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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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Financial System
Investments International Trade
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MODERN PRINCIPLES OF ECONOMICS
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MODERN PRINCIPLES OF ECONOMICS Second Edition
Tyler Cowen George Mason University
Alex Tabarrok George Mason University
Worth Publishers
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Senior Publisher: Catherine Woods Executive Editor: Charles Linsmeier Senior Acquisitions Editor: Sarah Dorger Executive Marketing Manager: Scott Guile Consulting Editor: Paul Shensa Senior Developmental Editor: Bruce Kaplan Supplements and Media Editor: Tom Acox Director of Market Research and Development: Steven Rigolosi Associate Managing Editor: Lisa Kinne Editorial Assistant: Mary Walsh Art Director: Babs Reingold Cover and Text Designer: Kevin Kall Project Editor: Anthony Calcara Photo Editor: Christine Buese Production Manager: Barbara Anne Seixas Supplements Production Manager: Stacey Alexander Supplements Project Editor: Edgar Bonilla Composition: TSI Graphics Printing and Binding: RR Donnelley Cover Image: Image Werks/Corbis and Jim Roof/myLoupe.com
Library of Congress Control Number: 2011940683
ISBN-13: 978-1-4292-3997-4 ISBN-10: 1-4292-3997-2
© 2013, 2010 by Worth Publishers
All rights reserved.
Printed in the United States of America
First printing 2011
Worth Publishers 41 Madison Avenue New York, NY 10010 www.worthpublishers.com
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http://www.worthpublishers.com
Economics is the study of how to get the most out of life.
Tyler and Alex
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A B O U T T H E A U T H O R S
Tyler Cowen (left) is Holbert C. Harris Professor of Economics at George Mason University. His latest book is The Great Stagnation. With Alex Tabarrok, he writes an economics blog at www.marginalrevolution.com. He has published in the American Economic Review, Journal of Political Economy, and many other economics journals. He also writes regularly for the popular press, including the New York Times, the Washington Post, Forbes, the Wilson Quarterly, Money Magazine, and many other outlets.
Alex Tabarrok (right) is Bartley J. Madden Chair in Economics at the Mercatus Center at George Mason University and director of research for The Independent Institute. His latest book is Launching the Innovation Renaissance. His recent research looks at bounty hunters, judicial incen- tives and elections, crime control, patent reform, methods to increase the supply of human organs for transplant, and the regulation of pharmaceuticals. He is the editor of the books Entrepreneurial Economics: Bright Ideas from the Dismal Science and The Voluntary City: Choice, Community, and Civil Society among others. His papers have appeared in the Journal of Law and Econom- ics, Public Choice, Economic Inquiry, the Journal of Health Economics, the Journal of Theoretical Politics, the American Law and Economics Review, and many other journals. Popular articles have appeared in the New York Times, the Wall Street Journal, Forbes, and many other magazines and newspapers.
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http://www.marginalrevolution.com
BRIEF CONTENTS Preface ........................................................................................................... xxiv
Part I: Supply and Demand CHAPTER 1 The Big Ideas in Economics ......................................................... 1
CHAPTER 2 The Power of Trade and Comparative Advantage .................... 13
CHAPTER 3 Supply and Demand .................................................................. 27
CHAPTER 4 Equilibrium: How Supply and Demand Determine Prices ......... 47
CHAPTER 5 Elasticity and Its Applications .................................................... 65
CHAPTER 6 Taxes and Subsidies .................................................................. 93
Part 2: The Price System CHAPTER 7 The Price System: Signals, Speculation, and Prediction .......... 113
CHAPTER 8 Price Ceilings and Floors ......................................................... 131
CHAPTER 9 International Trade .................................................................. 159
CHAPTER 10 Externalities: When Prices Send the Wrong Signals .............. 175
Part 3: Firms and Factor Markets CHAPTER 11 Costs and Profit Maximization Under Competition ............... 193
CHAPTER 12 Competition and the Invisible Hand...................................... 223
CHAPTER 13 Monopoly .............................................................................. 233
CHAPTER 14 Price Discrimination ............................................................... 257
CHAPTER 15 Cartels, Oligopolies, and Monopolistic Competition ............ 279
CHAPTER 16 Competing for Monopoly: The Economics of Network Goods .......................................................................................... 303
CHAPTER 17 Labor Markets ........................................................................ 319
Part 4: Government CHAPTER 18 Public Goods and the Tragedy of the Commons .................. 343
CHAPTER 19 Political Economy and Public Choice .................................... 361
CHAPTER 20 Economics, Ethics, and Public Policy ..................................... 385
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Brief Contents • ix
Part 5: Decision Making for Businesses, Investors, and Consumers CHAPTER 21 Managing Incentives ............................................................. 401
CHAPTER 22 Stock Markets and Personal Finance ..................................... 419
CHAPTER 23 Consumer Choice .................................................................. 435
Part 6: Economic Growth CHAPTER 24 GDP and the Measurement of Progress ................................ 461
CHAPTER 25 The Wealth of Nations and Economic Growth ...................... 483
CHAPTER 26 Growth, Capital Accumulation, and the Economics of Ideas: Catching Up vs. the Cutting Edge .............................................................. 509
CHAPTER 27 Saving, Investment, and the Financial System ...................... 543
Part 7: Business Fluctuations CHAPTER 28 Unemployment and Labor Force Participation ...................... 577
CHAPTER 29 Inflation and the Quantity Theory of Money ......................... 603
CHAPTER 30 Business Fluctuations: Aggregate Demand and Supply ....... 627
CHAPTER 31 Transmission and Amplification Mechanisms ........................ 657
Part 8: Macroeconomic Policy and Institutions CHAPTER 32 The Federal Reserve System and
Open Market Operations ........................................................................... 673
CHAPTER 33 Monetary Policy ..................................................................... 697
CHAPTER 34 The Federal Budget: Taxes and Spending ............................ 721
CHAPTER 35 Fiscal Policy ........................................................................... 745
Part 9: International Economics CHAPTER 36 International Finance ............................................................. 769
APPENDIX A Reading Graphs and Making Graphs .................................... A-1
APPENDIX B Solutions to Check Yourself Questions ..................................B-1
Glossary G-1
References R-1
Index I-1
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CONTENTS Preface xxiv
Part I: Supply and Demand
CHAPTER 1 The Big Ideas in Economics ......................................................... 1 Big Idea One: Incentives Matter 2
Big Idea Two: Good Institutions Align Self-Interest with the Social Interest 2
Big Idea Three: Trade-offs Are Everywhere 3 Opportunity Cost 4
Big Idea Four: Thinking on the Margin 5
Big Idea Five: The Power of Trade 6
Big Idea Six: The Importance of Wealth and Economic Growth 7
Big Idea Seven: Institutions Matter 7
Big Idea Eight: Economic Booms and Busts Cannot Be Avoided but Can Be Moderated 8
Big Idea Nine: Prices Rise When the Government Prints Too Much Money 9
Big Idea Ten: Central Banking Is a Hard Job 9
The Biggest Idea of All: Economics Is Fun 10
Chapter Review 11
CHAPTER 2 The Power of Trade and Comparative Advantage .................... 13 Trade and Preferences 13
Specialization, Productivity, and the Division of Knowledge 14
Comparative Advantage 16 The Production Possibility Frontier 16 Opportunity Costs and Comparative Advantage 17 Comparative Advantage and Wages 19 Adam Smith on Trade 21
Trade and Globalization 21
Takeaway 21 Chapter Review 22
CHAPTER 3 Supply and Demand .................................................................. 27 The Demand Curve for Oil 27
Consumer Surplus 30 What Shifts the Demand Curve? 31 Important Demand Shifters 31
The Supply Curve for Oil 34 Producer Surplus 37 What Shifts the Supply Curve? 37 Important Supply Shifters 37
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Takeaway 41 Chapter Review 41
CHAPTER 4 Equilibrium: How Supply and Demand Determine Prices ......... 47 Equilibrium and the Adjustment Process 47
Who Competes with Whom? 49
Gains from Trade Are Maximized at the Equilibrium Price and Quantity 49
Does the Model Work? Evidence from the Laboratory 52
Shifting Demand and Supply Curves 54
Terminology: Demand Compared with Quantity Demanded and Supply Compared with Quantity Supplied 56
Understanding the Price of Oil 58
Takeaway 60 Chapter Review 61
CHAPTER 5 Elasticity and Its Applications .................................................... 65 The Elasticity of Demand 66
Determinants of the Elasticity of Demand 67 Calculating the Elasticity of Demand 68 Total Revenues and the Elasticity of Demand 70 Applications of Demand Elasticity 72
The Elasticity of Supply 75 Determinants of the Elasticity of Supply 76 Calculating the Elasticity of Supply 77 Applications of Supply Elasticity 78
Using Elasticities for Quick Predictions 82 How Much Would the Price of Oil Fall if the Arctic National Wildlife Refuge Were
Opened Up for Drilling? 83
Takeaway 83 Chapter Review 84 Appendix 1: Other Types of Elasticities ........................................................ 89
The Cross-Price Elasticity of Demand.............................................................. 89
The Income Elasticity of Demand .................................................................... 89 Appendix 2: Using Excel to Calculate Elasticities .......................................... 91
CHAPTER 6 Taxes and Subsidies .................................................................. 93 Commodity Taxes 94
Who Ultimately Pays the Tax Does Not Depend on Who Writes the Check 95 Who Ultimately Pays the Tax Depends on the Relative Elasticities of Supply and Demand 97 Health Insurance Mandates and Tax Analysis 99 Who Pays the Cigarette Tax? 100 A Commodity Tax Raises Revenue and Reduces the Gains from Trade
(Creates Deadweight Loss) 101
Subsidies 103
Takeaway 106 Chapter Review 107
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Contents • xiii
Part 2: The Price System
CHAPTER 7 The Price System: Signals, Speculation, and Prediction .......... 113 Markets Link the World 113
Markets Link to One Another 114 From Oil to Candy Bars and Brick Driveways 115
Solving the Great Economic Problem 115
A Price Is a Signal Wrapped Up in an Incentive 118
Speculation 119
Signal Watching 122
Prediction Markets 123
Takeaway 125 Chapter Review 126
CHAPTER 8 Price Ceilings and Floors ......................................................... 131 Price Ceilings 131
Shortages 132 Reductions in Quality 132 Wasteful Lines and Other Search Costs 133 Lost Gains from Trade 135 Misallocation of Resources 136 The End of Price Ceilings 140
Rent Controls 141 Shortages 141 Reductions in Product Quality 143 Wasteful Lines, Search Costs, and Lost Gains from Trade 143 Misallocation of Resources 144 Rent Regulation 144
Arguments for Price Controls 145
Universal Price Controls 146
Price Floors 147 Surpluses 147 Lost Gains from Trade 148 Wasteful Increases in Quality 150 The Misallocation of Resources 152
Takeaway 152 Chapter Review 153
CHAPTER 9 International Trade .................................................................. 159 Analyzing Trade with Supply and Demand 159
Analyzing Tariffs with Demand and Supply 160
The Costs of Protectionism 162 Winners and Losers from Trade 164
Arguments Against International Trade 165 Trade and Jobs 165 Child Labor 166
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Trade and National Security 168 Key Industries 169 Strategic Trade Protectionism 169
Takeaway 170 Chapter Review 170
CHAPTER 10 Externalities: When Prices Send the Wrong Signals .............. 175 External Costs, External Benefits, and Efficiency 176
External Costs 177 External Benefits 179
Private Solutions to Externality Problems 181
Government Solutions to Externality Problems 183 Command and Control 183 Tradable Allowances 185 Comparing Tradable Allowances and Pigouvian Taxes—Advanced Material 187
Takeaway 188 Chapter Review 188
Part 3: Firms and Factor Markets
CHAPTER 11 Costs and Profit Maximization Under Competition ............... 193 What Price to Set? 193
What Quantity to Produce? 195 Don’t Forget: Opportunity Costs! 196 Maximizing Profit 197
Profits and the Average Cost Curve 200
Entry, Exit, and Shutdown Decisions 203 The Short-Run Shutdown Decision 203 Entry and Exit with Uncertainty and Sunk Costs 204
Entry, Exit, and Industry Supply Curves 205 Constant Cost Industries 205 Increasing Cost Industries 208 A Special Case: The Decreasing Cost Industry 210 Industry Supply Curves: Summary 210
Takeaway 211 Chapter Review 212 Chapter Appendix: Using Excel to Graph Cost Curves .............................. 219
CHAPTER 12 Competition and the Invisible Hand...................................... 223 Invisible Hand Property 1: The Minimization of Total Industry Costs of
Production 224
Invisible Hand Property 2: The Balance of Industries 226
Creative Destruction 228
The Invisible Hand Works with Competitive Markets 228
Takeaway 229 Chapter Review 229
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CHAPTER 13 Monopoly .............................................................................. 233 Market Power 234
How a Firm Uses Market Power to Maximize Profit 234 The Elasticity of Demand and the Monopoly Markup 237
The Costs of Monopoly: Deadweight Loss 239
The Costs of Monopoly: Corruption and Inefficiency 241
The Benefits of Monopoly: Incentives for Research and Development 241 Patent Buyouts—A Potential Solution? 243
Economies of Scale and the Regulation of Monopoly 244 I Want My MTV 246 Electric Shock 247 California’s Perfect Storm 247
Other Sources of Market Power 249
Takeaway 250 Chapter Review 250
CHAPTER 14 Price Discrimination ............................................................... 257 Price Discrimination 257
Preventing Arbitrage 259
Price Discrimination Is Common 260 Universities and Perfect Price Discrimination 262
Is Price Discrimination Bad? 264 Why Misery Loves Company and How Price Discrimination Helps to Cover Fixed Costs 265
Tying and Bundling 266 Tying 266 Bundling 267 Bundling and Cable TV 269
Takeaway 269 Chapter Review 270 Chapter Appendix: Solving Price Discrimination Problems with Excel ....... 275
CHAPTER 15 Cartels, Oligopolies, and Monopolistic Competition ............ 279 Cartels 280
The Incentive to Cheat 282 New Entrants and Demand Response Break Down Cartels 285 Government Prosecution and Regulation 286 Summing Up: Successful and Unsuccessful Cartels 287
Oligopolies 287
Monopolistic Competition 288
The Economics of Advertising 292 Informative Advertising 292 Advertising as Signaling 292 Advertising as Part of the Product 293
Takeaway 294 Chapter Review 295
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CHAPTER 16 Competing for Monopoly: The Economics of Network Goods .......................................................................................... 303
Network Goods Are Usually Sold by Monopolies or Oligopolies 304
The “Best” Product May Not Always Win 305
Standard Wars Are Common 307
Competition Is “For the Market” Instead of “In the Market” 307
Contestable Markets 308 Limiting Contestability with Switching Costs 310
Antitrust and Network Goods 311
Music Is a Network Good 312
Takeaway 313 Chapter Review 313
CHAPTER 17 Labor Markets ........................................................................ 319 The Demand for Labor and the Marginal Product of Labor 319
Supply of Labor 321
Labor Market Issues 323 Why Do Janitors in the United States Earn More Than Janitors in India Even When They
Do the Same Job? 323 Human Capital 325 Compensating Differentials 326 Do Unions Raise Wages? 329 Statistical Discrimination 331 Preference-Based Discrimination 331
How Bad Is Labor Market Discrimination, or Can Lakisha Catch a Break? 330 Why Discrimination Isn’t Always Easy to Identify 335
Takeaway 336 Chapter Review 337
Part 4: Government
CHAPTER 18 Public Goods and the Tragedy of the Commons .................. 343 Four Types of Goods 344
Private Goods and Public Goods 345
Nonrival Private Goods 347 The Peculiar Case of Advertising 347
Common Resources and the Tragedy of the Commons 348 Happy Solutions to the Tragedy of the Commons 350
Takeaway 352 Chapter Review 352 Chapter Appendix: The Tragedy of the Commons: How Fast? .................. 358
CHAPTER 19 Political Economy and Public Choice .................................... 361 Voters and the Incentive To Be Ignorant 362
Why Rational Ignorance Matters 363
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Contents • xvii
Special Interests and the Incentive To Be Informed 363
One Formula for Political Success: Diffuse Costs, Concentrate Benefits 365
Voter Myopia and Political Business Cycles 367
Two Cheers for Democracy 369 The Median Voter Theorem 370 Democracy and Nondemocracy 372 Democracy and Famine 373 Democracy and Growth 376
Takeaway 377 Chapter Review 378
CHAPTER 20 Economics, Ethics, and Public Policy ..................................... 385 The Case for Exporting Pollution and Importing Kidneys 386
Exploitation 387
Meddlesome Preferences 388
Fair and Equal Treatment 389
Cultural Goods and Paternalism 389
Poverty, Inequality, and the Distribution of Income 390 Rawls’s Maximin Principle 390 Utilitarianism 391 Robert Nozick’s Entitlement Theory 392
Who Counts? Immigration 394
Economic Ethics 395
Takeaway 396 Chapter Review 396
Part 5: Decision Making for Businesses, Investors, and Consumers
CHAPTER 21 Managing Incentives ............................................................. 401 Lesson One: You Get What You Pay For 401
Prisons for Profit? 403 Piece Rates vs. Hourly Wages 404
Lesson Two: Tie Pay to Performance to Reduce Risk 406 Tournament Theory 407 Improving Executive Compensation with Pay for Relative Performance 407 Environment Risk and Availability Risk 408 Tournaments and Grades 409
Lesson Three: Money Isn’t Everything 411
Takeaway 413 Chapter Review 414
CHAPTER 22 Stock Markets and Personal Finance ..................................... 419 Passive vs. Active Investing 420
Why Is It Hard to Beat the Market? 421
How to Really Pick Stocks, Seriously 423
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Diversify 423 Avoid High Fees 425 Compound Returns Build Wealth 426 The No Free Lunch Principle, or No Return Without Risk 427
Other Benefits and Costs of Stock Markets 429 Bubble, Bubble, Toil, and Trouble 430
Takeaway 432 Chapter Review 432
CHAPTER 23 Consumer Choice .................................................................. 435 How to Compare Apples and Oranges 435
The Demand Curve 438
The Budget Constraint 439
Preferences and Indifference Curves 442
Optimization and Consumer Choices 444
The Income and Substitution Effects 446
Applications of Income and Substitution Effects 448 Losing Your Ticket 448 How Much Should Costco Charge for Membership? 449 Labor Supply 450 Labor Supply and Welfare Programs 453
Takeaway 455 Chapter Review 455
Part 6: Economic Growth
CHAPTER 24 GDP and the Measurement of Progress ................................ 461 What Is GDP? 462
GDP Is the Market Value . . . 462 . . . of All Final . . . 463 . . . Goods and Services . . . 463 . . . Produced . . . 464 . . . within a Country . . . 464 . . . in a Year 464
Growth Rates 465
Nominal vs. Real GDP 465 The GDP Deflator 466 Real GDP Growth 467 Real GDP Growth per Capita 468
Cyclical and Short-Run Changes in GDP 469
The Many Ways of Splitting GDP 470 The National Spending Approach: Y 5 C 1 I 1 G 1 NX 470 The Factor Income Approach: The Other Side of the Spending Coin 472 Why Split? 473
Problems with GDP as a Measure of Output and Welfare 473 GDP Does Not Count the Underground Economy 473 GDP Does Not Count Nonpriced Production 474
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Contents • xix
GDP Does Not Count Leisure 475 GDP Does Not Count Bads: Environmental Costs 476 GDP Does Not Measure the Distribution of Income 476
Takeaway 477 Chapter Review 478
CHAPTER 25 The Wealth of Nations and Economic Growth ...................... 483 Key Facts About the Wealth of Nations and Economic Growth 484
Fact One: GDP per Capita Varies Enormously Among Nations 484 Fact Two: Everyone Used to Be Poor 485 Fact Three: There Are Growth Miracles and Growth Disasters 488 Summarizing the Facts: Good and Bad News 489
Understanding the Wealth of Nations 489 The Factors of Production 489
Incentives and Institutions 491 Institutions 494 Institutions and Growth Miracles Revisited 498
Takeaway 499 Chapter Review 499 Chapter Appendix: The Magic of Compound Growth
Using a Spreadsheet .................................................................................. 505
CHAPTER 26 Growth, Capital Accumulation, and the Economics of Ideas: Catching Up vs. the Cutting Edge .............................................................. 509
The Solow Model and Catch-Up Growth 510 Capital, Production and Diminishing Returns 511 Capital Growth Equals Investment Minus Depreciation 513 Why Capital Alone Cannot Be the Key to Economic Growth 514 Better Ideas Drive Long-Run Economic Growth 517
The Solow Model—Details and Further Lessons (Optional Section) 518 The Solow Model and an Increase in the Investment Rate 519 The Solow Model and Conditional Convergence 521 From Catching Up to Cutting Edge 522 Solow and the Economics of Ideas in One Diagram 523
Growing on the Cutting Edge: The Economics of Ideas 524 Research and Development Is Investment for Profit 524 Spillovers, and Why There Aren’t Enough Good Ideas 526 Government’s Role in the Production of New Ideas 527 Market Size and Research and Development 528
The Future of Economic Growth 528
Takeaway 530 Chapter Review 531 Chapter Appendix: Excellent Growth ......................................................... 538
CHAPTER 27 Saving, Investment, and the Financial System ...................... 543 The Supply of Savings 544
Individuals Want to Smooth Consumption 545
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Individuals Are Impatient 546 Marketing and Psychological Factors 546 The Interest Rate 547
The Demand to Borrow 547 Individuals Want to Smooth Consumption 548 Borrowing Is Necessary to Finance Large Investments 548 The Interest Rate 550
Equilibrium in the Market for Loanable Funds 550 Shifts in Supply and Demand 550
The Role of Intermediaries: Banks, Bonds, and Stock Markets 552 Banks 553 The Bond Market 554 The Stock Market 557
What Happens When Intermediation Fails? 558 Insecure Property Rights 558 Controls on Interest Rates 560 Politicized Lending and Government-Owned Banks 560 Bank Failures and Panics 561
The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking 561
Takeaway 566 Chapter Review 566 Chapter Appendix: Bond Pricing and Arbitrage ......................................... 571
Bond Pricing with a Spreadsheet ............................................................... 574
Part 7: Business Fluctuations
CHAPTER 28 Unemployment and Labor Force Participation ...................... 577 Defining Unemployment 579
How Good an Indicator Is the Unemployment Rate? 579
Frictional Unemployment 580
Structural Unemployment 582 Labor Regulations and Structural Unemployment 583 Labor Regulations to Reduce Structural Unemployment 588 Factors that Affect Structural Unemployment 588
Cyclical Unemployment 589 The Natural Unemployment Rate 592
Labor Force Participation 592 Lifecycle Effects and Demographics 593 Incentives 593
Takeaway 597 Chapter Review 598
CHAPTER 29 Inflation and the Quantity Theory of Money ......................... 603 Defining and Measuring Inflation 604
Price Indexes 604
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Inflation in the United States and Around the World 605
The Quantity Theory of Money 607 The Cause of Inflation 609 An Inflation Parable 612
The Costs of Inflation 612 Price Confusion and Money Illusion 613 Inflation Redistributes Wealth 614 Inflation Interacts with Other Taxes 618 Inflation Is Painful to Stop 618
Takeaway 619 Chapter Review 620 Chapter Appendix: Get Real! An Excellent Adventure ............................... 623
CHAPTER 30 Business Fluctuations: Aggregate Demand and Supply.................................................................................................. 627
The Dynamic Aggregate Demand Curve 629 Shifts in the Dynamic Aggregate Demand Curve 631
The Solow Growth Curve 632 Shifts in the Solow Growth Curve 632
Real Shocks 634 Oil Shocks 635 More Shocks 637
Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve 638
Shocks to the Components of Aggregate Demand 643 A Shock to C
→ 643
Why Changes in v → Tend to Be Temporary 644 Other AD Shocks 645
Understanding the Great Depression: Aggregate Demand Shocks and Real Shocks 646
Aggregate Demand Shocks and the Great Depression 646 Real Shocks and the Great Depression 648
Takeaway 649 Chapter Review 650
CHAPTER 31 Transmission and Amplification Mechanisms ........................ 657 Intertemporal Substitution 657
Uncertainty and Irreversible Investments 660
Labor Adjustment Costs 661
Time Bunching 661
Collateral Damage 662
Takeaway 665 Chapter Review 665 Chapter Appendix: Business Fluctuations and the Solow Model ............... 669
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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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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.
Chapter 1: The Big Ideas What is economics all about? We present the core ideas of incentives, op- portunity cost, trade, the importance of economic growth, and thinking on the margin, and some of the key insights of economics such as that tampering with the laws of supply and demand has consequences and good institutions align self-interest with the social interest. The point is to make economics in- tuitive and compelling and to hook the student with examples from everyday life.
Chapter 2: The Power of Trade and Comparative Advantage Why is trade so important and why is it a central idea of economics? We introduce ideas of gains from trade, the production possibilities frontier, and comparative ad- vantage to show the student some core ideas behind the economic way of think- ing. The key here is to illustrate the power of economic concepts in explaining the prosperity of the modern world. An instructor can either use this material to entice the student, or postpone the subject and move directly to the supply and demand chapters.
Chapter 3: Supply and Demand This chapter focuses on demand curves, supply curves, how and why they slope, and how they shift. The chapter presents some basic fundamentals of economic theory, using the central example of the market for oil. We also take special care to illustrate how demand and supply curves can be read “horizontally” or “vertically.” That is, a demand curve tells you the quantity demanded at every price and the maximum willingness to pay (per unit) for any quantity.
It takes a bit more work to explain these concepts early on, but students who learn to read demand curves in both ways get a deeper understanding of the curves and they find consumer and producer surplus, taxes, and the analysis of price controls much easier to understand.
Chapter 4: Equilibrium: How Supply and Demand Determine Prices Market clearing is an essential idea for both microeconomics and macro- economics. In this chapter, students learn how a well-functioning mar- ket operates, how prices clear markets, the meaning of maximizing gains from trade, and how to shift supply and demand curves. The chapter con- cludes with a section on understanding the price of oil, a topic that recurs throughout the text.
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Chapter 5: Elasticity and Its Applications Elasticity is often considered a dull topic so we begin this chapter with a shock- ing story:
In fall 2000, Harvard sophomore Jay Williams flew to the Sudan where a terrible civil war had resulted in many thousands of deaths. Women and children captured in raids by warring tribes were being enslaved and held for ransom. Working with Christian Solidarity International, Williams was able to pay for the release of 4,000 people. But did Williams do the right thing?
What is a discussion of modern slavery doing in a principles of economics book? We want to show students that economics is a social science, that it asks important questions and provides important answers for people who want to understand their world. We take economics seriously and in Modern Principles we analyze serious topics.
Once we have shocked the reader out of his or her complacency, we offer the reader an implicit deal—we are going to develop some technical concepts in economics, which at first may seem dry, but if you learn this material, there is going to be a payoff. We will use the tools to understand the economics of slave redemption as well as why the war on drugs can generate violence, why gun buyback programs are unlikely to work, and how to evaluate proposals to increase drilling in the Arctic National Wildlife Refuge.
Chapter 6: Taxes and Subsidies We analyze commodity taxes and subsidies, two core topics, to test, refine, and improve an understanding of microeconomics. We have all heard the question “Who pays?” and the statement “Follow the money,” but few people under- stand how to apply these ideas correctly. The economist knows that the final incidence of a tax depends not on the laws of Congress but on the laws of eco- nomics, and this can be taught as yet another invisible hand result. Teaching the incidence of taxes and subsidies also gives yet another way of driving home the concept of elasticity, its intuitive meaning, and its real-world importance. We also include in this chapter a timely discussion of wage subsidies to which we compare the minimum wage.
Part 2: The Price System Chapter 7: The Price System: Signals, Speculation, and Prediction “A price is a signal wrapped up in an incentive.” That’s one of the most im- portant ideas of economics, even if it takes a little work from the students. And that is an idea that we drive home in this chapter. Partial equilibrium analysis can sometimes obscure the big picture of markets and how they fit together. General equilibrium analysis, either done mathematically or with an Edgeworth box, captures neither the “marvel of the market” (to use Hayek’s phrase) nor the student’s interest. We give a fast-paced, intuitive, general equi- librium view of markets and how they tie together. We are linked to the world economy, and goods and services are shipped from one corner of the globe to another, yet without the guidance of a central planner. We show how the price of oil is linked to the price of candy bars. We also show how markets can predict the future, even the future of a movie like American Pie 2! For those familiar with Leonard Read’s classic essay, this chapter is “I, Pencil” for the twenty-first century.
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Chapter 8: Price Ceilings and Price Floors There is no better way to understand how the price system works than to see what happens when the price system does not work very well. That price controls bring shortages is one of the most basic and most solid results of microeconomics. When it comes to price controls, however, the bad consequences extend far beyond shortages. Price controls lead to quality reductions, wasteful lines, excess search, corruption, rent- seeking behavior, misallocated resources, and many other secondary consequences. Price controls are an object lesson in many important economic ideas and we teach the topic as such. Sometimes we’re all better off if the university charges more for parking! Price controls also offer a good chance to teach some political economy les- sons about why bad economic policies happen in the first place.
Sometimes governments prop up prices instead of keeping them down— the minimum wage for labor is one example, and airline regulation before the late 1970s was another. As with price ceilings, price floors bring misallocated resources, distortions in the quality of the good or service being sold, and rent- seeking. Maybe the government can prop up the price of an airline ticket, as it did in 1974, but each airline will offer lobster dinners to lure away customers.
Chapter 9: International Trade We build on the basics of international trade—the division of knowledge, economies of scale, and comparative advantage—covered in Chapter 2, to show students how they can use the tools of supply and demand to understand the microeconomics of trade. We consider the costs of protectionism, international trade and market power, trade and wages, and most of all trade and jobs. Is pro- tectionism ever a good idea? The chapter also offers a brief history of globaliza- tion as it relates to trade. We emphasize that the principles covering trade across nations are the same as those that govern trade within nations.
Chapter 10: Externalities: When Prices Send the Wrong Signals When do markets fail or otherwise produce undesired results? Prices do not always signal the right information and incentives, most of all when exter- nal costs and benefits are present. A medical patient may use an antibiotic, for instance, without taking into account the fact that disease-causing microorgan- isms evolve and mutate, and that antibiotic use can in the long run lead to bacte- ria that are antibiotic-resistant. Similarly, not enough people get flu vaccinations, because they don’t take into account how other people benefit from a lower chance of catching a contagious ailment. Private markets sometimes can “internalize” these external costs and benefits by writing good contracts, and we give students the tools to understand when such contracts will be possible and when not. Market contracts, tradable permits, taxes, and command and control are alternative means of treating externalities. Building on our previous understanding of the invisible hand, we consider when these approaches will produce efficient results and when not.
Part 3: Firms and Factor Markets Chapter 11: Costs and Profit Maximization Under Competition This chapter makes cost theory intuitive once again. Costs are indeed an im- portant economic concept; prices and costs send signals to firms and guide their production decisions, just as a price at Walmart shapes the behavior of
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consumers. But how exactly does this work? We’ve all seen textbooks that serve up an overwhelming confusion of different cost curves, all plastered on the same graph and not always corresponding in a simple or direct manner to economic intuition.
This chapter reduces the theory of cost and the theory of production to the essentials. A firm must make three key decisions: What price to set? What quantity to produce? When to enter and exit an industry? A simple notion of average cost suffices to cover decisions of firm entry and exit, while avoiding a tangle of excess concepts. Unlike many books, we stress the importance of “wait and see” and option value strategies. We can show firm-level and industry-level supply responses; constant, decreasing, and increasing cost industries; and how comparative statics differ for these cases.
Chapter 12: Competition and the Invisible Hand Profit maximization leads competitive firms to produce where P = MC, but why is this condition truly important? Most textbooks don’t teach the mar- velous result that when each firm produces where P = MC, total industry costs are minimized. Competitive firms minimize total industry costs despite the fact that no firm intends this result and perhaps never even understands this result. As Hayek says, the minimization of total industry costs is “a prod- uct of human action but not of human design.” We also show in this chapter how profit and loss signals result in a balancing of industries in a way that solves the great economic problem of getting the most value from our finite resources.
This material is so important that in the second edition we have given it its own chapter. This chapter gives a deeper insight into Adam Smith’s invisible hand, and how it relates to profit maximization, than does any other principles text.
Chapter 13: Monopoly When they can, firms use market power to maximize profit and this chapter shows how. (Some budding entrepreneurs in the class may take this as a how-to manual!) We build on concepts such as cost curves and elasticity to flesh out the economics and also the public policy of monopoly. If you own the intellectual property rights to an important anti-AIDS drug, just how much power do you have? It’s good for you, but does this help or hurt broader society? Monopolies sometimes bring higher rates of innovation but in other cases, such as natural monopolies on your water supply, monopolies raise prices and reduce quantity with few societal benefits. Again, formal economic concepts such as elasticity and cost help us see the very real costs and benefits of such regulations as we experience them in our daily lives.
Chapter 14: Price Discrimination Modern Principles devotes an entire chapter to this topic, which is fun, practical, and contains lots of economics. Students, in their roles as consumers, face (or, as sellers, practice!) price discrimination all the time, and that includes from their colleges and universities—remember in-state vs. out-of-state tuition? A lot of what students already “know” can be turned into more systematic economic intuition, including the concepts of demand and elasticity, and whether mar- ginal cost is rising or falling. The pricing of printers and ink, pharmaceuticals, and cable TV all derive naturally from this analysis. Once students understand price discrimination, their eyes will be open to a world of economics in prac- tice every day.
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Chapter 15: Cartels, Oligopolies, and Monopolistic Competition Can OPEC nations really collude to force up the price of oil? Or is the price of oil set by normal competitive forces of supply and demand in world markets? Under- standing when businesses “control price” and when they do not is one of the big- gest gaps in understanding between someone with economics training and someone without such training. Cartels usually collapse because of cheating by cartel members, new entrants into the market, and also legal prosecution from governments. Despite the challenges that cartels like OPEC face, many businesses nevertheless would love to cartelize their markets, even if they find it difficult to succeed for very long.
The incentive to cheat on cartels is a key to introducing game theory and also the prisoner’s dilemma. We also cover monopolistic competition in depth, focusing on the intuitions behind the concept. We show how monopolistic competition is a good analytic framework for understanding the economics of advertising, a topic that has a strong intuitive relevance for many students.
Chapter 16: The Economics of Network Goods: Competing for Monopoly Students are eager to understand the world they live in. Modern Principles talks not about the market for ice cream but the market for oil, printers and ink, cell phones, Google, Facebook and Match.com. In this chapter, we focus on network goods.
A lot of us use Microsoft Word because so many other people also do. Blu-Ray beat out the HD-DVD standard because again, for reasons of convenience, consum- ers want to share a common network or system. Markets like this have some unusual properties. They tend to have lots of monopoly and lots of innovation (competition “for the market” versus competition “in the market”), and they change suddenly in fits and starts, rather than gradually. We show the student why Facebook beat out MySpace and the associated economic lessons. How do frequent flyer programs work, why are they profitable, and what does the concept of a contestable market mean for both analysis and policy? How does Match.com work and why do friends so often enjoy the same musical songs? This “hands on” chapter serves up a lot of topics of im- mediate interest to students and relates them to core microeconomic concepts.
Chapter 17: Labor Markets Work touches almost all of our lives and most of the fundamental matters and conditions of work are ruled by economics. Wages. Working conditions. Bonuses. Investments in human capital and education. It’s the marginal product of labor that has the strongest influence over the wage of a particular job. Risky jobs, like going out on dangerous fishing boats, pay more. Labor unions boost the wages of some workers but will hurt the wages of others. There is also the controversial topic of discrimination in labor markets. We show how some kinds of discrimination may survive, while others will tend to fall away, due to the pressure of market forces.
Part 4: Government Chapter 18: Public Goods and the Tragedy of the Commons Public goods and externalities help us understand when private property rights do not always lead to good outcomes. The concepts of excludability and nonrivalry help us classify why governments have to provide national de- fense but why movie theaters are usually left to the private sector.
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Why is it that the world is running out of so many kinds of fish? Econom- ics has the best answer and it involves the tragedy of the commons. We show that economics is the single best entry point for understanding many common dilemmas of the environment.
Chapter 19: Political Economy If economics is so good, why doesn’t the world always listen? Political economy is one of the most important topics. Economics has a lot to say about how poli- tics works and the results aren’t always pretty. Voters have a rational incentive to be ignorant or underinformed, and the end result is that special interests have a big say over many economic policies. Dairy farmers have a bigger say over milk subsidies than do the people who drink milk, and that is why the United States has milk price supports.
That said, democratic systems still outperform the available alternatives. We present the median voter theorem and also explain why political competition produces results that are at least somewhat acceptable to the “person in the street. ”
Chapter 20: Economics, Ethics, and Public Policy Most principles students leave the classroom still underequipped to understand real-world policy debates over economic issues. So often the debate descends into ethics: Are markets fair? Is the distribution of income just? Is it important that individual rights be respected? When is paternalism justified? We do not try to provide final, take-away answers to these questions, but we do give the students the tools to unpack how these questions intersect with the economic issues they have been studying.
Should we give physically handicapped individuals better access to public facilities, or should the government simply send them more cash? Should there be a free market in transplantable human organs such as kidneys? For all the power of economics, virtually any public debate on questions like these will quickly bring in lots of ethical questions. We think that students should be fa- miliar with the major ethical objections to “the economic way of thinking,” and the strengths and weaknesses of those objections. We introduce the ideas of John Rawls and Robert Nozick, and also the philosophy of utilitarianism. In our view this chapter is an important supplement to the power of economic reasoning.
Part 5: Decision Making for Businesses, Investors, and Consumers Chapter 21: Managing Incentives Incentives matter! That may be the key single lesson of economics but a lot of textbooks don’t have a complete chapter on incentives. Business applications, sports applications, and personal life all provide plenty of illustrations of eco- nomic principles. You get what you pay for, so if you can’t measure quality very well, a lot of incentive schemes will backfire. Piece rates make a lot of workers more productive but strong incentives can impose risk on workers and induce them to quit their job altogether. As with grading on a curve, sometimes a boss wishes to pay workers relative to the performance of other workers. A lot of the most important incentives are about pride, fun, and fame, not just money.
Economists can never be doing enough to communicate what they know about incentives to a broader public. By making it easy, we want to increase the incentives here!
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Chapter 22: Stock Markets and Personal Finance The stock market is the one topic that just about every student of economics cares about, and yet it is neglected in many textbooks. We view the stock market as a “teaching moment” as well as an important topic in its own right. What other economic topic commands so much attention from the popular press? Yet not every principles course gives the student the tools to understand media discus- sions or to dissect fallacies. We remedy that state of affairs. This chapter covers pas- sive versus active investing, the trade-off between risk and return, “how to really pick stocks,” diversification, why high fees should be avoided, compound returns, and asset price bubbles. The operation of asset markets is something students need to know if they are to understand today’s economy and also the financial crisis.
And, yes, we do offer students some very direct and practical investment advice. Most people should diversify and “buy and hold,” and we explain why. In terms of direct, practical value, we try to make this book worth its price!
Chapter 23: Consumer Choice This chapter adds an extensive and foundational treatment of indifference curves to the book. It starts with the notions of diminishing marginal utility and relative price ratios to derive indifference curves. A budget constraint is added to indifference curves to generate the standard propositions of con- sumer theory, including marginal rates of substitution, income effects, sub- stitution effects, and the idea of a consumer optimum. The chapter includes novel applications, such as a unique and relevant application to Costco and why a company might charge consumers entry fees for membership.
Part 6: Economic Growth Why are some nations rich, while others are mired in terrible poverty? How can growth be extended to all parts of our world? Students are eager to un- derstand the key issues of growth and development and economics has much of importance to teach on this vital topic. Thus, we begin the macroeconomics part of the book with economic growth.
Chapter 24: GDP and the Measurement of Progress A visitor to India can see squalor in the streets but also cell phones, new stores, rising literacy, and better-fed people. In the United States, the economy moves from a boom in which jobs are easy to find to a bust when people tighten their belts and hope for better times. How do we measure these changes? We focus on the definition, limitations, and meaning of GDP and the motivation for studying GDP as a measure of economic change. GDP chapters can be dry so we enliven our treatment through real-world examples and comparisons.
Chapter 25: The Wealth of Nations and Economic Growth We present the basic facts of economic growth: (1) GDP per capita varies enormously between nations, (2) everyone used to be poor, and (3) there are growth miracles and growth disasters. The key factors behind economic growth include capital, labor, and technology, but we also offer the student a deeper understanding of the importance of incentives and institutions. It is important to connect the physical factors of production with an under- standing of how they got there. That means combining Solow and Romer- like models with institutional economics and an analysis of property rights.
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A quick tour of the world shows why the student needs to learn different approaches to understanding economic growth.
Let’s say we wish to understand why South Korea is wealthy, while North Korea starves. The best approach is to consider the roles of property rights and incentives in the two countries, a topic we cover in Chapter 25. Let’s say we want to understand why China had been growing at 10% a year for al- most 30 years. Then, the students need to learn the Solow model and the idea of “catch-up,” which we cover in the first half of Chapter 26. Finally, let’s say we want to understand why growth rates today are higher than in the nine- teenth century, or why the future might bring a very high standard of living. We then need to turn to the Romer model and the idea of increasing returns to scale, which we cover in the second half of Chapter 26. Our approach to economic growth presents all these ideas in an integrated fashion.
Chapter 26: Growth, Capital Accumulation, and the Economics of Ideas: Catching Up vs. the Cutting Edge Yes, the Solow model finally has come to a principles book. Maybe that sounds daunting, but we offer a super simple version of Solow, intuitive every step along the way. One reviewer for the chapter wrote:
This chapter is by itself one of the greatest selling points of the book. The chapter is superbly written and presents a difficult concept in a way that an intro-level student would not have trouble understanding. The authors . . . have done a great service to both instructors and students.
Another wrote:
My first reaction was “No way the Solow model belongs in macro prin- ciples.” However, after reading both the growth chapters, I changed my mind. These are excellent.
The Solow model stands at the foundation of modern approaches to eco- nomic growth. We cover some math but focus on the intuition behind the model, for instance, how diminishing returns to capital explains why China can grow faster than the United States. We cover capital growth, investment, and depreciation as concepts relevant for economic growth. As optional ma- terial, we explain how an increase in the investment rate increases GDP per capita but in the long run does not increase the growth rate. We also cover why ever more capital cannot be the reason for long-run economic growth and the importance of ideas for economic growth. The appendix offers the quantitative relations of the Solow model in a simple spreadsheet.
The Solow model also leads into a discussion of how ideas are generated and why incentives and spillovers matter for idea generation. Modern Principles introduces the notion of increasing returns, as can arise from the produc- tion of ideas, and explains its economic importance. Larger economies might grow faster than smaller economies, and growth rates might increase over time, for reasons explained by the work of Paul Romer and other economists.
Chapter 27: Savings, Investment, and the Financial System Financial intermediation doesn’t always receive a lot of attention from macro textbooks, but recent events have shown that the topic is critical. Modern Prin- ciples presents basic concepts behind intermediation, including consumption smoothing, the demand and supply of savings, equilibrium in the market for
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loanable funds, and the role of banks, bonds, and stock markets. We explain bank failures, panics, illiquidity, insolvency, and what happens when financial intermediation fails, with an emphasis on the financial crisis of 2007–2009. Students should understand why it is bad if a country has a broken banking system and how it got that way. All of this analysis will later be integrated with aggregate demand and supply. At the end of the chapter, an appendix presents bond pricing in terms of a spreadsheet and shows economically why bond prices and interest rates vary inversely. Modern macroeconomics is very much about banking and this chapter reflects the importance of the topic.
Part 7: Business Fluctuations Chapter 28: Unemployment and Labor Force Participation We define the different kinds of unemployment: frictional, structural, and cycli- cal. We consider how unemployment is linked to economic growth and how so much unemployment can arise from business cycles. We cover structural unemployment in both Europe and the United States, and we also cover labor- force participation rates to a greater extent than in other textbooks. Why is it, for example, that in Belgium only one-third of men ages 55–64 are working, while in the United States only one-third of men this age are retired! The chapter helps students to understand employment protection laws, labor-force participation, lifecycle effects, minimum wages, taxes, pensions, and even how the pill increased female labor-force participation. All of these points also will provide foundations for the later discussion of unemployment, wage stickiness, and aggregate demand.
Chapter 29: Inflation and the Quantity Theory of Money We start with a vivid example, namely hyperinflation in Zimbabwe, and explain how the rate of inflation rose into the quadrillions. We then introduce the quantity of money as a central concept in macroeconomics that will be used to explain inflation and, in future chapters, aggregate demand. We define inflation and present various price indices, including CPI, PPI, and the GDP deflator. As Milton Friedman explained, “Inflation is always and everywhere a mon- etary phenomenon.” The chapter covers the costs of inflation in detail: price confusion and money illusion, the redistribution of wealth, the breakdown of financial intermediation, and the interaction of inflation with the tax system. We explain why inflation happens and why inflation can be so difficult to end. An appendix creates a real price series for homes using Excel and the Internet.
Chapter 30: Business Fluctuations: Aggregate Demand and Supply In this chapter, we present our dynamic AD-AS model that allows for a balanced treatment of real shocks and aggregate demand shocks. We present the simplest real business cycle model and relate it to real-world concepts and examples. Supply-side fluctuations show up as shifts in the Solow growth curve, while a dynamic aggre- gate demand curve is based on the quantity theory. Using the quantity theory to derive an AD curve reduces the number of models students must learn and allows us to proceed quickly to sophisticated analyses of monetary and fiscal policy. We then introduce sticky prices and a short-run aggregate supply curve, responsive to both real and nominal shocks. The chapter ends by considering how the model can be used to explain the Great Depression of the 1930s.
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xl • Preface: To The Instructor
An instructor’s appendix available online (http://www.SeeTheInvisibleHand. com) discusses transition dynamics for both real and aggregate demand shocks.
Chapter 31: Transmission and Amplification Mechanisms In this chapter, which is optional, we explain in greater detail how economic forces can amplify shocks and transmit them across sectors of the economy and through time. When a shock is amplified, a mild negative shock can be transformed into a more serious reduction in output and a positive shock can be transformed into a boom. In addition, we show in this chapter how real shocks and aggregate demand shocks can interact—one type of shock can lead to the other, for example.
We illustrate real-world shocks and we give intuitive explanations of transmis- sion mechanisms such as intertemporal substitution, uncertainty and irreversible investments, labor adjustment costs, time bunching, and damage to collateral value.
The material in this chapter provides a richer understanding of business fluc- tuations that goes beyond shifting the curves. Using the material in this chapter, a teacher can better relate the model to historical and contemporary events, illustrate the differences among recessions as well as their commonalities, and show how economists adapt models to think about unique events.
Part 8: Macroeconomic Policy and Institutions Chapter 32: The Federal Reserve System and Open Market Operations To understand the Federal Reserve system, we introduce key concepts such as the U.S. money supplies, fractional reserve banking, the reserve ratio, the money multi- plier, open market operations, and Fed influence over interest rates. With these tools in hand, we revisit concepts of aggregate demand, in particular through monetary policy. We cover all the core tools of monetary policy, including the recent innova- tions of Ben Bernanke, such as the term auction facility and quantitative easing, in response to the financial crisis. We treat the Federal Reserve as a major manager of systematic risk and analyze when the Fed is likely to succeed in this task and why the task is a difficult one, with attention to the concepts of moral hazard and also confidence building. The appendix covers the money multiplier process in detail.
Chapter 33: Monetary Policy Building on the analysis of the Fed, we consider the dilemmas of monetary policy in detail. The relevant cases include, among others: negative shocks to aggregate demand, rules vs. discretion, analyzing a decline in the rate of monetary growth, how the Fed can contribute to asset price bubbles, and responding to negative real shocks. We devote special attention to the Fed as a manager of market confidence and to how the Fed should respond to positive shocks and possible asset price bubbles, including to the housing market.
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