Practice Worksheet

Chapter 1 — Ten Principles of Economics

Part 1

Scenario — Jake's Saturday (Principles 1–4)

Scenario It's a Saturday afternoon in Madison. Jake has 4 free hours. He can spend it three ways:

Study for his Econ 101 midterm (he estimates +5 points on the exam)
Pick up a 4-hour shift at his campus job (he'd earn $60)
Go to the Badgers football game with friends (ticket already cost him $45, non-refundable)

Jake decides to go to the game. Use the principles from Ch. 1 to analyze his choice.

Question a · Opportunity cost

What is Jake's opportunity cost of going to the Badgers game? Pick the best description.

The $45 he already paid for the ticket The $60 shift plus the 5 exam points — the sum of everything else he could have done Whichever of "the $60 shift" or "the 5 exam points" Jake values more — the single best forgone alternative Nothing — he wanted to go to the game, so there is no cost

Hint Opportunity cost is one thing — the single best alternative Jake gave up — not a sum of everything he could have done.

Explanation (c) is the definition of opportunity cost: the single best alternative forgone. Jake can't study and work at the same time, so only one alternative is truly "given up" by going to the game — whichever one he values more.

(a) is wrong — the $45 ticket is a sunk cost, not an opportunity cost (it's already spent and non-refundable; he'd lose it whether he went or not).
(b) is wrong — opportunity cost is not the sum of all alternatives. Jake only had 4 hours, so he could only do one other thing with that time, not both.
(d) is wrong — even things you want to do have an opportunity cost.

Question b · Sunk cost / marginal thinking

Saturday morning arrives and a huge snowstorm hits. Jake no longer wants to go stand in the cold for 4 hours. His friend says, "But you already paid $45 for the ticket — you have to go!" Using Principle 3 (think at the margin), should the $45 influence Jake's decision now?

Hint Is the $45 recoverable either way? Does Jake's decision now change how much he pays for the ticket?

Explanation No — the $45 is a sunk cost. It's gone whether Jake goes to the game or stays home. Marginal thinking compares only future benefit vs. future cost from this point forward.

Going forward: benefit = watching the game in a snowstorm (now low); cost = 4 cold hours + lost study/work value. If the benefit doesn't exceed the cost going forward, stay home — the ticket money is already spent either way.

This is the classic sunk cost fallacy: "I've already paid, so I have to use it." The rational rule is the opposite.

Question c · Incentives

Suppose Jake's campus job announces a "stormy Saturday" bonus: anyone who shows up for a shift on a bad-weather day earns $20/hour instead of $15. Jake now decides to work the shift instead of going to the game. Which principle best explains this change in behavior?

Principle 1: People face trade-offs Principle 2: Opportunity cost Principle 3: Rational people think at the margin Principle 4: People respond to incentives

Hint The employer changed the reward for one option. Jake changed his behavior in response.

Explanation (d) Principle 4. A change in the payoff (incentive) for working caused a change in behavior. Higher wage → higher marginal benefit of the shift → Jake switches.

All ten principles can be in the background of a decision (trade-offs always exist, there's always an opportunity cost, etc.), but the change in Jake's behavior here comes specifically from the change in incentives. That's Principle 4's signature.

Question d · Trade-offs

UW-Madison announces a new "equal weekends" policy: no student may work more than 2 hours on a Saturday, so all students have the same amount of free time. Does this policy eliminate trade-offs for Jake?

Hint Jake still has limited free time and many things he'd like to do with it. Has scarcity been eliminated?

Explanation No, trade-offs remain. Even with a work cap, Jake still has to choose between studying, the game, sleep, a friend's birthday, etc. Scarcity (limited time, unlimited wants) is what creates trade-offs — not any particular policy.

In fact, this policy creates a new trade-off at the social level: efficiency vs. equality. Jake's weekends are more "equal" to other students' weekends, but he can no longer earn the income he wanted (lower efficiency). Policies that equalize outcomes often reduce the total size of the pie.

Part 2

Scenario — Two Roommates, Two Skills (Principles 5–7)

Scenario Jake and his roommate Priya share a small apartment. Each week they each need to do two chores for themselves: cook their own dinner (one dinner per person per week, so two dinners total) and clean their own bedroom (two bedrooms total). Here's how long each chore takes them:

        
            Cook one dinner
            Clean one bedroom
          
            Jake
            4 hours
            2 hours
          
            Priya
            3 hours
            3 hours

	Cook one dinner	Clean one bedroom
Jake	4 hours	2 hours
Priya	3 hours	3 hours

Priya is faster than Jake at cooking, and Jake is faster than Priya at cleaning.

Question e · Gains from trade

If each roommate does both of their own chores, Jake spends 4 + 2 = 6 hours/week and Priya spends 3 + 3 = 6 hours/week. But suppose they specialize: Jake cleans both bedrooms and Priya cooks both dinners. How many total hours do the two of them spend together in this new arrangement (covering the same two dinners and two bedroom cleanings)?

Total hours for both together

Hint Jake now cleans both bedrooms (2 rooms at 2 hrs each). Priya now cooks both dinners (2 dinners at 3 hrs each). Add up.

Explanation Jake cleans both bedrooms: 2 × 2 hrs = 4 hours.
Priya cooks both dinners: 2 × 3 hrs = 6 hours.
Total: 4 + 6 = 10 hours.

Compare to the no-trade version: 6 + 6 = 12 hours. They saved 2 hours per week together just by specializing and "trading" chores — Principle 5 in action. Both can be better off because each focuses on what they do relatively well.

Question f · Markets organize activity (Principle 6)

Imagine that instead of Jake and Priya working out their own chore split, a "Dorm Czar" decided each week exactly who cooked and who cleaned in their apartment, based on what the Czar thought was fair. Give one reason this would likely produce a worse outcome than letting Jake and Priya negotiate freely. (Think about Principle 6 — the invisible hand.)

Your reasoning

Sample Answer The Dorm Czar doesn't know what Jake and Priya know: who hates cooking, who has allergies, who has a tight class schedule on cooking night, who owns a nice knife set, etc. Direct negotiation lets all that private information shape the decision automatically — the invisible hand.

Any reasonable answer along these lines counts:

Information: Jake and Priya know their own preferences and constraints; the Czar doesn't.
Incentives: Jake and Priya have to live with the outcome, so they'll negotiate seriously; the Czar doesn't bear the cost of a bad match.
Flexibility: direct negotiation can adjust daily as schedules change; a Czar's weekly plan can't.

This is Adam Smith's invisible hand: decentralized decisions with good incentives usually beat central planning.

Question g · When markets fail (Principle 7)

Now suppose Jake loves to practice drums at 2am. His drumming makes it hard for their downstairs neighbor to sleep. Jake and Priya's "market" for dividing chores works fine, but the drum noise is different. Which concept from Chapter 1 best describes the problem with the drums, and what general response does Principle 7 suggest?

Market power — rules should break up Jake's monopoly on the apartment Externality — Jake's action affects a bystander (the neighbor), so a rule or "noise tax" might improve outcomes Inflation — Jake's drumming is raising the general price level Opportunity cost — Jake is giving up sleep to drum

Hint The neighbor isn't part of Jake's "market" with Priya — but they're affected by Jake's decision. There's a word for that.

Explanation (b) Externality. An externality is when one person's action affects a bystander — someone who isn't party to the decision. Jake and Priya's negotiation doesn't factor in the neighbor's lost sleep, so the "market" outcome (lots of 2am drumming) is inefficient. Principle 7 says this is a case where a rule, a tax, or enforced property right (e.g., quiet hours, noise ordinance) can improve things.

(a) wrong: "market power" means one seller controlling a market, not one drummer.
(c) wrong: inflation is about the general price level.
(d) wrong: opportunity cost is about Jake's own trade-offs, not the effect on bystanders.

Part 3

Multiple Choice (all 10 principles)

Question 1

Economics is best defined as the study of:

How society manages its scarce resources How to run a business most profitably How to predict inflation, unemployment, and stock prices How the government can stop the harm from unchecked self-interest

Hint The opening sentence of Ch. 1: scarcity + resource allocation.

Explanation (a) is the textbook definition: economics is the study of how society manages its scarce resources (Mankiw Ch. 1.1). The other choices are applications, not the field's definition.

Question 2

You pay $15 for a movie ticket but halfway through realize the movie is terrible. The rational thing to do is:

Stay — you already paid $15, so leaving would waste your money Leave if the time you'd save is more valuable than the remaining entertainment value Stay — the marginal cost of watching the rest is $15 Leave — any amount of bad entertainment is irrational to consume

Hint The $15 is sunk — it's gone whether you stay or leave. Compare future benefit (rest of movie) to future cost (your time).

Explanation (b). Marginal thinking: the $15 is sunk — not recoverable either way. Compare remaining entertainment (future benefit) to what else you could do with the time (future opportunity cost). (a) and (c) are the sunk-cost fallacy. (d) is too absolute — a slightly boring movie can still be worth the remaining 45 minutes if you've got nothing better to do.

Question 3

Water is essential for life and cheap; diamonds are optional and expensive. Which principle best explains this?

People face trade-offs Rational people think at the margin Markets are usually a good way to organize economic activity Governments can sometimes improve market outcomes

Hint Water is abundant, so what's the marginal benefit of one more cup?

Explanation (b). Prices track marginal benefit, not total benefit. Water is plentiful, so the marginal cup is worth little. Diamonds are rare, so the marginal stone is worth a lot. The total life-sustaining value of water is huge, but it doesn't set the price — the margin does.

Question 4

Your opportunity cost of going to a movie tonight is:

The price of the ticket only The price of the ticket plus the popcorn you buy The total cash spent at the theater plus the value of your time Zero, as long as you enjoy it and consider it a worthwhile use of time and money

Hint Opportunity cost includes cash out-of-pocket and the value of what else you could do with those 2 hours.

Explanation (c). Opportunity cost = cash spent + the value of your time (because you can't work / study / see friends while watching). Mankiw uses this exact example in the Ch. 1 Quick Quiz. Leaving out your time is the most common error.

Question 5

A gasoline tax is raised from $0.20/gallon to $0.60/gallon. Which outcome is most consistent with Principle 4 (people respond to incentives)?

Drivers continue to drive the same amount, because driving is a necessity Drivers buy smaller cars, carpool, and use transit more Oil companies absorb the tax entirely so consumers don't notice The government always collects the full expected revenue

Hint Higher price for gas = higher cost of driving. Rational drivers will compare costs and benefits and shift behavior.

Explanation (b). Higher gas cost shifts incentives: cheaper to drive less, carpool, or buy fuel-efficient cars. This is Mankiw's own example (Europe's high gas taxes → smaller cars than U.S.). Option (a) ignores that people adjust. (c) usually doesn't happen. (d) is wrong: taxes change behavior, so revenue is lower than a static projection assumes.

Question 6

Adam Smith's "invisible hand" refers to:

Hidden methods businesses use to profit at consumers' expense The ability of free markets to reach desirable outcomes despite self-interested participants Government regulation benefiting consumers even when consumers are unaware of it How producers or consumers in unregulated markets impose costs on innocent bystanders

Hint Smith's point: butchers and bakers serve your dinner not out of kindness but because their own self-interest + market prices lead them to.

Explanation (b). The "invisible hand" is Smith's metaphor for how prices in a free market coordinate self-interested decisions into socially desirable outcomes. (d) describes an externality — a different concept. (a) is a common cynical misreading.

Question 7

The main reason some nations have higher average living standards than others is that:

Richer nations have exploited poorer ones Their central banks have created more money They have stronger laws protecting worker rights They have higher levels of productivity

Hint Principle 8 — output per unit of labor.

Explanation (d). Principle 8: standard of living depends on productivity. Countries where each worker produces more output per hour (more capital, better tech, better education) have higher incomes. This is the single most robust finding in development economics.

Question 8

If a central bank uses monetary policy to reduce the demand for goods and services, Principle 10 predicts that in the short run:

Inflation falls and unemployment falls Inflation falls and unemployment rises Inflation rises and unemployment rises Inflation rises and unemployment falls

Hint Less demand → firms sell less → fewer workers hired. Less demand also means slower price increases.

Explanation (b). The short-run Phillips trade-off: cooling demand lowers inflation and raises unemployment. The central bank's dilemma — you can't get both down simultaneously in the short run. (This is Ch. 1 Quick Quiz Q10, a common midterm question.)

Part 4

True or False

Question 9

"There is no such thing as a free lunch" is a restatement of Principle 1 (people face trade-offs).

Hint Even a "free" lunch was paid for by someone, and your time eating it has an opportunity cost.

Explanation True. Mankiw uses this exact phrase to introduce Principle 1. The "free" lunch wasn't actually free — someone paid for the food, and you pay with your time. Every choice means giving something up.

Question 10

The opportunity cost of an action is the sum of the value of every alternative you did not choose.

Hint You can only do one other thing at once — so only one alternative is truly "forgone."

Explanation False. Opportunity cost = the single best forgone alternative, not the sum of all of them. You can only do one other thing with your time or money, so only that one thing is the true cost. Adding up all alternatives would double-count.

Question 11

A trade between two countries must have a winner and a loser — one country's gain is the other's loss.

Hint Voluntary trade: neither side trades unless they expect to gain. So both sides can gain.

Explanation False. Principle 5: trade is positive-sum, not zero-sum. Each side gives up something they value less for something they value more. Both are better off. Specialization by comparative advantage (Ch. 3) is why.

Question 12

Principle 7 says government intervention always improves market outcomes.

Hint Read the principle carefully: "governments can sometimes improve market outcomes."

Explanation False. The principle says "can sometimes." Government intervention is justified mainly for market failure (externalities, market power) or equality goals — and even then, policies come from politics, not omniscient angels. Bad policy can make things worse. The principle is a permission, not a guarantee.

Question 13

In the long run, a sustained rise in a country's inflation rate is usually caused by the central bank printing too much money.

Hint Germany 1920s, Zimbabwe 2000s, Venezuela 2010s — one common cause.

Explanation True. Principle 9: almost every case of large or persistent inflation is caused by excess money creation. More money chasing the same quantity of goods pushes prices up. (Short-run blips from oil shocks or shipping snarls can happen, but sustained inflation is a monetary phenomenon.)

Question 14

The inflation–unemployment trade-off (Phillips curve) is a long-run relationship — a country can permanently reduce unemployment by accepting higher inflation forever.

Hint Read Principle 10 carefully — the trade-off is described as short-run.

Explanation False. Principle 10 explicitly says the trade-off is short run. In the long run, unemployment returns to its natural rate no matter what the inflation rate is — so permanently accepting higher inflation just gives you higher inflation, not permanently lower unemployment. (The full story is Ch. 33+ in the macro half of the textbook.)

Part 5

Concept Short Answer

Question h

Explain in 2–3 sentences why "there's no such thing as a free lunch" is really a restatement of Principle 1 (people face trade-offs) and Principle 2 (opportunity cost).

Your answer

Sample Answer A "free lunch" would mean getting something valuable without giving anything up. But in reality, resources are scarce: someone had to grow the food, and the person eating spends time they could have used elsewhere. So even a "free" lunch has an opportunity cost (the best alternative use of the eater's time, plus the cost the provider absorbed) — which means the eater is trading off that next-best activity for the meal.

The saying is a compact way of summarizing Principles 1 and 2 together: every choice involves giving something up, and what you give up is the cost.

Question i

Explain the short-run inflation–unemployment trade-off in your own words, and then explain why it does not hold in the long run. (3–4 sentences.)

Your answer

Sample Answer Short run: When the central bank increases the money supply, total spending rises. Firms initially respond by selling more and hiring more workers, so unemployment falls — but the extra demand also pushes prices up, so inflation rises. Lower unemployment, higher inflation: a trade-off.

Long run: Eventually, workers and firms catch up. Workers demand higher wages to match the higher prices, firms' costs rise, and the extra hiring disappears. Unemployment returns to its "natural rate" determined by real factors (skills, search frictions, technology), not by the inflation rate. So over the long run, more money just gives you more inflation — it doesn't permanently lower unemployment (Principle 9 reasserts itself; Principle 10 is explicitly a short-run claim).

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