theory and applications of economics

Theory and Applications of Economics v 1.0 This is the book Theory and Applications of Economics (v 1.0) This book is licensed under a Creative Commons by-nc-sa 3.0 (http://creativecommons.org/licenses/by-nc-sa/ 3.0/) license See the license for more details, but that basically means you can share this book as long as you credit the author (but see below), don't make money from it, and make it available to everyone else under the same terms This book was accessible as of December 29, 2012, and it was downloaded then by Andy Schmitz (http://lardbucket.org) in an effort to preserve the availability of this book Normally, the author and publisher would be credited here However, the publisher has asked for the customary Creative Commons attribution to the original publisher, authors, title, and book URI to be removed Additionally, per the publisher's request, their name has been removed in some passages More information is available on this project's attribution page (http://2012books.lardbucket.org/attribution.html?utm_source=header) For more information on the source of this book, or why it is available for free, please see the project's home page (http://2012books.lardbucket.org/) You can browse or download additional books there ii Table of Contents About the Authors Acknowledgments Dedications Preface Chapter 1: What Is Economics? Microeconomics in a Fast-Food Restaurant Macroeconomics in a Fast-Food Restaurant 13 What Is Economics, Really? 16 End-of-Chapter Material 18 Chapter 2: Microeconomics in Action 20 Four Examples of Microeconomics 21 The Microeconomic Approach 27 End-of-Chapter Material 34 Chapter 3: Macroeconomics in Action 36 Behind the Screens 43 Between News and Policy: The Framework of Macroeconomics 51 End-of-Chapter Material 56 Chapter 4: Everyday Decisions 58 Individual Decision Making: How You Spend Your Income 60 Individual Demand 80 Individual Decision Making: How You Spend Your Time 100 End-of-Chapter Material 111 Chapter 5: Life Decisions 116 Consumption and Saving 118 Using Discounted Present Values 143 Avoiding Risk 155 Embracing Risk 167 End-of-Chapter Material 173 iii Chapter 6: eBay and craigslist 178 craigslist and the Gains from Trade 183 eBay 193 Supply and Demand 202 Production Possibilities 215 End-of-Chapter Material 233 Chapter 7: Where Do Prices Come From? 237 The Goal of a Firm 239 The Revenues of a Firm 245 The Costs of a Firm 266 Markup Pricing: Combining Marginal Revenue and Marginal Cost 272 The Supply Curve of a Competitive Firm 281 End-of-Chapter Material 287 Chapter 8: Why Do Prices Change? 291 Market Supply and Market Demand 296 Using the Supply-and-Demand Framework 307 Another Perspective on Changing Prices 319 Three Important Markets 329 Beyond Perfect Competition 339 End-of-Chapter Material 346 Appendix: Algebraic Presentation of Supply and Demand 349 Chapter 9: Growing Jobs 352 How Do Firms Decide How Many Hours of Labor to Hire? 357 Entry and Exit 379 Search 390 Government Policies 398 End-of-Chapter Material 402 Chapter 10: Making and Losing Money on Wall Street 406 A Walk Down Wall Street 410 The Value of an Asset 420 Asset Markets and Asset Prices 429 Efficient Markets 438 End-of-Chapter Material 450 Appendix: A General Formulation of Discounted Present Value 454 iv Chapter 11: Raising the Wage Floor 456 Nominal Wages and Real Wages 461 The Effects of a Minimum Wage 470 Minimum Wage Changes 478 The Minimum Wage and the Distribution of Income 484 Empirical Evidence on Minimum Wages 492 End-of-Chapter Material 502 Chapter 12: Barriers to Trade and the Underground Economy 507 How the Government Controls What You Buy and Sell 511 Limits on Trade across Borders 534 Government and the Labor Market 542 End-of-Chapter Material 548 Chapter 13: Superstars 552 Facts about Inequality 556 The Sources of Inequality 570 Distributive Justice 581 Government Policy 592 End-of-Chapter Material 597 Chapter 14: Cleaning Up the Air and Using Up the Oil 601 The Economics of Clean Air 607 Externalities 619 Renewable, Nonrenewable, and Accumulable Resources 634 End-of-Chapter Material 646 Appendix: An Example of the Hotelling Rule in Operation 649 Chapter 15: Busting Up Monopolies 651 Market Power and Monopoly 654 Patents and Copyright 667 Markets with a Small Number of Sellers 677 End-of-Chapter Material 694 Chapter 16: A Healthy Economy 699 Supply and Demand in Health-Care Markets 704 Health Insurance 719 Government Policy 730 End-of-Chapter Material 737 v Chapter 17: Cars 742 The Demand for Automobiles 745 Supply of Cars 760 Market Outcomes in the Automobile Industry 768 Policy Issues 774 End-of-Chapter Material 780 Chapter 18: The State of the Economy 783 Measuring Economic Activity 787 Measuring Prices and Inflation 802 The Circular Flow of Income 813 The Meaning of Real GDP 825 End-of-Chapter Material 834 Chapter 19: The Interconnected Economy 838 Housing Supply and Demand 844 Comparative Statics: Changes in the Price of Housing 853 Three Important Markets 858 Linkages across Markets 876 End-of-Chapter Material 888 Chapter 20: Globalization and Competitiveness 892 The Production of Real GDP 900 Labor in the Aggregate Production Function 912 Physical Capital in the Aggregate Production Function 921 Other Inputs in the Aggregate Production Function 929 Accounting for Changes in GDP 936 Globalization and Competitiveness Revisited 943 End-of-Chapter Material 951 Chapter 21: Global Prosperity and Global Poverty 957 The Single-Person Economy 963 Four Reasons Why GDP Varies across Countries 975 The Accumulation of Physical Capital 982 Balanced Growth 994 The Role of International Institutions in Promoting Growth 1007 End-of-Chapter Material 1013 vi Chapter 22: The Great Depression 1019 What Happened during the Great Depression? 1024 The Great Depression: A Decrease in Potential Output? 1032 The Components of GDP during the Great Depression 1039 The Great Depression: A Decrease in Aggregate Spending? 1048 Policy Interventions and the Great Depression 1069 End-of-Chapter Material 1075 Chapter 23: Jobs in the Macroeconomy 1080 Unemployment 1085 Job and Worker Flows 1095 Hours Worked 1108 The Government and the Labor Market 1116 End-of-Chapter Material 1123 Chapter 24: Money: A User’s Guide 1128 What Is Money? 1132 Using Money to Buy Goods and Services 1141 Using Money to Buy Other Monies: Exchange Rates 1145 Using Money to Buy Assets: Interest Rates 1165 End-of-Chapter Material 1181 Chapter 25: Understanding the Fed 1186 Central Banks 1192 The Monetary Transmission Mechanism 1198 Monetary Policy, Prices, and Inflation 1214 Monetary Policy in the Open Economy 1225 The Tools of the Fed 1229 The Fed in Action 1238 End-of-Chapter Material 1247 Chapter 26: Inflations Big and Small 1251 The Quantity Theory of Money 1254 Facts about Inflation and Money Growth 1263 The Causes of Inflation 1275 The Costs of Inflation 1284 Policy Remedies 1288 End-of-Chapter Material 1295 vii Chapter 27: Income Taxes 1299 Basic Concepts of Taxation 1302 The Kennedy Tax Cut of 1964 1309 Income Taxes and Saving 1330 The Reagan Tax Cut 1333 End-of-Chapter Material 1343 Chapter 28: Social Security 1348 Individual and Government Perspectives on Social Security 1352 A Model of Consumption 1363 Social Security in Crisis? 1372 The Benefits and Costs of a Social Security System 1383 Social Security in the Real World 1388 End-of-Chapter Material 1395 Chapter 29: Balancing the Budget 1399 Deficits and Debt 1403 The Causes of Budget Deficits 1419 The Benefits of Deficits 1432 The Costs of Deficits 1438 The Ricardian Perspective 1446 End-of-Chapter Material 1456 Chapter 30: The Global Financial Crisis 1462 The Financial Crisis in the United States 1466 From Financial Crisis to Recession 1481 The Crisis in Europe and the Rest of the World 1490 Currency Crises 1508 End-of-Chapter Material 1511 viii Chapter 31: Toolkit 1514 Individual Demand 1516 Elasticity 1520 The Labor Market 1522 Choices over Time 1524 Discounted Present Value 1526 The Credit Market 1529 Expected Value 1531 Correcting for Inflation 1533 Supply and Demand 1536 Buyer Surplus and Seller Surplus 1540 Efficiency and Deadweight Loss 1543 Production Possibilities Frontier 1546 Comparative Advantage 1548 Costs of Production 1550 Pricing with Market Power 1553 Comparative Statics 1556 Production Function 1559 Nash Equilibrium 1562 Externalities and Public Goods 1565 Foreign Exchange Market 1567 Growth Rates 1570 Mean and Variance 1573 Correlation and Causality 1576 The Credit (Loan) Market (Macro) 1579 The Fisher Equation: Nominal and Real Interest Rates 1582 The Aggregate Production Function 1584 The Circular Flow of Income 1588 Growth Accounting 1594 The Solow Growth Model 1596 The Aggregate Expenditure Model 1604 Price Adjustment 1609 Consumption and Saving 1611 The Government Budget Constraint 1615 The Life-Cycle Model of Consumption 1618 Aggregate Supply and Aggregate Demand 1620 The IS-LM Model 1623 ix About the Authors Russell Cooper Dr Russell Cooper is a professor of economics at the European University Institute in Florence, Italy He has held positions at the University of Texas, Boston University, the University of Iowa, and Yale University as well as numerous visiting positions in Asia, Europe, North America, and South America He has taught principles of economics at many of these universities as well as numerous courses to PhD students Cooper’s research has focused on macroeconomics, labor economics, monetary policy, and industrial organization He received his PhD from the University of Pennsylvania in 1982 He was elected Fellow of the Econometric Society in 1997 A Andrew John Andrew John is an associate professor of economics at Melbourne Business School, Melbourne, Australia He received his undergraduate degree in economics from the University of Dublin, Trinity College, in 1981 and his PhD in economics from Yale University in 1988 He has held academic appointments at Michigan State University, the University of Virginia, and INSEAD He has also held visiting appointments at the University of Michigan, the Helsinki School of Economics and Business Administration, and the University of Texas at Austin He joined Melbourne Business School in January 2009 Andrew has consulting experience in the areas of marketing, economics, and strategy He has worked with clients in Australia, Europe, and throughout the AsiaPacific region He has extensive experience in the pharmaceutical industry and has also worked with firms in the consumer goods and consulting sectors Andrew has taught economics to undergraduates, PhD students, MBA students, and executives His research interests include state-dependent pricing models, environmental economics, coordination games, and consumer boycotts His published research has appeared in top economics and business journals, including American Economic Review, Quarterly Journal of Economics, Journal of Monetary Economics, Economic Journal, Journal of Public Economics, Management Science, Sloan Management Review, and Journal of Marketing His work is widely cited in economics journals Chapter 31 Toolkit 31.35 Aggregate Supply and Aggregate Demand The aggregate supply and aggregate demand (ASAD) model is presented here To understand the ASAD model, we need to explain both aggregate demand and aggregate supply and then the determination of prices and output The aggregate demand curve tells us the level of expenditure in an economy for a given price level It has a negative slope: the demand for real gross domestic product (real GDP) decreases when the price level increases The downward sloping aggregate demand curve does not follow from the microeconomic “law of demand.” As the price level increases, all prices in an economy increase together The substitution of expensive goods for cheap goods, which underlies the law of demand, does not occur in the aggregate economy Instead, the downward sloping demand curve comes from other forces First, as prices rise, the real value of nominal wealth falls, and this leads to a fall in household spending Second, as prices rise today relative to future prices, households are induced to postpone consumption Finally, a higher price level can lead to a higher interest rate through the response of monetary policy All these factors together imply that higher prices lead to lower overall demand for real GDP Aggregate supply is equal to potential output at all prices Potential output is determined by the available technology, physical capital, and labor force and is unaffected by the price level Thus the aggregate supply curve is vertical In contrast to a firm’s supply curve, as the price level increases, all prices in an economy increase This includes the prices of inputs, such as labor, into the production process Since no relative prices change when the price level increases, firms are not induced to change the quantity they supply Thus aggregate supply is vertical The determination of prices and output depends on the horizon: the long run or the short run In the long run, real GDP equals potential GDP, and real GDP also equals aggregate expenditure This means that, in the long run, the price level must be at the point where aggregate demand and aggregate supply meet This is shown in Figure 31.26 "Aggregate Supply and Aggregate Demand in the Long Run" 1620 Chapter 31 Toolkit Figure 31.26 Aggregate Supply and Aggregate Demand in the Long Run In the short run, output is determined by aggregate demand at the existing price level Prices need not be at their long-run equilibrium levels If they are not, then output will not equal potential output This is shown in Figure 31.27 "Aggregate Supply and Aggregate Demand in the Short Run" 31.35 Aggregate Supply and Aggregate Demand 1621 Chapter 31 Toolkit Figure 31.27 Aggregate Supply and Aggregate Demand in the Short Run The short-run price level is indicated on the vertical axis The level of output is determined by aggregate demand at that price level As prices are greater than the long-run equilibrium level of prices, output is below potential output The price level adjusts over time to its long-run level, according to the price-adjustment equation The Main Uses of This Tool We not explicitly use this tool in our chapter presentations However, the tool can be used to support the discussions in the following chapters • • • • Chapter 22 "The Great Depression" Chapter 25 "Understanding the Fed" Chapter 26 "Inflations Big and Small" Chapter 27 "Income Taxes" 31.35 Aggregate Supply and Aggregate Demand 1622 Chapter 31 Toolkit 31.36 The IS-LM Model The IS-LM model provides another way of looking at the determination of the level of short-run real gross domestic product (real GDP) in the economy Like the aggregate expenditure model, it takes the price level as fixed But whereas that model takes the interest rate as exogenous—specifically, a change in the interest rate results in a change in autonomous spending—the IS-LM model treats the interest rate as an endogenous variable The basis of the IS-LM model is an analysis of the money market and an analysis of the goods market, which together determine the equilibrium levels of interest rates and output in the economy, given prices The model finds combinations of interest rates and output (GDP) such that the money market is in equilibrium This creates the LM curve The model also finds combinations of interest rates and output such that the goods market is in equilibrium This creates the IS curve The equilibrium is the interest rate and output combination that is on both the IS and the LM curves LM Curve The LM curve represents the combinations of the interest rate and income such that money supply and money demand are equal The demand for money comes from households, firms, and governments that use money as a means of exchange and a store of value The law of demand holds: as the interest rate increases, the quantity of money demanded decreases because the interest rate represents an opportunity cost of holding money When interest rates are higher, in other words, money is less effective as a store of value Money demand increases when output rises because money also serves as a medium of exchange When output is larger, people have more income and so want to hold more money for their transactions The supply of money is chosen by the monetary authority and is independent of the interest rate Thus it is drawn as a vertical line The equilibrium in the money market is shown in Figure 31.28 "Money Market Equilibrium" When the money supply is chosen by the monetary authority, the interest rate is the price that brings the market into equilibrium Sometimes, in some countries, central banks target the money supply Alternatively, central banks may choose to target the interest rate (This was the case we considered in Chapter 25 "Understanding the Fed".) Figure 31.28 "Money Market Equilibrium" applies in either case: if the 1623 Chapter 31 Toolkit monetary authority targets the interest rate, then the money market tells us what the level of the money supply must be Figure 31.28 Money Market Equilibrium To trace out the LM curve, we look at what happens to the interest rate when the level of output in the economy changes and the supply of money is held fixed Figure 31.29 "A Change in Income" shows the money market equilibrium at two different levels of real GDP At the higher level of income, money demand is shifted to the right; the interest rate increases to ensure that money demand equals money supply Thus the LM curve is upward sloping: higher real GDP is associated with higher interest rates At each point along the LM curve, money supply equals money demand We have not yet been specific about whether we are talking about nominal interest rates or real interest rates In fact, it is the nominal interest rate that represents the opportunity cost of holding money When we draw the LM curve, however, we put the real interest rate on the axis, as shown in Figure 31.30 "The LM Curve" The simplest way to think about this is to suppose that we are considering an economy where the inflation rate is zero In this case, by the Fisher equation, the nominal and real interest rates are the same In a more complete analysis, we can 31.36 The IS-LM Model 1624 Chapter 31 Toolkit incorporate inflation by noting that changes in the inflation rate will shift the LM curve Changes in the money supply also shift the LM curve Figure 31.29 A Change in Income 31.36 The IS-LM Model 1625 Chapter 31 Toolkit Figure 31.30 The LM Curve IS Curve The IS curve relates the level of real GDP and the real interest rate It incorporates both the dependence of spending on the real interest rate and the fact that, in the short run, real GDP equals spending The IS curve is shown in Figure 31.29 "A Change in Income" We label the horizontal axis “real GDP” since, in the short run, real GDP is determined by aggregate spending The IS curve is downward sloping: as the real interest rate increases, the level of spending decreases 31.36 The IS-LM Model 1626 Chapter 31 Toolkit Figure 31.31 The IS Curve In fact, we derived the IS curve in Chapter 25 "Understanding the Fed" The dependence of spending on real interest rates comes partly from investment As the real interest rate increases, spending by firms on new capital and spending by households on new housing decreases Consumption also depends on the real interest rate: spending by households on durable goods decreases as the real interest rate increases The connection between spending and real GDP comes from the aggregate expenditure model Given a particular level of the interest rate, the aggregate expenditure model determines the level of real GDP Now suppose the interest rate increases This reduces those components of spending that depend on the interest rate In the aggregate expenditure framework, this is a reduction in autonomous spending The equilibrium level of output decreases Thus the IS curve slopes downwards: higher interest rates are associated with lower real GDP Equilibrium Combining the discussion of the LM and the IS curves will generate equilibrium levels of interest rates and output Note that both relationships are combinations of 31.36 The IS-LM Model 1627 Chapter 31 Toolkit interest rates and output Solving these two equations jointly determines the equilibrium This is shown graphically in Figure 31.32 This just combines the LM curve from Figure 31.30 "The LM Curve" and the IS curve from Figure 31.31 "The IS Curve" The crossing of these two curves is the combination of the interest rate and real GDP, denoted (r*,Y*), such that both the money market and the goods market are in equilibrium Figure 31.32 Equilibrium in the IS-LM Model Comparative Statics Comparative statics results for this model illustrate how changes in exogenous factors influence the equilibrium levels of interest rates and output For this model, there are two key exogenous factors: the level of autonomous spending (excluding any spending affected by interest rates) and the real money supply We can study how changes in these factors influence the equilibrium levels of output and interest rates both graphically and algebraically 31.36 The IS-LM Model 1628 Chapter 31 Toolkit Variations in the level of autonomous spending will lead to a shift in the IS curve, as shown in Figure 31.33 "A Shift in the IS Curve" If autonomous spending increases, then the IS curve shifts out The output level of the economy will increase Interest rates rise as we move along the LM curve, ensuring money market equilibrium One source of variations in autonomous spending is fiscal policy Autonomous spending includes government spending (G) Thus an increase in G leads to an increase in output and interest rates as shown in Figure 31.33 "A Shift in the IS Curve" Figure 31.33 A Shift in the IS Curve Variations in the real money supply shift the LM curve, as shown in Figure 31.34 "A Shift in the LM Curve" If the money supply decreases, then the LM curve shifts in This leads to a higher real interest rate and lower output as the LM curve shifts along the fixed IS curve 31.36 The IS-LM Model 1629 Chapter 31 Toolkit Figure 31.34 A Shift in the LM Curve More Formally We can represent the LM and IS curves algebraically LM Curve Let L(Y,r) represent real money demand at a level of real GDP of Y and a real interest rate of r (When we say “real” money demand, we mean that, as usual, we have deflated by the price level.) For simplicity, suppose that the inflation rate is zero, so the real interest rate is the opportunity cost of holding money.If we wanted to include inflation in our analysis, we could write the real demand for money as L(Y, r + π), where π is the inflation rate Assume that real money demand takes a particular form: L(Y,r) = L0 + L1Y – L2r In this equation, L0, L1, and L2 are all positive constants Real money demand is increasing in income and decreasing in the interest rate Letting M/P be the real stock of money in the economy, then money market equilibrium requires 31.36 The IS-LM Model 1630 Chapter 31 Toolkit M/P = L0 + L1Y – L2r Given a level of real GDP and the real stock of money, this equation can be used to solve for the interest rate such that money supply and money demand are equal This is given by r = (1/L2) [L0 + L1Y – M/P] From this equation we learn that an increase in the real stock of money lowers the interest rate, given the level of real GDP Further, an increase in the level of real GDP increases the interest rate, given the stock of money This is another way of saying that the LM curve is upward sloping IS Curve Recall the two equations from the aggregate expenditure model: Y=E and E = E0(r) + βY Here we have shown explicitly that the level of autonomous spending depends on the real interest rate r We can solve the two equations to find the values of E and Y that are consistent with both equations We find Y equil = × E0 (r) (1 − β) Given a level of the real interest rate, we solve for the level of autonomous spending (using the dependence of consumption and investment on the real interest rate) and then use this equation to find the level of output Here is an example Suppose that C = 100 + 0.6Y, I = 400 − 5r, 31.36 The IS-LM Model 1631 Chapter 31 Toolkit G = 300, and NX = 200 − 0.1Y, where C is consumption, I is investment, G is government purchases, and NX is net exports First group the components of spending as follows: C + I + G + NX = (100 + 400 − 5r + 300 + 200) + (0.6Y − 0.1Y) Adding together the first group of terms, we find autonomous spending: E0 = 100 + 400 + 300 + 200 − 5r = 1000 − 5r Adding the coefficients on the income terms, we find the marginal propensity to spend: β = 0.6 − 0.1 = 0.5 Using β = 0.5, we calculate the multiplier: 1 = = (1 − β) ( 1− ) We then calculate real GDP, given the real interest rate: Y = × (1000 − 5r) = 2000 − 10r Equilibrium Combining the discussion of the LM and the IS curves will generate equilibrium levels of interest rates and output Note that both relationships are combinations of interest rates and output Solving these two equations jointly determines the equilibrium Algebraically, we have an equation for the LM curve: r = (1/L2) [L0 + L1Y – M/P] And we have an equation for the IS curve: 31.36 The IS-LM Model 1632 Chapter 31 Toolkit Y = mE0(r), where we let m = (1/(1 – β)) denote the multiplier If we assume that the dependence of spending in the interest rate is linear, so that E0(r) = e0 – e1r, then the equation for the IS curve is Y = m (e0-e1r), To solve the IS and LM curves simultaneously, we substitute Y from the IS curve into the LM curve to get r = (1/L2) [L0 + L1 m(e0-e1r) – M/P] Solving this for r we get r = Ar – BrM/P where both Ar and Br are constants, with Ar = (L0 + L1me0)/(L1me1 + L2) and Br = 1/(L1me1 + L2) This equation gives us the equilibrium level of the real interest rate given the level of autonomous spending, summarized by e0, and the real stock of money, summarized by M/P To find the equilibrium level of output, we substitute this equation for r back into the equation for the IS curve This gives us Y = Ay + By(M/P), where both Ay and By are constants, with Ay = m(e0 – e1Ar) and By = me1Br This equation gives us the equilibrium level of output given the level of autonomous spending, summarized by e0, and the real stock of money, summarized by M/P Algebraically, we can use the equations to determine the magnitude of the responses of interest rates and output to exogenous changes An increase in the autonomous spending, e0, will increase both Ar and Ay, implying that both the interest rate and output increase.To see that Ay increases with e0 requires a bit more algebra An increase in the real money stock will reduce interest rates by Br and increase output by By A key part of monetary policy is the sensitivity of spending to the interest rate, given by e1 The more sensitive is spending to the interest rate, the larger is e1 and therefore the larger is By 31.36 The IS-LM Model 1633 Chapter 31 Toolkit The Main Uses of This Tool We not explicitly use this tool in our chapter presentations However, the tool can be used to support the discussions in the following chapters • • • • 31.36 The IS-LM Model Chapter 24 "Money: A User’s Guide" Chapter 25 "Understanding the Fed" Chapter 26 "Inflations Big and Small" Chapter 29 "Balancing the Budget" 1634 ... decisions, and the employment and career choices of firms and workers—are examples of what we study in the part of economics called microeconomics1 Microeconomics is about the behavior of individuals and. .. about economics that every educated individual should know Applications ahead of Theory We present all the theory that is standard in books on the principles of economics But by beginning with applications, ... author for microeconomics and another for macroeconomics Both of us have researched and taught both microeconomic and macroeconomic topics, and we have worked together on all aspects of the book