Chapter 2 — Exercises

Section A — Reading the PPF

A1. Sketch a production possibilities frontier for a small economy that produces only two goods: textbooks and bicycles. Label the axes. Mark a point on the frontier and identify what the slope at that point represents. Mark a point inside the frontier and explain what it represents. Mark a point outside the frontier and explain what it would take to get there.

A2. Suppose the economy in A1 experiences a technological breakthrough that doubles the productivity of bicycle-making (but does not change textbook-making). Sketch the new PPF on the same axes. Which intercepts move, and which don't?

A3. Suppose instead that a war destroys 30% of the economy's resources (workers, land, machines). Sketch the new PPF. Where are the new intercepts relative to the old ones?

A4. "Increasing opportunity cost" — the bowed-out shape of a typical PPF — comes from the fact that resources are not perfectly substitutable across uses. Give a real-world example of two industries where the resources are not easily moved from one to the other, and explain why.

A5. Look up the actual U.S. GDP from 1929 to 1933. The economy contracted by roughly 25% in those four years. Sketch what the U.S. PPF looked like before and after. Was the change a movement along the frontier, an inward shift of the frontier, or a movement inside the frontier from a previously efficient point? (Hint: the answer is partly philosophical — economists have argued about it for nearly a century.)

Section B — Circular flow

B1. Draw the simple two-actor (households and firms) circular flow diagram from §2.3. Label every arrow with what is flowing.

B2. Now add the government to the diagram. Where do the new arrows go? What is the government collecting, what is it spending, and on whom?

B3. Now add the foreign sector. Where do imports come from, and where do exports go?

B4. Now add the financial sector (banks). Households save some of their income; firms invest in new capital. Show how the financial sector intermediates between savers and investors.

B5. Why is it true that "one person's spending is another person's income"? Give an example of a transaction where this is obvious. Then give an example where it's less obvious (a tip to a waiter, a tax payment, a charitable donation).

Section C — Positive vs. normative

C1. For each of the following statements, identify whether it is positive or normative. If it's a mix, explain which parts are which. - (a) "The unemployment rate in March 2026 was 3.8%." - (b) "The unemployment rate is too high." - (c) "Raising the federal funds rate by 0.25% slowed inflation by approximately 0.4 percentage points over the following year." - (d) "The Federal Reserve should not have raised rates in 2022." - (e) "Free trade increases total economic output." - (f) "Free trade is good policy for the United States." - (g) "When governments increase spending during a recession, GDP recovers faster than when they cut spending." - (h) "The US should adopt single-payer healthcare."

C2. Take any policy debate you have heard about recently. Write down one positive claim each side is making and one normative claim each side is making. Are the positive claims compatible with each other? Are the normative claims?

C3. Find an opinion column in a newspaper that argues for a specific economic policy. Identify the positive claims (which could be checked against data) and the normative claims (which depend on values). Where does the column slide from positive to normative without flagging the slide?

Section D — Why economists disagree

D1. The chapter identifies four reasons economists disagree: facts, models, values, time horizons. For each reason, give an example of an economic debate that is primarily driven by that kind of disagreement.

D2. When two economists disagree about the effects of the 2017 Tax Cuts and Jobs Act on long-run growth, what kind of disagreement is most likely at the root? Justify your answer.

D3. When two economists disagree about whether the federal minimum wage should be raised to $15, what kinds of disagreement are likely at the root? (More than one of the four bucket types may apply — identify each.)

D4. Find an article about an economic policy debate and try to sort the disagreement into the four buckets. How much of it is factual? How much is model-selection? How much is values? How much is time horizon? You will rarely find a debate that is purely one of the four — but the proportions are illuminating.

Section E — Models and assumptions

E1. A weather forecast says: "There is a 70% chance of rain tomorrow." This is a model output. Identify three assumptions the model makes. Which of those assumptions are most likely to be wrong?

E2. A traffic engineering model says: "Adding a new lane to Highway 35 will reduce average commute times by 8 minutes." Identify three assumptions the model makes. (Hint: think about how drivers might respond to the new lane.) Which of those assumptions could go wrong?

E3. An economic model says: "A $1 increase in the minimum wage in Millbrook will reduce restaurant employment by approximately 2%." Identify three assumptions this prediction depends on. What evidence would you want before believing the prediction?

E4. A common assumption in economic models is that consumers are "rational" — meaning they have well-defined preferences, they know what they want, and they choose what maximizes their preferences. Give three real-world examples where this assumption is approximately right and three where it's approximately wrong. (We will study the wrong examples in much more depth in Chapter 10.)

Section F — Data lookup

F1. Go to FRED (fred.stlouisfed.org) and find the U.S. unemployment rate (UNRATE). Look at the chart from 2007 to 2010. Now look at the same chart from 2020 to 2022. Both periods include a recession. How are the two recessions different in shape? What does each suggest about the kind of shock that caused it?

F2. Look up real GDP per capita for the U.S. since 1947 (FRED series A939RX0Q048SBEA, or similar). Use the chart to identify approximately five recessions. Which is the deepest? Which is the shortest? Which had the slowest recovery?

Section G — Policy debate exercise (Economist vs. Layperson)

G1. A layperson says: "It's obvious that putting tariffs on Chinese imports will save American manufacturing jobs. Of course it will." Articulate the economist's response (using the lens of the PPF, opportunity cost, and the four reasons for disagreement). Where might the layperson and the economist still reasonably disagree even after the economic analysis?

G2. A layperson says: "The government should just print more money to pay for things instead of borrowing or taxing." Articulate the economist's response. (Hint: the response is not "this is impossible" — it is more nuanced, and we will return to it in Chapter 27.)

Reflection questions

• The chapter argues that "no model can tell you everything." Do you agree? Are there models in other fields (physics, biology, computer science) that come close to telling you everything about their domain?
• Which of the four reasons for disagreement do you find easiest to understand? Which is hardest?
• Have you ever changed your mind about an economic issue after reading new data? After encountering a different model? After reflecting on your own values?

Selected answers are in appendices/answers-to-selected.md.