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Principles Of Macro-Economics

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PRINCIPLES OF

ECONOMICS Eighth Edition

N. GREGORY MANKIW HARVARD UNIVERSITY

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ALL RIGHTS RESERVED. No part of this work covered by the copyright herein may be reproduced or distributed in any form or by any means, except as permitted by U.S. copyright law, without the prior written permission of the copyright owner.

Unless otherwise noted, all items © Cengage Learning.

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Principles of Economics, 8e N. Gregory Mankiw

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Printed in the United States of America Print Number: 01 Print Year: 2016

To Catherine, Nicholas, and Peter, my other contributions to the next generation

About the Author

N. Gregory Mankiw is the Robert M. Beren Professor of Economics at Harvard University. As a student, he studied economics at Princeton University and MIT. As a teacher, he has taught macroeconomics, microeco- nomics, statistics, and principles of economics. He even spent one summer long ago as a sailing instructor on Long Beach Island.

Professor Mankiw is a prolific writer and a regular participant in academic and policy debates. His work has been published in scholarly journals, such as the American Economic Review, Journal of Political Econ- omy, and Quarterly Journal of Economics, and in more popular forums, such as the New York Times and The Wall Street Journal. He is also author of the best-selling intermediate-level textbook Macroeconomics (Worth Publishers). In addition to his teaching, research, and writing, Professor Mankiw has been a research asso- ciate of the National Bureau of Economic Research, an adviser to the Congressional Budget Office and the Federal Reserve Banks of Boston and New York, and a member of the ETS test development committee for the Advanced Placement exam in economics. From 2003 to 2005, he served as chairman of the President’s Council of Economic Advisers.

Professor Mankiw lives in Wellesley, Massachusetts, with his wife, Deborah, three children, Catherine, Nicholas, and Peter, and their border terrier, Tobin.

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Brief Contents

PART I Introduction 1 1 Ten Principles of Economics 3 2 Thinking Like an Economist 19 3 Interdependence and the Gains from Trade 47

PART II How Markets Work 63 4 The Market Forces of Supply and Demand 65 5 Elasticity and Its Application 89 6 Supply, Demand, and Government Policies 111

PART III Markets and Welfare 131 7 Consumers, Producers, and the Efficiency

of Markets 133 8 Application: The Costs of Taxation 153 9 Application: International Trade 167

PART IV The Economics of the Public Sector 187 10 Externalities 189 11 Public Goods and Common Resources 211 12 The Design of the Tax System 227

PART V Firm Behavior and the Organization of Industry 245

13 The Costs of Production 247 14 Firms in Competitive Markets 267 15 Monopoly 289 16 Monopolistic Competition 319 17 Oligopoly 337

PART VI The Economics of Labor Markets 359 18 The Markets for the Factors of Production 361 19 Earnings and Discrimination 383 20 Income Inequality and Poverty 401

PART VII Topics for Further Study 423 21 The Theory of Consumer Choice 425 22 Frontiers of Microeconomics 451

PART VIII The Data of Macroeconomics 471 23 Measuring a Nation’s Income 473 24 Measuring the Cost of Living 495

PART IX The Real Economy in the Long Run 513 25 Production and Growth 515 26 Saving, Investment, and the Financial System 541 27 The Basic Tools of Finance 563 28 Unemployment 577

PART X Money and Prices in the Long Run 601 29 The Monetary System 603 30 Money Growth and Inflation 627

PART XI The Macroeconomics of Open Economies 651 31 Open-Economy Macroeconomics:

Basic Concepts 653 32 A Macroeconomic Theory of the

Open Economy 677

PART XII Short-Run Economic Fluctuations 699 33 Aggregate Demand and Aggregate Supply 701 34 The Influence of Monetary and Fiscal Policy

on Aggregate Demand 737 35 The Short-Run Trade-off between Inflation

and Unemployment 763

PART XIII Final Thoughts 787 36 Six Debates over Macroeconomic Policy 789

Brief Contents

“ conomics is a study of mankind in the ordinary business of life.” So wrote Alfred Marshall, the great 19th-century economist, in his textbook, Principles of Economics. We have learned much about the economy since Marshall’s

time, but this definition of economics is as true today as it was in 1890, when the first edition of his text was published.

Why should you, as a student in the 21st century, embark on the study of economics? There are three reasons.

The first reason to study economics is that it will help you understand the world in which you live. There are many questions about the economy that might spark your curiosity. Why are apartments so hard to find in New York City? Why do airlines charge less for a round-trip ticket if the traveler stays over a Saturday night? Why is Robert Downey, Jr., paid so much to star in movies? Why are living standards so meager in many African countries? Why do some countries have high rates of inflation while others have stable prices? Why are jobs easy to find in some years and hard to find in others? These are just a few of the questions that a course in economics will help you answer.

The second reason to study economics is that it will make you a more astute participant in the economy. As you go about your life, you make many economic decisions. While you are a student, you decide how many years to stay in school. Once you take a job, you decide how much of your income to spend, how much to save, and how to invest your savings. Someday you may find yourself running a small business or a large corporation, and you will decide what prices to charge for your products. The insights developed in the coming chapters will give you a new perspective on how best to make these decisions. Studying economics will not by itself make you rich, but it will give you some tools that may help in that endeavor.

The third reason to study economics is that it will give you a better understand- ing of both the potential and the limits of economic policy. Economic questions are always on the minds of policymakers in mayors’ offices, governors’ mansions, and the White House. What are the burdens associated with alternative forms of taxation? What are the effects of free trade with other countries? What is the best way to protect the environment? How does a government budget deficit affect the economy? As a voter, you help choose the policies that guide the allocation of society’s resources. An understanding of economics will help you carry out that responsibility. And who knows: Perhaps someday you will end up as one of those policymakers yourself.

Thus, the principles of economics can be applied in many of life’s situations. Whether the future finds you following the news, running a business, or sitting in the Oval Office, you will be glad that you studied economics.

N. Gregory Mankiw December 2016

Preface: To the Student

Video Application

C onceptClip videos help students master economics terms. These high-energy videos, embedded throughout the interactive book, address the known student challenge of understanding economics terminology when initially

introduced to the subject matter. Developed by Professor Mike Brandl of The Ohio State University, these concept-based animations provide students with memorable context to the key terminology required for your introductory economics course.

C onceptClip Videos

Video application features the book’s author introducing chapter content. Author Greg Mankiw introduces the important themes

in every chapter by delivering a highly relevant deposition on the real-world context to the economic principles that will be appearing in the upcoming chapter. These videos are intended to motivate students to better understand how economics relates to their day-to-day lives and in the world around them.

“I have always wanted supplemental material such as

this to help me understand certain concepts in economics.”

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Graph Builder

G raph Builder allows students to move step-by-step through complex graphical figures. Designed specifically for

introductory economics students, Graph Builder interactive exercises help students first understand complex graphs by deconstructing a graph into finite steps that build upon one another, then practice graphing by drawing out a similar scenario from scratch. This drawing method supports the kinesthetic learning approach valued by instructors, like you— all within the context of the interactive book!

“I have not used anything like this before.”

“The Graph Builder is amazing! This would help me a lot and the

concept is great. I think all students should have access to this feature

because it would better their knowledge of how to make graphs.”

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Adaptive Test Prep Prepares Your Students for High-Stakes Testing

Are your students constantly asking you for more practice questions as exam time comes closer? Do your students complain because the test bank-type

questions in the exam do not have the same look and feel as their homework assignments?

Adaptive Test Prep is a powerful tool that uses 4,000 new test bank-like questions to give students almost unlimited practice for each chapter and section. They can take as many tests as they like that are immediately graded for them. Students see how they did and the program gives them immediate remediation in the form of very robust feedback, a link right back into the text where the question topic resides, and for about 2,000 questions, they get a brief Quick Coach video with an instructor walking them through the exact question they missed!

Students can generate reports that show them which chapters and sections they need the most help on so they can tailor future practice tests just on the areas they are struggling with.

o t

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n writing this book, I benefited from the input of many talented people. Indeed, the list of people who have contributed to this project is so long, and their contributions so valuable, that it seems an injustice that only a single

name appears on the cover. Let me begin with my colleagues in the economics profession. The many edi-

tions of this text and its supplemental materials have benefited enormously from their input. In reviews and surveys, they have offered suggestions, identified challenges, and shared ideas from their own classroom experience. I am indebted to them for the perspectives they have brought to the text. Unfortunately, the list has become too long to thank those who contributed to previous editions, even though students reading the current edition are still benefiting from their insights.

Most important in this process has been David Hakes (University of Northern Iowa). David, a dedicated teacher, has served as a reliable sounding board for ideas and is a hardworking partner with me in putting together the superb pack- age of supplements. In addition, a special thanks to Ron Cronovich, an insightful instructor and trusted advisor, for his many years of consultation.

A special thanks to the team of teaching economists who worked on the test bank and ancillaries for this edition, many of whom have been working on the Mankiw ancillaries from the beginning. To Ken McCormick for vetting the entire test bank (with 17,000 questions) for correctness, and to Ken Brown, Sarah Cos- grove, Harold Elder, Michael Enz, Lisa Jepsen, Bryce Kanago, Daniel Marburger, Amanda Nguyen, Alicia Rosburg, Forrest Spence, and Kelvin Wong for authoring new questions and updating existing ones.

The following reviewers of the seventh edition provided suggestions for refining the content, organization, and approach in the eighth.

Mark Abajian, San Diego Mesa College

Rahi Abouk, University of Wisconsin Milwaukee

Mathew Abraham, Indiana University – Purdue University Indianapolis

Nathanael Adams, Cardinal Stritch University

Seemi Ahmad, Dutchess Community College

May Akabogu-Collins, Mira Costa College–Oceanside

Ercument Aksoy, Los Angeles Valley College

Basil Al-Hashimi, Mesa Community College

Rashid Al-Hmoud, Texas Tech University

William Aldridge, University of Alabama–Tuscaloosa

Donald L. Alexander, Western Michigan University

Hassan Aly, Ohio State University Michelle Amaral, University of the

Pacific Shahina Amin, University of Northern

Iowa Catalina Amuedo-Dorantes,

San Diego State University Vivette Ancona, Hunter

College–CUNY Aba Anil, University of Utah Diane Anstine, North Central College Carolyn Arcand, University of

Massachusetts Boston Becca Arnold, San Diego Community

College

Ali Ataiifar, Delaware County Community College

Shannon Aucoin, University of Louisiana Lafayette

Lisa Augustyniak, Lake Michigan College

Wesley Austin, University of Louisiana Lafayette

Dennis Avola, Framingham State University

Regena M. Aye, Allen Community College

Sang Hoo Bae, Clark University Karen Baehler, Hutchinson

Community College Sahar Bahmani, University of

Wisconsin-Parkside Mohsen Bahmani-Oskooee,

University of Wisconsin Milwaukee

Acknowledgments

xiACKNOWLEDGMENTS

Richard Baker, Copiah-Lincoln Community College

Stephen Baker, Capital University Tannista Banerjee, Auburn University Bob Barnes, DePaul University Hamid Bastin, Shippensburg University James Bathgate, Western Nevada College Leon Battista, Albertus Magnus College Gerald Baumgardner, Susquehanna

University Christoph Bauner, University of

Massachusetts–Amherst Elizabeth Bayley, University of Delaware Ergin Bayrak, University of Southern

California Nihal Bayraktar, Pennsylvania State

University Mike Belleman, St. Clair County

Community College Audrey Benavidez, Del Mar College Cynthia Benelli, University of California

Santa Barbara Charles Bennett, Gannon University Bettina Berch, Borough of Manhattan

Community College Stacey Bertke, Owensboro Community &

Technical College Tibor Besedes, Georgia Institute of

Technology Abhijeet Bhattacharya, Illinois Valley

Community College Ronald Bishop, Lake Michigan College Thomas Bishop, California State Channel

Islands Nicole Bissessar, Kent State

University-Ashtabula Janet Blackburn, San Jacinto South

College Jeanne Boeh, Augsburg College Natalia Boliari, Manhattan College Antonio Bos, Tusculum College Jennifer Bossard, Doane College James Boudreau, University of Texas–

Pan American Mike Bowyer, Montgomery Community

College William Brennan, Minnesota State

University–Mankato Genevieve Briand, Washington State

University Scott Broadbent, Western Kentucky

University Greg Brock, Georgia Southern University Ivy Broder, American University Todd Broker, Murray State University

Stacey Brook, University of Iowa Keith Brouhle, Grinnell College Byron Brown, Michigan State University Crystal Brown, Anderson University Kris Bruckerhoff, University of

Minnesota-Crookston Christopher Brunt, Lake Superior State

University Laura Bucila, Texas Christian University Donna Bueckman, University of

Tennessee–Knoxville Don Bumpass, Sam Houston State

University Joe Bunting, St. Andrews University Benjamin Burden, Temple College Mariya Burdina, University of Central

Oklahoma Rob Burrus, University of North

Carolina–Wilmington James Butkiewicz, University of Delaware William Byrd, Troy University Anna Cai, University of

Alabama–Tuscaloosa Samantha Cakir, Macalester College Michael Carew, Baruch College William Carner, Westminster College Craig Carpenter, Albion College John Carter, California State

University-Stanislaus Ginette Carvalho, Fordham University Onur Celik, Quinnipiac University Avik Chakrabarti, University of

Wisconsin–Milwaukee Kalyan Chakraborty, Emporia State

University Suparna Chakraborty, Baruch

College–CUNY Dustin Chambers, Salisbury University Silvana Chambers, Salisbury University Krishnamurti Chandrasekar, New York

Institute of Technology Yong Chao, University of Louisville David Chaplin, Northwest Nazarene

University Xudong Chen, Baldwin-Wallace College Yi-An Chen, University of Washington,

Seattle Kirill Chernomaz, San Francisco State

University Ron Cheung, Oberlin College Hui-Chu Chiang, University of Central

Oklahoma Mainul Chowdhury, Northern Illinois

University

Dmitriy Chulkov, Indiana University Kokomo

Lawrence Cima, John Carroll University Cindy Clement, University of

Maryland Matthew Clements, St. Edward’s

University Sondra Collins, University of Southern

Mississippi Tina Collins, San Joaquin Valley College Scott Comparato, Southern Illinois

University Kathleen Conway, Carnegie Mellon

University Stephen Cotten, University of Houston

Clear Lake Jim Cox, Georgia Perimeter College Michael Craig, University of

Tennessee–Knoxville Matt Critcher, University of Arkansas

Community College at Batesville George Crowley, Troy University, Troy David Cullipher, Arkansas State

University-Mountain Home Dusan Curcic, University of Virginia Norman Cure, Macomb Community

College Maria DaCosta, University of

Wisconsin–EauClaire Bruce Dalgaard, St. Olaf College Anusua Datta, Philadelphia University Earl Davis, Nicholls State University Amanda Dawsey, University of

Montana Prabal De, City College of New York Rooj Debasis, Kishwaukee College Dennis Debrecht, Carroll University William DeFrance, University of

Michigan-Flint Theresa J. Devine, Brown University Paramita Dhar, Central Connecticut

State University Ahrash Dianat, George Mason

University Stephanie Dieringer, University of South

Florida St. Petersburg Du Ding, Northern Arizona University Liang Ding, Macalester College Parks Dodd, Georgia Institute of

Technology Veronika Dolar, Long Island University Zachary Donohew, University of

Central Arkansas Kirk Doran, University of Notre Dame Craig Dorsey, College of DuPage

xii ACKNOWLEDGMENTS

Caf Dowlah, Queensborough Community College–CUNY

Tanya Downing, Cuesta College Michael J. Driscoll, Adelphi University Ding Du, Northern Arizona University Kevin Dunagan, Oakton community

college Nazif Durmaz, University of

Houston–Victoria Tomas Dvorak, Union College Eva Dziadula, Lake Forest College Dirk Early, Southwestern University Ann Eike, University of Kentucky Harold Elder, University of

Alabama–Tuscaloosa Lynne Elkes, Loyola University

Maryland Diantha Ellis, Abraham Baldwin College Noha Emara, Columbia University Michael Enz, Framingham State

University David Epstein, The College of New Jersey Lee Erickson, Taylor University Sarah Estelle, Hope College Pat Euzent, University of Central

Florida–Orlando Timothy Ewest, Wartburg College Yang Fan, University of Washington Amir Farmanesh, University of

Maryland MohammadMahdi Farsiabi, Wayne

State University Julie Finnegan, Mendocino College Ryan Finseth, University of Montana Donna Fisher, Georgia Southern

University Nikki Follis, Chadron State College Joseph Franklin, Newberry College Matthew Freeman, Mississippi State

University Gary Frey, City College of New York Ted Fu, Shenandoah University Winnie Fung, Wheaton College Marc Fusaro, Arkansas Tech University Todd Gabe, University of Maine Mary Gade, Oklahoma State University Jonathan Gafford, Columbia State

Community College Iris Geisler, Austin Community College Jacob Gelber, University of Alabama at

Birmingham Robert Gentenaar, Pima Downtown

Community College Soma Ghosh, Albright College

Edgar Ghossoub, University of Texas at San Antonio

Alex Gialanella, Manhattanville College Bill Gibson, University of Vermont Kenneth Gillingham, Yale University Gregory Gilpin, Montana State

University Robert Godby, University of Wyoming Jayendra Gokhale, Oregon State

University Joel Goldhar, IIT/Stuart School of

Business Michael Goode, Central Piedmont

Community College Michael J Gootzeit, University of

Memphis Jackson Grant, US Air Force Academy Jeremy Groves, Northern Illinois

University Ilhami Gunduz, Brooklyn

College–CUNY Roberts Halsey, Indiana University Michele Hampton, Cuyahoga

Community College Eastern James Hartley, Mount Holyoke College Mike Haupert, University of Wisconsin

LaCrosse David Hedrick, Central Washington

University Evert Van Der Heide, Calvin College Sara Helms, Samford University Jessica Hennessey, Furman University Thomas Henry, Mississippi State

University Alexander Hill, University of

Colorado-Boulder Bob Holland, Purdue University Paul Holmes, Ashland University Kim Hoolda, Fordham University Aaron Hoshide, University of Maine Michael Hoyte, York College Glenn Hsu, University of Central

Oklahoma Kuang-Chung Hsu, University of

Central Oklahoma Jim Hubert, Seattle Central Community

College George Hughes, University of Hartford Andrew Hussey, University of

Memphis Christopher Hyer, University of New

Mexico Kent Hymel, California State

University–Northridge Miren Ivankovic, Anderson University

Eric Jacobson, University of Delaware Bolormaa Jamiyansuren, Augsburg

College Justin Jarvis, Orange Coast College Andres Jauregui, Columbus State

University Ricot Jean, Valencia College Michal Jerzmanowski, Clemson

University Bonnie Johnson, California Lutheran

University Bruce Johnson, Centre College Paul Johnson, University of Alaska

Anchorage Philipp Jonas, KV Community College Adam Jones, University of North

Carolina–Wilmington Jason Jones, Furman University Roger Jordan, Baker College James Jozefowicz, Indiana University of

Pennsylvania Sujana Kabiraj, Louisiana State University Simran Kahai, John Carroll University Leo Kahane, Providence College Venoo Kakar, San Francisco State

University David Kalist, Shippensburg University Lillian Kamal, University of Hartford Willie Kamara, North Lake College Robert Kane, State University of New

York-Fredonia David Karemera, St. Cloud State

University Logan Kelly, University of Wisconsin Craig Kerr, California State Polytechnic

University-Pomona Wahhab Khandker, University of

Wisconsin–LaCrosse Jongsung Kim, Bryant University Kihwan Kim, Rutgers Elsy Kizhakethalackal, Bowling Green

State University Todd Knoop, Cornell College Fred Kolb, University of

Wisconsin–EauClaire Oleg Korenok, Virginia Commonwealth

University Janet Koscianski, Shippensburg

University Kafui Kouakou, York College Mikhail Kouliavtsev, Stephen F. Austin

State University Maria Kula, Roger Williams University Nakul Kumar, Bloomsburg University Ben Kyer, Francis Marion University

xiiiACKNOWLEDGMENTS

Yuexing Lan, Auburn Montgomery Daniel Lawson, Oakland Community

College Elena Lazzari, Marygrove College Quan Le, Seattle University Chun Lee, Loyola Marymount

University Daniel Lee, Shippensburg University Jihoon Lee, Northeastern University Jim Lee, Texas A&M–Corpus Christi Junghoon Lee, Emory University Ryan Lee, Indiana University Sang Lee, Southeastern Louisiana

University James Leggette, Belhaven University Bozena Leven, The College of New Jersey Qing Li, College of the Mainland Zhen Li, Albion College Carlos Liard-Muriente, Central

Connecticut State University Larry Lichtenstein, Canisius College Jenny Liu, Portland State University Jialu Liu, Allegheny College Sam Liu, West Valley College Xuepeng Liu, Kennesaw State University Jie Ma, Indiana University Michael Machiorlatti, Oklahoma City

Community College Bruce Madariaga, Montgomery College

and Northwestern University Brinda Mahalingam, University of

Alabama-Huntsville C. Lucy Malakar, Lorain County

Community College Paula Manns, Atlantic Cape Community

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University Dan Marburger, Arizona State

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University Christina Marsh, Wake Forest University William McAndrew,

Gannon University Katherine McClain, University of

Georgia Michael McIlhon, Century College Steven McMullen, Hope College Jennifer McNiece, Howard Payne

University Robert Menafee, Sinclair Community

College Fabio Mendez, Loyola University

Maryland

Charles Meyrick, Housatonic Community College

Heather Micelli, Mira Costa College Laura Middlesworth, University of

Wisconsin–Eau Claire Meghan Mihal, St. Thomas Aquinas

College Eric Miller, Oakton Community College Phillip Mixon, Troy University–Troy Evan Moore, Auburn

University–Montgomery Francis Mummery, California State

University–Fullerton John Mundy, St. Johns River State

University Charles Murray, The College of Saint

Rose James Murray, University of

Wisconsin–LaCrosse Christopher Mushrush, Illinois State

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College Mihai Nica, University of Central

Oklahoma Scott Niederjohn, Lakeland College Mark Nixon, Fordham University George Norman, Tufts University David O’Hara, Metropolitan State

University Brian O’Roark, Robert Morris University Yanira Ogrodnik, Post University Wafa Orman, University of Alabama in

Huntsville Glenda Orosco, Oklahoma State

University Institute of Technology Orgul Ozturk, University of South

Carolina Jennifer Pakula, Saddleback College Maria Papapavlou, San Jacinto Central

College Nitin Paranjpe, Wayne State University Irene Parietti, Felician College Jooyoun Park, Kent State University Dodd Parks, Georgia Institute of

Technology Jason Patalinghug, University of New

Haven Michael Patton, St. Louis Community

College–Wildwood Wesley Pech, Wofford College Josh Phillips, Iowa Central Community

College

Germain Pichop, Oklahoma City Community College

Lodovico Pizzati, University of Southern California

Florenz Plassmann, Binghamton University

Lana Podolak, Community College of Beaver County

Gyan Pradhan, Eastern Kentucky University

Curtis Price, University of Southern Indiana

Silvia Prina, Case Western Reserve University

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Mississippi John Stuart Rabon, Missouri State

University Mark Reavis, Arkansas Tech University Robert Rebelein, Vassar College Agne Reizgeviciute, California State

University-Chico Matt Rendleman, Southern Illinois

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University Josh Robinson, University of

Alabama-Birmingham Kristen Roche, Mount Mary College Antonio Rodriguez, Texas A&M

International University Debasis Rooj, Kishwaukee College Larry Ross, University of Alaska Subhasree Basu Roy, Missouri State

University Jeff Rubin, Rutgers University–New

Brunswick Jason C. Rudbeck, University of Georgia Jeff Ruggiero, University of Dayton Robert Rycroft, University of Mary

Washington Allen Sanderson, University of Chicago Malkiat Sandhu, San Jose City College Lisle Sanna, Ursinus College Nese Sara, University of Cincinnati Naveen Sarna, Northern Virginia

Community College–Alexandria Eric Sartell, Whitworth University Martin Schonger, Princeton University Andy Schuchart, Iowa Central

Community College

xiv ACKNOWLEDGMENTS

Michael Schultz, Menlo College Jessica Schuring, Central College Danielle Schwarzmann, Towson

University Gerald Scott, Florida Atlantic University Elan Segarra, San Francisco State

University Bhaswati Sengupta, Iona College Reshmi Sengupta, Northern Illinois

University Dan Settlage, University of Arkansas-

Fort Smith David Shankle, Blue Mountain College Alex Shiu, McLennan Community

College Robert Shoffner, Central Piedmont

Community College Mark Showalter, Brigham Young

University Sanchit Shrivastava, University of Utah Johnny Shull, Wake Tech Community

College Suann Shumaker, Las Positas College Nicholas Shunda, University of

Redlands Milan Sigetich, Southern Oregon

University Jonathan Silberman, Oakland University Joe Silverman, Mira Costa

College–Oceanside Silva Simone, Murray State University Harmeet Singh, Texas A&M

University–Kingsville Catherine Skura, Sandhills Community

College Gary Smith, Canisius College Richard Smith, University of South

Florida–St. Petersburg Joe Sobieralski, Southwestern Illinois

College–Belleville Mario Solis-Garcia, Macalester College Arjun Sondhi, Wayne State University Soren Soumbatiants, Franklin

University Matt Souza, Indiana University – Purdue

University Columbus Nekeisha Spencer, Binghamton

University

Dean Stansel, Florida Gulf Coast University

Sylwia Starnawska, D’Youville College Keva Steadman, Augustana College Rebecca Stein, University of

Pennsylvania Dale Steinreich, Drury University Paul Stock, University of Mary

Hardin-Baylor Michael Stroup, Stephen F. Austin State

University Edward Stuart, Northeastern Illinois

University Yang Su, University of Washington Yu-hsuan Su, University of Washington Samanta Subarna, The College of New

Jersey Abdul Sukar, Cameron University Burak Sungu, Miami University John Susenburger, Utica College James Swofford, University of South

Alabama Vera Tabakova, East Carolina U

niversity Ariuna Taivan, University of

Minnesota-Duluth Eftila Tanellari, Radford University Eric Taylor, Central Piedmont

Community College Erdal Tekin, Georgia State University Noreen Templin, Butler Community

College Thomas Tenerelli, Central Washington

University Anna Terzyan, California State

University-Los Angeles Petros Tesfazion, Ithaca College Charles Thompson, Brunswick

Community College Flint Thompson, Chippewa Valley

Technical College Deborah Thorsen, Palm Beach State

College–Central James Tierney, University of California

Irvine Julie Trivitt, Arkansas Tech University Arja Turunen-Red, University of New

Orleans

Mark Tuttle, Sam Houston State University

Jennifer VanGilder, Ursinus College Ross vanWassenhove, University of

Houston Ben Vaughan, Trinity University Roumen Vesselinov, Queens College,

City University of New York Rubina Vohra, St. Peter’s College Will Walsh, Samford University Chih-Wei Wang, Pacific Lutheran

University Jingjing Wang, University of New

Mexico Chad Wassell, Central Washington

University Christine Wathen, Middlesex

Community College J. Douglas Wellington, Husson

University Adam Werner, California Polytechnic

State University Sarah West, Macalester College Elizabeth Wheaton, Southern Methodist

University Oxana Wieland, University of

Minnesota, Crookston Christopher Wimer, Bowling Green

State University–Firelands College Do Youn Won, University of Utah Kelvin Wong, University of Minnesota Ken Woodward, Saddleback College Irena Xhurxhi, York College Xu Xu, Mississippi state university Ying Yang, University of Rhode Island Young-Ro Yoon,

Wayne State University Eric Zemjic, Kent State University Yongchen Zhao, Towson University Zhen Zhu, University of Central

Oklahoma Kent Zirlott, University of

Alabama–Tuscaloosa Joseph Zwiller,

Lake Michigan College

xvACKNOWLEDGMENTS

The team of editors who worked on this book improved it tremendously. Jane Tufts, developmental editor, provided truly spectacular editing—as she always does. Michael Parthenakis, senior product manager, did a splendid job of over- seeing the many people involved in such a large project. Anita Verma, senior con- tent developer, was crucial in assembling an extensive and thoughtful group of reviewers to give me feedback on the previous edition, while putting together an excellent team to revise the supplements. Colleen Farmer, senior content project manager, had the patience and dedication necessary to turn my manuscript into this book. Kasie Jean, digital content designer and a trained economist, designed and implemented all of the valuable student resources in MindTap. Michelle Kunkler, senior art director, gave this book its clean, friendly look. Bruce Morser, the illustrator, helped make the book more visually appealing and the economics in it less abstract. Pamela Rockwell, copyeditor, refined my prose, and Lumina Datamatic’s indexer, prepared a careful and thorough index. John Carey, exec- utive marketing manager, worked long hours getting the word out to potential users of this book. The rest of the Cengage team has, as always, been consistently professional, enthusiastic, and dedicated.

I am grateful also to Denis Fedin and Nina Vendhan, two star Harvard undergraduates, who helped me refine the manuscript and check the page proofs for this edition.

As always, I must thank my “in-house” editor Deborah Mankiw. As the first reader of most things I write, she continued to offer just the right mix of criticism and encouragement.

Finally, I would like to mention my three children Catherine, Nicholas, and Peter. Their contribution to this book was putting up with a father spending too many hours in his study. The four of us have much in common—not least of which is our love of ice cream (which becomes apparent in Chapter 4).

N. Gregory Mankiw December 2016

xvi

Contents

Preface: To the Student vi

Acknowledgments x

PART I Introduction 1 CHAPTER 1 Ten Principles of Economics 3 1-1 How People Make Decisions 4

1-1a Principle 1: People Face Trade-offs 4 1-1b Principle 2: The Cost of Something

Is What You Give Up to Get It 5 1-1c Principle 3: Rational People Think at the Margin 6 1-1d Principle 4: People Respond to Incentives 7

1-2 How People Interact 8 1-2a Principle 5: Trade Can Make Everyone Better Off 8 1-2b Principle 6: Markets Are Usually a Good Way to

Organize Economic Activity 9 FYI: Adam Smith and the Invisible Hand 10 CASE STUDY: Adam Smith Would Have Loved Uber 11 1-2c Principle 7: Governments Can Sometimes

Improve Market Outcomes 11

1-3 How the Economy as a Whole Works 13 1-3a Principle 8: A Country’s Standard of Living Depends

on Its Ability to Produce Goods and Services 13 1-3b Principle 9: Prices Rise When the Government

Prints Too Much Money 13

1-3c Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment 14

1-4 Conclusion 15 Summary 16 Key Concepts 16 Questions for Review 16 Problems and Applications 17

CHAPTER 2 Thinking Like an Economist 19 2-1 The Economist as Scientist 20

2-1a The Scientific Method: Observation, Theory, and More Observation 20

2-1b The Role of Assumptions 21 2-1c Economic Models 22 2-1d Our First Model: The Circular-Flow Diagram 22 2-1e Our Second Model: The Production Possibilities Frontier 24 2-1f Microeconomics and Macroeconomics 26

2-2 The Economist as Policy Adviser 27 2-2a Positive versus Normative Analysis 27 2-2b Economists in Washington 28 2-2c Why Economists’ Advice Is Not Always Followed 29

2-3 Why Economists Disagree 30 2-3a Differences in Scientific Judgments 30 2-3b Differences in Values 30 2-3c Perception versus Reality 31 ASK THE EXPERTS: Ticket Resale 32

2-4 Let’s Get Going 32 IN THE NEWS: Why You Should Study Economics 33

Summary 34 Key Concepts 34 Questions for Review 35 Problems and Applications 35 Appendix Graphing: A Brief Review 37

CHAPTER 3 Interdependence and the Gains from Trade 47 3-1 A Parable for the Modern Economy 48

3-1a Production Possibilities 49 3-1b Specialization and Trade 50

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3-2 Comparative Advantage: The Driving Force of Specialization 52

3-2a Absolute Advantage 52 3-2b Opportunity Cost and Comparative Advantage 52 3-2c Comparative Advantage and Trade 53 3-2d The Price of the Trade 54 FYI: The Legacy of Adam Smith and David Ricardo 55

3-3 Applications of Comparative Advantage 55 3-3a Should Serena Williams Mow Her Own Lawn? 55 IN THE NEWS: Economics within a Marriage 56 3-3b Should the United States Trade with Other Countries? 56 ASK THE EXPERTS: Trade between China and

the United States 58

3-4 Conclusion 58 Summary 59 Key Concepts 59 Questions for Review 60 Problems and Applications 60

PART II How Markets Work 63

CHAPTER 4 The Market Forces of Supply and Demand 65 4-1 Markets and Competition 66

4-1a What Is a Market? 66 4-1b What Is Competition? 66

4-2 Demand 67 4-2a The Demand Curve: The Relationship between

Price and Quantity Demanded 67 4-2b Market Demand versus Individual Demand 68 4-2c Shifts in the Demand Curve 69 CASE STUDY: Two Ways to Reduce the Quantity of Smoking

Demanded 71

4-3 Supply 73 4-3a The Supply Curve: The Relationship between Price

and Quantity Supplied 73 4-3b Market Supply versus Individual Supply 74 4-3c Shifts in the Supply Curve 75

4-4 Supply and Demand Together 76 4-4a Equilibrium 76 4-4b Three Steps to Analyzing Changes in Equilibrium 78

4-5 Conclusion: How Prices Allocate Resources 83 ASK THE EXPERTS: Price Gouging 83 IN THE NEWS: Price Increases after Disasters 84

Summary 86 Key Concepts 86 Questions for Review 87 Problems and Applications 87

CHAPTER 5 Elasticity and Its Application 89 5-1 The Elasticity of Demand 90

5-1a The Price Elasticity of Demand and Its Determinants 90 5-1b Computing the Price Elasticity of Demand 91 5-1c The Midpoint Method: A Better Way to Calculate

Percentage Changes and Elasticities 92 5-1d The Variety of Demand Curves 93 FYI: A Few Elasticities from the Real World 93 5-1e Total Revenue and the Price Elasticity of Demand 95 5-1f Elasticity and Total Revenue along a Linear

Demand Curve 96 5-1g Other Demand Elasticities 98

5-2 The Elasticity of Supply 99 5-2a The Price Elasticity of Supply and Its Determinants 99 5-2b Computing the Price Elasticity of Supply 99 5-2c The Variety of Supply Curves 100

5-3 Three Applications of Supply, Demand, and Elasticity 102 5-3a Can Good News for Farming Be Bad News for

Farmers? 102 5-3b Why Did OPEC Fail to Keep the Price of Oil High? 104 5-3c Does Drug Interdiction Increase or Decrease

Drug-Related Crime? 105

5-4 Conclusion 107 Summary 108 Key Concepts 108 Questions for Review 109 Problems and Applications 109

CHAPTER 6 Supply, Demand, and Government Policies 111 6-1 Controls on Prices 112

6-1a How Price Ceilings Affect Market Outcomes 112 CASE STUDY: Lines at the Gas Pump 114

xviii CONTENTS

CASE STUDY: Rent Control in the Short Run and the Long Run 115

6-1b How Price Floors Affect Market Outcomes 116 ASK THE EXPERTS: Rent Control 116 CASE STUDY: The Minimum Wage 118 ASK THE EXPERTS: The Minimum Wage 119 6-1c Evaluating Price Controls 120

6-2 Taxes 120 6-2a How Taxes on Sellers Affect Market Outcomes 121 6-2b How Taxes on Buyers Affect Market Outcomes 122 CASE STUDY: Can Congress Distribute the Burden

of a Payroll Tax? 124 6-2c Elasticity and Tax Incidence 124 CASE STUDY: Who Pays the Luxury Tax? 126

6-3 Conclusion 127 Summary 128 Key Concepts 128 Questions for Review 128 Problems and Applications 129

PART III Markets and Welfare 131

CHAPTER 7 Consumers, Producers, and the Efficiency of Markets 133 7-1 Consumer Surplus 134

7-1a Willingness to Pay 134 7-1b Using the Demand Curve to Measure Consumer

Surplus 135 7-1c How a Lower Price Raises Consumer Surplus 136 7-1d What Does Consumer Surplus Measure? 137

7-2 Producer Surplus 139 7-2a Cost and the Willingness to Sell 139 7-2b Using the Supply Curve to Measure Producer Surplus 140 7-2c How a Higher Price Raises Producer Surplus 141

7-3 Market Efficiency 142 7-3a The Benevolent Social Planner 143 7-3b Evaluating the Market Equilibrium 144 IN THE NEWS: The Invisible Hand Can Park Your Car 146 CASE STUDY: Should There Be a Market for Organs? 147 ASK THE EXPERTS: Supplying Kidneys 148

7-4 Conclusion: Market Efficiency and Market Failure 148 Summary 150 Key Concepts 150 Questions for Review 150 Problems and Applications 150

CHAPTER 8 Application: The Costs of Taxation 153 8-1 The Deadweight Loss of Taxation 154

8-1a How a Tax Affects Market Participants 155 8-1b Deadweight Losses and the Gains from Trade 157

8-2 The Determinants of the Deadweight Loss 158 CASE STUDY: The Deadweight Loss Debate 160

8-3 Deadweight Loss and Tax Revenue as Taxes Vary 161 CASE STUDY: The Laffer Curve and Supply-Side

Economics 162 ASK THE EXPERTS: The Laffer Curve 163

8-4 Conclusion 164 Summary 165 Key Concept 165 Questions for Review 165 Problems and Applications 165

CHAPTER 9 Application: International Trade 167 9-1 The Determinants of Trade 168

9-1a The Equilibrium without Trade 168 9-1b The World Price and Comparative Advantage 169

9-2 The Winners and Losers from Trade 170 9-2a The Gains and Losses of an Exporting Country 170 9-2b The Gains and Losses of an Importing Country 171 9-2c Effects of a Tariff 173 FYI: Import Quotas: Another Way to Restrict Trade 175 9-2d The Lessons for Trade Policy 175 9-2e Other Benefits of International Trade 176 IN THE NEWS: Trade as a Tool for Economic Development 177

9-3 The Arguments for Restricting Trade 178 9-3a The Jobs Argument 178 IN THE NEWS: Should the Winners from Free Trade

Compensate the Losers? 179 9-3b The National-Security Argument 180 9-3c The Infant-Industry Argument 180 9-3d The Unfair-Competition Argument 181 9-3e The Protection-as-a-Bargaining-Chip Argument 181

xixCONTENTS

CASE STUDY: Trade Agreements and the World Trade Organization 181

ASK THE EXPERTS: Trade Deals 182

9-4 Conclusion 182 Summary 184 Key Concepts 184 Questions for Review 184 Problems and Applications 185

PART IV The Economics of the Public Sector 187

CHAPTER 10 Externalities 189 10-1 Externalities and Market Inefficiency 191

10-1a Welfare Economics: A Recap 191 10-1b Negative Externalities 192 10-1c Positive Externalities 193 CASE STUDY: Technology Spillovers, Industrial Policy,

and Patent Protection 194

10-2 Public Policies toward Externalities 195 10-2a Command-and-Control Policies: Regulation 195 10-2b Market-Based Policy 1: Corrective Taxes and

Subsidies 196 ASK THE EXPERTS: Vaccines 196 CASE STUDY: Why Is Gasoline Taxed So Heavily? 197 IN THE NEWS: What Should We Do about Climate

Change? 199 10-2c Market-Based Policy 2: Tradable Pollution

Permits 200 ASK THE EXPERTS: Carbon Taxes 200 10-2d Objections to the Economic Analysis of Pollution 202

10-3 Private Solutions to Externalities 202 10-3a The Types of Private Solutions 202 10-3b The Coase Theorem 203 10-3c Why Private Solutions Do Not Always Work 204 IN THE NEWS: The Coase Theorem in Action 205

10-4 Conclusion 206

Summary 207 Key Concepts 207 Questions for Review 207 Problems and Applications 208

CHAPTER 11 Public Goods and Common Resources 211 11-1 The Different Kinds of Goods 212

11-2 Public Goods 214 11-2a The Free-Rider Problem 214 11-2b Some Important Public Goods 214 CASE STUDY: Are Lighthouses Public Goods? 216 11-2c The Difficult Job of Cost–Benefit Analysis 216 CASE STUDY: How Much Is a Life Worth? 217

11-3 Common Resources 218 11-3a The Tragedy of the Commons 218 11-3b Some Important Common Resources 219 ASK THE EXPERTS: Congesting Pricing 219 IN THE NEWS: The Case for Toll Roads 220 CASE STUDY: Why the Cow Is Not Extinct 222

11-4 Conclusion: The Importance of Property Rights 223 Summary 224 Key Concepts 224 Questions for Review 224 Problems and Applications 224

CHAPTER 12 The Design of the Tax System 227 12-1 An Overview of U.S. Taxation 228

12-1a Taxes Collected by the Federal Government 228 12-1b Taxes Collected by State and Local Governments 231

12-2 Taxes and Efficiency 232 12-2a Deadweight Losses 232 CASE STUDY: Should Income or Consumption

Be Taxed? 233 12-2b Administrative Burden 234 12-2c Marginal Tax Rates versus Average Tax Rates 235 12-2d Lump-Sum Taxes 235

12-3 Taxes and Equity 236 12-3a The Benefits Principle 236 12-3b The Ability-to-Pay Principle 237 CASE STUDY: How the Tax Burden Is Distributed 238 12-3c Tax Incidence and Tax Equity 239 IN THE NEWS: Tax Expenditures 240 CASE STUDY: Who Pays the Corporate Income Tax? 240

12-4 Conclusion: The Trade-off between Equity and Efficiency 242 Summary 243 Key Concepts 243 Questions for Review 244 Problems and Applications 244

xx CONTENTS

PART V Firm Behavior and the Organization of Industry 245

CHAPTER 13 The Costs of Production 247 13-1 What Are Costs? 248

13-1a Total Revenue, Total Cost, and Profit 248 13-1b Costs as Opportunity Costs 249 13-1c The Cost of Capital as an Opportunity Cost 249 13-1d Economic Profit versus Accounting Profit 250

13-2 Production and Costs 251 13-2a The Production Function 251 13-2b From the Production Function to the Total-Cost

Curve 253

13-3 The Various Measures of Cost 254 13-3a Fixed and Variable Costs 255 13-3b Average and Marginal Cost 255 13-3c Cost Curves and Their Shapes 256 13-3d Typical Cost Curves 258

13-4 Costs in the Short Run and in the Long Run 259 13-4a The Relationship between Short-Run and Long-Run

Average Total Cost 260 13-4b Economies and Diseconomies of Scale 261 FYI: Lessons from a Pin Factory 261

13-5 Conclusion 262 Summary 263 Key Concepts 264 Questions for Review 264 Problems and Applications 264

CHAPTER 14 Firms in Competitive Markets 267 14-1 What Is a Competitive Market? 268

14-1a The Meaning of Competition 268 14-1b The Revenue of a Competitive Firm 269

14-2 Profit Maximization and the Competitive Firm’s Supply Curve 270

14-2a A Simple Example of Profit Maximization 270 14-2b The Marginal-Cost Curve and the Firm’s Supply

Decision 271 14-2c The Firm’s Short-Run Decision to Shut Down 273 14-2d Spilt Milk and Other Sunk Costs 275 CASE STUDY: Near-Empty Restaurants and Off-Season

Miniature Golf 275 14-2e The Firm’s Long-Run Decision to Exit or Enter a

Market 276 14-2f Measuring Profit in Our Graph for the Competitive

Firm 277

14-3 The Supply Curve in a Competitive Market 279 14-3a The Short Run: Market Supply with a Fixed Number

of Firms 279 14-3b The Long Run: Market Supply with Entry

and Exit 279 14-3c Why Do Competitive Firms Stay in Business

If They Make Zero Profit? 280 14-3d A Shift in Demand in the Short Run and

Long Run 281 14-3e Why the Long-Run Supply Curve Might Slope

Upward 282

14-4 Conclusion: Behind the Supply Curve 284 Summary 285 Key Concepts 285 Questions for Review 285 Problems and Applications 286

CHAPTER 15 Monopoly 289 15-1 Why Monopolies Arise 290

15-1a Monopoly Resources 291 15-1b Government-Created Monopolies 291 15-1c Natural Monopolies 292

15-2 How Monopolies Make Production and Pricing Decisions 293

15-2a Monopoly versus Competition 293 15-2b A Monopoly’s Revenue 294 15-2c Profit Maximization 296 15-2d A Monopoly’s Profit 298 FYI: Why a Monopoly Does Not Have a Supply Curve 298 CASE STUDY: Monopoly Drugs versus Generic Drugs 299

xxiCONTENTS

15-3 The Welfare Cost of Monopolies 300 15-3a The Deadweight Loss 301 15-3b The Monopoly’s Profit: A Social Cost? 303

15-4 Price Discrimination 303 15-4a A Parable about Pricing 304 15-4b The Moral of the Story 305 15-4c The Analytics of Price Discrimination 305 15-4d Examples of Price Discrimination 306 IN THE NEWS: Price Discrimination in Higher

Education 308

15-5 Public Policy toward Monopolies 308 15-5a Increasing Competition with Antitrust Laws 308 15-5b Regulation 309 ASK THE EXPERTS: Airline Mergers 309 15-5c Public Ownership 310 15-5d Doing Nothing 311

15-6 Conclusion: The Prevalence of Monopolies 311 Summary 313 Key Concepts 313 Questions for Review 314 Problems and Applications 314

CHAPTER 16 Monopolistic Competition 319 16-1 Between Monopoly and Perfect Competition 320

16-2 Competition with Differentiated Products 322 16-2a The Monopolistically Competitive Firm in the

Short Run 322 16-2b The Long-Run Equilibrium 323 16-2c Monopolistic versus Perfect Competition 324 16-2d Monopolistic Competition and the Welfare of

Society 327

16-3 Advertising 328 16-3a The Debate over Advertising 328 CASE STUDY: Advertising and the Price of Eyeglasses 329 16-3b Advertising as a Signal of Quality 330 16-3c Brand Names 331

16-4 Conclusion 332 Summary 333 Key Concepts 334 Questions for Review 334 Problems and Applications 334

CHAPTER 17 Oligopoly 337 17-1 Markets with Only a Few Sellers 338

17-1a A Duopoly Example 338 17-1b Competition, Monopolies, and Cartels 339 17-1c The Equilibrium for an Oligopoly 340 17-1d How the Size of an Oligopoly Affects the Market

Outcome 341 ASK THE EXPERTS: Nash Equilibrium 341

17-2 The Economics of Cooperation 342 17-2a The Prisoners’ Dilemma 343 17-2b Oligopolies as a Prisoners’ Dilemma 344 CASE STUDY: OPEC and the World Oil Market 345 17-2c Other Examples of the Prisoners’ Dilemma 346 17-2d The Prisoners’ Dilemma and the Welfare of Society 347 17-2e Why People Sometimes Cooperate 348 CASE STUDY: The Prisoners’ Dilemma Tournament 348

17-3 Public Policy toward Oligopolies 349 17-3a Restraint of Trade and the Antitrust Laws 349 CASE STUDY: An Illegal Phone Call 350 17-3b Controversies over Antitrust Policy 350 CASE STUDY: The Microsoft Case 352 IN THE NEWS: Europe versus Google 354

17-4 Conclusion 354 Summary 355 Key Concepts 356 Questions for Review 356 Problems and Applications 356

PART VI The Economics of Labor Markets 359

CHAPTER 18 The Markets for the Factors of Production 361 18-1 The Demand for Labor 362

18-1a The Competitive Profit-Maximizing Firm 363 18-1b The Production Function and the Marginal Product of

Labor 363 18-1c The Value of the Marginal Product and the Demand for

Labor 365 18-1d What Causes the Labor-Demand Curve to Shift? 366 FYI: Input Demand and Output Supply: Two Sides

of the Same Coin 367

18-2 The Supply of Labor 368 18-2a The Trade-off between Work and Leisure 368

xxii CONTENTS

18-2b What Causes the Labor-Supply Curve to Shift? 368 ASK THE EXPERTS: Immigration 369

18-3 Equilibrium in the Labor Market 369 18-3a Shifts in Labor Supply 370 18-3b Shifts in Labor Demand 371 IN THE NEWS: The Economics of Immigration 372 CASE STUDY: Productivity and Wages 373 FYI: Monopsony 374

18-4 The Other Factors of Production: Land and Capital 375 18-4a Equilibrium in the Markets for Land and Capital 375 FYI: What Is Capital Income? 376 18-4b Linkages among the Factors of Production 377 CASE STUDY: The Economics of the Black Death 377

18-5 Conclusion 378 Summary 379 Key Concepts 379 Questions for Review 379 Problems and Applications 380

CHAPTER 19 Earnings and Discrimination 383 19-1 Some Determinants of Equilibrium Wages 384

19-1a Compensating Differentials 384 19-1b Human Capital 385 CASE STUDY: The Increasing Value of Skills 385 ASK THE EXPERTS: Inequality and Skills 386 IN THE NEWS: Schooling as a Public Investment 387 19-1c Ability, Effort, and Chance 388 CASE STUDY: The Benefits of Beauty 388 19-1d An Alternative View of Education: Signaling 389 19-1e The Superstar Phenomenon 390 19-1f Above-Equilibrium Wages: Minimum-Wage Laws,

Unions, and Efficiency Wages 390

19-2 The Economics of Discrimination 391 19-2a Measuring Labor-Market Discrimination 391 CASE STUDY: Is Emily More Employable than

Lakisha? 393 19-2b Discrimination by Employers 393 CASE STUDY: Segregated Streetcars and the Profit

Motive 394 19-2c Discrimination by Customers and

Governments 395 CASE STUDY: Discrimination in Sports 395

19-3 Conclusion 396 Summary 397 Key Concepts 398 Questions for Review 398 Problems and Applications 398

CHAPTER 20 Income Inequality and Poverty 401 20-1 The Measurement of Inequality 402

20-1a U.S. Income Inequality 402 20-1b Inequality around the World 403 IN THE NEWS: A Worldwide View of the Income

Distribution 405 20-1c The Poverty Rate 406 20-1d Problems in Measuring Inequality 407 CASE STUDY: Alternative Measures of Inequality 408 20-1e Economic Mobility 409

20-2 The Political Philosophy of Redistributing Income 409 20-2a Utilitarianism 410 20-2b Liberalism 411 20-2c Libertarianism 412

20-3 Policies to Reduce Poverty 413 20-3a Minimum-Wage Laws 413 20-3b Welfare 414 20-3c Negative Income Tax 414 20-3d In-Kind Transfers 415 20-3e Antipoverty Programs and Work Incentives 415 IN THE NEWS: International Differences in Income

Redistribution 416

20-4 Conclusion 418 Summary 419 Key Concepts 420 Questions for Review 420 Problems and Applications 420

PART VII Topics for Further Study 423

CHAPTER 21 The Theory of Consumer Choice 425 21-1 The Budget Constraint: What the Consumer Can Afford 426

21-2 Preferences: What the Consumer Wants 428 21-2a Representing Preferences with Indifference

Curves 428 21-2b Four Properties of Indifference Curves 429

xxiiiCONTENTS

21-2c Two Extreme Examples of Indifference Curves 430

21-3 Optimization: What the Consumer Chooses 432 21-3a The Consumer’s Optimal Choices 432 FYI: Utility: An Alternative Way to Describe Preferences and

Optimization 433 21-3b How Changes in Income Affect the Consumer’s

Choices 434 21-3c How Changes in Prices Affect the Consumer’s

Choices 435 21-3d Income and Substitution Effects 436 21-3e Deriving the Demand Curve 438

21-4 Three Applications 439 21-4a Do All Demand Curves Slope Downward? 439 CASE STUDY: The Search for Giffen Goods 440 21-4b How Do Wages Affect Labor Supply? 440 CASE STUDY: Income Effects on Labor Supply: Historical

Trends, Lottery Winners, and the Carnegie Conjecture 443 21-4c How Do Interest Rates Affect Household Saving? 444

21-5 Conclusion: Do People Really Think This Way? 446 Summary 447 Key Concepts 448 Questions for Review 448 Problems and Applications 448

CHAPTER 22 Frontiers of Microeconomics 451 22-1 Asymmetric Information 452

22-1a Hidden Actions: Principals, Agents, and Moral Hazard 452

FYI: Corporate Management 453 22-1b Hidden Characteristics: Adverse Selection and

the Lemons Problem 454 22-1c Signaling to Convey Private Information 455 CASE STUDY: Gifts as Signals 455 22-1d Screening to Uncover Private Information 456 22-1e Asymmetric Information and Public Policy 456

22-2 Political Economy 457 22-2a The Condorcet Voting Paradox 457 22-2b Arrow’s Impossibility Theorem 458 22-2c The Median Voter Is King 459 22-2d Politicians Are People Too 461

22-3 Behavioral Economics 461 22-3a People Aren’t Always Rational 462 22-3b People Care about Fairness 463 IN THE NEWS: Using Deviations from Rationality 464 22-3c People Are Inconsistent over Time 466

22-4 Conclusion 467 Summary 468 Key Concepts 468 Questions for Review 468 Problems and Applications 468

PART VIII The Data of Macroeconomics 471

CHAPTER 23 Measuring a Nation’s Income 473 23-1 The Economy’s Income and Expenditure 474

23-2 The Measurement of GDP 476 23-2a “GDP Is the Market Value . . .” 476 23-2b “. . . of All . . .” 476 23-2c “. . . Final . . .” 476 23-2d “. . . Goods and Services . . .” 477 23-2e “. . . Produced . . .” 477 23-2f “. . . Within a Country . . .” 477 23-2g “. . . In a Given Period of Time.” 477 FYI: Other Measures of Income 478

23-3 The Components of GDP 479 23-3a Consumption 479 23-3b Investment 479 IN THE NEWS: Sex, Drugs, and GDP 480 23-3c Government Purchases 480 23-3d Net Exports 480 CASE STUDY: The Components of U.S. GDP 481

23-4 Real versus Nominal GDP 482 23-4a A Numerical Example 482 23-4b The GDP Deflator 484 CASE STUDY: A Half Century of Real GDP 485 IN THE NEWS: Gauging the High-Tech Economy 486

23-5 Is GDP a Good Measure of Economic Well-Being? 486 IN THE NEWS: Measuring Macroeconomic Well-Being 488 CASE STUDY: International Differences in GDP and the

Quality of Life 490

23-6 Conclusion 491 Summary 492 Key Concepts 492 Questions for Review 492 Problems and Applications 493

xxiv CONTENTS

CHAPTER 24 Measuring the Cost of Living 495 24-1 The Consumer Price Index 496

24-1a How the CPI Is Calculated 496 FYI: What’s in the CPI’s Basket? 498 24-1b Problems in Measuring the Cost of Living 499 IN THE NEWS: Monitoring Inflation in the Internet Age 500 24-1c The GDP Deflator versus the Consumer Price Index 502

24-2 Correcting Economic Variables for the Effects of Inflation 503

24-2a Dollar Figures from Different Times 503 FYI: Mr. Index Goes to Hollywood 504 CASE STUDY: Regional Differences in the Cost of Living 505 24-2b Indexation 506 24-2c Real and Nominal Interest Rates 506 CASE STUDY: Interest Rates in the U.S. Economy 508

24-3 Conclusion 508 Summary 510 Key Concepts 510 Questions for Review 510 Problems and Applications 511

PART IX The Real Economy in the Long Run 513

CHAPTER 25 Production and Growth 515 25-1 Economic Growth around the World 516

25-2 Productivity: Its Role and Determinants 518 25-2a Why Productivity Is So Important 518 FYI: Are You Richer Than the Richest American? 518 25-2b How Productivity Is Determined 519 FYI: A Picture Is Worth a Thousand Statistics 520 FYI: The Production Function 523 CASE STUDY: Are Natural Resources a Limit to Growth? 524

25-3 Economic Growth and Public Policy 525 25-3a Saving and Investment 525 25-3b Diminishing Returns and the Catch-Up Effect 525 25-3c Investment from Abroad 527 25-3d Education 528 25-3e Health and Nutrition 528 25-3f Property Rights and Political Stability 529 25-3g Free Trade 530 25-3h Research and Development 531 ASK THE EXPERTS: Innovation and Growth 531 IN THE NEWS: Curmudgeon versus Optimist 532 25-3i Population Growth 534 IN THE NEWS: Using Experiments to Evaluate Aid 536

25-4 Conclusion: The Importance of Long-Run Growth 538 Summary 539 Key Concepts 539 Questions for Review 539 Problems and Applications 540

CHAPTER 26 Saving, Investment, and the Financial System 541 26-1 Financial Institutions in the U.S. Economy 542

26-1a Financial Markets 542 26-1b Financial Intermediaries 544 FYI: Key Numbers for Stock Watchers 545 26-1c Summing Up 546

26-2 Saving and Investment in the National Income Accounts 547

26-2a Some Important Identities 547 26-2b The Meaning of Saving and Investment 549

26-3 The Market for Loanable Funds 549 26-3a Supply and Demand for Loanable Funds 550 26-3b Policy 1: Saving Incentives 551 26-3c Policy 2: Investment Incentives 553 26-3d Policy 3: Government Budget Deficits and Surpluses 554 ASK THE EXPERTS: Fiscal Policy and Saving 555 CASE STUDY: The History of U.S. Government Debt 556 FYI: Financial Crises 558

26-4 Conclusion 558 Summary 559 Key Concepts 560 Questions for Review 560 Problems and Applications 560

CHAPTER 27 The Basic Tools of Finance 563 27-1 Present Value: Measuring the Time Value of Money 564

FYI: The Magic of Compounding and the Rule of 70 566

27-2 Managing Risk 566 27-2a Risk Aversion 566

xxvCONTENTS

27-2b The Markets for Insurance 567 27-2c Diversification of Firm-Specific Risk 568 27-2d The Trade-off between Risk and Return 569

27-3 Asset Valuation 571 27-3a Fundamental Analysis 571 27-3b The Efficient Markets Hypothesis 571 CASE STUDY: Random Walks and Index Funds 572 ASK THE EXPERTS: Diversification 573 27-3c Market Irrationality 573

27-4 Conclusion 574 Summary 575 Key Concepts 575 Questions for Review 575 Problems and Applications 576

CHAPTER 28 Unemployment 577 28-1 Identifying Unemployment 578

28-1a How Is Unemployment Measured? 578 CASE STUDY: Labor-Force Participation of Men and Women in

the U.S. Economy 581 28-1b Does the Unemployment Rate Measure What We Want It

To? 582 28-1c How Long Are the Unemployed without Work? 584 28-1d Why Are There Always Some People Unemployed? 584 FYI: The Jobs Number 585

28-2 Job Search 586 28-2a Why Some Frictional Unemployment Is Inevitable 586 28-2b Public Policy and Job Search 586 28-2c Unemployment Insurance 587

28-3 Minimum-Wage Laws 588 CASE STUDY: Who Earns the Minimum Wage? 589 IN THE NEWS: Should the Minimum Wage Be Raised

to $15 an Hour? 590

28-4 Unions and Collective Bargaining 592 28-4a The Economics of Unions 592 28-4b Are Unions Good or Bad for the Economy? 593

28-5 The Theory of Efficiency Wages 594 28-5a Worker Health 594 28-5b Worker Turnover 594 28-5c Worker Quality 595 28-5d Worker Effort 595 CASE STUDY: Henry Ford and the Very Generous $5-a-Day

Wage 595

28-6 Conclusion 596 Summary 597 Key Concepts 598 Questions for Review 598 Problems and Applications 598

PART X Money and Prices in the Long Run 601

CHAPTER 29 The Monetary System 603 29-1 The Meaning of Money 604

29-1a The Functions of Money 605 29-1b The Kinds of Money 605 IN THE NEWS: Why Gold? 606 29-1c Money in the U.S. Economy 607 CASE STUDY: Where Is All the Currency? 608 FYI: Why Credit Cards Aren’t Money 609

29-2 The Federal Reserve System 609 29-2a The Fed’s Organization 609 29-2b The Federal Open Market Committee 610

29-3 Banks and the Money Supply 611 29-3a The Simple Case of 100-Percent-Reserve Banking 611 29-3b Money Creation with Fractional-Reserve Banking 612 29-3c The Money Multiplier 613 29-3d Bank Capital, Leverage, and the Financial Crisis

of 2008–2009 615

29-4 The Fed’s Tools of Monetary Control 616 29-4a How the Fed Influences the Quantity of Reserves 617 29-4b How the Fed Influences the Reserve Ratio 618 29-4c Problems in Controlling the Money Supply 619 CASE STUDY: Bank Runs and the Money Supply 619 IN THE NEWS: A Trip to Jekyll Island 620 29-4d The Federal Funds Rate 621

29-5 Conclusion 622 Summary 623 Key Concepts 624 Questions for Review 624 Problems and Applications 624

xxvi CONTENTS

CHAPTER 30 Money Growth and Inflation 627 30-1 The Classical Theory of Inflation 629

30-1a The Level of Prices and the Value of Money 629 30-1b Money Supply, Money Demand, and Monetary

Equilibrium 630 30-1c The Effects of a Monetary Injection 631 30-1d A Brief Look at the Adjustment Process 632 30-1e The Classical Dichotomy and Monetary Neutrality 633 30-1f Velocity and the Quantity Equation 634 CASE STUDY: Money and Prices during Four

Hyperinflations 636 30-1g The Inflation Tax 637 FYI: Hyperinflation in Zimbabwe 638 30-1h The Fisher Effect 639

30-2 The Costs of Inflation 640 30-2a A Fall in Purchasing Power? The Inflation Fallacy 641 30-2b Shoeleather Costs 641 30-2c Menu Costs 642 30-2d Relative-Price Variability and the Misallocation of

Resources 642 30-2e Inflation-Induced Tax Distortions 643 30-2f Confusion and Inconvenience 644 30-2g A Special Cost of Unexpected Inflation: Arbitrary

Redistributions of Wealth 645 30-2h Inflation Is Bad, but Deflation May Be Worse 646 CASE STUDY: The Wizard of Oz and the Free-Silver

Debate 646

30-3 Conclusion 647 Summary 649 Key Concepts 649 Questions for Review 649 Problems and Applications 649

PART XI The Macroeconomics of Open Economies 651

CHAPTER 31 Open-Economy Macroeconomics: Basic Concepts 653 31-1 The International Flows of Goods and Capital 654

31-1a The Flow of Goods: Exports, Imports, and Net Exports 654

CASE STUDY: The Increasing Openness of the U.S. Economy 655

IN THE NEWS: The Complicated Politics of Trade Agreements 656

31-1b The Flow of Financial Resources: Net Capital Outflow 658

31-1c The Equality of Net Exports and Net Capital Outflow 659

31-1d Saving, Investment, and Their Relationship to the International Flows 660

31-1e Summing Up 661 CASE STUDY: Is the U.S. Trade Deficit a National

Problem? 662 ASK THE EXPERTS: Trade Balances and Trade Negotiations 664

31-2 The Prices for International Transactions: Real and Nominal Exchange Rates 664

31-2a Nominal Exchange Rates 665 31-2b Real Exchange Rates 665 FYI: The Euro 666

31-3 A First Theory of Exchange-Rate Determination: Purchasing-Power Parity 667

31-3a The Basic Logic of Purchasing-Power Parity 668 31-3b Implications of Purchasing-Power Parity 668 CASE STUDY: The Nominal Exchange Rate during a

Hyperinflation 670 31-3c Limitations of Purchasing-Power Parity 671 CASE STUDY: The Hamburger Standard 671

31-4 Conclusion 672 Summary 673 Key Concepts 673 Questions for Review 674 Problems and Applications 674

CHAPTER 32 A Macroeconomic Theory of the Open Economy 677 32-1 Supply and Demand for Loanable Funds and for Foreign- Currency Exchange 678

32-1a The Market for Loanable Funds 678 32-1b The Market for Foreign-Currency Exchange 680

xxviiCONTENTS

FYI: Purchasing-Power Parity as a Special Case 682

32-2 Equilibrium in the Open Economy 683 32-2a Net Capital Outflow: The Link between the

Two Markets 683 32-2b Simultaneous Equilibrium in Two Markets 684 FYI: Disentangling Supply and Demand 685

32-3 How Policies and Events Affect an Open Economy 686 32-3a Government Budget Deficits 686 32-3b Trade Policy 688 32-3c Political Instability and Capital Flight 690 IN THE NEWS: Is a Strong Currency Always in a Nation’s

Interest? 692 CASE STUDY: Capital Flows from China 694 ASK THE EXPERTS: Currency Manipulation 695

32-4 Conclusion 695 Summary 696 Key Concepts 696 Questions for Review 696 Problems and Applications 697

PART XII Short-Run Economic Fluctuations 699

CHAPTER 33 Aggregate Demand and Aggregate Supply 701 33-1 Three Key Facts about Economic Fluctuations 702

33-1a Fact 1: Economic Fluctuations Are Irregular and Unpredictable 702

33-1b Fact 2: Most Macroeconomic Quantities Fluctuate Together 704

33-1c Fact 3: As Output Falls, Unemployment Rises 704

33-2 Explaining Short-Run Economic Fluctuations 705 33-2a The Assumptions of Classical Economics 705 33-2b The Reality of Short-Run Fluctuations 705 33-2c The Model of Aggregate Demand and

Aggregate Supply 706

33-3 The Aggregate-Demand Curve 707 33-3a Why the Aggregate-Demand Curve Slopes Downward 707 33-3b Why the Aggregate-Demand Curve Might Shift 710

33-4 The Aggregate-Supply Curve 712 33-4a Why the Aggregate-Supply Curve Is Vertical in the

Long Run 712 33-4b Why the Long-Run Aggregate-Supply Curve

Might Shift 713 33-4c Using Aggregate Demand and Aggregate Supply to

Depict Long-Run Growth and Inflation 715 33-4d Why the Aggregate-Supply Curve Slopes Upward

in the Short Run 716 33-4e Why the Short-Run Aggregate-Supply Curve

Might Shift 720

33-5 Two Causes of Economic Fluctuations 721 33-5a The Effects of a Shift in Aggregate Demand 722 FYI: Monetary Neutrality Revisited 724 CASE STUDY: Two Big Shifts in Aggregate Demand:

The Great Depression and World War II 725 CASE STUDY: The Great Recession of 2008–2009 726 IN THE NEWS: What Have We Learned? 728 33-5b The Effects of a Shift in Aggregate Supply 728 CASE STUDY: Oil and the Economy 731 FYI: The Origins of the Model of Aggregate Demand

and Aggregate Supply 732

33-6 Conclusion 733 Summary 734 Key Concepts 734 Questions for Review 735 Problems and Applications 735

CHAPTER 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand 737 34-1 How Monetary Policy Influences Aggregate Demand 738

34-1a The Theory of Liquidity Preference 739 34-1b The Downward Slope of the Aggregate-Demand

Curve 741 FYI: Interest Rates in the Long Run and the Short Run 742 34-1c Changes in the Money Supply 743 34-1d The Role of Interest-Rate Targets in Fed Policy 745 CASE STUDY: Why the Fed Watches the Stock Market (and

Vice Versa) 745 34-1e The Zero Lower Bound 746

34-2 How Fiscal Policy Influences Aggregate Demand 747 34-2a Changes in Government Purchases 747 34-2b The Multiplier Effect 748 34-2c A Formula for the Spending Multiplier 748 34-2d Other Applications of the Multiplier Effect 750 34-2e The Crowding-Out Effect 750 34-2f Changes in Taxes 752 FYI: How Fiscal Policy Might Affect Aggregate Supply 752

34-3 Using Policy to Stabilize the Economy 753 34-3a The Case for Active Stabilization Policy 753 IN THE NEWS: How Large Is the Fiscal Policy Multiplier? 754

xxviii CONTENTS

CASE STUDY: Keynesians in the White House 756 ASK THE EXPERTS: Economic Stimulus 756 34-3b The Case against Active Stabilization Policy 756 34-3c Automatic Stabilizers 758

34-4 Conclusion 758 Summary 759 Key Concepts 760 Questions for Review 760 Problems and Applications 760

CHAPTER 35 The Short-Run Trade-off between Inflation and Unemployment 763 35-1 The Phillips Curve 764

35-1a Origins of the Phillips Curve 764 35-1b Aggregate Demand, Aggregate Supply, and the

Phillips Curve 765

35-2 Shifts in the Phillips Curve: The Role of Expectations 767 35-2a The Long-Run Phillips Curve 767 35-2b The Meaning of “Natural” 769 35-2c Reconciling Theory and Evidence 770 35-2d The Short-Run Phillips Curve 771 35-2e The Natural Experiment for the Natural-Rate

Hypothesis 772

35-3 Shifts in the Phillips Curve: The Role of Supply Shocks 773

35-4 The Cost of Reducing Inflation 776 35-4a The Sacrifice Ratio 777 35-4b Rational Expectations and the Possibility of Costless

Disinflation 778 35-4c The Volcker Disinflation 779 35-4d The Greenspan Era 780 35-4e A Financial Crisis Takes Us for a Ride along the Phillips

Curve 781

35-5 Conclusion 782 Summary 784 Key Concepts 784 Questions for Review 784 Problems and Applications 784

PART XIII Final Thoughts 787 CHAPTER 36 Six Debates over Macroeconomic Policy 789 36-1 Should Monetary and Fiscal Policymakers Try to Stabilize the Economy? 790

36-1a Pro: Policymakers Should Try to Stabilize the Economy 790

36-1b Con: Policymakers Should Not Try to Stabilize the Economy 790

36-2 Should the Government Fight Recessions with Spending Hikes Rather Than Tax Cuts? 792

36-2a Pro: The Government Should Fight Recessions with Spending Hikes 792

36-2b Con: The Government Should Fight Recessions with Tax Cuts 793

36-3 Should Monetary Policy Be Made by Rule Rather Than by Discretion? 794

36-3a Pro: Monetary Policy Should Be Made by Rule 795 36-3b Con: Monetary Policy Should Not Be Made by Rule 796 FYI: Inflation Targeting 797

36-4 Should the Central Bank Aim for Zero Inflation? 797 36-4a Pro: The Central Bank Should Aim for Zero Inflation 798 36-4b Con: The Central Bank Should Not Aim for Zero

Inflation 799 IN THE NEWS: On Kiwis and Currencies 800

36-5 Should the Government Balance Its Budget? 802 36-5a Pro: The Government Should Balance Its Budget 802 36-5b Con: The Government Should Not Balance

Its Budget 803

36-6 Should the Tax Laws Be Reformed to Encourage Saving? 805

36-6a Pro: The Tax Laws Should Be Reformed to Encourage Saving 805

ASK THE EXPERTS: Taxing Capital and Labor 806 36-6b Con: The Tax Laws Should Not Be Reformed

to Encourage Saving 806

36-7 Conclusion 807 Summary 808 Questions for Review 809 Problems and Applications 809

Glossary 811 Index 819

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4 PART I INTRODUCTION

Like a household, a society faces many decisions. It must find some way to decide what jobs will be done and who will do them. It needs some people to grow food, other people to make clothing, and still others to design computer soft- ware. Once society has allocated people (as well as land, buildings, and machines) to various jobs, it must also allocate the goods and services they produce. It must decide who will eat caviar and who will eat potatoes. It must decide who will drive a Tesla and who will take the bus.

The management of society’s resources is important because resources are scarce. Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Just as each member of a household cannot get everything she wants, each individual in a society cannot attain the highest standard of living to which she might aspire.

Economics is the study of how society manages its scarce resources. In most so- cieties, resources are allocated not by an all-powerful dictator but through the com- bined choices of millions of households and firms. Economists, therefore, study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people inter- act with one another. For instance, they examine how the multitude of buyers and sellers of a good together determine the price at which the good is sold and the quantity that is sold. Finally, economists analyze the forces and trends that affect the economy as a whole, including the growth in average income, the fraction of the population that cannot find work, and the rate at which prices are rising.

The study of economics has many facets, but it is unified by several central ideas. In this chapter, we look at Ten Principles of Economics. Don’t worry if you don’t understand them all at first or if you aren’t completely convinced. We explore these ideas more fully in later chapters. The ten principles are introduced here to give you an overview of what economics is all about. Consider this chapter a “preview of coming attractions.”

scarcity the limited nature of society’s resources

economics the study of how soci- ety manages its scarce resources

There is no mystery to what an economy is. Whether we are talking about the economy of Los Angeles, the United States, or the whole world, an economy is just a group of people dealing with one another as they go about their lives. Because the behavior of an economy reflects the behavior of the individuals who make up the economy, we begin our study of economics with four principles about indi- vidual decision making.

1-1a Principle 1: People Face Trade-offs You may have heard the old saying, “There ain’t no such thing as a free lunch.” Grammar aside, there is much truth to this adage. To get something that we like, we usually have to give up something else that we also like. Making decisions requires trading off one goal against another.

Consider a student who must decide how to allocate her most valuable resource—her time. She can spend all of her time studying economics, spend all of it studying psychology, or divide it between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other. And for every hour she spends studying, she gives up an hour she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money.

1-1 How People Make Decisions

5CHAPTER 1 TEN PRINCIPLES OF ECONOMICS

Consider parents deciding how to spend their family income. They can buy food, clothing, or a family vacation. Or they can save some of the family income for retirement or the children’s college education. When they choose to spend an extra dollar on one of these goods, they have one less dollar to spend on some other good.

When people are grouped into societies, they face different kinds of trade-offs. One classic trade-off is between “guns and butter.” The more a society spends on national defense (guns) to protect its shores from foreign aggressors, the less it can spend on consumer goods (butter) to raise the standard of living at home. Also important in modern society is the trade-off between a clean environment and a high level of income. Laws that require firms to reduce pollution raise the cost of producing goods and services. Because of these higher costs, the firms end up earn- ing smaller profits, paying lower wages, charging higher prices, or some combina- tion of these three. Thus, while pollution regulations yield the benefit of a cleaner environment and the improved health that comes with it, they come at the cost of reducing the incomes of the regulated firms’ owners, workers, and customers.

Another trade-off society faces is between efficiency and equality. Efficiency means that society is getting the maximum benefits from its scarce resources. Equal- ity means that those benefits are distributed uniformly among society’s members. In other words, efficiency refers to the size of the economic pie, and equality refers to how the pie is divided into individual slices.

When government policies are designed, these two goals often conflict. Consider, for instance, policies aimed at equalizing the distribution of economic well-being. Some of these policies, such as the welfare system or unemployment insurance, try to help the members of society who are most in need. Others, such as the in- dividual income tax, ask the financially successful to contribute more than others to support the government. Though they achieve greater equality, these policies reduce efficiency. When the government redistributes income from the rich to the poor, it reduces the reward for working hard; as a result, people work less and produce fewer goods and services. In other words, when the government tries to cut the economic pie into more equal slices, the pie gets smaller.

Recognizing that people face trade-offs does not by itself tell us what decisions they will or should make. A student should not abandon the study of psychology just because doing so would increase the time available for the study of economics. Society should not stop protecting the environment just because environmental reg- ulations reduce our material standard of living. The poor should not be ignored just because helping them distorts work incentives. Nonetheless, people are likely to make good decisions only if they understand the options that are available to them. Our study of economics, therefore, starts by acknowledging life’s trade-offs.

1-1b Principle 2: The Cost of Something Is What You Give Up to Get It Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative courses of action. In many cases, however, the cost of an action is not as obvious as it might first appear.

Consider the decision to go to college. The main benefits are intellectual enrich- ment and a lifetime of better job opportunities. But what are the costs? To answer this question, you might be tempted to add up the money you spend on tuition, books, room, and board. Yet this total does not truly represent what you give up to spend a year in college.

There are two problems with this calculation. First, it includes some things that are not really costs of going to college. Even if you quit school, you need a place

efficiency the property of society getting the most it can from its scarce resources

equality the property of distribut- ing economic prosperity uniformly among the members of society

6 PART I INTRODUCTION

to sleep and food to eat. Room and board are costs of going to college only to the extent that they are more expensive at college than elsewhere. Second, this calcu- lation ignores the largest cost of going to college—your time. When you spend a year listening to lectures, reading textbooks, and writing papers, you cannot spend that time working at a job. For most students, the earnings they give up to attend school are the single largest cost of their education.

The opportunity cost of an item is what you give up to get that item. When making any decision, decision makers should be aware of the opportunity costs that accompany each possible action. In fact, they usually are. College athletes who can earn millions if they drop out of school and play professional sports are well aware that their opportunity cost of attending college is very high. It is not surprising that they often decide that the benefit of a college education is not worth the cost.

1-1c Principle 3: Rational People Think at the Margin Economists normally assume that people are rational. Rational people systemat- ically and purposefully do the best they can to achieve their objectives, given the available opportunities. As you study economics, you will encounter firms that decide how many workers to hire and how much of their product to manufacture and sell to maximize profits. You will also encounter individuals who decide how much time to spend working and what goods and services to buy with the result- ing income to achieve the highest possible level of satisfaction.

Rational people know that decisions in life are rarely black and white but usu- ally involve shades of gray. At dinnertime, the question you face is not “Should I fast or eat like a pig?” More likely, you will be asking yourself “Should I take that extra spoonful of mashed potatoes?” When exams roll around, your decision is not between blowing them off and studying 24 hours a day but whether to spend an extra hour reviewing your notes instead of watching TV. Economists use the term marginal change to describe a small incremental adjustment to an existing plan of action. Keep in mind that margin means “edge,” so marginal changes are adjustments around the edges of what you are doing. Rational people often make decisions by comparing marginal benefits and marginal costs.

For example, suppose you are considering calling a friend on your cell phone. You decide that talking with her for 10 minutes would give you a benefit that you value at about $7. Your cell phone service costs you $40 per month plus $0.50 per minute for whatever calls you make. You usually talk for 100 minutes a month, so your total monthly bill is $90 ($0.50 per minute times 100 minutes, plus the $40 fixed fee). Under these circumstances, should you make the call? You might be tempted to reason as follows: “Because I pay $90 for 100 minutes of calling each month, the average minute on the phone costs me $0.90. So a 10-minute call costs $9. Because that $9 cost is greater than the $7 benefit, I am going to skip the call.” That conclusion is wrong, however. Although the average cost of a 10-minute call is $9, the marginal cost—the amount your bill increases if you make the extra call—is only $5. You will make the right decision only by comparing the marginal benefit and the marginal cost. Because the marginal benefit of $7 is greater than the mar- ginal cost of $5, you should make the call. This is a principle that people innately understand: Cell phone users with unlimited minutes (that is, minutes that are free at the margin) are often prone to making long and frivolous calls.

Thinking at the margin works for business decisions as well. Consider an airline deciding how much to charge passengers who fly standby. Suppose that flying a 200-seat plane across the United States costs the airline $100,000. In this case, the

opportunity cost whatever must be given up to obtain some item

rational people people who systematically and purposefully do the best they can to achieve their objectives

marginal change a small incremental adjustment to a plan of action

7CHAPTER 1 TEN PRINCIPLES OF ECONOMICS

average cost of each seat is $100,000/200, which is $500. One might be tempted to conclude that the airline should never sell a ticket for less than $500. But a ratio- nal airline can increase its profits by thinking at the margin. Imagine that a plane is about to take off with 10 empty seats and a standby passenger waiting at the gate is willing to pay $300 for a seat. Should the airline sell the ticket? Of course it should. If the plane has empty seats, the cost of adding one more passenger is tiny. The average cost of flying a passenger is $500, but the marginal cost is merely the cost of the can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal cost, selling the ticket is profitable.

Marginal decision making can help explain some otherwise puzzling economic phenomena. Here is a classic question: Why is water so cheap, while diamonds are so expensive? Humans need water to survive, while diamonds are unneces- sary. Yet people are willing to pay much more for a diamond than for a cup of water. The reason is that a person’s willingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield. The marginal bene- fit, in turn, depends on how many units a person already has. Water is essential, but the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large.

A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. This principle explains why people use their cell phones as much as they do, why airlines are willing to sell tickets below aver- age cost, and why people are willing to pay more for diamonds than for water. It can take some time to get used to the logic of marginal thinking, but the study of economics will give you ample opportunity to practice.

1-1d Principle 4: People Respond to Incentives An incentive is something (such as the prospect of a punishment or reward) that induces a person to act. Because rational people make decisions by comparing costs and benefits, they respond to incentives. You will see that incentives play a central role in the study of economics. One economist went so far as to suggest that the entire field could be summarized as simply “People respond to incen- tives. The rest is commentary.”

Incentives are key to analyzing how markets work. For example, when the price of an apple rises, people decide to eat fewer apples. At the same time, apple orchards decide to hire more workers and harvest more apples. In other words, a higher price in a market provides an incentive for buyers to consume less and an incentive for sellers to produce more. As we will see, the influence of prices on the behavior of consumers and producers is crucial to how a market economy allocates scarce resources.

Public policymakers should never forget about incentives: Many policies change the costs or benefits that people face and, as a result, alter their behavior. A tax on gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars. That is one reason people drive smaller cars in Europe, where gasoline taxes are high, than in the United States, where gasoline taxes are low. A higher gasoline tax also encourages people to carpool, take public transportation, and live closer to where they work. If the tax were larger, more people would be driving hybrid cars, and if it were large enough, they would switch to electric cars.

When policymakers fail to consider how their policies affect incentives, they often end up facing unintended consequences. For example, consider public policy regarding auto safety. Today, all cars have seat belts, but this was not true

incentive something that induces a person to act

“ Is the marginal benefit of this call greater than the marginal cost?”

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8 PART I INTRODUCTION

60 years ago. In 1965, Ralph Nader’s book Unsafe at Any Speed generated much public concern over auto safety. Congress responded with laws requiring seat belts as standard equipment on new cars.

How does a seat belt law affect auto safety? The direct effect is obvious: When a person wears a seat belt, the probability of surviving an auto accident rises. But that’s not the end of the story because the law also affects behavior by altering incentives. The relevant behavior here is the speed and care with which drivers op- erate their cars. Driving slowly and carefully is costly because it uses the driver’s time and energy. When deciding how safely to drive, rational people compare, per- haps unconsciously, the marginal benefit from safer driving to the marginal cost. As a result, they drive more slowly and carefully when the benefit of increased safety is high. For example, when road conditions are icy, people drive more atten- tively and at lower speeds than they do when road conditions are clear.

Consider how a seat belt law alters a driver’s cost–benefit calculation. Seat belts make accidents less costly because they reduce the likelihood of injury or death. In other words, seat belts reduce the benefits of slow and careful driving. People respond to seat belts as they would to an improvement in road conditions—by driving faster and less carefully. The result of a seat belt law, therefore, is a larger number of accidents. The decline in safe driving has a clear, adverse impact on pedestrians, who are more likely to find themselves in an accident but (unlike the drivers) don’t have the benefit of added protection.

At first, this discussion of incentives and seat belts might seem like idle specu- lation. Yet in a classic 1975 study, economist Sam Peltzman argued that auto-safety laws have had many of these effects. According to Peltzman’s evidence, these laws give rise to fewer deaths per accident but also to more accidents. He con- cluded that the net result is little change in the number of driver deaths and an increase in the number of pedestrian deaths.

Peltzman’s analysis of auto safety is an offbeat and controversial example of the general principle that people respond to incentives. When analyzing any pol- icy, we must consider not only the direct effects but also the less obvious indirect effects that work through incentives. If the policy changes incentives, it will cause people to alter their behavior.

QuickQuiz Describe an important trade-off you recently faced. Give an example of some action that has both a monetary and nonmonetary opportunity cost.

Describe an incentive your parents offered to you in an effort to influence your behavior.

1-2 How People Interact The first four principles discussed how individuals make decisions. As we go about our lives, many of our decisions affect not only ourselves but other people as well. The next three principles concern how people interact with one another.

1-2a Principle 5: Trade Can Make Everyone Better Off You may have heard on the news that the Chinese are our competitors in the world economy. In some ways, this is true because American and Chinese firms produce many of the same goods. Companies in the United States and China compete for the same customers in the markets for clothing, toys, solar panels, automobile tires, and many other items.

Yet it is easy to be misled when thinking about competition among countries. Trade between the United States and China is not like a sports contest in which

9CHAPTER 1 TEN PRINCIPLES OF ECONOMICS

one side wins and the other side loses. In fact, the opposite is true: Trade between two countries can make each country better off.

To see why, consider how trade affects your family. When a member of your family looks for a job, she competes against members of other families who are looking for jobs. Families also compete against one another when they go shop- ping because each family wants to buy the best goods at the lowest prices. In a sense, each family in an economy competes with all other families.

Despite this competition, your family would not be better off isolating itself from all other families. If it did, your family would need to grow its own food, make its own clothes, and build its own home. Clearly, your family gains much from its ability to trade with others. Trade allows each person to specialize in the activities she does best, whether it is farming, sewing, or home building. By trad- ing with others, people can buy a greater variety of goods and services at lower cost.

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