invisible hand,” coordinating an economy by rationing what is scarce
and providing incentives to produce the most desired goods and services.
In market economies, firms rarely worry about the availability of inputs to produce their products,
whereas in command economies input availability is a constant concern. Why the difference?
In market economies, buyers of inputs know that sellers want to make resources available for sale
because that is how they earn their profits. If there aren’t enough resources available, prices will
rise until suppliers come forth with the desired amounts. In command economies the availability
of inputs depends on what was specified in the plan, and how well the plan was executed. There
is no opportunity (at least not legally) to offer greater payments to get those resources provided.
Distinguish between the resource market and product market in the circular flow model. In what
way are businesses and households both sellers and buyers in this model? What are the flows in
the circular flow model?
The resource markets are where the owners of the resources (the households) sell their resources
to the buyers of the resources (businesses). In the product markets, businesses sell the goods and
services they have produced to the buyers of the goods and services, the households.
Households (individuals) either own all economic resources directly or own them indirectly
through their ownership of business corporations. These households are willing to sell their
resources to businesses because attractive prices draw them into specific resource markets.
Businesses buy resources because they are necessary for producing goods and services. The
interaction of the buyers and sellers establishes the price of each resource.
In the product market, businesses are the sellers and householders are the buyers; their role in the
market has been reversed. Each group of economic units both buys and sells.
One flow is the flow of real goods and services (including resource services) and the other flow is
the flow of money (money income, consumption expenditures, revenue, production costs).
(Last Word) What explains why millions of economic resources tend to get arranged logically
and productively rather than haphazardly and unproductively?
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Chapter 02 - The Market System and the Circular Flow
The institution of private property is a primary reason why resources are arranged logically and
productively. Private property eliminates randomness to the allocation of resources, as property
owners act in deliberate ways to protect and maximize the benefits from their property. Owners
pursue the greatest possible returns from their property, drawing resources to their most valued
uses. Through the interaction of millions of economic agents all trying to use their private
property to maximize well-being, a complex, logical, and productive arrangement of resources
results. Slopes: at A = +4; at B = 0; at C = -4.
1A-8
In the accompanying graph, is the slope of curve AA’ positive or negative? Does the slope
increase or decrease as we move along the curve from A to A’? Answer the same two questions
for curve BB’.
Slope of AA’ is positive (rising from left to right). The slope increases as we move from A to A’.
Slope of BB’ is negative (dropping from left to right). The slope becomes more negative, thereby
decreasing, as we move from B to B’.
The slopes of both curves are tending to infinity as they continue to move to the right.
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