Https openstax org details principles economics

Principles of Economics 2e

SENIOR CONTRIBUTING AUTHORS STEVEN A. GREENLAW, UNIVERSITY OF MARY WASHINGTON DAVID SHAPIRO, PENNSYLVANIA STATE UNIVERSITY Based on the 2nd edition of Principles of Economics, Economics and the Economy, 2e by Timothy Taylor, published in 2011.

OpenStax Rice University 6100 Main Street MS-375 Houston, Texas 77005 To learn more about OpenStax, visit https://openstax.org. Individual print copies and bulk orders can be purchased through our website. ©2018 Rice University. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution 4.0 International License (CC BY 4.0). Under this license, any user of this textbook or the textbook contents herein must provide proper attribution as follows:

- If you redistribute this textbook in a digital format (including but not limited to PDF and HTML), then you must retain on every page the following attribution: “Download for free at https://openstax.org/details/books/principles-economics-2e.”

- If you redistribute this textbook in a print format, then you must include on every physical page the following attribution: “Download for free at https://openstax.org/details/books/principles-economics-2e.”

- If you redistribute part of this textbook, then you must retain in every digital format page view (including but not limited to PDF and HTML) and on every physical printed page the following attribution: “Download for free at https://openstax.org/details/books/principles-economics-2e.”

- If you use this textbook as a bibliographic reference, please include https://openstax.org/details/books/principles-economics-2e in your citation.

For questions regarding this licensing, please contact support@openstax.org. Trademarks The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, OpenStax CNX logo, OpenStax Tutor name, Openstax Tutor logo, Connexions name, Connexions logo, Rice University name, and Rice University logo are not subject to the license and may not be reproduced without the prior and express written consent of Rice University. Portions of the Demand and Supply chapter were derived from "Why It Matters: Government in Action by Steve Greenlaw and Lumen Learning." Located at: https://courses.lumenlearning.com/waymakermacroxmasterfall2016/chapter/why-it-matters-government- action/. License: CC BY 4.0. PRINT BOOK ISBN-10 1-947172-36-0 PRINT BOOK ISBN-13 978-1-947172-36-4 PDF VERSION ISBN-10 1-947172-37-9 PDF VERSION ISBN-13 978-1-947172-37-1 ENHANCED TEXTBOOK ISBN-10 1-947172-48-4 ENHANCED TEXTBOOK ISBN-13 978-1-947172-48-7 Revision Number PE2-2017-002-(03/18)-LC Original Publication Year 2017

OPENSTAX OpenStax provides free, peer-reviewed, openly licensed textbooks for introductory college and Advanced Placement® courses and low-cost, personalized courseware that helps students learn. A nonprofit ed tech initiative based at Rice University, we’re committed to helping students access the tools they need to complete their courses and meet their educational goals.

RICE UNIVERSITY OpenStax, OpenStax CNX, and OpenStax Tutor are initiatives of Rice University. As a leading research university with a distinctive commitment to undergraduate education, Rice University aspires to path-breaking research, unsurpassed teaching, and contributions to the betterment of our world. It seeks to fulfill this mission by cultivating a diverse community of learning and discovery that produces leaders across the spectrum of human endeavor.

FOUNDATION SUPPORT OpenStax is grateful for the tremendous support of our sponsors. Without their strong engagement, the goal of free access to high-quality textbooks would remain just a dream.

Laura and John Arnold Foundation (LJAF) actively seeks opportunities to invest in organizations and thought leaders that have a sincere interest in implementing fundamental changes that not only yield immediate gains, but also repair broken systems for future generations. LJAF currently focuses its strategic investments on education, criminal justice, research integrity, and public accountability.

The William and Flora Hewlett Foundation has been making grants since 1967 to help solve social and environmental problems at home and around the world. The Foundation concentrates its resources on activities in education, the environment, global development and population, performing arts, and philanthropy, and makes grants to support disadvantaged communities in the San Francisco Bay Area. Calvin K. Kazanjian was the founder and president of Peter Paul (Almond Joy), Inc. He firmly believed that the more people understood about basic economics the happier and more prosperous they would be. Accordingly, he established the Calvin K. Kazanjian Economics Foundation Inc, in 1949 as a philanthropic, nonpolitical educational organization to support efforts that enhanced economic understanding.

Guided by the belief that every life has equal value, the Bill & Melinda Gates Foundation works to help all people lead healthy, productive lives. In developing countries, it focuses on improving people’s health with vaccines and other life-saving tools and giving them the chance to lift themselves out of hunger and extreme poverty. In the United States, it seeks to significantly improve education so that all young people have the opportunity to reach their full potential. Based in Seattle, Washington, the foundation is led by CEO Jeff Raikes and Co-chair William H. Gates Sr., under the direction of Bill and Melinda Gates and Warren Buffett. The Maxfield Foundation supports projects with potential for high impact in science, education, sustainability, and other areas of social importance.

Our mission at The Michelson 20MM Foundation is to grow access and success by eliminating unnecessary hurdles to affordability. We support the creation, sharing, and proliferation of more effective, more affordable educational content by leveraging disruptive technologies, open educational resources, and new models for collaboration between for-profit, nonprofit, and public entities. The Bill and Stephanie Sick Fund supports innovative projects in the areas of Education, Art, Science and Engineering.

Our textbook’s new web version works with you to help you study

Access. The future of education. openstax.org

Whether you’re an expert color-coder or first-time notetaker, our new web view makes it easy to highlight and annotate your book online! And, we’ve created a detailed study guide to help you prepare for tests and remember what you’ve read.

Our books are free and flexible, forever.

Get started at openstax.org/details/books/principles- economics-2e

Table of Contents Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Chapter 1: Welcome to Economics! . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

1.1 What Is Economics, and Why Is It Important? . . . . . . . . . . . . . . . . . . . . . . . . . . 10 1.2 Microeconomics and Macroeconomics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 1.3 How Economists Use Theories and Models to Understand Economic Issues . . . . . . . . . . 15 1.4 How To Organize Economies: An Overview of Economic Systems . . . . . . . . . . . . . . . 18

Chapter 2: Choice in a World of Scarcity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 2.1 How Individuals Make Choices Based on Their Budget Constraint . . . . . . . . . . . . . . . 28 2.2 The Production Possibilities Frontier and Social Choices . . . . . . . . . . . . . . . . . . . . 33 2.3 Confronting Objections to the Economic Approach . . . . . . . . . . . . . . . . . . . . . . . 38

Chapter 3: Demand and Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services . . . . . . . . . . . . . 46 3.2 Shifts in Demand and Supply for Goods and Services . . . . . . . . . . . . . . . . . . . . . 51 3.3 Changes in Equilibrium Price and Quantity: The Four-Step Process . . . . . . . . . . . . . . 61 3.4 Price Ceilings and Price Floors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 3.5 Demand, Supply, and Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

Chapter 4: Labor and Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 4.1 Demand and Supply at Work in Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . 84 4.2 Demand and Supply in Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 4.3 The Market System as an Efficient Mechanism for Information . . . . . . . . . . . . . . . . . 98

Chapter 5: Elasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 5.1 Price Elasticity of Demand and Price Elasticity of Supply . . . . . . . . . . . . . . . . . . . 108 5.2 Polar Cases of Elasticity and Constant Elasticity . . . . . . . . . . . . . . . . . . . . . . . 113 5.3 Elasticity and Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 5.4 Elasticity in Areas Other Than Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

Chapter 6: Consumer Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 6.1 Consumption Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 6.2 How Changes in Income and Prices Affect Consumption Choices . . . . . . . . . . . . . . 141 6.3 Behavioral Economics: An Alternative Framework for Consumer Choice . . . . . . . . . . . 147

Chapter 7: Production, Costs, and Industry Structure . . . . . . . . . . . . . . . . . . . . . . . . 155 7.1 Explicit and Implicit Costs, and Accounting and Economic Profit . . . . . . . . . . . . . . . 157 7.2 Production in the Short Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 7.3 Costs in the Short Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164 7.4 Production in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 7.5 Costs in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

Chapter 8: Perfect Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187 8.1 Perfect Competition and Why It Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 8.2 How Perfectly Competitive Firms Make Output Decisions . . . . . . . . . . . . . . . . . . . 189 8.3 Entry and Exit Decisions in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . 204 8.4 Efficiency in Perfectly Competitive Markets . . . . . . . . . . . . . . . . . . . . . . . . . . 206

Chapter 9: Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215 9.1 How Monopolies Form: Barriers to Entry . . . . . . . . . . . . . . . . . . . . . . . . . . . 216 9.2 How a Profit-Maximizing Monopoly Chooses Output and Price . . . . . . . . . . . . . . . . 220

Chapter 10: Monopolistic Competition and Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . 235 10.1 Monopolistic Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236 10.2 Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244

Chapter 11: Monopoly and Antitrust Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255 11.1 Corporate Mergers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256 11.2 Regulating Anticompetitive Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262 11.3 Regulating Natural Monopolies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264 11.4 The Great Deregulation Experiment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267

Chapter 12: Environmental Protection and Negative Externalities . . . . . . . . . . . . . . . . . 275 12.1 The Economics of Pollution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276 12.2 Command-and-Control Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280 12.3 Market-Oriented Environmental Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281 12.4 The Benefits and Costs of U.S. Environmental Laws . . . . . . . . . . . . . . . . . . . . . 285 12.5 International Environmental Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

12.6 The Tradeoff between Economic Output and Environmental Protection . . . . . . . . . . . 289 Chapter 13: Positive Externalities and Public Goods . . . . . . . . . . . . . . . . . . . . . . . . 301

13.1 Why the Private Sector Underinvests in Innovation . . . . . . . . . . . . . . . . . . . . . 303 13.2 How Governments Can Encourage Innovation . . . . . . . . . . . . . . . . . . . . . . . . 306 13.3 Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309

Chapter 14: Labor Markets and Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 14.1 The Theory of Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320 14.2 Wages and Employment in an Imperfectly Competitive Labor Market . . . . . . . . . . . . 326 14.3 Market Power on the Supply Side of Labor Markets: Unions . . . . . . . . . . . . . . . . . 330 14.4 Bilateral Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337 14.5 Employment Discrimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338 14.6 Immigration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343

Chapter 15: Poverty and Economic Inequality . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 15.1 Drawing the Poverty Line . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354 15.2 The Poverty Trap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357 15.3 The Safety Net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360 15.4 Income Inequality: Measurement and Causes . . . . . . . . . . . . . . . . . . . . . . . . 364 15.5 Government Policies to Reduce Income Inequality . . . . . . . . . . . . . . . . . . . . . . 370

Chapter 16: Information, Risk, and Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381 16.1 The Problem of Imperfect Information and Asymmetric Information . . . . . . . . . . . . . 382 16.2 Insurance and Imperfect Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388

Chapter 17: Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 401 17.1 How Businesses Raise Financial Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . 403 17.2 How Households Supply Financial Capital . . . . . . . . . . . . . . . . . . . . . . . . . . 406 17.3 How to Accumulate Personal Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 418

Chapter 18: Public Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429 18.1 Voter Participation and Costs of Elections . . . . . . . . . . . . . . . . . . . . . . . . . . 430 18.2 Special Interest Politics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432 18.3 Flaws in the Democratic System of Government . . . . . . . . . . . . . . . . . . . . . . . 435

Chapter 19: The Macroeconomic Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443 19.1 Measuring the Size of the Economy: Gross Domestic Product . . . . . . . . . . . . . . . . 445 19.2 Adjusting Nominal Values to Real Values . . . . . . . . . . . . . . . . . . . . . . . . . . . 454 19.3 Tracking Real GDP over Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460 19.4 Comparing GDP among Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462 19.5 How Well GDP Measures the Well-Being of Society . . . . . . . . . . . . . . . . . . . . . 465

Chapter 20: Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473 20.1 The Relatively Recent Arrival of Economic Growth . . . . . . . . . . . . . . . . . . . . . . 474 20.2 Labor Productivity and Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . 477 20.3 Components of Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484 20.4 Economic Convergence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488

Chapter 21: Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499 21.1 How Economists Define and Compute Unemployment Rate . . . . . . . . . . . . . . . . . 500 21.2 Patterns of Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505 21.3 What Causes Changes in Unemployment over the Short Run . . . . . . . . . . . . . . . . 510 21.4 What Causes Changes in Unemployment over the Long Run . . . . . . . . . . . . . . . . 514

Chapter 22: Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527 22.1 Tracking Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 528 22.2 How to Measure Changes in the Cost of Living . . . . . . . . . . . . . . . . . . . . . . . 532 22.3 How the U.S. and Other Countries Experience Inflation . . . . . . . . . . . . . . . . . . . 537 22.4 The Confusion Over Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542 22.5 Indexing and Its Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 547

Chapter 23: The International Trade and Capital Flows . . . . . . . . . . . . . . . . . . . . . . . 555 23.1 Measuring Trade Balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556 23.2 Trade Balances in Historical and International Context . . . . . . . . . . . . . . . . . . . . 560 23.3 Trade Balances and Flows of Financial Capital . . . . . . . . . . . . . . . . . . . . . . . 562 23.4 The National Saving and Investment Identity . . . . . . . . . . . . . . . . . . . . . . . . . 565 23.5 The Pros and Cons of Trade Deficits and Surpluses . . . . . . . . . . . . . . . . . . . . . 569 23.6 The Difference between Level of Trade and the Trade Balance . . . . . . . . . . . . . . . 571

Chapter 24: The Aggregate Demand/Aggregate Supply Model . . . . . . . . . . . . . . . . . . . 579

This OpenStax book is available for free at http://cnx.org/content/col12122/1.4

24.1 Macroeconomic Perspectives on Demand and Supply . . . . . . . . . . . . . . . . . . . . 581 24.2 Building a Model of Aggregate Demand and Aggregate Supply . . . . . . . . . . . . . . . 582 24.3 Shifts in Aggregate Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 588 24.4 Shifts in Aggregate Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 590 24.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation . . . . . . . . . 594 24.6 Keynes’ Law and Say’s Law in the AD/AS Model . . . . . . . . . . . . . . . . . . . . . . 597

Chapter 25: The Keynesian Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 607 25.1 Aggregate Demand in Keynesian Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 608 25.2 The Building Blocks of Keynesian Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 612 25.3 The Phillips Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615 25.4 The Keynesian Perspective on Market Forces . . . . . . . . . . . . . . . . . . . . . . . . 619

Chapter 26: The Neoclassical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625 26.1 The Building Blocks of Neoclassical Analysis . . . . . . . . . . . . . . . . . . . . . . . . 627 26.2 The Policy Implications of the Neoclassical Perspective . . . . . . . . . . . . . . . . . . . 632 26.3 Balancing Keynesian and Neoclassical Models . . . . . . . . . . . . . . . . . . . . . . . 639

Chapter 27: Money and Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645 27.1 Defining Money by Its Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 646 27.2 Measuring Money: Currency, M1, and M2 . . . . . . . . . . . . . . . . . . . . . . . . . . 648 27.3 The Role of Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 651 27.4 How Banks Create Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 656

Chapter 28: Monetary Policy and Bank Regulation . . . . . . . . . . . . . . . . . . . . . . . . . 665 28.1 The Federal Reserve Banking System and Central Banks . . . . . . . . . . . . . . . . . . 666 28.2 Bank Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 669 28.3 How a Central Bank Executes Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . 672 28.4 Monetary Policy and Economic Outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . 675 28.5 Pitfalls for Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680

Chapter 29: Exchange Rates and International Capital Flows . . . . . . . . . . . . . . . . . . . . 691 29.1 How the Foreign Exchange Market Works . . . . . . . . . . . . . . . . . . . . . . . . . . 692 29.2 Demand and Supply Shifts in Foreign Exchange Markets . . . . . . . . . . . . . . . . . . 700 29.3 Macroeconomic Effects of Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . 705 29.4 Exchange Rate Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 707

Chapter 30: Government Budgets and Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . 719 30.1 Government Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720 30.2 Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 723 30.3 Federal Deficits and the National Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . 725 30.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation . . . . . . . . . . . . 728 30.5 Automatic Stabilizers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 731 30.6 Practical Problems with Discretionary Fiscal Policy . . . . . . . . . . . . . . . . . . . . . 733 30.7 The Question of a Balanced Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737

Chapter 31: The Impacts of Government Borrowing . . . . . . . . . . . . . . . . . . . . . . . . . 745 31.1 How Government Borrowing Affects Investment and the Trade Balance . . . . . . . . . . 746 31.2 Fiscal Policy and the Trade Balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 749 31.3 How Government Borrowing Affects Private Saving . . . . . . . . . . . . . . . . . . . . . 752 31.4 Fiscal Policy, Investment, and Economic Growth . . . . . . . . . . . . . . . . . . . . . . . 754

Chapter 32: Macroeconomic Policy Around the World . . . . . . . . . . . . . . . . . . . . . . . 763 32.1 The Diversity of Countries and Economies across the World . . . . . . . . . . . . . . . . 765 32.2 Improving Countries’ Standards of Living . . . . . . . . . . . . . . . . . . . . . . . . . . . 768 32.3 Causes of Unemployment around the World . . . . . . . . . . . . . . . . . . . . . . . . . 773 32.4 Causes of Inflation in Various Countries and Regions . . . . . . . . . . . . . . . . . . . . 774 32.5 Balance of Trade Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 775

Chapter 33: International Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 785 33.1 Absolute and Comparative Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . 786 33.2 What Happens When a Country Has an Absolute Advantage in All Goods . . . . . . . . . 792 33.3 Intra-industry Trade between Similar Economies . . . . . . . . . . . . . . . . . . . . . . . 796 33.4 The Benefits of Reducing Barriers to International Trade . . . . . . . . . . . . . . . . . . 800

Chapter 34: Globalization and Protectionism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 807 34.1 Protectionism: An Indirect Subsidy from Consumers to Producers . . . . . . . . . . . . . . 808 34.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions . . . . . . . . 815 34.3 Arguments in Support of Restricting Imports . . . . . . . . . . . . . . . . . . . . . . . . . 818

34.4 How Governments Enact Trade Policy: Globally, Regionally, and Nationally . . . . . . . . 823 34.5 The Tradeoffs of Trade Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 827

A | The Use of Mathematics in Principles of Economics . . . . . . . . . . . . . . . . . . . . . . . 835 B | Indifference Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 851 C | Present Discounted Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 865 D | The Expenditure-Output Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 869 Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 957

This OpenStax book is available for free at http://cnx.org/content/col12122/1.4

PREFACE Welcome to Principles of Economics 2e (2nd Edition), an OpenStax resource. This textbook was written to increase student access to high-quality learning materials, maintaining highest standards of academic rigor at little to no cost.

About OpenStax OpenStax is a nonprofit based at Rice University, and it’s our mission to improve student access to education. Our first openly licensed college textbook was published in 2012, and our library has since scaled to over 25 books for college and AP® courses used by hundreds of thousands of students. OpenStax Tutor, our low-cost personalized learning tool, is being used in college courses throughout the country. Through our partnerships with philanthropic foundations and our alliance with other educational resource organizations, OpenStax is breaking down the most common barriers to learning and empowering students and instructors to succeed.

About OpenStax resources Customization Principles of Economics 2e is licensed under a Creative Commons Attribution 4.0 International (CC BY) license, which means that you can distribute, remix, and build upon the content, as long as you provide attribution to OpenStax and its content contributors.

Because our books are openly licensed, you are free to use the entire book or pick and choose the sections that are most relevant to the needs of your course. Feel free to remix the content by assigning your students certain chapters and sections in your syllabus, in the order that you prefer. You can even provide a direct link in your syllabus to the sections in the web view of your book.

Instructors also have the option of creating a customized version of their OpenStax book. The custom version can be made available to students in low-cost print or digital form through their campus bookstore. Visit the Instructor Resources section of your book page on OpenStax.org for more information.

Errata All OpenStax textbooks undergo a rigorous review process. However, like any professional-grade textbook, errors sometimes occur. Since our books are web based, we can make updates periodically when deemed pedagogically necessary. If you have a correction to suggest, submit it through the link on your book page on OpenStax.org. Subject matter experts review all errata suggestions. OpenStax is committed to remaining transparent about all updates, so you will also find a list of past errata changes on your book page on OpenStax.org.

Format You can access this textbook for free in web view or PDF through OpenStax.org, and for a low cost in print.

About Principles of Economics 2e Principles of Economics 2e (2nd edition) covers the scope and sequence of requirements for a two-semester introductory economics course. The authors take a balanced approach to micro-and macroeconomics, to both Keynesian and classical views, and to the theory and application of economics concepts. The text also includes many current examples, which are handled in a politically equitable way. The second edition has been thoroughly revised to increase clarity, update data and current event impacts, and incorporate the feedback from many reviewers and adopters.

Coverage and scope To develop the first edition of Principles of Economics, we acquired the rights to Timothy Taylor’s Principles of Economics and solicited ideas from economics instructors at all levels of higher education, from community colleges to PhD-granting universities. For the second edition, we received even more expansive and actionable feedback from hundreds of adopters who had used the book for several academic terms. These knowledgeable instructors informed the pedagogical courses, learning objective development and fulfillment, and the chapter arrangements. Faculty who taught from the material provided critical and detailed commentary.

Preface 1

The result is a book that covers the breadth of economics topics and also provides the necessary depth to ensure the course is manageable for instructors and students alike. We strove to balance theory and application, as well as the amount of calculation and mathematical examples.

The book is organized into eight main parts:

What is Economics? The first two chapters introduce students to the study of economics with a focus on making choices in a world of scarce resources.

Supply and Demand, Chapters 3 and 4, introduces and explains the first analytical model in economics: supply, demand, and equilibrium, before showing applications in the markets for labor and finance.

The Fundamentals of Microeconomic Theory, Chapters 5 through 10, begins the microeconomics portion of the text, presenting the theories of consumer behavior, production and costs, and the different models of market structure, including some simple game theory.

Microeconomic Policy Issues, Chapters 11 through 18, covers the range of topics in applied micro, framed around the concepts of public goods and positive and negative externalities. Students explore competition and antitrust policies, environmental problems, poverty, income inequality, and other labor market issues. The text also covers information, risk and financial markets, as well as public economy.

The Macroeconomic Perspective and Goals, Chapters 19 through 23, introduces a number of key concepts in macro: economic growth, unemployment and inflation, and international trade and capital flows.

A Framework for Macroeconomic Analysis, Chapters 24 through 26, introduces the principal analytic model in macro, namely the aggregate demand/aggregate supply model. The model is then applied to the Keynesian and Neoclassical perspectives. The expenditure-output model is fully explained in a stand-alone appendix.

Monetary and Fiscal Policy, Chapters 27 through 31, explains the role of money and the banking system, as well as monetary policy and financial regulation. Then the discussion switches to government deficits and fiscal policy.

International Economics, Chapters 32 through 34, the final part of the text, introduces the international dimensions of economics, including international trade and protectionism.

Alternate Sequencing

Principles of Economics 2e was conceived and written to fit a particular topical sequence, but it can be used flexibly to accommodate other course structures. One such potential structure, which will fit reasonably well with the textbook content, is provided below. Please consider, however, that the chapters were not written to be completely independent, and that the proposed alternate sequence should be carefully considered for student preparation and textual consistency.

Chapter 1 Welcome to Economics! Chapter 2 Choice in a World of Scarcity Chapter 3 Demand and Supply Chapter 4 Labor and Financial Markets Chapter 5 Elasticity Chapter 6 Consumer Choices Chapter 33 International Trade Chapter 7 Cost and Industry Structure Chapter 12 Environmental Protection and Negative Externalities Chapter 13 Positive Externalities and Public Goods Chapter 8 Perfect Competition Chapter 9 Monopoly Chapter 10 Monopolistic Competition and Oligopoly Chapter 11 Monopoly and Antitrust Policy Chapter 14 Poverty and Economic Inequality Chapter 15 Issues in Labor Markets: Unions, Discrimination, Immigration Chapter 16 Information, Risk, and Insurance Chapter 17 Financial Markets Chapter 18 Public Economy

2 Preface

This OpenStax book is available for free at http://cnx.org/content/col12122/1.4

Chapter 19 The Macroeconomic Perspective Chapter 20 Economic Growth Chapter 21 Unemployment Chapter 22 Inflation Chapter 23 The International Trade and Capital Flows Chapter 24 The Aggregate Demand/Aggregate Supply Model Chapter 25 The Keynesian Perspective Chapter 26 The Neoclassical Perspective Chapter 27 Money and Banking Chapter 28 Monetary Policy and Bank Regulation Chapter 29 Exchange Rates and International Capital Flows Chapter 30 Government Budgets and Fiscal Policy Chapter 31 The Impacts of Government Borrowing Chapter 32 Macroeconomic Policy Around the World Chapter 34 Globalization and Protectionism

Appendix A The Use of Mathematics in Principles of Economics Appendix B Indifference Curves Appendix C Present Discounted Value Appendix D The Expenditure-Output Model

Changes to the second edition OpenStax only undertakes revisions when significant modifications to a text are necessary. In the case of Principles of Economics 2e, we received a wealth of constructive feedback. Many of the book’s users felt that consequential movement in economic data, coupled with the impacts of national and global events, warranted a full revision. We also took advantage of the opportunity to improve the writing and sequencing of the text, as well as many of the calculation examples. The major changes are summarized below.

Augmented explanations in chapters one through four provide a more comprehensive and informative foundation for the book.

A clearer explanation, using a numerical example, has been given for finding the utility maximizing combination of goods and services a consumer should choose.

The Theory of Production has been added to the chapter on costs & industry structure.

A more complete treatment has been given to labor markets, including the theories of competitive and monopsonistic labor markets, and bilateral monopoly; and the labor markets chapter and the poverty and economic inequality chapter have been resequenced.

Substantial revisions to the AD/AS model in chapters 24-26 present the core concepts of macroeconomics in a clearer, more dynamic manner.

Case studies and examples have been revised and, in some cases, replaced to provide more relevant and useful information for students.

Economic data, tables, and graphs, as well as discussion and analysis around that data, have been thoroughly updated.

Wherever possible, data from the Federal Reserve Economic Database (FRED) was included and referenced. In most of these uses, links to the direct source of the FRED data are provided, and students are encouraged to explore the information and the overall FRED resources more thoroughly.

Additional updates and revisions appear throughout the book. They reflect changes to economic realities and policies regarding international trade, taxation, insurance, and other topics. For issues that may change in the months or years following the textbook's publication, the authors often provided a more open-ended explanation, but we will update the text annually to address further changes.

The revision of Principles of Economics 2e was undertaken by Steven Greenlaw (University of Mary Washington) and David Shapiro (Pennsylvania State University), with significant input by lead reviewer Daniel MacDonald (California State University, San Bernardino).

Preface 3

Pedagogical foundation Throughout the OpenStax version of Principles of Economics 2e, you will find new features that engage the students in economic inquiry by taking selected topics a step further. Our features include:

Bring It Home: This added feature is a brief case study, specific to each chapter, which connects the chapter’s main topic to the real word. It is broken up into two parts: the first at the beginning of the chapter (in the intro module) and the second at chapter’s end, when students have learned what’s necessary to understand the case and “bring home” the chapter’s core concepts.

Work It Out: This added feature asks students to work through a generally analytical or computational problem, and guides them step by step to find out how its solution is derived.

Clear It Up: This boxed feature, which includes pre-existing features from Taylor’s text, addresses common student misconceptions about the content. Clear It Ups are usually deeper explanations of something in the main body of the text. Each CIU starts with a question. The rest of the feature explains the answer.

Link It Up: This added feature is a very brief introduction to a website that is pertinent to students’ understanding and enjoyment of the topic at hand.

Questions for each level of learning The OpenStax version of Principles of Economics 2e further expands on Taylor’s original end of chapter materials by offering four types of end of module questions for students:

Self-Checks are analytical self-assessment questions that appear at the end of each module. They “click to reveal” an answer in the web view so students can check their understanding before moving on to the next module. Self-Check questions are not simple look-up questions. They push the student to think beyond what is said in the text. Self-Check questions are designed for formative (rather than summative) assessment. The questions and answers are explained so that students feel like they are being walked through the problem.

Review Questions have been retained from Taylor’s version, and are simple recall questions from the chapter in open-response format (not multiple choice or true/false). The answers can be looked up in the text.

Critical Thinking Questions are new higher-level, conceptual questions that ask students to demonstrate their understanding by applying what they have learned in different contexts. They ask for outside-the-box thinking, for reasoning about the concepts. They push the student to places they wouldn’t have thought of going themselves.

Problems are exercises that give students additional practice working with the analytic and computational concepts in the module.

Updated art Principles of Economics 2e includes an updated art program to better inform today’s student, providing the latest data on covered topics.

4 Preface

This OpenStax book is available for free at http://cnx.org/content/col12122/1.4

Additional resources Student and instructor resources We’ve compiled additional resources for both students and instructors, including Getting Started Guides, an instructor

Preface 5

solution manual, test bank, and PowerPoint slides. Instructor resources require a verified instructor account, which you can apply for when you log in or create your account on OpenStax.org. Take advantage of these resources to supplement your OpenStax book.

Community Hubs

6 Preface

OpenStax partners with the Institute for the Study of Knowledge Management in Education (ISKME) to offer Community Hubs on OER Commons – a platform for instructors to share community-created resources that support OpenStax books, free of charge. Through our Community Hubs, instructors can upload their own materials or download resources to use in their own courses, including additional ancillaries, teaching material, multimedia, and relevant course content. We encourage instructors to join the hubs for the subjects most relevant to your teaching and research as an opportunity both to enrich your courses and to engage with other faculty.

To reach the Community Hubs, visit www.oercommons.org/hubs/OpenStax.

Technology partners As allies in making high-quality learning materials accessible, our technology partners offer optional low-cost tools that are integrated with OpenStax books. To access the technology options for your text, visit your book page on OpenStax.org.

About the authors Senior contributing authors Steven A. Greenlaw, University of Mary Washington Steven Greenlaw has been teaching principles of economics for more than 30 years. In 1999, he received the Grellet C. Simpson Award for Excellence in Undergraduate Teaching at the University of Mary Washington. He is the author of Doing Economics: A Guide to Doing and Understanding Economic Research, as well as a variety of articles on economics pedagogy and instructional technology, published in the Journal of Economic Education, the International Review of Economic Education, and other outlets. He wrote the module on Quantitative Writing for Starting Point: Teaching and Learning Economics, the web portal on best practices in teaching economics. Steven Greenlaw lives in Alexandria, Virginia with his wife Kathy and their three children.

David Shapiro, Pennsylvania State University David Shapiro is Professor Emeritus of Economics, Demography, and Women’s, Gender, and Sexuality Studies at the Pennsylvania State University. He received a BA in economics and political science from the University of Michigan, and an MA as well as a PhD in economics from Princeton University. He began his academic career at Ohio State University in 1971, and moved to Penn State in 1980. His early research focused on women and youth in the United States labor market. Following a 1978-79 stint as a Fulbright professor at the University of Kinshasa in the Democratic Republic of the Congo, his research shifted focus to fertility in Kinshasa and more broadly, in sub- Saharan Africa. He has also received the top prize for teaching at both Ohio State and Penn State.

Special thanks to Christian Potter from University of Mary Washington, who thoroughly researched and applied many of the data updates and provided the foundation for many new and revised illustrations.

This OpenStax book is available for free at http://cnx.org/content/col12122/1.4

Development editor Thomas Sigel

Contributing authors Eric Dodge, Hanover College Cynthia Gamez, University of Texas at El Paso Andres Jauregui, Columbus State University Diane Keenan, Cerritos College Dan MacDonald, California State University San Bernardino Amyaz Moledina, The College of Wooster Craig Richardson, Winston-Salem State University David Shapiro, Pennsylvania State University Ralph Sonenshine, American University

Reviewers Bryan Aguiar, Northwest Arkansas Community College Basil Al Hashimi, Mesa Community College Emil Berendt, Mount St. Mary's University Zena Buser, Adams State University Douglas Campbell, The University of Memphis Sanjukta Chaudhuri, University of Wisconsin - Eau Claire Xueyu Cheng, Alabama State University Robert Cunningham, Alma College Rosa Lea Danielson, College of DuPage Steven Deloach, Elon University Michael Enz, Framingham State University Debbie Evercloud, University of Colorado Denver Reza Ghorashi, Richard Stockton College of New Jersey Robert Gillette, University of Kentucky Shaomin Huang, Lewis-Clark State College George Jones, University of Wisconsin-Rock County Charles Kroncke, College of Mount St. Joseph Teresa Laughlin, Palomar Community College Carlos Liard-Muriente, Central Connecticut State University Heather Luea, Kansas State University Steven Lugauer, University of Notre Dame William Mosher, Nashua Community College Michael Netta, Hudson County Community College Nick Noble, Miami University Joe Nowakowski, Muskingum University Shawn Osell, University of Wisconsin-Superior Mark Owens, Middle Tennessee State University Sonia Pereira, Barnard College Jennifer Platania, Elon University Robert Rycroft, University of Mary Washington Adrienne Sachse, Florida State College at Jacksonville Hans Schumann, Texas A&M University Gina Shamshak, Goucher College Chris Warburton, John Jay College of Criminal Justice, CUNY Mark Witte, Northwestern University

Preface 7

Preface

This OpenStax book is available for free at http://cnx.org/content/col12122/1.4

1 | Welcome to Economics!

Figure 1.1 Do You Use Facebook? Economics is greatly impacted by how well information travels through society. Today, social media giants Twitter, Facebook, and Instagram are major forces on the information super highway. (Credit: Johan Larsson/Flickr)

Decisions ... Decisions in the Social Media Age To post or not to post? Every day we are faced with a myriad of decisions, from what to have for breakfast, to which route to take to class, to the more complex—“Should I double major and add possibly another semester of study to my education?” Our response to these choices depends on the information we have available at any given moment. Economists call this “imperfect” because we rarely have all the data we need to make perfect decisions. Despite the lack of perfect information, we still make hundreds of decisions a day.

Now we have another avenue in which to gather information—social media. Outlets like Facebook and Twitter are altering the process by which we make choices, how we spend our time, which movies we see, which products we buy, and more. How many of you chose a university without checking out its Facebook page or Twitter stream first for information and feedback?