Principles of economics 5th edition

Brief ContentsPART I INTRODUCTION C HAPTER 1Ten Principles of Economics C HAPTER 2Thinking Like an Economist C HAPTER 3Interdependence and the Gains from Trade PART II HOW MARKETS WORK C

Principles of Economics, 5e

N Gregory Mankiw

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

About the Author

N Gregory Mankiw is professor of economics at Harvard University As a student, hestudied economics at Princeton University and MIT As a teacher, he has taughtmacroeconomics, microeconomics, statistics, and principles of economics He evenspent 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 Economy, 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 associate of the National Bureau of EconomicResearch, an adviser to the Federal Reserve Bank of Boston and the CongressionalBudget Office, and a member of the ETS test development committee for the AdvancedPlacement exam in economics From 2003 to 2005, he served as chairman of thePresident’s Council of Economic Advisers

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

Brief Contents

PART I INTRODUCTION

C HAPTER 1Ten Principles of Economics

C HAPTER 2Thinking Like an Economist

C HAPTER 3Interdependence and the Gains from Trade

PART II HOW MARKETS WORK

C HAPTER 4The Market Forces of Supply and Demand

C HAPTER 5Elasticity and Its Application

C HAPTER 6Supply, Demand, and Government Policies

PART III MARKETS AND WELFARE

C HAPTER 7Consumers, Producers, and the Efficiency of Markets

C HAPTER 8Application: The Costs of Taxation

C HAPTER 9Application: International Trade

PART IV THE ECONOMICS OF THE PUBLIC SECTOR

C HAPTER 10Externalities

C HAPTER 11Public Goods and Common Resources

C HAPTER 12The Design of the Tax System

PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

C HAPTER 13The Costs of Production

C HAPTER 14Firms in Competitive Markets

C HAPTER 15Monopoly

C HAPTER 16Monopolistic Competition

C HAPTER 17Oligopoly

PART VI THE ECONOMICS OF LABOR MARKETS

C HAPTER 18The Markets for the Factors of Production

C HAPTER 19Earnings and Discrimination

C HAPTER 20Income Inequality and Poverty

PART VII TOPICS FOR FURTHER STUDY

C HAPTER 21The Theory of Consumer Choice

C HAPTER 22Frontiers of Microeconomics

PART VIII THE DATA OF MACROECONOMICS

C HAPTER 23Measuring a Nation’s Income

C HAPTER 24Measuring the Cost of Living

PART IX THE REAL ECONOMY IN THE LONG RUN

C HAPTER 25Production and Growth

C HAPTER 26Saving, Investment, and the Financial System

C HAPTER 27The Basic Tools of Finance

C HAPTER 28Unemployment

PART X MONEY AND PRICES IN THE LONG RUN

C HAPTER 29The Monetary System

C HAPTER 30Money Growth and Inflation

PART XI THE MACROECONOMICS OF OPEN ECONOMIES

C HAPTER 31Open-Economy Macroeconomics: Basic Concepts

C HAPTER 32A Macroeconomic Theory of the Open Economy

PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

C HAPTER 33Aggregate Demand and Aggregate Supply

C HAPTER 34The Influence of Monetary and Fiscal Policy on Aggregate Demand

C HAPTER 35The Short-Run Trade-off between Inflation and Unemployment PART XIII FINAL THOUGHTS

C HAPTER 36Five Debates over Macroeconomic Policy

Preface: To the Student

“Economics 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.

Although we have learned much about the economy since Marshall’s time, thisdefinition of economics is as true today as it was in 1890, when the first edition of histext was published

Why should you, as a student at the beginning of 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 whichyou 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 around-trip ticket if the traveler stays over a Saturday night? Why is Johnny Depp paid somuch 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 Whileyou 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 investyour savings Someday you may find yourself running a small business or a largecorporation, and you will decide what prices to charge for your products The insightsdeveloped in the coming chapters will give you a new perspective on how best to makethese decisions Studying economics will not by itself make you rich, but it will give yousome tools that may help in that endeavor

The third reason to study economics is that it will give you a better understanding ofboth the potential and the limits of economic policy Economic questions are always onthe minds of policymakers in mayors’ offices, governors’ mansions, and the WhiteHouse What are the burdens associated with alternative forms of taxation? What arethe effects of free trade with other countries? What is the best way to protect theenvironment? 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 Anunderstanding 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 Whetherthe future finds you reading the newspaper, running a business, or sitting in the OvalOffice, you will be glad that you studied economics

N Gregory Mankiw September 2008

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In 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 sovaluable, 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 four editions of thistext and its supplemental materials have benefited enormously from their input Inreviews and surveys, they have offered suggestions, identified challenges, and sharedideas from their own classroom experience I am indebted to them for the perspectivesthey have brought to the text Unfortunately, the list has become too long to thank thosewho contributed to previous editions, even though students reading the current editionare still benefiting from their insights

Most important in this process have been Ron Cronovich (Carthage College) and DavidHakes (University of Northern Iowa) Ron and David, both dedicated teachers, haveserved as reliable sounding boards for ideas and hardworking partners with me inputting together the superb package of supplements

For this new edition, the following diary reviewers recorded their day-to-day experienceover the course of a semester, offering detailed suggestions about how to improve thetext

John Crooker, University of Central Missouri

Rachel Friedberg, Brown University

Greg Hunter, California State University, Polytechnic, Pomona

Lillian Kamal, Northwestern University

Francis Kemegue, Bryant University

Douglas Miller, University of Missouri

Babu Nahata, University of Louisville

Edward Skelton, Southern Methodist University

The following reviewers of the fourth edition provided suggestions for refining thecontent, organization, and approach in the fifth

Syed Ahmed, Cameron University

Farhad Ameen, State University of New York, Westchester Community College

Mohammad Bajwa, Northampton Community College

Carl Bauer, Oakton Community College

Roberta Biby, Grand Valley State University

Stephen Billings, University of Colorado at Boulder

Bruce Brown, California State University, Polytechnic, Pomona

Lynn Burbridge, Northern Kentucky University

Mark Chester, Reading Area Community College

David Ching, University of Hawaii, Manoa

Sarah Cosgrove, University of Massachusetts, Dartmouth

Craig Depken, University of North Carolina, Charlotte

Angela Dzata, Alabama State University

Jose Esteban, Palomar College

Mark Frascatore, Clarkson University

Satyajit Ghosh, University of Scranton

Soma Ghosh, Bridgewater State College

Daniel Giedeman, Grand Valley State University

Robert L Holland, Purdue University

Anisul Islam, University of Houston, Downtown

Nancy Jianakoplos, Colorado State University

Paul Johnson, University of Alaska, Anchorage

Robert Jones, University of Massachusetts, Dartmouth

Lillian Kamal, Northwestern University

Jongsung Kim, Bryant University

Marek Kolar, Delta College

Leonard Lardaro, University of Rhode Island

Nazma Latif-Zaman, Providence College

William Mertens, University of Colorado

Francis Mummery, Fullerton College

David Mushinski, Colorado State University

Christopher Mushrush, Illinois State University

Babu Nahata, University of Louisville

Laudo Ogura, Grand Valley State University

Michael Patrono, Okaloosa-Walton College

Jeff Rubin, Rutgers University, New Brunswick

Samuel Sarri, College of Southern Nevada

Harinder Singh, Grand Valley State University

David Spencer, University of Michigan

David Switzer, Saint Cloud State University

Henry Terrell, University of Maryland

Ngocbich Tran, San Jacinto College

Miao Wang, Marquette University

Elizabeth Wheaton, Southern Methodist University

Martin Zelder, Northwestern University

I received detailed feedback on specific elements in the text, including all end-of-chapterproblems and applications, from the following instructors

Casey R Abington, Kansas State University

Seemi Ahmad, Dutchess Community College

Farhad Ameen, State University of New York, Westchester Community College

J J Arias, Georgia College & State University

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David Franck, Francis Marion University

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Charles E Hegji, Auburn University at Montgomery

Andrew J Hussey, University of Memphis

Hans R Isakson, University of Northern Iowa

Simran Kahai, John Carroll University

David E Kalist, Shippensburg University

Mark P Karscig, University of Central Missouri

Theodore Kuhn, Butler University

Dong Li, Kansas State University

Daniel Lin, George Mason University

Nathaniel Manning, Southern University

Vince Marra, University of Delaware

Akbar Marvasti, University of Southern Mississippi

Heather Mattson, University of Saint Thomas

Charles C Moul, Washington University in St Louis

Albert A Okunade, University of Memphis

J Brian O’Roark, Robert Morris University

Anthony L Ostrosky, Illinois State University

Nitin V Paranjpe, Wayne State University & Oakland University

Sanela Por a, University of South Carolina, Aiken

Walter G Park, American University

Reza M Ramazani, Saint Michael’s College

Rhonda Vonshay Sharpe, University of Vermont

Carolyn Fabian Stumph, Indiana University–Purdue University Fort Wayne

Rick Tannery, Slippery Rock University

Aditi Thapar, New York University

Michael H Tew, Troy University

Jennifer A Vincent, Champlain College

Milos Vulanovic, Lehman College

Bhavneet Walia, Kansas State University

Douglas M Walker, College of Charleston

Patrick Walsh, Saint Michael’s College

Larry Wolfenbarger, Macon State College

William C Wood, James Madison University

Chiou-nan Yeh, Alabama State University

The accuracy of a textbook is critically important I am responsible for any remainingerrors, but I am grateful to the following professors for reading through the finalmanuscript and page proofs with me:

Joel Dalafave, Bucks County Community College

Greg Hunter, California State University –Pomona

Lillian Kamal, Northwestern University

Francis Kemegue, Bryant University

Douglas Miller, University of Missouri

Ed Skelton, Southern Methodist University

The team of editors who worked on this book improved it tremendously Jane Tufts,developmental editor, provided truly spectacular editing—as she always does MikeWorls, economics executive editor, did a splendid job of overseeing the many peopleinvolved in such a large project Jennifer Thomas (senior developmental editor) andKatie Yanos (developmental editor) were crucial in assembling an extensive andthoughtful group of reviewers to give me feedback on the previous edition, while puttingtogether an excellent team to revise the supplements Colleen Farmer, senior contentproject manager, and Katherine Wilson, senior project manager, had the patience anddedication necessary to turn my manuscript into this book Michelle Kunkler, senior artdirector, gave this book its clean, friendly look Michael Steirnagle, the illustrator, helpedmake the book more visually appealing and the economics in it less abstract CarolynCrabtree, copyeditor, refined my prose, and Terry Casey, indexer, prepared a carefuland thorough index Brian Joyner, executive marketing manager, worked long hoursgetting the word out to potential users of this book The rest of the Cengage team,

including Jean Buttrom, Sandra Milewski and Deepak Kumar, was also consistentlyprofessional, enthusiastic, and dedicated.

I am grateful also to Josh Bookin, a former Advanced Placement economics teacherand recently an extraordinary section leader for Ec 10, the introductory course atHarvard Josh helped me refine the manuscript and check the page proofs for thisedition

As always, I must thank my “in-house” editor Deborah Mankiw As the first reader ofalmost everything I write, she continued to offer just the right mix of criticism andencouragement

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

Chapter 4

) Maybe sometime soon one of them will pick up my passion for economics as well

N Gregory Mankiw September 2008

TEN PRINCIPLES OF ECONOMICS

How People Make Decisions

Principle 1: People Face Trade-offs

Principle 2: The Cost of Something Is What You Give Up to Get It

Principle 3: Rational People Think at the Margin

Principle 4: People Respond to Incentives

How People Interact

Principle 5: Trade Can Make Everyone Better Off

Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

IN THE NEWSIncentive Pay

Principle 7: Governments Can Sometimes Improve Market Outcomes

FYIAdam Smith and the Invisible Hand

How the Economy as a Whole Works

Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods andServices

Principle 9: Prices Rise When the Government Prints Too Much Money

IN THE NEWSWhy You Should Study Economics

Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment

Conclusion

FYIHow to Read This Book

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 2

THINKING LIKE AN ECONOMIST

The Economist as Scientist

The Scientific Method: Observation, Theory, and More Observation

The Role of Assumptions

Economic Models

Our First Model: The Circular-Flow Diagram

Our Second Model: The Production Possibilities Frontier

Microeconomics and Macroeconomics

FYIWho Studies Economics?

The Economist as Policy Adviser

Positive versus Normative Analysis

Economists in Washington

IN THE NEWSFootball Economics

Why Economists’ Advice Is Not Always Followed

Why Economists Disagree

Differences in Scientific Judgments

Differences in Values

Perception versus Reality

Let’s Get Going

IN THE NEWSEnvironmental Economics

Summary

Key Concepts

Questions for Review

Problems and Applications

APPENDIX Graphing: A Brief Review

Graphs of a Single Variable

Graphs of Two Variables: The Coordinate System

Curves in the Coordinate System

Slope

Cause and Effect

CHAPTER 3

INTERDEPENDENCE AND THE GAINS FROM TRADE

A Parable for the Modern Economy

Production Possibilities

Specialization and Trade

Comparative Advantage: The Driving Force of Specialization

Absolute Advantage

Opportunity Cost and Comparative Advantage

Comparative Advantage and Trade

The Price of the Trade

Applications of Comparative Advantage

FYIThe Legacy of Adam Smith and David Ricardo

Should Tiger Woods Mow His Own Lawn?

Should the United States Trade with Other Countries?

IN THE NEWSThe Changing Face of International Trade

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

PART II

HOW MARKETS WORK

CHAPTER 4

THE MARKET FORCES OF SUPPLY AND DEMAND

Markets and Competition

What Is a Market?

What Is Competition?

Demand

The Demand Curve: The Relationship between Price and Quantity Demanded

Market Demand versus Individual Demand

Shifts in the Demand Curve

CASE STUDYTwo Ways to Reduce the Quantity of Smoking Demanded

Supply

The Supply Curve: The Relationship between Price and Quantity Supplied

Market Supply versus Individual Supply

Shifts in the Supply Curve

Supply and Demand Together

Equilibrium

Three Steps to Analyzing Changes in Equilibrium

Conclusion: How Prices Allocate Resources

IN THE NEWSThe Helium Market

IN THE NEWSPrice Increases after Natural Disasters

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 5

ELASTICITY AND ITS APPLICATION

The Elasticity of Demand

The Price Elasticity of Demand and Its Determinants

Computing the Price Elasticity of Demand

The Midpoint Method: A Better Way to Calculate Percentage Changes and ElasticitiesThe Variety of Demand Curves

Total Revenue and the Price Elasticity of Demand

Elasticity and Total Revenue along a Linear Demand Curve

Other Demand Elasticities

IN THE NEWSEnergy Demand

The Elasticity of Supply

The Price Elasticity of Supply and Its Determinants

Computing the Price Elasticity of Supply

The Variety of Supply Curves

Three Applications of Supply, Demand, and Elasticity

Can Good News for Farming Be Bad News for Farmers?

Why Did OPEC Fail to Keep the Price of Oil High?

Does Drug Interdiction Increase or Decrease Drug-Related Crime?

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 6

SUPPLY, DEMAND, AND GOVERNMENT POLICIES

Controls on Prices

How Price Ceilings Affect Market Outcomes

CASE STUDYLines at the Gas Pump

CASE STUDYRent Control in the Short Run and the Long Run

How Price Floors Affect Market Outcomes

CASE STUDYThe Minimum Wage

Evaluating Price Controls

IN THE NEWSPresident Chavez versus the Market

Taxes

How Taxes on Sellers Affect Market Outcomes

How Taxes on Buyers Affect Market Outcomes

CASE STUDYCan Congress Distribute the Burden of a Payroll Tax?

Elasticity and Tax Incidence

CASE STUDYWho Pays the Luxury Tax?

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

Using the Demand Curve to Measure Consumer Surplus

How a Lower Price Raises Consumer Surplus

What Does Consumer Surplus Measure?

Producer Surplus

Cost and the Willingness to Sell

Using the Supply Curve to Measure Producer Surplus

How a Higher Price Raises Producer Surplus

Market Efficiency

The Benevolent Social Planner

Evaluating the Market Equilibrium

CASE STUDYShould There Be a Market in Organs?

IN THE NEWSTicket Scalping

Conclusion: Market Efficiency and Market Failure

IN THE NEWSThe Miracle of the Market

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 8

APPLICATION: THE COSTS OF TAXATION

The Deadweight Loss of Taxation

How a Tax Affects Market Participants

Deadweight Losses and the Gains from Trade

The Determinants of the Deadweight Loss

CASE STUDYThe Deadweight Loss Debate

Deadweight Loss and Tax Revenue as Taxes Vary

FYIHenry George and the Land Tax

CASE STUDYThe Laffer Curve and Supply-Side Economics

IN THE NEWSOn the Way to France

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 9

APPLICATION: INTERNATIONAL TRADE

The Determinants of Trade

The Equilibrium without Trade

The World Price and Comparative Advantage

The Winners and Losers from Trade

The Gains and Losses of an Exporting Country

The Gains and Losses of an Importing Country

The Effects of a Tariff

The Lessons for Trade Policy

FYIImport Quotas: Another Way to Restrict Trade

Other Benefits of International Trade

IN THE NEWSShould the Winners from Free Trade Compensate the Losers? The Arguments for Restricting Trade

The Jobs Argument

IN THE NEWSOffshore Outsourcing

The National-Security Argument

The Infant-Industry Argument

The Unfair-Competition Argument

The Protection-as-a-Bargaining-Chip Argument

IN THE NEWSSecond Thoughts about Free Trade

CASE STUDYTrade Agreements and the World Trade Organization

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

PART IV

THE ECONOMICS OF THE PUBLIC SECTOR

CHAPTER 10

EXTERNALITIES

Externalities and Market Inefficiency

Welfare Economics: A Recap

Negative Externalities

Positive Externalities

CASE STUDYTechnology Spillovers, Industrial Policy, and Patent Protection Public Policies toward Externalities

Command-and-Control Policies: Regulation

Market-Based Policy 1: Corrective Taxes and Subsidies

CASE STUDYWhy Is Gasoline Taxed So Heavily?

Market-Based Policy 2: Tradable Pollution Permits

Objections to the Economic Analysis of Pollution

Private Solutions to Externalities

The Types of Private Solutions

IN THE NEWSThe Case for Taxing Carbon

The Coase Theorem

Why Private Solutions Do Not Always Work

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 11

PUBLIC GOODS AND COMMON RESOURCES

The Different Kinds of Goods

Public Goods

The Free-Rider Problem

Some Important Public Goods

CASE STUDYAre Lighthouses Public Goods?

The Difficult Job of Cost–Benefit Analysis

CASE STUDYHow Much Is a Life Worth?

Common Resources

The Tragedy of the Commons

Some Important Common Resources

IN THE NEWSThe Bloomberg Plan

CASE STUDYWhy the Cow Is Not Extinct

Conclusion: The Importance of Property Rights

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 12

THE DESIGN OF THE TAX SYSTEM

A Financial Overview of the U.S Government

The Federal Government

CASE STUDYThe Fiscal Challenge Ahead

State and Local Government

Taxes and Efficiency

Deadweight Losses

CASE STUDYShould Income or Consumption Be Taxed?

Administrative Burden

Marginal Tax Rates versus Average Tax Rates

Lump-Sum Taxes

Taxes and Equity

The Benefits Principle

The Ability-to-Pay Principle

CASE STUDYHow the Tax Burden Is Distributed

Tax Incidence and Tax Equity

CASE STUDYWho Pays the Corporate Income Tax?

IN THE NEWSQuestions and Answers about Tax Reform

Conclusion: The Trade-off between Equity and Efficiency

Summary

Key Concepts

Questions for Review

Problems and Applications

PART V

FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

CHAPTER 13

THE COSTS OF PRODUCTION

What Are Costs?

Total Revenue, Total Cost, and Profit

Costs as Opportunity Costs

The Cost of Capital as an Opportunity Cost

Economic Profit versus Accounting Profit

Production and Costs

The Production Function

From the Production Function to the Total-Cost Curve

The Various Measures of Cost

Fixed and Variable Costs

Average and Marginal Cost

Cost Curves and Their Shapes

Typical Cost Curves

Costs in the Short Run and in the Long Run

The Relationship between Short-Run and Long-Run Average Total CostEconomies and Diseconomies of Scale

FYILessons from a Pin Factory

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

What Is a Competitive Market?

The Meaning of Competition

The Revenue of a Competitive Firm

Profit Maximization and the Competitive Firm’s Supply Curve

A Simple Example of Profit Maximization

The Marginal-Cost Curve and the Firm’s Supply Decision

The Firm’s Short-Run Decision to Shut Down

Spilt Milk and Other Sunk Costs

CASE STUDYNear-Empty Restaurants and Off-Season Miniature Golf

The Firm’s Long-Run Decision to Exit or Enter a Market

Measuring Profit in Our Graph for the Competitive Firm

The Supply Curve in a Competitive Market

The Short Run: Market Supply with a Fixed Number of Firms

The Long Run: Market Supply with Entry and Exit

Why Do Competitive Firms Stay in Business If They Make Zero Profit?

A Shift in Demand in the Short Run and Long Run

Why the Long-Run Supply Curve Might Slope Upward

Conclusion: Behind the Supply Curve

Summary

Key Concepts

Questions for Review

Problems and Applications

How Monopolies Make Production and Pricing Decisions

Monopoly versus Competition

A Monopoly’s Revenue

Profit Maximization

FYIWhy a Monopoly Does Not Have a Supply Curve

A Monopoly’s Profit

CASE STUDYMonopoly Drugs versus Generic Drugs

The Welfare Cost of Monopolies

The Deadweight Loss

The Monopoly’s Profit: A Social Cost?

Price Discrimination

A Parable about Pricing

The Moral of the Story

The Analytics of Price Discrimination

Examples of Price Discrimination

IN THE NEWSTKTS and Other Schemes

Public Policy toward Monopolies

Increasing Competition with Antitrust Laws

Regulation

IN THE NEWSAirline Mergers

IN THE NEWS Public Transport and Private Enterprise

Public Ownership

Doing Nothing

Conclusion: The Prevalence of Monopolies

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 16

MONOPOLISTIC COMPETITION

Between Monopoly and Perfect Competition

Competition with Differentiated Products

The Monopolistically Competitive Firm in the Short RunThe Long-Run Equilibrium

Monopolistic versus Perfect Competition

Monopolistic Competition and the Welfare of Society

IN THE NEWSInsufficient Variety as a Market Failure Advertising

The Debate over Advertising

CASE STUDYAdvertising and the Price of Eyeglasses

Advertising as a Signal of Quality

FYIGalbraith versus Hayek

Brand Names

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 17

OLIGOPOLY

Markets with Only a Few Sellers

A Duopoly Example

Competition, Monopolies, and Cartels

The Equilibrium for an Oligopoly

How the Size of an Oligopoly Affects the Market Outcome

The Economics of Cooperation

The Prisoners’ Dilemma

Oligopolies as a Prisoners’ Dilemma

CASE STUDYOPEC and the World Oil Market

Other Examples of the Prisoners’ Dilemma

The Prisoners’ Dilemma and the Welfare of Society

Why People Sometimes Cooperate

CASE STUDYThe Prisoners’ Dilemma Tournament

IN THE NEWSAumann and Schelling

Public Policy toward Oligopolies

Restraint of Trade and the Antitrust Laws

CASE STUDYAn Illegal Phone Call

Controversies over Antitrust Policy

IN THE NEWSPublic Price Fixing

IN THE NEWSA Reversal of Policy

CASE STUDYThe Microsoft Case

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

PART VI

THE ECONOMICS OF LABOR MARKETS

CHAPTER 18

THE MARKETS FOR THE FACTORS OF PRODUCTION

The Demand for Labor

The Competitive Profit-Maximizing Firm

The Production Function and the Marginal Product of Labor

The Value of the Marginal Product and the Demand for LaborWhat Causes the Labor-Demand Curve to Shift?

FYIInput Demand and Output Supply: Two Sides of the Same Coin FYIThe Luddite Revolt

The Supply of Labor

The Trade-off between Work and Leisure

What Causes the Labor-Supply Curve to Shift?

Equilibrium in the Labor Market

Shifts in Labor Supply

IN THE NEWSThe Economics of Immigration

Shifts in Labor Demand

CASE STUDYProductivity and Wages

The Other Factors of Production: Land and Capital

FYIMonopsony

Equilibrium in the Markets for Land and Capital

Linkages among the Factors of Production

FYIWhat Is Capital Income?

CASE STUDYThe Economics of the Black Death

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 19

EARNINGS AND DISCRIMINATION

Some Determinants of Equilibrium Wages

Compensating Differentials

Human Capital

CASE STUDYThe Increasing Value of Skills

Ability, Effort, and Chance

IN THE NEWSThe Loss of Manufacturing Jobs

CASE STUDYThe Benefits of Beauty

An Alternative View of Education: Signaling

The Superstar Phenomenon

IN THE NEWSThe Human Capital of Terrorists

Above-Equilibrium Wages: Minimum-Wage Laws, Unions, and Efficiency Wages

The Economics of Discrimination

Measuring Labor-Market Discrimination

CASE STUDYIs Emily More Employable than Lakisha?

Discrimination by Employers

CASE STUDYSegregated Streetcars and the Profit Motive

IN THE NEWSGender Differences

Discrimination by Customers and Governments

CASE STUDYDiscrimination in Sports

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 20

INCOME INEQUALITY AND POVERTY

The Measurement of Inequality

U.S Income Inequality

Inequality around the World

The Poverty Rate

Problems in Measuring Inequality

CASE STUDYAlternative Measures of Inequality

Economic Mobility

IN THE NEWSWhat to Make of Rising Inequality

The Political Philosophy of Redistributing Income

IN THE NEWSChild Labor

Antipoverty Programs and Work Incentives

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

PART VII

TOPICS FOR FURTHER STUDY

CHAPTER 21

THE THEORY OF CONSUMER CHOICE

The Budget Constraint: What the Consumer Can Afford

Preferences: What the Consumer Wants

Representing Preferences with Indifference Curves

Four Properties of Indifference Curves

Two Extreme Examples of Indifference Curves

Optimization: What the Consumer Chooses

The Consumer’s Optimal Choices

FYIUtility: An Alternative Way to Describe Preferences and Optimization

How Changes in Income Affect the Consumer’s Choices

How Changes in Prices Affect the Consumer’s Choices

Income and Substitution Effects

Deriving the Demand Curve

Three Applications

Do All Demand Curves Slope Downward?

CASE STUDYThe Search for Giffen Goods

How Do Wages Affect Labor Supply?

CASE STUDYIncome Effects on Labor Supply: Historical Trends, Lottery Winners, and

the Carnegie Conjecture

How Do Interest Rates Affect Household Saving?

Conclusion: Do People Really Think This Way?

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 22

FRONTIERS OF MICROECONOMICS

Asymmetric Information

Hidden Actions: Principals, Agents, and Moral Hazard

Hidden Characteristics: Adverse Selection and the Lemons Problem

FYICorporate Management

Signaling to Convey Private Information

CASE STUDYGifts as Signals

Screening to Induce Information Revelation

Asymmetric Information and Public Policy

Political Economy

The Condorcet Voting Paradox

Arrow’s Impossibility Theorem

The Median Voter Is King

Politicians Are People Too

IN THE NEWS Farm Policy and Politics

Behavioral Economics

People Aren’t Always Rational

People Care about Fairness

People Are Inconsistent over Time

IN THE NEWSThis Is Your Brain on Economics

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

PART VIII

THE DATA OF MACROECONOMICS

CHAPTER 23

MEASURING A NATION’S INCOME

The Economy’s Income and Expenditure

The Measurement of Gross Domestic Product

“GDP Is the Market Value ”

CASE STUDYThe Components of U.S GDP

Real versus Nominal GDP

A Numerical Example

The GDP Deflator

CASE STUDYReal GDP Over Recent History

Is GDP a Good Measure of Economic Well-Being?

IN THE NEWSThe Underground Economy

CASE STUDYInternational Differences in GDP and the Quality of Life Conclusion

FYIWho Wins at the Olympics?

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 24

MEASURING THE COST OF LIVING

The Consumer Price Index

How the Consumer Price Index Is Calculated

Problems in Measuring the Cost of Living

FYIWhat Is In the CPI’s Basket?

IN THE NEWSAccounting for Quality Change

The GDP Deflator versus the Consumer Price Index

Correcting Economic Variables for the Effects of Inflation

Dollar Figures from Different Times

Real and Nominal Interest Rates

FYIMr Index Goes to Hollywood

CASE STUDYInterest Rates in the U.S Economy

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

PART IX

THE REAL ECONOMY IN THE LONG RUN

CHAPTER 25

PRODUCTION AND GROWTH

Economic Growth around the World

FYIA Picture Is Worth a Thousand Statistics

FYIAre You Richer Than the Richest American?

Productivity: Its Role and Determinants

Why Productivity Is So Important

How Productivity Is Determined

FYIThe Production Function

IN THE NEWSMeasuring Capital

CASE STUDYAre Natural Resources a Limit to Growth? Economic Growth and Public Policy

Saving and Investment

Diminishing Returns and the Catch-Up Effect

Investment from Abroad

Education

IN THE NEWSPromoting Human Capital

Health and Nutrition

Property Rights and Political Stability

Free Trade

Research and Development

Population Growth

IN THE NEWSEscape from Malthus

Conclusion: The Importance of Long-Run Growth Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 26

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

Financial Institutions in the U.S Economy

Financial Markets

Financial Intermediaries

FYIKey Numbers for Stock Watchers

Summing Up

Saving and Investment in the National Income Accounts

Some Important Identities

The Meaning of Saving and Investment

The Market for Loanable Funds

Supply and Demand for Loanable Funds

Policy 1: Saving Incentives

Policy 2: Investment Incentives

IN THE NEWSIn Praise of Misers

Policy 3: Government Budget Deficits and Surpluses

CASE STUDYThe History of U.S Government Debt

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 27

THE BASIC TOOLS OF FINANCE

Present Value: Measuring the Time Value of Money

FYIThe Magic of Compounding and the Rule of 70

Managing Risk

Risk Aversion

The Markets for Insurance

FYIThe Peculiarities of Health Insurance

Diversification of Firm-Specific Risk

The Trade-off between Risk and Return

Asset Valuation

Fundamental Analysis

The Efficient Markets Hypothesis

CASE STUDYRandom Walks and Index Funds

Questions for Review

Problems and Applications

CHAPTER 28

UNEMPLOYMENT

Identifying Unemployment

How Is Unemployment Measured?

CASE STUDYLabor-Force Participation of Men and Women in the U.S Economy

IN THE NEWSThe Rise of Adult Male Joblessness

Does the Unemployment Rate Measure What We Want It To?

How Long Are the Unemployed without Work?

Why Are There Always Some People Unemployed?

Job Search

Why Some Frictional Unemployment Is Inevitable

FYIThe Jobs Number

Public Policy and Job Search

Unemployment Insurance

IN THE NEWSUnemployment Policy At Home and Abroad

Minimum-Wage Laws

Unions and Collective Bargaining

FYIWho Earns the Minimum Wage?

The Economics of Unions

Are Unions Good or Bad for the Economy?

The Theory of Efficiency Wages

Questions for Review

Problems and Applications

PART X

MONEY AND PRICES IN THE LONG RUN

CHAPTER 29

THE MONETARY SYSTEM

The Meaning of Money

The Functions of Money

The Kinds of Money

IN THE NEWSMonetary Lessons from Iraq

Money in the U.S Economy

FYICredit Cards, Debit Cards, and Money

CASE STUDYWhere Is All the Currency?

The Federal Reserve System

The Fed’s Organization

The Federal Open Market Committee

Banks and the Money Supply

The Simple Case of 100-Percent-Reserve Banking

Money Creation with Fractional-Reserve Banking

The Money Multiplier

The Fed’s Tools of Monetary Control

IN THE NEWSThe Financial Crisis of 2008

Problems in Controlling the Money Supply

CASE STUDYBank Runs and the Money Supply

The Federal Funds Rate

Conclusion

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 30

MONEY GROWTH AND INFLATION

The Classical Theory of Inflation

The Level of Prices and the Value of Money

Money Supply, Money Demand, and Monetary Equilibrium

The Effects of a Monetary Injection

A Brief Look at the Adjustment Process

The Classical Dichotomy and Monetary Neutrality

Velocity and the Quantity Equation

CASE STUDYMoney and Prices During Four Hyperinflations

The Inflation Tax

The Fisher Effect

IN THE NEWSA Recipe for Economic Disaster

The Costs of Inflation

A Fall in Purchasing Power? The Inflation Fallacy

Shoeleather Costs

Menu Costs

Relative-Price Variability and the Misallocation of Resources

Inflation-Induced Tax Distortions

Confusion and Inconvenience

A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth

CASE STUDYThe Wizard of Ozand the Free-Silver Debate

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

PART XI

THE MACROECONOMICS OF OPEN ECONOMIES

CHAPTER 31

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

The International Flows of Goods and Capital

The Flow of Goods: Exports, Imports, and Net Exports

CASE STUDYThe Increasing Openness of the U.S Economy

IN THE NEWSBreaking Up the Chain of Production

The Flow of Financial Resources: Net Capital Outflow

The Equality of Net Exports and Net Capital Outflow

Saving, Investment, and Their Relationship to the International FlowsSumming Up

CASE STUDYIs the U.S Trade Deficit a National Problem?

The Prices for International Transactions: Real and Nominal Exchange Rates

Nominal Exchange Rates

FYIThe Euro

Real Exchange Rates

IN THE NEWSHow a Weak Dollar Boosts Exports

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

The Basic Logic of Purchasing-Power Parity

Implications of Purchasing-Power Parity

CASE STUDYThe Nominal Exchange Rate During a Hyperinflation

Limitations of Purchasing-Power Parity

CASE STUDYThe Hamburger Standard

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 32

A MACROECONOMIC THEORY OF THE OPEN ECONOMY

Supply and Demand for Loanable Funds and for Foreign-Currency Exchange

The Market for Loanable Funds

The Market for Foreign-Currency Exchange

FYIPurchasing-Power Parity as a Special Case

Equilibrium in the Open Economy

Net Capital Outflow: The Link between the Two Markets

Simultaneous Equilibrium in Two Markets

FYIDisentangling Supply and Demand

How Policies and Events Affect an Open Economy

Government Budget Deficits

IN THE NEWSWhat Causes the U.S Trade Deficit?

Trade Policy

Political Instability and Capital Flight

CASE STUDYCapital Flows from China

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

PART XII

SHORT-RUN ECONOMIC FLUCTUATIONS

CHAPTER 33

AGGREGATE DEMAND AND AGGREGATE SUPPLY

Three Key Facts about Economic Fluctuations

Fact 1: Economic Fluctuations Are Irregular and Unpredictable

Fact 2: Most Macroeconomic Quantities Fluctuate Together

Fact 3: As Output Falls, Unemployment Rises

Explaining Short-Run Economic Fluctuations

The Assumptions of Classical Economics

IN THE NEWSOffbeat Indicators

The Reality of Short-Run Fluctuations

The Model of Aggregate Demand and Aggregate Supply

The Aggregate-Demand Curve

Why the Aggregate-Demand Curve Slopes Downward

Why the Aggregate-Demand Curve Might Shift

IN THE NEWSThe 2008 Fiscal Stimulus

The Aggregate-Supply Curve

Why the Aggregate-Supply Curve Is Vertical in the Long Run

Why the Long-Run Aggregate-Supply Curve Might Shift

Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth andInflation

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

Why the Short-Run Aggregate-Supply Curve Might Shift

Two Causes of Economic Fluctuations

The Effects of a Shift in Aggregate Demand

FYIMonetary Neutrality Revisited

CASE STUDYTwo Big Shifts in Aggregate Demand: The Great Depression and World

War II

CASE STUDYThe Recession of 2001

The Effects of a Shift in Aggregate Supply

FYIThe Origins of Aggregate Demand and Aggregate Supply

CASE STUDYOil and the Economy

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 34

THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

How Monetary Policy Influences Aggregate Demand

The Theory of Liquidity Preference

The Downward Slope of the Aggregate-Demand Curve

FYIInterest Rates in the Long Run and the Short Run

Changes in the Money Supply

The Role of Interest-Rate Targets in Fed Policy

IN THE NEWSThe FOMC Explains Itself

CASE STUDYWhy the Fed Watches the Stock Market (and Vice Versa)

How Fiscal Policy Influences Aggregate Demand

Changes in Government Purchases

The Multiplier Effect

A Formula for the Spending Multiplier

Other Applications of the Multiplier Effect

The Crowding-Out Effect

Changes in Taxes

FYIHow Fiscal Policy Might Affect Aggregate Supply

Using Policy to Stabilize the Economy

The Case for Active Stabilization Policy

CASE STUDYKeynesians in the White House

The Case against Active Stabilization Policy

Automatic Stabilizers

Conclusion

Summary

Key Concepts

Questions for Review

Problems and Applications

CHAPTER 35

THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

The Phillips Curve

Origins of the Phillips Curve

Aggregate Demand, Aggregate Supply, and the Phillips Curve

Shifts in the Phillips Curve: The Role of Expectations

The Long-Run Phillips Curve

The Meaning of “Natural”

Reconciling Theory and Evidence

The Short-Run Phillips Curve

The Natural Experiment for the Natural-Rate Hypothesis

Shifts in the Phillips Curve: The Role of Supply Shocks

IN THE NEWSWill Stagflation Return?

The Cost of Reducing Inflation

The Sacrifice Ratio

Rational Expectations and the Possibility of Costless Disinflation

The Volcker Disinflation

The Greenspan Era

Questions for Review

Problems and Applications

PART XIII

FINAL THOUGHTS

CHAPTER 36

FIVE DEBATES OVER MACROECONOMIC POLICY

Should Monetary and Fiscal Policymakers Try to Stabilize the Economy?

Pro: Policymakers Should Try to Stabilize the Economy

Con: Policymakers Should Not Try to Stabilize the Economy

Should Monetary Policy Be Made by Rule Rather Than by Discretion?

Pro: Monetary Policy Should Be Made by Rule

Con: Monetary Policy Should Not Be Made by Rule

IN THE NEWSInflation Targeting

Should the Central Bank Aim for Zero Inflation?

Pro: The Central Bank Should Aim for Zero Inflation

Con: The Central Bank Should Not Aim for Zero Inflation

Should the Government Balance Its Budget?

Pro: The Government Should Balance Its Budget

Con: The Government Should Not Balance Its Budget

Should the Tax Laws Be Reformed to Encourage Saving?

Pro: The Tax Laws Should Be Reformed to Encourage Saving

IN THE NEWSDealing with Deficits

Con: The Tax Laws Should Not Be Reformed to Encourage Saving

Conclusion

Summary

Questions for Review

Problems and Applications

Glossary

Index

PART I Introduction

CHAPTER 1 Ten Principles of Economics

The word economy comes from the Greek word oikonomos, which means “one who

manages a household.” At first, this origin might seem peculiar But in fact, householdsand economies have much in common

A household faces many decisions It must decide which members of the household dowhich tasks and what each member gets in return: Who cooks dinner? Who does thelaundry? Who gets the extra dessert at dinner? Who gets to choose what TV show towatch? In short, the household must allocate its scarce resources among its variousmembers, taking into account each member’s abilities, efforts, and desires

Like a household, a society faces many decisions A society must find some way todecide 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 software Oncesociety has allocated people (as well as land, buildings, and machines) to various jobs,

it must also allocate the output of goods and services they produce It must decide whowill eat caviar and who will eat potatoes It must decide who will drive a Ferrari and whowill 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 goodsand services people wish to have Just as each member of a household cannot geteverything he or she wants, each individual in a society cannot attain the higheststandard of living to which he or she might aspire

at which the good is sold and the quantity that is sold Finally, economists analyzeforces 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 pricesare rising.

economics

the study of how society manages its scarce resources

The study of economics has many facets, but it is unified by several central ideas Inthis 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 will explore theseideas more fully in later chapters The ten principles are introduced here to give you anoverview of what economics is all about Consider this chapter a “preview of comingattractions.”

HOW PEOPLE MAKE DECISIONS

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 ofpeople 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, webegin our study of economics with four principles of individual decision making

PRINCIPLE1: PEOPLEFACETRADE-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 one thing that we like, weusually have to give up another thing that we like Making decisions requires trading offone goal against another

Consider a student who must decide how to allocate her most valuable resource—hertime She can spend all her time studying economics, spend all of it studyingpsychology, 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 shespends studying, she gives up an hour that she could have spent napping, bike riding,watching TV, or working at her part-time job for some extra spending money

Or 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 Theclassic trade-off is between “guns and butter.” The more a society spends on nationaldefense (guns) to protect its shores from foreign aggressors, the less it can spend onconsumer goods (butter) to raise the standard of living at home Also important inmodern 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 andservices Because of the higher costs, these firms end up earning smaller profits, payinglower wages, charging higher prices, or some combination of these three Thus, whilepollution regulations yield the benefit of a cleaner environment and the improved healththat comes with it, they have the cost of reducing the incomes of the firms’ owners,workers, and customers

Another trade-off society faces is between efficiency and equality

efficiency

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

a result, people work less and produce fewer goods and services In other words, whenthe government tries to cut the economic pie into more equal slices, the pie getssmaller.

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 becausedoing so would increase the time available for the study of economics Society shouldnot stop protecting the environment just because environmental regulations reduce ourmaterial standard of living The poor should not be ignored just because helping themdistorts work incentives Nonetheless, people are likely to make good decisions only ifthey understand the options they have available Our study of economics, therefore,starts by acknowledging life’s trade-offs

PRINCIPLE2: THECOST OFSOMETHINGISWHATYOUGIVEUP TOGETIT

Because people face trade-offs, making decisions requires comparing the costs andbenefits 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 enrichmentand a lifetime of better job opportunities But what are the costs? To answer thisquestion, 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 incollege

There are two problems with this calculation First, it includes some things that are notreally costs of going to college Even if you quit school, you need a place to sleep andfood to eat Room and board are costs of going to college only to the extent that theyare more expensive at college than elsewhere Second, this calculation ignores thelargest 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 Formost students, the earnings given up to attend school are the largest single cost of theireducation

whatever must be given up to obtain some item

PRINCIPLE3: RATIONALPEOPLETHINK AT THEMARGIN

Economists normally assume that people are rational