According to one of dr. sarbaum's videos, when did other (non-tariff) protectionism become popular?

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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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Contents • xv

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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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

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Part 8: Macroeconomic Policy and Institutions

CHAPTER 32 The Federal Reserve System and Open Market Operations ........................................................................... 673

What Is the Federal Reserve System? 673

The U.S. Money Supplies 674

Fractional Reserve Banking, the Reserve Ratio, and the Money Multiplier 677

How the Fed Controls the Money Supply 679 Open Market Operations 679 Discount Rate Lending and the Term Auction Facility 681 Payment of Interest on Reserves 684

The Federal Reserve and Systemic Risk 684

Revisiting Aggregate Demand and Monetary Policy 685

Who Controls the Fed? 687

Takeaway 688 Chapter Review 689 Chapter Appendix: The Money Multiplier Process in Detail ...................... 693

CHAPTER 33 Monetary Policy ..................................................................... 697 Monetary Policy: The Best Case 698

Rules vs. Discretion 700 Reversing Course and Engineering a Decrease in AD 701 The Fed as Manager of Market Confidence 702

The Negative Real Shock Dilemma 703

When the Fed Does Too Much 705 Dealing with Asset Price Bubbles 708

Takeaway 708 Chapter Review 709

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

The Individual Income Tax 722 Social Security and Medicare Taxes 725 The Corporate Income Tax 726 The Bottom Line on the Distribution of Federal Taxes 726

Spending 728 Social Security 729 Defense 731 Medicare and Medicaid 731 Unemployment Insurance and Welfare Spending 732 Everything Else 732 The National Debt, Interest on the National Debt, and Deficits 733

Will the U.S. Government Go Bankrupt? 735 The Future Is Hard to Predict 737

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Revenues and Spending Undercount the Role of Government in the Economy 739

Takeaway 739 Chapter Review 740

CHAPTER 35 Fiscal Policy ........................................................................... 745 Fiscal Policy: The Best Case 746

The Multiplier 747

The Limits to Fiscal Policy 748 Crowding Out 749 A Drop in the Bucket: Can Government Spend Enough to Stimulate Aggregate Demand? 753 A Matter of Timing 754 Government Spending versus Tax Cuts as Expansionary Fiscal Policy 756 Fiscal Policy Does Not Work Well to Combat Real Shocks 757

When Fiscal Policy Might Make Matters Worse 758

So When Is Fiscal Policy a Good Idea? 759

Takeaway 760 Chapter Review 761

Part 9: International Economics

CHAPTER 36 International Finance ............................................................. 769 The U.S. Trade Deficit and Your Trade Deficit 770

The Balance of Payments 771 The Current Account 772 The Capital Account, Sometimes Called the Financial Account 772 The Official Reserves Account 773 How the Pieces Fit Together 773 Two Sides, One Coin 773 The Bottom Line on the Trade Deficit 775

What Are Exchange Rates? 776 Exchange Rate Determination in the Short Run 776 Exchange Rate Determination in the Long Run 780

How Monetary and Fiscal Policy Affect Exchange Rates and How Exchange Rates Affect Aggregate Demand 783

Monetary Policy 783 Fiscal Policy 785

Fixed vs. Floating Exchange Rates 786 The Problem with Pegs 787

What Are the IMF and the World Bank? 788 International Monetary Fund 788 The World Bank 788

Takeaway 789 Chapter Review 790

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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PREFACE: TO THE INSTRUCTOR

Welcome to the second edition of Modern Principles of Economics. The response to our first edition was tremendous. Instructors and students responded to our key themes: Make the invisible hand visible. Demonstrate the power of incen- tives. Present modern models and vivid applications. Make it simpler. These were our goals in writing Modern Principles of Economics and they remain our goals in this second edition.

Make the Invisible Hand Visible One of the most remarkable discoveries of economic science is that under the right conditions the pursuit of self-interest can promote the social good. Nobel laureate Vernon Smith put it this way:

At the heart of economics is a scientific mystery . . . a scientific mystery as deep, fundamental and inspiring as that of the expanding universe or the forces that bind matter. . . . How is order produced from freedom of choice?

We want students to be inspired by this mystery and by how economists have begun to solve it. Thus, we will explain how markets generate cooperation from people across the world, how prices act as signals and coordinate appropriate re- sponses to changes in economic conditions, and how profit maximization leads to the minimization of industry costs (even though no one intends such an end). We strive to make the invisible hand visible.

In Chapter 7, for example, we show how the invisible hand links romantic American teenagers with Kenyan flower growers, Dutch clocks, British air- planes, Colombian coffee, and Finnish cell phones. We also show how prices signal information and how markets help to solve the great economic problem of arranging our limited resources to satisfy as many of our wants as possible.

The focus on the invisible hand or the price system continues in Chapter 8. As in other texts, we show how a price ceiling causes a shortage. But a shortage in one market can spill over into other markets (e.g., shortages of oil in the 1970s meant that oil rigs off the coast of California could not get enough oil to oper- ate). In addition, a price ceiling reduces the incentive to move resources from low-value uses to high-value uses, so in the 1970s we saw long lines for gaso- line in some states yet at the same time gas was plentiful in other states just a few hours away. Price ceilings, therefore, cause a misallocation of resources across markets as well as a shortage within a particular market. We think of Chapters 7 and 8 as a package: Chapter 7 illustrates the price system when it is working and Chapter 8 illustrates what happens when the price system is impeded.

Students who catch even a glimpse of the invisible hand learn something of great importance. Civilization is possible only because under some conditions the pursuit of self-interest promotes the public good.

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In discussing the invisible hand, we bring more Hayekian economics into the classroom without proselytizing for Hayekian politics. That is, we want to show how prices communicate information and coordinate action while still recogniz- ing that markets do not always communicate the right information. Thus, our chapters on the price system are rounded out with what we think is an equally interesting and compelling chapter on externalities. The subtitle of Chapter 10, “When Prices Send the Wrong Signals,” harkens directly back to Chapter 7. By giving examples where the price signal is right and examples where the price sig- nal is wrong, we convey a sophisticated understanding of the role of prices.

Demonstrate the Power of Incentives Our second goal in writing Modern Principles of Economics is to show—again and again—that incentives matter. In fact, incentives are the theme through- out Modern Principles, whether discussing the tragedy of the commons, political economy, or what economics has to say about wise investing. We also include Chapter 21, “Managing Incentives.” In this chapter, we explain topics such as the trade-offs between fixed salaries and piece rates, when tournaments work well, and how best to incentivize executives. This chapter can be read profitably by anyone with an interest in incentive design—by managers, teachers, even par- ents! Chapter 21 will be of special interest to business and MBA students (and professors).

Present Modern Models and Vivid Applications “Modern” is our third goal in writing Modern Principles. For example, we in- clude an entire chapter on price discrimination, in which we cover not just traditional models but also tying and bundling. Students today are familiar with tied goods like cell phones and minutes, or printers and ink, as well as with bundles like Microsoft Office. A modern economics textbook should help stu- dents to understand their world.

We include business examples and topics throughout the text. We cover business issues as diverse as why businesses cluster and how network externali- ties push businesses to compete “for the market” rather than “in the market,” to how successful cartels such as the NBA deal with the incentive to cheat, to how businesses actually go about price discriminating. Our chapter on incentives, already mentioned, is critical for managers in a variety of fields.

We also present a modern perspective on the costs and benefits of market power. A significant amount of market power today is tied to innovation, patents, and high fixed costs. Understanding the trade-offs involved with pricing AIDS drugs at marginal cost, for example, is critically important to understanding pharmaceutical policy. Similar issues arise with music, movies, software, chip design, and universities. Our material on monopoly and innovation is consistent with and provides a foun- dation for modern theories of economic growth.

Our chapters on monopoly and price discrimination (Chapters 13 and 14) are filled with business applications, real-world examples, and insightful discus- sions of policy.

Our game theory chapters (Chapter 15 and 16) are especially geared toward modern real-world choices and problems. Naturally, we cover cartel behavior. We also cover network externalities extensively. In many high-tech and online markets, the value of a good depends on how many other people are using the

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same good. Students are very familiar with examples such as Facebook and they want to know how the principles of economics apply to these contem- porary goods. We even challenge students by showing how the principles of network externalities apply to cultural goods and even to the songs they put on their iPods!

In our chapter on costs (Chapter 11), we jettison some of the old and incor- rect rules about when to enter and exit an industry and instead give students a more modern introduction to sunk costs, uncertainty, and the necessity of esti- mating lifetime expected profits. Our discussion is more modern than in other texts yet it’s also simpler and more streamlined, with less focus on the menag- erie of cost curves that in other texts chokes off learning.

Modern Principles is also an integrated textbook; our macroeconomics truly builds on the microfoundations laid down in earlier chapters. Our modern discussion of cost curves connects with our discussion of the real business cycle in Chapter 31. In that chapter, we show how uncertainty and sunk costs can cause businesses and workers to delay investment decisions during a recession. Uncertainty and sunk costs are exactly the same principles that we use to discuss entry and exit decisions in Chapter 11. Macroeconomics in Modern Principles is truly based on and consistent with micro- economic intuitions.

A modern text needs to place economics in context. We have a whole chapter on normative judgments (Chapter 20). It covers the assumptions behind cost-benefit analysis, the idea of a Pareto improvement, and the ethical judgments that have been used to praise or condemn economic reasoning. Rightly or wrongly, commentators often mix economic and moral judgments and we teach students to recognize which is which. We stress to the student that economics cannot answer normative issues but the student should be aware of what those normative issues are.

We offer an entire chapter (Chapter 22) on the stock market, a topic of direct practical concern to many students. We teach the basic trade-off between risk and return (no free lunches) and explain why it is a good idea to diversify investments. We also explain the microeconomics of bubbles, which of course bridges to current macroeconomic issues.

We knew that to reflect modern macroeconomics, we had to cover the Solow model and the economics of ideas, real business cycles, and New Keynesian econom- ics. While most textbooks now cover the rudiments of economic growth, the impor- tance of ideas as a driving factor is rarely even mentioned. Other textbooks do not offer a balanced treatment of real business cycle theory and New Keynesian theory, instead favoring one theory and relegating the other to a few pages that are poorly integrated with the overall macro model. In contrast, we believe that adequately ex- plaining business fluctuations, unemployment, and both the potential and limits of monetary and fiscal policy requires a balanced but unified treatment that draws on ideas from both models.

We also knew that financial crises and bubbles are very real, and that fluc- tuations in output and employment are a social and economic issue around the world. In fact, we included substantial material on banking panics, bubbles, wealth shocks, and the importance of financial intermediation in the very first draft of Modern Principles. Our book incorporates these topics from the ground floor rather than attempting to squeeze such material into hastily added boxes or appended paragraphs. In the second edition, we include more material on the shadow banking system and on the importance of housing and other sources of collateral shocks.

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Make It Simpler We also knew that our efforts to reflect modern economics would be wasted if we reached only a small percentage of students. We had to make the material simpler, more compelling, and more intuitive. We had to get to the point right away. We knew that we were writing for a generation that doesn’t always have the patience for slow delivery.

Our text is motivated by the following pedagogical guidelines: > Economics is a set of powerful tools for understanding the world. > We develop no tools that we do not use to better understand the world. > Theory is developed alongside real examples. > Economics is everywhere. Law, management, politics, personal relations—

we draw from it all. > Economics is fun.

Make the invisible hand visible. Demonstrate the power of incentives. Present modern models and vivid applications. Make it simpler. Those are just some of the reasons why we call our text Modern Principles of Economics. We have taken recent advances in how economists think and describe economics and we have integrated them throughout the text. We truly seek to get students enthused about the economic way of thinking and to internalize it for the rest of their lives. We hope you will see that this text provides the best coverage of what it means to think like an economist.

Guiding Principles and Innovations: In a Nutshell Modern Principles offers the following features and benefits: 1. We teach the economic way of thinking. 2. Modern Principles has a more intuitive development of markets and their

interconnectedness than does any other textbook. More than any other textbook, we teach students how the price system works.

3. Modern Principles helps students to see the invisible hand. We offer an intui- tive proof of several “invisible hand theorems.” For example, we show that through the operation of incentives and the price system, well-functioning markets will minimize the aggregate sum of the costs of production even though no one intends this result. Local knowledge creates a global benefit.

4. We offer an entire chapter on incentives and how they apply to business decisions, sports, and incentive design. When, for instance, should you re- ward your employees with a tournament form of compensation, and when a straight salary? Most texts are oddly silent on such practical issues, but it is precisely such issues that interest many students and show them the rel- evance of the economic way of thinking. We also offer an entire chapter on network goods, which covers Facebook, the tech sector, and music.

5. We offer an entire chapter on the stock market, a topic of concern to many students. We teach the basic trade-off between risk and return and explain why it is a good idea to diversify investments. We also explain the microeconomics of bubbles.

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6. Why are some nations rich and other nations poor? Modern Principles has more material on development and growth than any other principles textbook.

7. Modern Principles offers the most intuitive development of the Solow model of growth in any textbook.

8. Modern Principles is the only principles book with a balanced treatment of real business cycle theory and New Keynesian macroeconomics.

9. Financial panics and asset bubbles are covered—a topic of great interest in today’s environment! There are separate and comprehensive chapters on financial intermediation and on the stock market. We also cover the finan- cial crisis that began in 2007.

10. We look closely at unemployment, its nature and causes, including the unusually long duration of unemployment experienced in the United States after the financial crisis. We also look at labor force participation rates in the United States over time and around the world. Why have women increased their labor force participation and why are only one-third of Belgian men aged 55–64 in the labor force?

11. Modern Principles explains how fiscal and monetary policy work differently, depending on whether the shock hitting the economy is a real shock or a nominal shock.

12. Today’s students live in a globalized economy. Events in China, India, Europe, and the Middle East affect their lives. Modern Principles features international examples and applications throughout, rather than just segre- gating all of the international topics in a single chapter.

13. Less is more. This is a textbook of principles, not a survey or an encyclope- dia. A textbook that focuses on what is important helps the student to focus on what is important. There are fewer yet more consistent and more comprehensive models.

14. No tools without applications. Real-world vivid applications are used to develop theory. Applications are not pushed aside into distracting boxes that students do not read.

15. Excel is used as a tool in appendices to help students develop insight, hands-on experience, and modeling ability.

What’s New in the Second Edition? Every book must change with the time and ours has, too. The new edition of Modern Principles of Economics includes many additions and structural changes: • A new Chapter 2, “The Power of Trade and Comparative Advantage,”

introduces the core ideas of trade and production, using the production pos- sibilities frontier, earlier in the book and gives them greater coverage, for those instructors who want to cover this material before supply and demand.

• “Taxes and Subsidies” now gets its own chapter (Chapter 6), rather than being mixed in with price floors.

• The previous costs chapter has been split up into two new chapters. The first, Chapter 11, “Costs and Profit Maximization Under Competition,” covers basic cost issues more thoroughly than before. The second, Chapter 12, “Competition and the Invisible Hand,” expands on our previous dem- onstration of how competition minimizes total costs of production.

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• Chapter 15, “Cartels, Oligopolies, and Monopolistic Competition,” adds a whole new section on monopolistic competition, with an application to advertising.

• A new Chapter 16 focuses on “The Economics of Network Goods: Com- peting for Monopoly,” with easy-to-teach examples from Facebook and musical songs.

• New Chapter 23, “Consumer Choice,” adds extensive coverage of indiffer- ence curves, and income and substitution effects, to the book.

• Chapter 24, “GDP and the Measure of Progress,” includes a discussion of the GDP deflator.

• Chapter 25, “The Wealth of Nations and Economic Growth,” now dis- cusses the Industrial Revolution.

• Chapter 27, “Savings, Investment, and the Financial System,” includes a new section on the financial crisis of 2007–2009 and what happens when financial intermediation fails.

• Increased coverage of asset price bubbles can be found in Chapter 22 on stock markets and Chapter 33 on monetary policy.

• Chapter 28, “Unemployment and Labor Force Participation,” has been fully updated to account for the persistently high rates of unemployment following the financial crisis of 2007–2009.

• Chapter 30, “Business Fluctuations: Aggregate Demand and Supply,” is presented in a simpler and more economical manner.

• Damage to collateral values as a means of transmitting business cycles has been added to Chapter 31, “Transmission and Amplification Mechanisms.”

• Quantitative easing is included in Chapter 32 on the Fed. • Chapter 33 on monetary policy contains a new section “When the Fed

Does Too Much” on Fed culpability and actions in the financial crisis and a new subsection on dealing with asset bubbles.

• Chapter 35, “Fiscal Policy,” covers President Barack Obama’s recent pro- gram of fiscal policy stimulus.

Most importantly, we’ve kept all of the qualities and features that made the first edition so popular.

Tools for Learning Economics should come across as elegant, intuitive, and unified, falling directly out of real-world experience. Thus, we focus on the core tools of supply and demand and price elasticity, leavened with lots of economic intuition and a dash of game theory. In macroeconomics, we cover more content with fewer distinct models than ever before, thereby focusing on what is truly essential. We spend more time on the core tools than do other textbooks, we introduce “no tools without applications,” and we focus on tools that we use repeatedly. 1. Vivid applications

Nothing sticks with a student like a good example. Modern Principles is full of vivid illustrations of core economic principles. From the first sentence in our textbook, “The prisoners were dying of scurvy, typhoid fever, and smallpox, but nothing was killing them more than bad incentives,” we strive to draw students into the economic way of thinking and to teach them that economics matters.

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2. Simpler graphs Modern Principles presents economics with fewer curves than you will find in other

economics books, yet without skimping on substantive results. This follows from our presentation of integrated and consistent models. For instance, on cost curves we strip the key ideas down to their intuitive essentials. If you look at the clunkier expo- sitions of cost curves—which multiply the number of curves beyond reason—how many students actually learn or remember all of the distinctions presented? More- over, as we know from the modern theory of investment under uncertainty, the old shut-down “rules” such as P < AVC are wrong, so why present them?*

In macroeconomics, our presentation of integrated and consistent macro- economic models, especially for aggregate demand and aggregate supply, means we don’t need to shift to a new analytical apparatus for each macroeconomic topic. To the student, it will feel that macroeconomics makes sense and that macro-economics involves learning one integrated approach, covering both growth and business cycles. Some textbooks serve up a bewildering array of shifting curves, multiple and possibly conflicting graphs, or even overlaid trans- parencies to capture all of the curves and shifts.

We say if the idea is intuitive—as good economics should be—the graph should be intuitive, too. Economics students do need to learn how to think in terms of graphs. But that’s best done by making graphs manageable, not by making graphs forbidding. 3. No set-off boxes that interrupt the flow of the text

We know that students usually skip these boxes. So we’ve also skipped them. If the material is important enough for the student to learn, we’ve put it in the text. If it’s not important, we’ve left it out. We want our pages to look attractive and easy to read. That will get students to read more of the material that really matters. 4. Extensive questions and problems sections

At the end of each chapter, we typically start with “Facts and Tools” ques- tions designed to test knowledge of basic concepts. The next section, “Thinking and Problem Solving,” tests whether the student can apply those concepts to examples and also to problems that require a definite solution. The final section, “Challenges,” tests whether students understand key concepts in a deep fash- ion and can apply them to nontrivial examples and problems. If a student can do well in the challenges, he or she has not just memorized some material but is truly thinking like an economist. The multiple tiers for the end-of-chapter material help us teach both different skills and different levels of understanding. 5. Nuggets

The chapter margins offer captioned photos, cartoons, and short informational bits. The examples are chosen because they are memorable and sometimes humor- ous. Reading a principles textbook is not always sugar, but every now and then it should be fun. The students should look forward to at least some part of the reading and some part of the lesson. We have written Modern Principles with this philosophy. 6. Notation

The book has a minimum of notational requirements. Students need to be familiar with simple one-line equations, with basic algebra, and with read- ing graphs. For help with reading graphs, we offer a useful 14-page appendix. Overall our notation is minimal and standard.

* On the modern theory of investment under uncertainty, see Dixit, Avinash. 1992. Investment and hysteresis. Journal of Economic Perspectives 6(1): 107–132.

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What’s in the Chapters?

Part 1: Supply and Demand We review the key aspects of supply and demand and the price system, done in six chapters. We present incentives as the most important idea in microeco- nomics. Microeconomics should be intuitive, should teach the skill of think- ing like an economist, and should be drawn from examples from everyday life. Along these lines, these chapters run as follows.