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C O W E N • T A B A R R O K M O D E R N P R I N C I P L E S O F E C O N O M I C S , S E C O N D E D I T I O N

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When you write this well, you don’t need boxes to maintain interest…

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Financial System

Investments International Trade

Wealth of Nations

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MODERN PRINCIPLES OF ECONOMICS

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MODERN PRINCIPLES OF ECONOMICS Second Edition

Tyler Cowen George Mason University

Alex Tabarrok George Mason University

Worth Publishers

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Senior Publisher: Catherine Woods Executive Editor: Charles Linsmeier Senior Acquisitions Editor: Sarah Dorger Executive Marketing Manager: Scott Guile Consulting Editor: Paul Shensa Senior Developmental Editor: Bruce Kaplan Supplements and Media Editor: Tom Acox Director of Market Research and Development: Steven Rigolosi Associate Managing Editor: Lisa Kinne Editorial Assistant: Mary Walsh Art Director: Babs Reingold Cover and Text Designer: Kevin Kall Project Editor: Anthony Calcara Photo Editor: Christine Buese Production Manager: Barbara Anne Seixas Supplements Production Manager: Stacey Alexander Supplements Project Editor: Edgar Bonilla Composition: TSI Graphics Printing and Binding: RR Donnelley Cover Image: Image Werks/Corbis and Jim Roof/myLoupe.com

Library of Congress Control Number: 2011940683

ISBN-13: 978-1-4292-3997-4 ISBN-10: 1-4292-3997-2

© 2013, 2010 by Worth Publishers

All rights reserved.

Printed in the United States of America

First printing 2011

Worth Publishers 41 Madison Avenue New York, NY 10010 www.worthpublishers.com

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http://www.worthpublishers.com
Economics is the study of how to get the most out of life.

Tyler and Alex

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A B O U T T H E A U T H O R S

Tyler Cowen (left) is Holbert C. Harris Professor of Economics at George Mason University. His latest book is The Great Stagnation. With Alex Tabarrok, he writes an economics blog at www.marginalrevolution.com. He has published in the American Economic Review, Journal of Political Economy, and many other economics journals. He also writes regularly for the popular press, including the New York Times, the Washington Post, Forbes, the Wilson Quarterly, Money Magazine, and many other outlets.

Alex Tabarrok (right) is Bartley J. Madden Chair in Economics at the Mercatus Center at George Mason University and director of research for The Independent Institute. His latest book is Launching the Innovation Renaissance. His recent research looks at bounty hunters, judicial incen- tives and elections, crime control, patent reform, methods to increase the supply of human organs for transplant, and the regulation of pharmaceuticals. He is the editor of the books Entrepreneurial Economics: Bright Ideas from the Dismal Science and The Voluntary City: Choice, Community, and Civil Society among others. His papers have appeared in the Journal of Law and Econom- ics, Public Choice, Economic Inquiry, the Journal of Health Economics, the Journal of Theoretical Politics, the American Law and Economics Review, and many other journals. Popular articles have appeared in the New York Times, the Wall Street Journal, Forbes, and many other magazines and newspapers.

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http://www.marginalrevolution.com
BRIEF CONTENTS Preface ........................................................................................................... xxiv

Part I: Supply and Demand CHAPTER 1 The Big Ideas in Economics ......................................................... 1

CHAPTER 2 The Power of Trade and Comparative Advantage .................... 13

CHAPTER 3 Supply and Demand .................................................................. 27

CHAPTER 4 Equilibrium: How Supply and Demand Determine Prices ......... 47

CHAPTER 5 Elasticity and Its Applications .................................................... 65

CHAPTER 6 Taxes and Subsidies .................................................................. 93

Part 2: The Price System CHAPTER 7 The Price System: Signals, Speculation, and Prediction .......... 113

CHAPTER 8 Price Ceilings and Floors ......................................................... 131

CHAPTER 9 International Trade .................................................................. 159

CHAPTER 10 Externalities: When Prices Send the Wrong Signals .............. 175

Part 3: Firms and Factor Markets CHAPTER 11 Costs and Profit Maximization Under Competition ............... 193

CHAPTER 12 Competition and the Invisible Hand...................................... 223

CHAPTER 13 Monopoly .............................................................................. 233

CHAPTER 14 Price Discrimination ............................................................... 257

CHAPTER 15 Cartels, Oligopolies, and Monopolistic Competition ............ 279

CHAPTER 16 Competing for Monopoly: The Economics of Network Goods .......................................................................................... 303

CHAPTER 17 Labor Markets ........................................................................ 319

Part 4: Government CHAPTER 18 Public Goods and the Tragedy of the Commons .................. 343

CHAPTER 19 Political Economy and Public Choice .................................... 361

CHAPTER 20 Economics, Ethics, and Public Policy ..................................... 385

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Brief Contents • ix

Part 5: Decision Making for Businesses, Investors, and Consumers CHAPTER 21 Managing Incentives ............................................................. 401

CHAPTER 22 Stock Markets and Personal Finance ..................................... 419

CHAPTER 23 Consumer Choice .................................................................. 435

Part 6: Economic Growth CHAPTER 24 GDP and the Measurement of Progress ................................ 461

CHAPTER 25 The Wealth of Nations and Economic Growth ...................... 483

CHAPTER 26 Growth, Capital Accumulation, and the Economics of Ideas: Catching Up vs. the Cutting Edge .............................................................. 509

CHAPTER 27 Saving, Investment, and the Financial System ...................... 543

Part 7: Business Fluctuations CHAPTER 28 Unemployment and Labor Force Participation ...................... 577

CHAPTER 29 Inflation and the Quantity Theory of Money ......................... 603

CHAPTER 30 Business Fluctuations: Aggregate Demand and Supply ....... 627

CHAPTER 31 Transmission and Amplification Mechanisms ........................ 657

Part 8: Macroeconomic Policy and Institutions CHAPTER 32 The Federal Reserve System and

Open Market Operations ........................................................................... 673

CHAPTER 33 Monetary Policy ..................................................................... 697

CHAPTER 34 The Federal Budget: Taxes and Spending ............................ 721

CHAPTER 35 Fiscal Policy ........................................................................... 745

Part 9: International Economics CHAPTER 36 International Finance ............................................................. 769

APPENDIX A Reading Graphs and Making Graphs .................................... A-1

APPENDIX B Solutions to Check Yourself Questions ..................................B-1

Glossary G-1

References R-1

Index I-1

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CONTENTS Preface xxiv

Part I: Supply and Demand

CHAPTER 1 The Big Ideas in Economics ......................................................... 1 Big Idea One: Incentives Matter 2

Big Idea Two: Good Institutions Align Self-Interest with the Social Interest 2

Big Idea Three: Trade-offs Are Everywhere 3 Opportunity Cost 4

Big Idea Four: Thinking on the Margin 5

Big Idea Five: The Power of Trade 6

Big Idea Six: The Importance of Wealth and Economic Growth 7

Big Idea Seven: Institutions Matter 7

Big Idea Eight: Economic Booms and Busts Cannot Be Avoided but Can Be Moderated 8

Big Idea Nine: Prices Rise When the Government Prints Too Much Money 9

Big Idea Ten: Central Banking Is a Hard Job 9

The Biggest Idea of All: Economics Is Fun 10

Chapter Review 11

CHAPTER 2 The Power of Trade and Comparative Advantage .................... 13 Trade and Preferences 13

Specialization, Productivity, and the Division of Knowledge 14

Comparative Advantage 16 The Production Possibility Frontier 16 Opportunity Costs and Comparative Advantage 17 Comparative Advantage and Wages 19 Adam Smith on Trade 21

Trade and Globalization 21

Takeaway 21 Chapter Review 22

CHAPTER 3 Supply and Demand .................................................................. 27 The Demand Curve for Oil 27

Consumer Surplus 30 What Shifts the Demand Curve? 31 Important Demand Shifters 31

The Supply Curve for Oil 34 Producer Surplus 37 What Shifts the Supply Curve? 37 Important Supply Shifters 37

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Takeaway 41 Chapter Review 41

CHAPTER 4 Equilibrium: How Supply and Demand Determine Prices ......... 47 Equilibrium and the Adjustment Process 47

Who Competes with Whom? 49

Gains from Trade Are Maximized at the Equilibrium Price and Quantity 49

Does the Model Work? Evidence from the Laboratory 52

Shifting Demand and Supply Curves 54

Terminology: Demand Compared with Quantity Demanded and Supply Compared with Quantity Supplied 56

Understanding the Price of Oil 58

Takeaway 60 Chapter Review 61

CHAPTER 5 Elasticity and Its Applications .................................................... 65 The Elasticity of Demand 66

Determinants of the Elasticity of Demand 67 Calculating the Elasticity of Demand 68 Total Revenues and the Elasticity of Demand 70 Applications of Demand Elasticity 72

The Elasticity of Supply 75 Determinants of the Elasticity of Supply 76 Calculating the Elasticity of Supply 77 Applications of Supply Elasticity 78

Using Elasticities for Quick Predictions 82 How Much Would the Price of Oil Fall if the Arctic National Wildlife Refuge Were

Opened Up for Drilling? 83

Takeaway 83 Chapter Review 84 Appendix 1: Other Types of Elasticities ........................................................ 89

The Cross-Price Elasticity of Demand.............................................................. 89

The Income Elasticity of Demand .................................................................... 89 Appendix 2: Using Excel to Calculate Elasticities .......................................... 91

CHAPTER 6 Taxes and Subsidies .................................................................. 93 Commodity Taxes 94

Who Ultimately Pays the Tax Does Not Depend on Who Writes the Check 95 Who Ultimately Pays the Tax Depends on the Relative Elasticities of Supply and Demand 97 Health Insurance Mandates and Tax Analysis 99 Who Pays the Cigarette Tax? 100 A Commodity Tax Raises Revenue and Reduces the Gains from Trade

(Creates Deadweight Loss) 101

Subsidies 103

Takeaway 106 Chapter Review 107

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Contents • xiii

Part 2: The Price System

CHAPTER 7 The Price System: Signals, Speculation, and Prediction .......... 113 Markets Link the World 113

Markets Link to One Another 114 From Oil to Candy Bars and Brick Driveways 115

Solving the Great Economic Problem 115

A Price Is a Signal Wrapped Up in an Incentive 118

Speculation 119

Signal Watching 122

Prediction Markets 123

Takeaway 125 Chapter Review 126

CHAPTER 8 Price Ceilings and Floors ......................................................... 131 Price Ceilings 131

Shortages 132 Reductions in Quality 132 Wasteful Lines and Other Search Costs 133 Lost Gains from Trade 135 Misallocation of Resources 136 The End of Price Ceilings 140

Rent Controls 141 Shortages 141 Reductions in Product Quality 143 Wasteful Lines, Search Costs, and Lost Gains from Trade 143 Misallocation of Resources 144 Rent Regulation 144

Arguments for Price Controls 145

Universal Price Controls 146

Price Floors 147 Surpluses 147 Lost Gains from Trade 148 Wasteful Increases in Quality 150 The Misallocation of Resources 152

Takeaway 152 Chapter Review 153

CHAPTER 9 International Trade .................................................................. 159 Analyzing Trade with Supply and Demand 159

Analyzing Tariffs with Demand and Supply 160

The Costs of Protectionism 162 Winners and Losers from Trade 164

Arguments Against International Trade 165 Trade and Jobs 165 Child Labor 166

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Trade and National Security 168 Key Industries 169 Strategic Trade Protectionism 169

Takeaway 170 Chapter Review 170

CHAPTER 10 Externalities: When Prices Send the Wrong Signals .............. 175 External Costs, External Benefits, and Efficiency 176

External Costs 177 External Benefits 179

Private Solutions to Externality Problems 181

Government Solutions to Externality Problems 183 Command and Control 183 Tradable Allowances 185 Comparing Tradable Allowances and Pigouvian Taxes—Advanced Material 187

Takeaway 188 Chapter Review 188

Part 3: Firms and Factor Markets

CHAPTER 11 Costs and Profit Maximization Under Competition ............... 193 What Price to Set? 193

What Quantity to Produce? 195 Don’t Forget: Opportunity Costs! 196 Maximizing Profit 197

Profits and the Average Cost Curve 200

Entry, Exit, and Shutdown Decisions 203 The Short-Run Shutdown Decision 203 Entry and Exit with Uncertainty and Sunk Costs 204

Entry, Exit, and Industry Supply Curves 205 Constant Cost Industries 205 Increasing Cost Industries 208 A Special Case: The Decreasing Cost Industry 210 Industry Supply Curves: Summary 210

Takeaway 211 Chapter Review 212 Chapter Appendix: Using Excel to Graph Cost Curves .............................. 219

CHAPTER 12 Competition and the Invisible Hand...................................... 223 Invisible Hand Property 1: The Minimization of Total Industry Costs of

Production 224

Invisible Hand Property 2: The Balance of Industries 226

Creative Destruction 228

The Invisible Hand Works with Competitive Markets 228

Takeaway 229 Chapter Review 229

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CHAPTER 13 Monopoly .............................................................................. 233 Market Power 234

How a Firm Uses Market Power to Maximize Profit 234 The Elasticity of Demand and the Monopoly Markup 237

The Costs of Monopoly: Deadweight Loss 239

The Costs of Monopoly: Corruption and Inefficiency 241

The Benefits of Monopoly: Incentives for Research and Development 241 Patent Buyouts—A Potential Solution? 243

Economies of Scale and the Regulation of Monopoly 244 I Want My MTV 246 Electric Shock 247 California’s Perfect Storm 247

Other Sources of Market Power 249

Takeaway 250 Chapter Review 250

CHAPTER 14 Price Discrimination ............................................................... 257 Price Discrimination 257

Preventing Arbitrage 259

Price Discrimination Is Common 260 Universities and Perfect Price Discrimination 262

Is Price Discrimination Bad? 264 Why Misery Loves Company and How Price Discrimination Helps to Cover Fixed Costs 265

Tying and Bundling 266 Tying 266 Bundling 267 Bundling and Cable TV 269

Takeaway 269 Chapter Review 270 Chapter Appendix: Solving Price Discrimination Problems with Excel ....... 275

CHAPTER 15 Cartels, Oligopolies, and Monopolistic Competition ............ 279 Cartels 280

The Incentive to Cheat 282 New Entrants and Demand Response Break Down Cartels 285 Government Prosecution and Regulation 286 Summing Up: Successful and Unsuccessful Cartels 287

Oligopolies 287

Monopolistic Competition 288

The Economics of Advertising 292 Informative Advertising 292 Advertising as Signaling 292 Advertising as Part of the Product 293

Takeaway 294 Chapter Review 295

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CHAPTER 16 Competing for Monopoly: The Economics of Network Goods .......................................................................................... 303

Network Goods Are Usually Sold by Monopolies or Oligopolies 304

The “Best” Product May Not Always Win 305

Standard Wars Are Common 307

Competition Is “For the Market” Instead of “In the Market” 307

Contestable Markets 308 Limiting Contestability with Switching Costs 310

Antitrust and Network Goods 311

Music Is a Network Good 312

Takeaway 313 Chapter Review 313

CHAPTER 17 Labor Markets ........................................................................ 319 The Demand for Labor and the Marginal Product of Labor 319

Supply of Labor 321

Labor Market Issues 323 Why Do Janitors in the United States Earn More Than Janitors in India Even When They

Do the Same Job? 323 Human Capital 325 Compensating Differentials 326 Do Unions Raise Wages? 329 Statistical Discrimination 331 Preference-Based Discrimination 331

How Bad Is Labor Market Discrimination, or Can Lakisha Catch a Break? 330 Why Discrimination Isn’t Always Easy to Identify 335

Takeaway 336 Chapter Review 337

Part 4: Government

CHAPTER 18 Public Goods and the Tragedy of the Commons .................. 343 Four Types of Goods 344

Private Goods and Public Goods 345

Nonrival Private Goods 347 The Peculiar Case of Advertising 347

Common Resources and the Tragedy of the Commons 348 Happy Solutions to the Tragedy of the Commons 350

Takeaway 352 Chapter Review 352 Chapter Appendix: The Tragedy of the Commons: How Fast? .................. 358

CHAPTER 19 Political Economy and Public Choice .................................... 361 Voters and the Incentive To Be Ignorant 362

Why Rational Ignorance Matters 363

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Contents • xvii

Special Interests and the Incentive To Be Informed 363

One Formula for Political Success: Diffuse Costs, Concentrate Benefits 365

Voter Myopia and Political Business Cycles 367

Two Cheers for Democracy 369 The Median Voter Theorem 370 Democracy and Nondemocracy 372 Democracy and Famine 373 Democracy and Growth 376

Takeaway 377 Chapter Review 378

CHAPTER 20 Economics, Ethics, and Public Policy ..................................... 385 The Case for Exporting Pollution and Importing Kidneys 386

Exploitation 387

Meddlesome Preferences 388

Fair and Equal Treatment 389

Cultural Goods and Paternalism 389

Poverty, Inequality, and the Distribution of Income 390 Rawls’s Maximin Principle 390 Utilitarianism 391 Robert Nozick’s Entitlement Theory 392

Who Counts? Immigration 394

Economic Ethics 395

Takeaway 396 Chapter Review 396

Part 5: Decision Making for Businesses, Investors, and Consumers

CHAPTER 21 Managing Incentives ............................................................. 401 Lesson One: You Get What You Pay For 401

Prisons for Profit? 403 Piece Rates vs. Hourly Wages 404

Lesson Two: Tie Pay to Performance to Reduce Risk 406 Tournament Theory 407 Improving Executive Compensation with Pay for Relative Performance 407 Environment Risk and Availability Risk 408 Tournaments and Grades 409

Lesson Three: Money Isn’t Everything 411

Takeaway 413 Chapter Review 414

CHAPTER 22 Stock Markets and Personal Finance ..................................... 419 Passive vs. Active Investing 420

Why Is It Hard to Beat the Market? 421

How to Really Pick Stocks, Seriously 423

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Diversify 423 Avoid High Fees 425 Compound Returns Build Wealth 426 The No Free Lunch Principle, or No Return Without Risk 427

Other Benefits and Costs of Stock Markets 429 Bubble, Bubble, Toil, and Trouble 430

Takeaway 432 Chapter Review 432

CHAPTER 23 Consumer Choice .................................................................. 435 How to Compare Apples and Oranges 435

The Demand Curve 438

The Budget Constraint 439

Preferences and Indifference Curves 442

Optimization and Consumer Choices 444

The Income and Substitution Effects 446

Applications of Income and Substitution Effects 448 Losing Your Ticket 448 How Much Should Costco Charge for Membership? 449 Labor Supply 450 Labor Supply and Welfare Programs 453

Takeaway 455 Chapter Review 455

Part 6: Economic Growth

CHAPTER 24 GDP and the Measurement of Progress ................................ 461 What Is GDP? 462

GDP Is the Market Value . . . 462 . . . of All Final . . . 463 . . . Goods and Services . . . 463 . . . Produced . . . 464 . . . within a Country . . . 464 . . . in a Year 464

Growth Rates 465

Nominal vs. Real GDP 465 The GDP Deflator 466 Real GDP Growth 467 Real GDP Growth per Capita 468

Cyclical and Short-Run Changes in GDP 469

The Many Ways of Splitting GDP 470 The National Spending Approach: Y 5 C 1 I 1 G 1 NX 470 The Factor Income Approach: The Other Side of the Spending Coin 472 Why Split? 473

Problems with GDP as a Measure of Output and Welfare 473 GDP Does Not Count the Underground Economy 473 GDP Does Not Count Nonpriced Production 474

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Contents • xix

GDP Does Not Count Leisure 475 GDP Does Not Count Bads: Environmental Costs 476 GDP Does Not Measure the Distribution of Income 476

Takeaway 477 Chapter Review 478

CHAPTER 25 The Wealth of Nations and Economic Growth ...................... 483 Key Facts About the Wealth of Nations and Economic Growth 484

Fact One: GDP per Capita Varies Enormously Among Nations 484 Fact Two: Everyone Used to Be Poor 485 Fact Three: There Are Growth Miracles and Growth Disasters 488 Summarizing the Facts: Good and Bad News 489

Understanding the Wealth of Nations 489 The Factors of Production 489

Incentives and Institutions 491 Institutions 494 Institutions and Growth Miracles Revisited 498

Takeaway 499 Chapter Review 499 Chapter Appendix: The Magic of Compound Growth

Using a Spreadsheet .................................................................................. 505

CHAPTER 26 Growth, Capital Accumulation, and the Economics of Ideas: Catching Up vs. the Cutting Edge .............................................................. 509

The Solow Model and Catch-Up Growth 510 Capital, Production and Diminishing Returns 511 Capital Growth Equals Investment Minus Depreciation 513 Why Capital Alone Cannot Be the Key to Economic Growth 514 Better Ideas Drive Long-Run Economic Growth 517

The Solow Model—Details and Further Lessons (Optional Section) 518 The Solow Model and an Increase in the Investment Rate 519 The Solow Model and Conditional Convergence 521 From Catching Up to Cutting Edge 522 Solow and the Economics of Ideas in One Diagram 523

Growing on the Cutting Edge: The Economics of Ideas 524 Research and Development Is Investment for Profit 524 Spillovers, and Why There Aren’t Enough Good Ideas 526 Government’s Role in the Production of New Ideas 527 Market Size and Research and Development 528

The Future of Economic Growth 528

Takeaway 530 Chapter Review 531 Chapter Appendix: Excellent Growth ......................................................... 538

CHAPTER 27 Saving, Investment, and the Financial System ...................... 543 The Supply of Savings 544

Individuals Want to Smooth Consumption 545

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Individuals Are Impatient 546 Marketing and Psychological Factors 546 The Interest Rate 547

The Demand to Borrow 547 Individuals Want to Smooth Consumption 548 Borrowing Is Necessary to Finance Large Investments 548 The Interest Rate 550

Equilibrium in the Market for Loanable Funds 550 Shifts in Supply and Demand 550

The Role of Intermediaries: Banks, Bonds, and Stock Markets 552 Banks 553 The Bond Market 554 The Stock Market 557

What Happens When Intermediation Fails? 558 Insecure Property Rights 558 Controls on Interest Rates 560 Politicized Lending and Government-Owned Banks 560 Bank Failures and Panics 561

The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking 561

Takeaway 566 Chapter Review 566 Chapter Appendix: Bond Pricing and Arbitrage ......................................... 571

Bond Pricing with a Spreadsheet ............................................................... 574

Part 7: Business Fluctuations

CHAPTER 28 Unemployment and Labor Force Participation ...................... 577 Defining Unemployment 579

How Good an Indicator Is the Unemployment Rate? 579

Frictional Unemployment 580

Structural Unemployment 582 Labor Regulations and Structural Unemployment 583 Labor Regulations to Reduce Structural Unemployment 588 Factors that Affect Structural Unemployment 588

Cyclical Unemployment 589 The Natural Unemployment Rate 592

Labor Force Participation 592 Lifecycle Effects and Demographics 593 Incentives 593

Takeaway 597 Chapter Review 598

CHAPTER 29 Inflation and the Quantity Theory of Money ......................... 603 Defining and Measuring Inflation 604

Price Indexes 604

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Inflation in the United States and Around the World 605

The Quantity Theory of Money 607 The Cause of Inflation 609 An Inflation Parable 612

The Costs of Inflation 612 Price Confusion and Money Illusion 613 Inflation Redistributes Wealth 614 Inflation Interacts with Other Taxes 618 Inflation Is Painful to Stop 618

Takeaway 619 Chapter Review 620 Chapter Appendix: Get Real! An Excellent Adventure ............................... 623

CHAPTER 30 Business Fluctuations: Aggregate Demand and Supply.................................................................................................. 627

The Dynamic Aggregate Demand Curve 629 Shifts in the Dynamic Aggregate Demand Curve 631

The Solow Growth Curve 632 Shifts in the Solow Growth Curve 632

Real Shocks 634 Oil Shocks 635 More Shocks 637

Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve 638

Shocks to the Components of Aggregate Demand 643 A Shock to C

→ 643

Why Changes in v → Tend to Be Temporary 644 Other AD Shocks 645

Understanding the Great Depression: Aggregate Demand Shocks and Real Shocks 646

Aggregate Demand Shocks and the Great Depression 646 Real Shocks and the Great Depression 648

Takeaway 649 Chapter Review 650

CHAPTER 31 Transmission and Amplification Mechanisms ........................ 657 Intertemporal Substitution 657

Uncertainty and Irreversible Investments 660

Labor Adjustment Costs 661

Time Bunching 661

Collateral Damage 662

Takeaway 665 Chapter Review 665 Chapter Appendix: Business Fluctuations and the Solow Model ............... 669