Survey of ECON
© MARIO TAMA/GETTY IMAGES
Robert L. Sexton
Chapter 1
The Role and Method
of Economics
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Chapter 1 Sections
– Economics: A Brief Introduction
– Economic Behavior
– Markets
– Economic Theory
– Pitfalls to Avoid in Scientific Thinking
– Positive and Normative Economics
– Why Study Economics?
Appendix: Working with Graphs
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Economics:
A Brief Introduction
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Section 1
SECTION 1
QUESTIONS
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Economics: A Brief
Introduction
ECONOMICS
the study of choices we make among our many wants and
desires given our limited resources
RESOURCES
inputs used to produce goods and services
SCARCITY
exists when human wants (material and nonmaterial) exceed
available resources
THE ECONOMIC PROBLEM
scarcity forces us to choose, and choices are costly because
we must give up other opportunities that we value
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Scarcity and Unlimited
Human Wants
• Economics is primarily concerned with
scarcity–how well we satisfy our
unlimited wants in a world of limited
resources.
• As long as human wants exceed
available resources, scarcity will exist.
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Scarcity and Limited
Resources
The scarce resources that are used in the
production of goods and services can be
grouped into four categories:
–
–
–
–
labor
land
capital
entrepreneurship
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Scarcity and Limited
Resources
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• Labor is the physical and human effort
used in the production of goods and
services.
© ISTOCKPHOTO.COM
• Land is the natural resources used in the
production of goods and services.
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Scarcity and Limited
Resources
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• Capital is the equipment and structures used to
produce goods and services (such as office
buildings, tools, machines, and factories).
• Capital also includes
human capital, the
productive knowledge
and skill people receive
from education, on-thejob training, health, and
other factors that
increase productivity.
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Scarcity and Limited
Resources
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• Entrepreneurship is the process of
combining the labor, land, and capital to
produce goods and services.
• The entrepreneur is the
one who makes the
tough and risky
decisions about what to
produce and how to
produce.
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Scarcity and Limited
Resources
• Entrepreneurs are always looking for new
ways to improve production techniques or
to create new products. They are driven by
the lure of positive incentives—profits.
• We are all entrepreneurs when we try new
products or when we find better ways to
manage our households or our study time.
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Goods and Services
• Goods are items we value or desire.
• They can be tangible goods that can be
held, heard, tasted, or smelled or
intangible goods that we cannot touch,
such as fairness, friendship, knowledge,
security, and health.
• Services are intangible items of value
provided to consumers, such as
education.
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Goods and Services:
Economic Goods
ECONOMIC GOODS
the scarce goods that are
created from scarce resources
• If there are not enough economic goods
for all of us, we will have to compete for
those scarce goods.
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Does Everyone Face
Scarcity?
• We all face scarcity, because we cannot
have all of the goods and services that
we desire.
• However, because we all have different
wants and desires, scarcity affects
everyone differently.
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Does Everyone Face
Scarcity?
• Even the richest person must live with
scarcity and must, at some point, choose
one want or desire over another.
• As we get more affluent, we learn of new
luxuries to provide us with satisfaction.
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Does Everyone Face
Scarcity?
• There is no evidence that people would
not find a valuable use for additional
income, no matter how rich they become.
• Even the wealthy individual who decides
to donate all of her money to charity faces
the constraints of scarcity.
• If she had greater resources, she could do
still more for others.
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Will Scarcity Ever Be
Eradicated?
• 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.
• 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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Section 1
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Economic Behavior
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Section 2
SECTION 2
QUESTIONS
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Self-Interest
• Economists assume that individuals act as if they
are motivated by self-interest and respond in
predictable ways to changing circumstances.
• To a worker, self-interest
means pursuing a higher
paying job and/or better
working conditions.
• To a consumer, selfinterest means gaining a
greater level of
satisfaction from limited
income and time.
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Rational Behavior
• To an economist, rational behavior
means that people do the best they can,
based on their values and information,
under current and anticipated future
circumstances.
• Actions have consequences—even
inactions, which are choices not to do
something or not to make changes, have
consequences—failing to study for an
exam.
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Rational Behavior
• In mainstream economics, to say that
people are rational is not to assume that
they never make mistakes. It is merely to
say that they do NOT make systematic
mistakes.
• In sum, rational individuals weigh the
benefits and costs of their actions, and
they only pursue actions if they perceive
the benefits to be greater than the costs.
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Incentives
• In acting rationally, people are
responding to incentives. They react to
changes in benefits and costs.
• Much of human behavior can be
explained and predicted as a response to
incentives.
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Incentives
• Human behavior is influenced in
predictable ways by changes in economic
incentives.
• Economists use this information to predict
what will happen when the benefits and
costs of any choice are changed.
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Incentives
• If salaries increase for engineers and
decrease for MBAs, it could be predicted that
fewer people would go to graduate school in
business and more would go into
engineering.
• A permanent change to a much higher price
of gasoline could lead to fewer gas guzzlers
on the highway.
• People who work on commission tend to
work harder.
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Incentives: Examples
• Would birth rates fall if the income-tax
deduction for dependents was
removed?
• Would a death sentence for drug
traffickers reduce drug trafficking?
• Would stricter penalties deter
cheating on tests?
• Would stricter drunk driving laws
reduce drunk driving?
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Section 2
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Markets
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Section 3
SECTION 3
QUESTIONS
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Markets
• A market is the process of buyers and
sellers exchanging goods and services.
• Supermarkets, the New York Stock
Exchange, drug stores, roadside stands,
garage sales, Internet stores, and
restaurants are all markets.
• Every market is different: the conditions
under which the exchange between
buyers and sellers takes place can vary.
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Markets:
Allocating Scarce Resources
• Efficiency is achieved when the economy
gets the most out of its scarce resources.
• Buyers and sellers indicate their wants
through their actions and inactions in the
marketplace.
• This collective “voice” determines how
resources are allocated.
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Market Prices
• Market prices serve as the language of
the market system and communicate
crucial information to both consumers
and suppliers.
• These prices communicate information
about the relative availability of products
to consumers, and they provide suppliers
with critical information about the relative
value that consumers place on those
products.
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Market Prices
• The basis of a market economy is
voluntary exchange and the price system
that guides people’s choices and
produces solutions to the questions of
what goods to produce and how to
produce and distribute those goods.
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© ISTOCKPHOTO.COM
The Pencil: Example
• Where did the producer find the wood? The
graphite? The eraser? Who knows?
• Market forces coordinate this production
activity among thousands of people from
different countries speaking different
languages to make a pencil.
• Why? The market economy has provided the
incentive for people to pursue activities that
benefit others through the price system.
Malaysia?
Michigan?
Georgia?
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Countries That Do Not
Rely on a Market System
• Countries that do not rely on the market
system have no clear communication
between buyers and sellers.
• The former Soviet Union, where quality
was virtually nonexistent, experienced
many shortages of quality goods and
surpluses of low-quality goods.
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Market Failure
• The market mechanism is a simple but
effective and efficient general means of
allocating resources among alternative
uses.
MARKET FAILURE
when the economy fails
to allocate resources
efficiently on its own
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Market Failure
• Examples of market failure include
pollution and scientific research.
• When the economy produces too little or
too much of something, the government
can improve society’s well-being by
intervening.
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Market Failure
• Sometimes the market economy does
not communicate accurately.
• Some firms may have market power to
distort prices, and without adequate
information, unscrupulous producers may
be able to misrepresent products to the
disadvantage of the unwary.
• These situations may also lead to
government intervention.
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Markets and Income
Distribution
• There is sometimes a painful tradeoff
between how much an economy can
produce efficiently and how that output is
distributed—the degree of equality.
• There is no guarantee that the market
economy will provide everyone with
adequate amounts of food, shelter, and
health care.
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Markets and Income
Distribution
• That is, not only does the market
determine what goods are going to be
produced, and in what quantities, but it
also determines the distribution of output
among members of society.
• This equity argument can generate some
sharp disagreements, as what seems “fair”
to one person may seem highly “unfair” to
someone else.
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The Circular Flow Model
• Product markets are the markets in which
households are buyers and firms are sellers of
goods and services.
• Factor or input markets are markets in which
households sell the use of their inputs (capital,
land, labor and entrepreneurship) to firms.
• In the factor markets, households are the
sellers and firms are the buyers.
• Wages, rents, interest, and profit are the
payments for labor, land, capital and
entrepreneurship.
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The Circular Flow Model
• Income flows from firms to households
(factor markets), and spending flows from
households to firms (product markets).
• This simple circular flow model shows how
households and firms interact in product
markets and factor markets and how the
two markets are interrelated.
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© FRANCES TWITTY/ISTOCKPHOTO.COM / © BILL NOLL/ISTOCKPHOTO.COM
Exhibit 1.1: The Circular Flow Diagram
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The Circular
Flow Model: Example
• Suppose a teacher’s supply of labor
generates personal income in the form of
wages (the factor market), which she can
use to buy automobiles, vacations, food,
and other goods (the product market).
• Suppose she buys an automobile (product
market); the automobile dealer now has
revenue to pay for his inputs (factor
market)—wages to workers, purchase of
new cars to replenish his inventory, rent
for his building, and so on.
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Section 3
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Economic Theory
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Section 4
SECTION 4
QUESTIONS
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Economic Theories
THEORIES
statements or propositions
used to explain and predict
behavior in the real world
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• Because of the complexity of human behavior,
economists must abstract to focus on the most
important components of a particular problem.
• This is similar to
maps that
highlight the
important
information (and
assume away
many of the minor
details) to help
people get from
here to there.
© CARINA LOCHNER/ISTOCKPHOTO.COM / © JAMI GARRISON/ISTOCKPHOTO.COM
Abstraction
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Developing a Testable
Proposition
• A hypothesis in economic theory is a
testable proposition that makes some
type of prediction about behavior in
response to certain changes in conditions
based on our assumptions.
• For example, if the price of CDs
increases, we can hypothesize that fewer
CDs will be sold.
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Empirical Analysis
EMPIRICAL ANALYSIS
the use of data to test a
hypothesis
• Empirical analysis is applied to determine
whether a hypothesis fits well with the facts.
If an economic hypothesis is supported by
the data, we can tentatively accept it as an
economic theory.
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The Ceteris Paribus
Assumption
CETERIS PARIBUS
holding all other things constant
• Virtually all theories in economics are expressed
using a ceteris paribus assumption.
• For example, the theory that if you study harder
you will perform better on a test must carefully hold
other things constant. What if you studied so hard
you overslept or you were too sleepy to think
clearly? Or what if you studied the wrong material?
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Predicting on a
Group Level
• Economics, like the other social sciences, is
concerned with reaching generalizations about
human behavior.
– Observation and prediction are harder in
economics than in physical sciences.
• Prediction on a group level
– Looking at the behaviors of a large group
allows economists to discern general
patterns of actions.
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Two Branches of Economics:
Microeconomics and Macroeconomics
• Two main branches of economics are
microeconomics and macroeconomics.
• Microeconomics deals with the smaller units
within the economy.
• It attempts to understand
the decision-making
behavior of firms and
households and their
interaction in markets for
particular goods or
services.
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Two Branches of Economics:
Microeconomics and Macroeconomics
• Macroeconomics is the study of the aggregate,
or total economy.
• It looks at economic
problems as they influence
the whole of society,
including the topics of
inflation, unemployment,
business cycles, and
economic growth.
• Microeconomics looks at
the trees; macroeconomics
looks at the forest.
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Section 4
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Pitfalls to Avoid in
Scientific Thinking
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Section 5
SECTION 5
QUESTIONS
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Confusing Correlation
and Causation
• One must always be careful not to confuse
correlation with causation.
• The fact that two events usually occur together
(correlation) does not necessarily mean that
one caused the other to occur (causation).
• Does a rooster’s crowing cause the sun to
rise? Why are ice cream sales and crime
positively correlated? People drive slowly when
roads are icy—are lower speeds the cause of
increased accidents? Or do icy roads lead to
lower speeds and more accidents?
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The Fallacy of
Composition
• Fallacy of composition—the incorrect view
that what is true for the individual is always true
for the group.
• For example, standing up at a football game or
a concert to see better only works if others do
not do the same thing. How about getting to
school early to get a better parking spot? What
if everybody gets up early to get a better
parking spot?
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Section 5
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Positive and
Normative Economics
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Section 6
SECTION 6 QUESTIONS
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Positive and Normative
Statements
• Economists are asked to explain the
world as scientists and improve the world
as policy advisers. Positive analysis
deals with factual statements trying to
explain the world. Normative analysis
deals with value judgments trying to
improve the world.
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Positive and Normative
Statements
• Positive statement—an objective, testable
statement that describes what happens and why
it happens.
• Normative statement—a subjective,
contestable statement that attempts to describe
what should be done.
• For example, should the government give “free”
prescription drugs to seniors? Or should the
government increase spending in the space
program?
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Disagreement is Common
in Most Disciplines
• The majority of disagreements in
economics stem from normative issues.
• However, there is some disagreement
over positive analysis—there may be
mixed empirical evidence or insufficient
information.
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Economists Do Agree
• Most economists agree on a wide range
of issues including the effects of rent
control, import tariffs, export restrictions,
the use of wage and price controls to
curb inflation, and the minimum wage.
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Section 6
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Why Study
Economics?
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Why Study Economics?
• Many of the things that concern us are at
least partly economic in character.
• The study of economics helps improve
our understanding of these concerns.
• Economics gives us clues on how to
intelligently evaluate options.
• It helps develop a disciplined method of
thinking about problems.
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Economics Is All
Around Us
• The economic way of thinking.
– Causes those in many types of fields to
ask the right kind of questions.
• Economics won’t necessarily make you
richer, but it may keep you from making
some decisions that would make you
poorer.
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Working
Appendix
with Graphs
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APPENDIX
Working with Graphs
Graphs are an important economic tool. They:
• Allow economists to better understand the
workings of the economy
and
• Enhance the understanding of important
economic relationships.
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Working with Graphs
Exhibit 1.2: Plotting a Graph
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Working with Graphs
Types of Graphs
Four common types of graphs:
•
Pie charts
•
Bar graphs
•
Time series graphs
•
Scatter diagrams
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Working with Graphs
Exhibit 1.3a: Pie Chart—Tax Revenues—
Federal Government, 2009
SOURCE: Economic Report of the President, 2010. Statistical Tables. Table B-80. Washington, D.C., February 2010. Available at
http://www.gpoaccess.gov/eop/tables10.html (accessed March 25, 2010).
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Working with Graphs
Exhibit 1.3b: Bar Graph—U.S.
Unemployment, by Sex and Age
SOURCE: Bureau of Labor Statistics, Current Population Survey, Employment Situation Summary
Table A. Washington, D.C., March 5, 2010. Available at
http://www.bls.gov/news.release/empsit.a.htm (accessed March 25, 2010).
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Working with Graphs
Exhibit 1.3c: Time-Series Graph—Inflation
in the United States, 1913–2009
SOURCE: Bureau of Labor Statistics, Consumer Price Index, Table Containing History of CPI-U U.S. All Items Indexes and Annual Percent Changes from 1913 to Present.
Washington, D.C., March 18, 2010. Available at ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt (accessed March 25, 2010).
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Working with Graphs
Exhibit 1.3d: Scatter Diagram—Saving
Rates and GDP Growth
SOURCE: World Bank, World Development Report, 1996, Oxford University Press, 1996. Republished with permission of the World Bank; permission
conveyed through Copyright Clearance Center, Inc.
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Working with Graphs
Relationships Between Two
Variables
• Graphs can be used to show the relationship
between two variables.
• A variable is something that is measured by
a number, such as your height.
• Relationships between two variables can be
expressed in a simple two-dimensional
graph.
81
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Working with Graphs
• A positive relationship means that two variables
move in the same direction.
• An increase in one
variable (practice time)
is accompanied by an
increase in another
variable (overall score),
or a decrease in one
variable is accompanied
by a decrease in
another variable.
Exhibit 1.4: A Positive Relationship
82
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Working with Graphs
•
•
•
•
When two variables move in different directions, there is a negative
relationship between the two variables.
When one variable rises, the other variable falls.
A downward-sloping line, the
demand curve, shows the
different combinations of price
and quantity purchased.
The higher you go up on the
vertical (price) axis, the smaller
the quantity purchased on the
horizontal axis, and the lower you
go down along the vertical (price)
axis, the greater the quantity
purchased.
Exhibit 1.5: A Negative Relationship
83
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Working with Graphs
Relationships Between
Three Variables
• Even when only two variables are shown
on the axes, graphs can be used to show
the relationship between three variables.
• For example, a rise in income may increase
the quantity of CDs purchased at each
possible price.
• This would shift the whole demand curve
for CDs outward to a new position.
84
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Working with Graphs
Exhibit 1.6a: Shifting a Curve – Demand
Curve with Higher Income
85
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Working with Graphs
Exhibit 1.6b: Shifting a Curve – Demand
Curve with Lower Income
86
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Working with Graphs
Shifts versus Movements
• It is important to remember the difference
between a movement up and down along a
curve and a shift in the whole curve.
• A change in one of the variables on the
graph, such as price or quantity purchased,
will cause a movement along the curve.
• A change in one of the variables not shown,
such as income in our example, will cause
the whole curve to shift.
87
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Working with Graphs
• Going from Point
A to B indicates
movement along
a demand curve.
• Going from D1to
D2 is a shift.
Exhibit 1.7: Shifts versus Movements
88
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Working with Graphs
Slope
• The slope, or steepness, of curves is defined
as the ratio of rise (change in the Y variable)
over run (change in the X variable).
• A curve that is downward sloping represents
an inverse, or negative, relationship between
the two variables.
• A curve that is upward sloping represents a
direct, or positive, relationship between the
two variables.
89
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Working with Graphs
Slope
• A downward-sloping curve represents
a negative relationship between two
variables.
• An upward-sloping curve represents a
positive relationship between two
variables.
90
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Working with Graphs
Exhibit 1.8a: Downward-Sloping
Linear Curve
91
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Working with Graphs
Exhibit 1.8b: Upward-Sloping
Linear Curve
92
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Working with Graphs
Slope: Linear Curves
• The slope of a linear curve between
two points measures the relative rates
of change of two variables.
93
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Working with Graphs
Exhibit 1.9: Slopes of Positive
and Negative Curves
94
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Working with Graphs
Slope: Nonlinear Curves
• Along a nonlinear curve, the slope
varies from point to point.
• However, we can find the slope of
such a curve at any point by finding
the slope of the tangent to that curve
at that point.
95
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Working with Graphs
Exhibit 1.10: Slopes of a
Nonlinear Curve
96
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