Mankiw s principles of microeconomics 2nd ed

IN THIS CHAPTER YOU WILL Learn that economics is about the allocation of scarce resources Examine some of the tradeof fs that people face Learn the meaning of oppor tunity cost See how to use marginal reasoning when making decisions TEN OF PRINCIPLES Discuss how incentives af fect people’s behavior ECONOMICS The word economy comes from the Greek word for “one who manages a household.” At first, this origin might seem peculiar But, in fact, households and economies have much in common A household faces many decisions It must decide which members of the household which tasks and what each member gets in return: Who cooks dinner? Who does the laundry? Who gets the extra dessert at dinner? Who gets to choose what TV show to watch? In short, the household must allocate its scarce resources among its various members, taking into account each member’s abilities, efforts, and desires Like a household, a society faces many decisions A society must decide what jobs will be done and who will them It needs some people to grow food, other people to make clothing, and still others to design computer software Once society has allocated people (as well as land, buildings, and machines) to various jobs, Consider why trade among people or nations can be good for everyone Discuss why markets are a good, but not per fect, way to allocate resources Learn what determines some trends in the overall economy PA R T O N E INTRODUCTION scarcity the limited nature of society’s resources economics the study of how society manages its scarce resources it must also allocate the output of goods and services that they produce It must decide who will eat caviar and who will eat potatoes It must decide who will drive a Porsche 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 a household cannot give every member everything he or she wants, a society cannot give every individual the highest standard of living to which he or she might aspire Economics is the study of how society manages its scarce resources In most societies, resources are allocated not by a single central planner but through the combined actions 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 interact 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 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 Although the study of economics has many facets, the field is unified by several central ideas In the rest of this chapter, we look at Ten Principles of Economics These principles recur throughout this book and are introduced here to give you an overview of what economics is all about You can think of this chapter as a “preview of coming attractions.” HOW PEOPLE MAKE DECISIONS There is no mystery to what an “economy” is Whether we are talking about the economy of Los Angeles, of the United States, or of the whole world, an economy is just a group of people interacting 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 start our study of economics with four principles of individual decisionmaking P R I N C I P L E # : P E O P L E FA C E T R A D E O F F S The first lesson about making decisions is summarized in the adage: “There is no such thing as a free lunch.” To get one thing that we like, we usually have to give up another thing that we 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; she can spend all of her time studying psychology; or she can divide her time 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 that she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money CHAPTER TEN PRINCIPLES OF ECONOMICS 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 tradeoffs The classic tradeoff is between “guns and butter.” The more we spend on national defense to protect our shores from foreign aggressors (guns), the less we can spend on consumer goods to raise our standard of living at home (butter) Also important in modern society is the tradeoff 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 the higher costs, these firms end up earning smaller profits, paying lower wages, charging higher prices, or some combination of these three Thus, while pollution regulations give us the benefit of a cleaner environment and the improved health that comes with it, they have the cost of reducing the incomes of the firms’ owners, workers, and customers Another tradeoff society faces is between efficiency and equity Efficiency means that society is getting the most it can from its scarce resources Equity means that the benefits of those resources are distributed fairly among society’s members In other words, efficiency refers to the size of the economic pie, and equity refers to how the pie is divided Often, when government policies are being designed, these two goals conflict Consider, for instance, policies aimed at achieving a more equal distribution of economic well-being Some of these policies, such as the welfare system or unemployment insurance, try to help those members of society who are most in need Others, such as the individual income tax, ask the financially successful to contribute more than others to support the government Although these policies have the benefit of achieving greater equity, they have a cost in terms of reduced 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 tradeoffs 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 regulations reduce our material standard of living The poor should not be ignored just because helping them distorts work incentives Nonetheless, acknowledging life’s tradeoffs is important because people are likely to make good decisions only if they understand the options that they have available PRINCIPLE #2: THE COST OF SOMETHING IS W H AT Y O U G I V E U P T O G E T I T Because people face tradeoffs, making decisions requires comparing the costs and benefits of alternative courses of action In many cases, however, the cost of some action is not as obvious as it might first appear Consider, for example, the decision whether to go to college The benefit is intellectual enrichment and a lifetime of better job opportunities But what is the cost? To answer this question, you might be tempted to add up the money you ef ficiency the property of society getting the most it can from its scarce resources equity the property of distributing economic prosperity fairly among the members of society PA R T O N E INTRODUCTION oppor tunity cost whatever must be given up to obtain some item spend on tuition, books, room, and board Yet this total does not truly represent what you give up to spend a year in college The first problem with this answer is that it includes some things that are not really costs of going to college Even if you quit school, you would need a place 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 Indeed, the cost of room and board at your school might be less than the rent and food expenses that you would pay living on your own In this case, the savings on room and board are a benefit of going to college The second problem with this calculation of costs is that it 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 wages given up to attend school are the largest single cost of their education The opportunity cost of an item is what you give up to get that item When making any decision, such as whether to attend college, decisionmakers should be aware of the opportunity costs that accompany each possible action In fact, they usually are College-age athletes who can earn millions if they drop out of school and play professional sports are well aware that their opportunity cost of college is very high It is not surprising that they often decide that the benefit is not worth the cost P R I N C I P L E # : R AT I O N A L P E O P L E T H I N K AT T H E M A R G I N marginal changes small incremental adjustments to a plan of action Decisions in life are rarely black and white but usually involve shades of gray When it’s time for dinner, the decision you face is not between fasting or eating like a pig, but whether to take that extra spoonful of mashed potatoes When exams roll around, your decision is not between blowing them off or studying 24 hours a day, but whether to spend an extra hour reviewing your notes instead of watching TV Economists use the term marginal changes to describe small incremental adjustments 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 In many situations, people make the best decisions by thinking at the margin Suppose, for instance, that you asked a friend for advice about how many years to stay in school If he were to compare for you the lifestyle of a person with a Ph.D to that of a grade school dropout, you might complain that this comparison is not helpful for your decision You have some education already and most likely are deciding whether to spend an extra year or two in school To make this decision, you need to know the additional benefits that an extra year in school would offer (higher wages throughout life and the sheer joy of learning) and the additional costs that you would incur (tuition and the forgone wages while you’re in school) By comparing these marginal benefits and marginal costs, you can evaluate whether the extra year is worthwhile As another example, consider an airline deciding how much to charge passengers who fly standby Suppose that flying a 200-seat plane across the country costs the airline $100,000 In this case, the 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 In fact, however, the airline can raise its profits by CHAPTER TEN PRINCIPLES OF ECONOMICS thinking at the margin Imagine that a plane is about to take off with ten empty seats, and a standby passenger is waiting at the gate willing to pay $300 for a seat Should the airline sell it to him? Of course it should If the plane has empty seats, the cost of adding one more passenger is minuscule Although the average cost of flying a passenger is $500, the marginal cost is merely the cost of the bag of peanuts and can of soda that the extra passenger will consume As long as the standby passenger pays more than the marginal cost, selling him a ticket is profitable As these examples show, individuals and firms can make better decisions by thinking at the margin A rational decisionmaker takes an action if and only if the marginal benefit of the action exceeds the marginal cost PRINCIPLE #4: PEOPLE RESPOND TO INCENTIVES Because people make decisions by comparing costs and benefits, their behavior may change when the costs or benefits change That is, people respond to incentives When the price of an apple rises, for instance, people decide to eat more pears and fewer apples, because the cost of buying an apple is higher At the same time, apple orchards decide to hire more workers and harvest more apples, because the benefit of selling an apple is also higher As we will see, the effect of price on the behavior of buyers and sellers in a market—in this case, the market for apples—is crucial for understanding how the economy works Public policymakers should never forget about incentives, for many policies change the costs or benefits that people face and, therefore, alter behavior A tax on gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars It also encourages people to take public transportation rather than drive and to live closer to where they work If the tax were large enough, people would start driving electric cars When policymakers fail to consider how their policies affect incentives, they can end up with results that they did not intend For example, consider public policy regarding auto safety Today all cars have seat belts, but that was not true 40 years ago In the late 1960s, Ralph Nader’s book Unsafe at Any Speed generated much public concern over auto safety Congress responded with laws requiring car companies to make various safety features, including seat belts, standard equipment on all new cars How does a seat belt law affect auto safety? The direct effect is obvious With seat belts in all cars, more people wear seat belts, and the probability of surviving a major auto accident rises In this sense, seat belts save lives But that’s not the end of the story To fully understand the effects of this law, we must recognize that people change their behavior in response to the incentives they face The relevant behavior here is the speed and care with which drivers operate 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 the marginal benefit from safer driving to the marginal cost They drive more slowly and carefully when the benefit of increased safety is high This explains why people drive more slowly and carefully when roads are icy than when roads are clear Now consider how a seat belt law alters the cost–benefit calculation of a rational driver Seat belts make accidents less costly for a driver because they reduce the probability of injury or death Thus, a seat belt law reduces the benefits to slow and careful driving People respond to seat belts as they would to an improvement BASKETBALL STAR KOBE BRYANT UNDERSTANDS OPPORTUNITY COST AND INCENTIVES DESPITE GOOD HIGH SCHOOL SAT SCORES, HE DECIDED GRADES AND TO SKIP COLLEGE AND GO STRAIGHT TO NBA, WHERE HE EARNED ABOUT $10 MILLION OVER FOUR YEARS THE PA R T O N E INTRODUCTION in road conditions—by faster and less careful driving The end result of a seat belt law, therefore, is a larger number of accidents How does the law affect the number of deaths from driving? Drivers who wear their seat belts are more likely to survive any given accident, but they are also more likely to find themselves in an accident The net effect is ambiguous Moreover, the reduction in safe driving has an adverse impact on pedestrians (and on drivers who not wear their seat belts) They are put in jeopardy by the law because they are more likely to find themselves in an accident but are not protected by a seat belt Thus, a seat belt law tends to increase the number of pedestrian deaths At first, this discussion of incentives and seat belts might seem like idle speculation Yet, in a 1975 study, economist Sam Peltzman showed that the auto-safety laws have, in fact, had many of these effects According to Peltzman’s evidence, these laws produce both fewer deaths per accident and more accidents 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 example of the general principle that people respond to incentives Many incentives that economists study are more straightforward than those of the auto-safety laws No one is surprised that people drive smaller cars in Europe, where gasoline taxes are high, than in the United States, where gasoline taxes are low Yet, as the seat belt example shows, policies can have effects that are not obvious in advance When analyzing any policy, we must consider not only the direct effects but also the indirect effects that work through incentives If the policy changes incentives, it will cause people to alter their behavior Q U I C K Q U I Z : List and briefly explain the four principles of individual decisionmaking 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 PRINCIPLE #5: TRADE CAN MAKE EVERYONE BETTER OFF You have probably heard on the news that the Japanese are our competitors in the world economy In some ways, this is true, for American and Japanese firms produce many of the same goods Ford and Toyota compete for the same customers in the market for automobiles Compaq and Toshiba compete for the same customers in the market for personal computers Yet it is easy to be misled when thinking about competition among countries Trade between the United States and Japan is not like a sports contest, where one CHAPTER TEN PRINCIPLES OF ECONOMICS 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, he or she competes against members of other families who are looking for jobs Families also compete against one another when they go shopping, because each family wants to buy the best goods at the lowest prices So, in a sense, each family in the economy is competing 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 he or she does best, whether it is farming, sewing, or home building By trading with others, people can buy a greater variety of goods and services at lower cost Countries as well as families benefit from the ability to trade with one another Trade allows countries to specialize in what they best and to enjoy a greater variety of goods and services The Japanese, as well as the French and the Egyptians and the Brazilians, are as much our partners in the world economy as they are our competitors “For $5 a week you can watch baseball without being nagged to cut the grass!” P R I N C I P L E # : M A R K E T S A R E U S U A L LY A G O O D WAY TO ORGANIZE ECONOMIC ACTIVITY The collapse of communism in the Soviet Union and Eastern Europe may be the most important change in the world during the past half century Communist countries worked on the premise that central planners in the government were in the best position to guide economic activity These planners decided what goods and services were produced, how much was produced, and who produced and consumed these goods and services The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole Today, most countries that once had centrally planned economies have abandoned this system and are trying to develop market economies In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households Firms decide whom to hire and what to make Households decide which firms to work for and what to buy with their incomes These firms and households interact in the marketplace, where prices and self-interest guide their decisions At first glance, the success of market economies is puzzling After all, in a market economy, no one is looking out for the economic well-being of society as a whole Free markets contain many buyers and sellers of numerous goods and services, and all of them are interested primarily in their own well-being Yet, despite decentralized decisionmaking and self-interested decisionmakers, market economies have proven remarkably successful in organizing economic activity in a way that promotes overall economic well-being In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an “invisible hand” that leads them to desirable market outcomes One of our goals in market economy an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services 10 PA R T O N E INTRODUCTION FYI Adam Smith and the Invisible Hand It may be only a coincidence that Adam Smith’s great book, An Inquiry into the Nature and Causes of the Wealth of Nations, was published in 1776, the exact year American revolutionaries signed the Declaration of Independence But the two documents share a point of view that was prevalent at the time—that individuals are usually best left to their own devices, without the heavy hand of government guiding their actions This political philosophy provides the intellectual basis for the market economy, and for free society more generally Why decentralized market economies work so well? Is it because people can be counted on to treat one another with love and kindness? Not at all Here is Adam Smith’s description of how people interact in a market economy: Man has almost constant occasion for the help of his brethren, and it is vain for him to expect it from their benevolence only He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to for him what he requires of them It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest Every individual neither intends to promote the public interest, nor knows how much he is promoting it He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote ADAM SMITH an end which was no part of his intention Nor is it always the worse for the society that it was no part of it By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it Smith is saying that participants in the economy are motivated by self-interest and that the “invisible hand” of the marketplace guides this self-interest into promoting general economic well-being Many of Smith’s insights remain at the center of modern economics Our analysis in the coming chapters will allow us to express Smith’s conclusions more precisely and to analyze fully the strengths and weaknesses of the market’s invisible hand this book is to understand how this invisible hand works its magic As you study economics, you will learn that prices are the instrument with which the invisible hand directs economic activity Prices reflect both the value of a good to society and the cost to society of making the good Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social benefits and costs of their actions As a result, prices guide these individual decisionmakers to reach outcomes that, in many cases, maximize the welfare of society as a whole There is an important corollary to the skill of the invisible hand in guiding economic activity: When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the millions of households and firms that make up the economy This corollary explains why taxes adversely affect the allocation of resources: Taxes distort prices and thus the decisions of households and firms It also explains the even greater harm caused by policies that directly control prices, such as rent control And it explains the failure of communism In communist countries, prices were not determined in the marketplace but were dictated by central planners These planners lacked the information that gets reflected in prices when prices are free to respond to market CHAPTER TEN PRINCIPLES OF ECONOMICS 11 forces Central planners failed because they tried to run the economy with one hand tied behind their backs—the invisible hand of the marketplace PRINCIPLE #7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET OUTCOMES Although markets are usually a good way to organize economic activity, this rule has some important exceptions There are two broad reasons for a government to intervene in the economy: to promote efficiency and to promote equity That is, most policies aim either to enlarge the economic pie or to change how the pie is divided The invisible hand usually leads markets to allocate resources efficiently Nonetheless, for various reasons, the invisible hand sometimes does not work Economists use the term market failure to refer to a situation in which the market on its own fails to allocate resources efficiently One possible cause of market failure is an externality An externality is the impact of one person’s actions on the well-being of a bystander The classic example of an external cost is pollution If a chemical factory does not bear the entire cost of the smoke it emits, it will likely emit too much Here, the government can raise economic well-being through environmental regulation The classic example of an external benefit is the creation of knowledge When a scientist makes an important discovery, he produces a valuable resource that other people can use In this case, the government can raise economic well-being by subsidizing basic research, as in fact it does Another possible cause of market failure is market power Market power refers to the ability of a single person (or small group of people) to unduly influence market prices For example, suppose that everyone in town needs water but there is only one well The owner of the well has market power—in this case a monopoly—over the sale of water The well owner is not subject to the rigorous competition with which the invisible hand normally keeps self-interest in check You will learn that, in this case, regulating the price that the monopolist charges can potentially enhance economic efficiency The invisible hand is even less able to ensure that economic prosperity is distributed fairly A market economy rewards people according to their ability to produce things that other people are willing to pay for The world’s best basketball player earns more than the world’s best chess player simply because people are willing to pay more to watch basketball than chess The invisible hand does not ensure that everyone has sufficient food, decent clothing, and adequate health care A goal of many public policies, such as the income tax and the welfare system, is to achieve a more equitable distribution of economic well-being To say that the government can improve on markets outcomes at times does not mean that it always will Public policy is made not by angels but by a political process that is far from perfect Sometimes policies are designed simply to reward the politically powerful Sometimes they are made by well-intentioned leaders who are not fully informed One goal of the study of economics is to help you judge when a government policy is justifiable to promote efficiency or equity and when it is not Q U I C K Q U I Z : List and briefly explain the three principles concerning economic interactions market failure a situation in which a market left on its own fails to allocate resources efficiently externality the impact of one person’s actions on the well-being of a bystander market power the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices 480 PA R T S E V E N A D VA N C E D T O P I C Figure 21-13 T HE W ORK -L EISURE D ECISION This figure shows Sally’s budget constraint for deciding how much to work, her indifference curves for consumption and leisure, and her optimum Consumption $5,000 Optimum I3 2,000 I2 I1 60 100 Hours of Leisure H O W D O WA G E S A F F E C T L A B O R S U P P LY ? So far we have used the theory of consumer choice to analyze how a person decides how to allocate his income between two goods We can use the same theory to analyze how a person decides to allocate his time between work and leisure Consider the decision facing Sally, a freelance software designer Sally is awake for 100 hours per week She spends some of this time enjoying leisure—riding her bike, watching television, studying economics, and so on She spends the rest of this time at her computer developing software For every hour she spends developing software, she earns $50, which she spends on consumption goods Thus, her wage ($50) reflects the tradeoff Sally faces between leisure and consumption For every hour of leisure she gives up, she works one more hour and gets $50 of consumption Figure 21-13 shows Sally’s budget constraint If she spends all 100 hours enjoying leisure, she has no consumption If she spends all 100 hours working, she earns a weekly consumption of $5,000 but has no time for leisure If she works a normal 40-hour week, she enjoys 60 hours of leisure and has weekly consumption of $2,000 Figure 21-13 uses indifference curves to represent Sally’s preferences for consumption and leisure Here consumption and leisure are the two “goods” between which Sally is choosing Because Sally always prefers more leisure and more consumption, she prefers points on higher indifference curves to points on lower ones At a wage of $50 per hour, Sally chooses a combination of consumption and leisure represented by the point labeled “optimum.” This is the point on the budget constraint that is on the highest possible indifference curve, which is curve I2 Now consider what happens when Sally’s wage increases from $50 to $60 per hour Figure 21-14 shows two possible outcomes In each case, the budget constraint, shown in the left-hand graph, shifts outward from BC1 to BC2 In the process, the budget constraint becomes steeper, reflecting the change in relative CHAPTER 21 (a) For a person with these preferences Consumption THE THEORY OF CONSUMER CHOICE the labor supply curve slopes upward Wage Labor supply When the wage rises BC1 BC2 I I1 hours of leisure decrease Hours of Leisure and hours of labor increase the labor supply curve slopes backward (b) For a person with these preferences Consumption Hours of Labor Supplied Wage BC2 When the wage rises Labor supply BC1 I2 I1 hours of leisure increase Hours of Leisure Hours of Labor Supplied and hours of labor decrease A N I NCREASE IN THE WAGE The two panels of this figure show how a person might respond to an increase in the wage The graphs on the left show the consumer’s initial budget constraint BC1 and new budget constraint BC2 , as well as the consumer’s optimal choices over consumption and leisure The graphs on the right show the resulting labor supply curve Because hours worked equal total hours available minus hours of leisure, any change in leisure implies an opposite change in the quantity of labor supplied In panel (a), when the wage rises, consumption rises and leisure falls, resulting in a labor supply curve that slopes upward In panel (b), when the wage rises, both consumption and leisure rise, resulting in a labor supply curve that slopes backward price: At the higher wage, Sally gets more consumption for every hour of leisure that she gives up Sally’s preferences, as represented by her indifference curves, determine the resulting responses of consumption and leisure to the higher wage In both panels, Figure 21-14 481 482 PA R T S E V E N A D VA N C E D T O P I C consumption rises Yet the response of leisure to the change in the wage is different in the two cases In panel (a), Sally responds to the higher wage by enjoying less leisure In panel (b), Sally responds by enjoying more leisure Sally’s decision between leisure and consumption determines her supply of labor, for the more leisure she enjoys the less time she has left to work In each panel, the right-hand graph in Figure 21-14 shows the labor supply curve implied by Sally’s decision In panel (a), a higher wage induces Sally to enjoy less leisure and work more, so the labor supply curve slopes upward In panel (b), a higher wage induces Sally to enjoy more leisure and work less, so the labor supply curve slopes “backward.” At first, the backward-sloping labor supply curve is puzzling Why would a person respond to a higher wage by working less? The answer comes from considering the income and substitution effects of a higher wage Consider first the substitution effect When Sally’s wage rises, leisure becomes more costly relative to consumption, and this encourages Sally to substitute consumption for leisure In other words, the substitution effect induces Sally to work harder in response to higher wages, which tends to make the labor supply curve slope upward Now consider the income effect When Sally’s wage rises, she moves to a higher indifference curve She is now better off than she was As long as consumption and leisure are both normal goods, she tends to want to use this increase in well-being to enjoy both higher consumption and greater leisure In other words, the income effect induces her to work less, which tends to make the labor supply curve slope backward In the end, economic theory does not give a clear prediction about whether an increase in the wage induces Sally to work more or less If the substitution effect is greater than the income effect for Sally, she works more If the income effect is greater than the substitution effect, she works less The labor supply curve, therefore, could be either upward or backward sloping CASE STUDY “NO MORE 9-TO-5 FOR ME.” INCOME EFFECTS ON LABOR SUPPLY: HISTORICAL TRENDS, LOTTERY WINNERS, AND THE CARNEGIE CONJECTURE The idea of a backward-sloping labor supply curve might at first seem like a mere theoretical curiosity, but in fact it is not Evidence indicates that the labor supply curve, considered over long periods of time, does in fact slope backward A hundred years ago many people worked six days a week Today five-day workweeks are the norm At the same time that the length of the workweek has been falling, the wage of the typical worker (adjusted for inflation) has been rising Here is how economists explain this historical pattern: Over time, advances in technology raise workers’ productivity and, thereby, the demand for labor The increase in labor demand raises equilibrium wages As wages rise, so does the reward for working Yet rather than responding to this increased incentive by working more, most workers choose to take part of their greater prosperity in the form of more leisure In other words, the income effect of higher wages dominates the substitution effect Further evidence that the income effect on labor supply is strong comes from a very different kind of data: winners of lotteries Winners of large prizes CHAPTER 21 THE THEORY OF CONSUMER CHOICE in the lottery see large increases in their incomes and, as a result, large outward shifts in their budget constraints Because the winners’ wages have not changed, however, the slopes of their budget constraints remain the same There is, therefore, no substitution effect By examining the behavior of lottery winners, we can isolate the income effect on labor supply The results from studies of lottery winners are striking Of those winners who win more than $50,000, almost 25 percent quit working within a year, and another percent reduce the number of hours they work Of those winners who win more than $1 million, almost 40 percent stop working The income effect on labor supply of winning such a large prize is substantial Similar results were found in a study, published in the May 1993 issue of the Quarterly Journal of Economics, of how receiving a bequest affects a person’s labor supply The study found that a single person who inherits more than $150,000 is four times as likely to stop working as a single person who inherits less than $25,000 This finding would not have surprised the nineteenth-century industrialist Andrew Carnegie Carnegie warned that “the parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would.” That is, Carnegie viewed the income effect on labor supply to be substantial and, from his paternalistic perspective, regrettable During his life and at his death, Carnegie gave much of his vast fortune to charity H O W D O I N T E R E S T R AT E S A F F E C T H O U S E H O L D S AV I N G ? An important decision that every person faces is how much income to consume today and how much to save for the future We can use the theory of consumer choice to analyze how people make this decision and how the amount they save depends on the interest rate their savings will earn Consider the decision facing Sam, a worker planning ahead for retirement To keep things simple, let’s divide Sam’s life into two periods In the first period, Sam is young and working In the second period, he is old and retired When young, Sam earns a total of $100,000 He divides this income between current consumption and saving When he is old, Sam will consume what he has saved, including the interest that his savings have earned Suppose that the interest rate is 10 percent Then for every dollar that Sam saves when young, he can consume $1.10 when old We can view “consumption when young” and “consumption when old” as the two goods that Sam must choose between The interest rate determines the relative price of these two goods Figure 21-15 shows Sam’s budget constraint If he saves nothing, he consumes $100,000 when young and nothing when old If he saves everything, he consumes nothing when young and $110,000 when old The budget constraint shows these and all the intermediate possibilities Figure 21-15 uses indifference curves to represent Sam’s preferences for consumption in the two periods Because Sam prefers more consumption in both periods, he prefers points on higher indifference curves to points on lower ones Given his preferences, Sam chooses the optimal combination of consumption in both periods of life, which is the point on the budget constraint that is on the highest possible indifference curve At this optimum, Sam consumes $50,000 when young and $55,000 when old 483 484 PA R T S E V E N A D VA N C E D T O P I C Figure 21-15 T HE C ONSUMPTION -S AVING D ECISION This figure shows the budget constraint for a person deciding how much to consume in the two periods of his life, the indifference curves representing his preferences, and the optimum Consumption when Old Budget constraint $110,000 55,000 Optimum I3 I2 I1 $50,000 100,000 Consumption when Young Now consider what happens when the interest rate increases from 10 percent to 20 percent Figure 21-16 shows two possible outcomes In both cases, the budget constraint shifts outward and becomes steeper At the new higher interest rate, Sam gets more consumption when old for every dollar of consumption that he gives up when young The two panels show different preferences for Sam and the resulting response to the higher interest rate In both cases, consumption when old rises Yet the response of consumption when young to the change in the interest rate is different in the two cases In panel (a), Sam responds to the higher interest rate by consuming less when young In panel (b), Sam responds by consuming more when young Sam’s saving, of course, is his income when young minus the amount he consumes when young In panel (a), consumption when young falls when the interest rate rises, so saving must rise In panel (b), Sam consumes more when young, so saving must fall The case shown in panel (b) might at first seem odd: Sam responds to an increase in the return to saving by saving less Yet this behavior is not as peculiar as it might seem We can understand it by considering the income and substitution effects of a higher interest rate Consider first the substitution effect When the interest rate rises, consumption when old becomes less costly relative to consumption when young Therefore, the substitution effect induces Sam to consume more when old and less when young In other words, the substitution effect induces Sam to save more Now consider the income effect When the interest rate rises, Sam moves to a higher indifference curve He is now better off than he was As long as consumption in both periods consists of normal goods, he tends to want to use this increase in well-being to enjoy higher consumption in both periods In other words, the income effect induces him to save less CHAPTER 21 THE THEORY OF CONSUMER CHOICE (a) Higher Interest Rate Raises Saving Consumption when Old (b) Higher Interest Rate Lowers Saving Consumption when Old BC BC A higher interest rate rotates the budget constraint outward A higher interest rate rotates the budget constraint outward BC BC I2 I1 I2 I1 resulting in lower consumption when young and, thus, higher saving Consumption when Young resulting in higher consumption when young and, thus, lower saving A N I NCREASE IN THE I NTEREST R ATE In both panels, an increase in the interest rate shifts the budget constraint outward In panel (a), consumption when young falls, and consumption when old rises The result is an increase in saving when young In panel (b), consumption in both periods rises The result is a decrease in saving when young The end result, of course, depends on both the income and substitution effects If the substitution effect of a higher interest rate is greater than the income effect, Sam saves more If the income effect is greater than the substitution effect, Sam saves less Thus, the theory of consumer choice says that an increase in the interest rate could either encourage or discourage saving Although this ambiguous result is interesting from the standpoint of economic theory, it is disappointing from the standpoint of economic policy It turns out that an important issue in tax policy hinges in part on how saving responds to interest rates Some economists have advocated reducing the taxation of interest and other capital income, arguing that such a policy change would raise the after-tax interest rate that savers can earn and would thereby encourage people to save more Other economists have argued that because of offsetting income and substitution effects, such a tax change might not increase saving and could even reduce it Unfortunately, research has not led to a consensus about how interest rates affect saving As a result, there remains disagreement among economists about whether changes in tax policy aimed to encourage saving would, in fact, have the intended effect DO THE POOR PREFER TO RECEIVE CASH OR IN-KIND TRANSFERS? Paul is a pauper Because of his low income, he has a meager standard of living The government wants to help It can either give Paul $1,000 worth of food Consumption when Young Figure 21-16 485 486 PA R T S E V E N A D VA N C E D T O P I C (a) The Constraint Is Not Binding Cash Transfer In-Kind Transfer Food Food BC (with $1,000 cash) BC (with $1,000 food stamps) BC BC B B I2 I2 $1,000 $1,000 A A I1 I1 Nonfood Consumption Nonfood Consumption (b) The Constraint Is Binding Cash Transfer In-Kind Transfer Food Food BC (with $1,000 cash) BC (with $1,000 food stamps) BC BC B A I1 Figure 21-17 C $1,000 $1,000 B A I2 Nonfood Consumption I1 I3 I2 Nonfood Consumption C ASH VERSUS I N -K IND T RANSFERS Both panels compare a cash transfer and a similar in-kind transfer of food In panel (a), the in-kind transfer does not impose a binding constraint, and the consumer ends up on the same indifference curve under the two policies In panel (b), the in-kind transfer imposes a binding constraint, and the consumer ends up on a lower indifference curve with the in-kind transfer than with the cash transfer (perhaps by issuing him food stamps) or simply give him $1,000 in cash What does the theory of consumer choice have to say about the comparison between these two policy options? Figure 21-17 shows how the two options might work If the government gives Paul cash, then the budget constraint shifts outward He can divide the extra cash CHAPTER 21 THE THEORY OF CONSUMER CHOICE between food and nonfood consumption however he pleases By contrast, if the government gives Paul an in-kind transfer of food, then his new budget constraint is more complicated The budget constraint has again shifted out But now the budget constraint has a kink at $1,000 of food, for Paul must consume at least that amount in food That is, even if Paul spends all his money on nonfood consumption, he still consumes $1,000 in food The ultimate comparison between the cash transfer and in-kind transfer depends on Paul’s preferences In panel (a), Paul would choose to spend at least $1,000 on food even if he receives a cash transfer Therefore, the constraint imposed by the in-kind transfer is not binding In this case, his consumption moves from point A to point B regardless of the type of transfer That is, Paul’s choice between food and nonfood consumption is the same under the two policies In panel (b), however, the story is very different In this case, Paul would prefer to spend less than $1,000 on food and spend more on nonfood consumption The cash transfer allows him discretion to spend the money as he pleases, and he consumes at point B By contrast, the in-kind transfer imposes the binding constraint that he consume at least $1,000 of food His optimal allocation is at the kink, point C Compared to the cash transfer, the in-kind transfer induces Paul to consume more food and less of other goods The in-kind transfer also forces Paul to end up on a lower (and thus less preferred) indifference curve Paul is worse off than if he had the cash transfer Thus, the theory of consumer choice teaches a simple lesson about cash versus in-kind transfers If an in-kind transfer of a good forces the recipient to consume more of the good than he would on his own, then the recipient prefers the cash transfer If the in-kind transfer does not force the recipient to consume more of the good than he would on his own, then the cash and in-kind transfer have exactly the same effect on the consumption and welfare of the recipient Q U I C K Q U I Z : Explain how an increase in the wage can potentially decrease the amount that a person wants to work CONCLUSION: DO PEOPLE R E A L LY T H I N K T H I S WAY ? The theory of consumer choice describes how people make decisions As we have seen, it has broad applicability It can explain how a person chooses between Pepsi and pizza, work and leisure, consumption and saving, and on and on At this point, however, you might be tempted to treat the theory of consumer choice with some skepticism After all, you are a consumer You decide what to buy every time you walk into a store And you know that you not decide by writing down budget constraints and indifference curves Doesn’t this knowledge about your own decisionmaking provide evidence against the theory? The answer is no The theory of consumer choice does not try to present a literal account of how people make decisions It is a model And, as we first discussed in Chapter 2, models are not intended to be completely realistic The best way to view the theory of consumer choice is as a metaphor for how consumers make decisions No consumer (except an occasional economist) goes 487 488 PA R T S E V E N A D VA N C E D T O P I C through the explicit optimization envisioned in the theory Yet consumers are aware that their choices are constrained by their financial resources And, given those constraints, they the best they can to achieve the highest level of satisfaction The theory of consumer choice tries to describe this implicit, psychological process in a way that permits explicit, economic analysis The proof of the pudding is in the eating And the test of a theory is in its applications In the last section of this chapter we applied the theory of consumer choice to four practical issues about the economy If you take more advanced courses in economics, you will see that this theory provides the framework for much additional analysis Summary ◆ A consumer’s budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods The slope of the budget constraint equals the relative price of the goods ◆ The consumer’s indifference curves represent his preferences An indifference curve shows the various bundles of goods that make the consumer equally happy Points on higher indifference curves are preferred to points on lower indifference curves The slope of an indifference curve at any point is the consumer’s marginal rate of substitution—the rate at which the consumer is willing to trade one good for the other ◆ The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve At this point, the slope of the indifference curve (the marginal rate of substitution between the goods) equals the slope of the budget constraint (the relative price of the goods) ◆ When the price of a good falls, the impact on the consumer’s choices can be broken down into an income effect and a substitution effect The income effect is the change in consumption that arises because a lower price makes the consumer better off The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper The income effect is reflected in the movement from a lower to a higher indifference curve, whereas the substitution effect is reflected by a movement along an indifference curve to a point with a different slope ◆ The theory of consumer choice can be applied in many situations It can explain why demand curves can potentially slope upward, why higher wages could either increase or decrease the quantity of labor supplied, why higher interest rates could either increase or decrease saving, and why the poor prefer cash to in-kind transfers Key Concepts budget constraint, p 465 indifference curve, p 466 marginal rate of substitution, p 467 perfect substitutes, p 470 perfect complements, p 470 normal good, p 473 inferior good, p 473 income effect, p 475 substitution effect, p 475 Giffen good, p 479 Questions for Review A consumer has income of $3,000 Wine costs $3 a glass, and cheese costs $6 a pound Draw the consumer’s budget constraint What is the slope of this budget constraint? CHAPTER 21 Draw a consumer’s indifference curves for wine and cheese Describe and explain four properties of these indifference curves Pick a point on an indifference curve for wine and cheese and show the marginal rate of substitution What does the marginal rate of substitution tell us? Show a consumer’s budget constraint and indifference curves for wine and cheese Show the optimal consumption choice If the price of wine is $3 a glass and the price of cheese is $6 a pound, what is the marginal rate of substitution at this optimum? A person who consumes wine and cheese gets a raise, so his income increases from $3,000 to $4,000 Show what happens if both wine and cheese are normal goods Now show what happens if cheese is an inferior good THE THEORY OF CONSUMER CHOICE 489 The price of cheese rises from $6 to $10 a pound, while the price of wine remains $3 a glass For a consumer with a constant income of $3,000, show what happens to consumption of wine and cheese Decompose the change into income and substitution effects Can an increase in the price of cheese possibly induce a consumer to buy more cheese? Explain Suppose a person who buys only wine and cheese is given $1,000 in food stamps to supplement his $1,000 income The food stamps cannot be used to buy wine Might the consumer be better off with $2,000 in income? Explain in words and with a diagram Problems and Applications Jennifer divides her income between coffee and croissants (both of which are normal goods) An early frost in Brazil causes a large increase in the price of coffee in the United States a Show the effect of the frost on Jennifer’s budget constraint b Show the effect of the frost on Jennifer’s optimal consumption bundle assuming that the substitution effect outweighs the income effect for croissants c Show the effect of the frost on Jennifer’s optimal consumption bundle assuming that the income effect outweighs the substitution effect for croissants Compare the following two pairs of goods: ◆ Coke and Pepsi ◆ Skis and ski bindings In which case you expect the indifference curves to be fairly straight, and in which case you expect the indifference curves to be very bowed? In which case will the consumer respond more to a change in the relative price of the two goods? Mario consumes only cheese and crackers a Could cheese and crackers both be inferior goods for Mario? Explain b Suppose that cheese is a normal good for Mario whereas crackers are an inferior good If the price of cheese falls, what happens to Mario’s consumption of crackers? What happens to his consumption of cheese? Explain Jim buys only milk and cookies a In 2001, Jim earns $100, milk costs $2 per quart, and cookies cost $4 per dozen Draw Jim’s budget constraint b Now suppose that all prices increase by 10 percent in 2002 and that Jim’s salary increases by 10 percent as well Draw Jim’s new budget constraint How would Jim’s optimal combination of milk and cookies in 2002 compare to his optimal combination in 2001? Consider your decision about how many hours to work a Draw your budget constraint assuming that you pay no taxes on your income On the same diagram, draw another budget constraint assuming that you pay a 15 percent tax b Show how the tax might lead to more hours of work, fewer hours, or the same number of hours Explain Sarah is awake for 100 hours per week Using one diagram, show Sarah’s budget constraints if she earns $6 per hour, $8 per hour, and $10 per hour Now draw indifference curves such that Sarah’s labor supply curve is upward sloping when the wage is between $6 and $8 per hour, and backward sloping when the wage is between $8 and $10 per hour Draw the indifference curve for someone deciding how much to work Suppose the wage increases Is it possible that the person’s consumption would fall? Is this 490 PA R T S E V E N A D VA N C E D T O P I C plausible? Discuss (Hint: Think about income and substitution effects.) Suppose you take a job that pays $30,000 and set some of this income aside in a savings account that pays an annual interest rate of percent Use a diagram with a budget constraint and indifference curves to show how your consumption changes in each of the following situations To keep things simple, assume that you pay no taxes on your income a Your salary increases to $40,000 b The interest rate on your bank account rises to percent As discussed in the text, we can divide an individual’s life into two hypothetical periods: “young” and “old.” Suppose that the individual earns income only when young and saves some of that income to consume when old If the interest rate on savings falls, can you tell what happens to consumption when young? Can you tell what happens to consumption when old? Explain 10 Suppose that your state gives each town $5 million in aid per year The way in which the money is spent is currently unrestricted, but the governor has proposed that towns be required to spend the entire $5 million on education You can illustrate the effect of this proposal on your town’s spending on education using a budget constraint and indifference-curve diagram The two goods are education and noneducation spending a Draw your town’s budget constraint under the existing policy, assuming that your town’s only source of revenue besides the state aid is a property tax that yields $10 million On the same diagram, draw the budget constraint under the governor’s proposal b Would your town spend more on education under the governor’s proposal than under the existing policy? Explain c Now compare two towns—Youngsville and Oldsville—with the same revenue and the same state aid Youngsville has a large school-age population, and Oldsville has a large elderly population In which town is the governor’s proposal most likely to increase education spending? Explain 11 (This problem is challenging.) The welfare system provides income to some needy families Typically, the maximum payment goes to families that earn no income; then, as families begin to earn income, the welfare payment declines gradually and eventually disappears Let’s consider the possible effects of this program on a family’s labor supply a Draw a budget constraint for a family assuming that the welfare system did not exist On the same diagram, draw a budget constraint that reflects the existence of the welfare system b Adding indifference curves to your diagram, show how the welfare system could reduce the number of hours worked by the family Explain, with reference to both the income and substitution effects c Using your diagram from part (b), show the effect of the welfare system on the well-being of the family 12 (This problem is challenging.) Suppose that an individual owed no taxes on the first $10,000 she earned and 15 percent of any income she earned over $10,000 (This is a simplified version of the actual U.S income tax.) Now suppose that Congress is considering two ways to reduce the tax burden: a reduction in the tax rate and an increase in the amount on which no tax is owed a What effect would a reduction in the tax rate have on the individual’s labor supply if she earned $30,000 to start? Explain in words using the income and substitution effects You not need to use a diagram b What effect would an increase in the amount on which no tax is owed have on the individual’s labor supply? Again, explain in words using the income and substitution effects 13 (This problem is challenging.) Consider a person deciding how much to consume and how much to save for retirement This person has particular preferences: Her lifetime utility depends on the lowest level of consumption during the two periods of her life That is, Utility ϭ Minimum {consumption when young, consumption when old} a b c Draw this person’s indifference curves (Hint: Recall that indifference curves show the combinations of consumption in the two periods that yield the same level of utility.) Draw the budget constraint and the optimum When the interest rate increases, does this person save more or less? Explain your answer using income and substitution effects G LOS S ARY ability-to-pay principle—the idea that taxes should be levied on a person according to how well that person can shoulder the burden absolute advantage—the comparison among producers of a good according to their productivity accounting profit—total revenue minus total explicit cost average fixed cost—fixed costs divided by the quantity of output average revenue—total revenue divided by the quantity sold average tax rate—total taxes paid divided by total income average total cost—total cost divided by the quantity of output average variable cost—variable costs divided by the quantity of output benefits principle—the idea that people should pay taxes based on the benefits they receive from government services budget constraint—the limit on the consumption bundles that a consumer can afford budget deficit—a shortfall of tax revenue from government spending budget surplus—an excess of government receipts over government spending capital—the equipment and structures used to produce goods and services cartel—a group of firms acting in unison ceteris paribus—a Latin phrase, translated as “other things being equal,” used as a reminder that all variables other than the ones being studied are assumed to be constant circular-flow diagram—a visual model of the economy that shows how dollars flow through markets among households and firms Coase theorem—the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own collusion—an agreement among firms in a market about quantities to produce or prices to charge common resources—goods that are rival but not excludable comparable worth—a doctrine according to which jobs deemed comparable should be paid the same wage comparative advantage—the comparison among producers of a good according to their opportunity cost compensating differential—a difference in wages that arises to offset the nonmonetary characteristics of different jobs competitive market—a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker complements—two goods for which an increase in the price of one leads to a decrease in the demand for the other constant returns to scale—the property whereby long-run average total cost stays the same as the quantity of output changes consumer surplus—a buyer’s willingness to pay minus the amount the buyer actually pays cost—the value of everything a seller must give up to produce a good cost-benefit analysis—a study that compares the costs and benefits to society of providing a public good cross-price elasticity of demand—a measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price deadweight loss—the fall in total surplus that results from a market distortion, such as a tax demand curve—a graph of the relationship between the price of a good and the quantity demanded demand schedule—a table that shows the relationship between the price of a good and the quantity demanded diminishing marginal product—the property whereby the marginal product of an input declines as the quantity of the input increases discrimination—the offering of different opportunities to similar individuals who differ only by race, ethnic group, sex, age, or other personal characteristics diseconomies of scale—the property whereby long-run average total cost rises as the quantity of output increases 491 dominant strategy—a strategy that is best for a player in a game regardless of the strategies chosen by the other players economic profit—total revenue minus total cost, including both explicit and implicit costs economics—the study of how society manages its scarce resources economies of scale—the property whereby long-run average total cost falls as the quantity of output increases efficiency—the property of society getting the most it can from its scarce resources efficiency wages—above-equilibrium wages paid by firms in order to increase worker productivity efficient scale—the quantity of output that minimizes average total cost elasticity—a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants equilibrium—a situation in which supply and demand have been brought into balance equilibrium price—the price that balances supply and demand equilibrium quantity—the quantity supplied and the quantity demanded when the price has adjusted to balance supply and demand equity—the property of distributing economic prosperity fairly among the members of society excludability—the property of a good whereby a person can be prevented from using it explicit costs—input costs that require an outlay of money by the firm exports—goods and services that are produced domestically and sold abroad externality—the impact of one person’s actions on the well-being of a bystander factors of production—the inputs used to produce goods and services fixed costs—costs that not vary with the quantity of output produced free rider—a person who receives the benefit of a good but avoids paying for it 492 G L O S S A RY game theory—the study of how people behave in strategic situations Giffen good—a good for which an increase in the price raises the quantity demanded horizontal equity—the idea that taxpayers with similar abilities to pay taxes should pay the same amount human capital—the accumulation of investments in people, such as education and on-the-job training implicit costs—input costs that not require an outlay of money by the firm import quota—a limit on the quantity of a good that can be produced abroad and sold domestically imports—goods and services that are produced abroad and sold domestically in-kind transfers—transfers to the poor given in the form of goods and services rather than cash income effect—the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve income elasticity of demand—a measure of how much the quantity demanded of a good responds to a change in consumers’ income, computed as the percentage change in quantity demanded divided by the percentage change in income indifference curve—a curve that shows consumption bundles that give the consumer the same level of satisfaction inferior good—a good for which, other things equal, an increase in income leads to a decrease in demand inflation—an increase in the overall level of prices in the economy internalizing an externality—altering incentives so that people take account of the external effects of their actions law of demand—the claim that, other things equal, the quantity demanded of a good falls when the price of the good rises law of supply—the claim that, other things equal, the quantity supplied of a good rises when the price of the good rises law of supply and demand—the claim that the price of any good adjusts to bring the supply and demand for that good into balance liberalism—the political philosophy according to which the government should choose policies deemed to be just, as evaluated by an impartial observer behind a “veil of ignorance” libertarianism—the political philosophy according to which the government should punish crimes and enforce voluntary agreements but not redistribute income life cycle—the regular pattern of income variation over a person’s life lump-sum tax—a tax that is the same amount for every person macroeconomics—the study of economy-wide phenomena, including inflation, unemployment, and economic growth marginal changes—small incremental adjustments to a plan of action marginal cost—the increase in total cost that arises from an extra unit of production marginal product—the increase in output that arises from an additional unit of input marginal product of labor—the increase in the amount of output from an additional unit of labor marginal rate of substitution—the rate at which a consumer is willing to trade one good for another marginal revenue—the change in total revenue from an additional unit sold marginal tax rate—the extra taxes paid on an additional dollar of income market—a group of buyers and sellers of a particular good or service market economy—an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services market failure—a situation in which a market left on its own fails to allocate resources efficiently market power—the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices maximin criterion—the claim that the government should aim to maximize the well-being of the worst-off person in society microeconomics—the study of how households and firms make decisions and how they interact in markets monopolistic competition—a market structure in which many firms sell products that are similar but not identical monopoly—a firm that is the sole seller of a product without close substitutes Nash equilibrium—a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen natural monopoly—a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms negative income tax—a tax system that collects revenue from highincome households and gives transfers to low-income households normal good—a good for which, other things equal, an increase in income leads to an increase in demand normative statements—claims that attempt to prescribe how the world should be oligopoly—a market structure in which only a few sellers offer similar or identical products opportunity cost—whatever must be given up to obtain some item perfect complements—two goods with right-angle indifference curves perfect substitutes—two goods with straight-line indifference curves permanent income—a person’s normal income Phillips curve—a curve that shows the short-run tradeoff between inflation and unemployment Pigovian tax—a tax enacted to correct the effects of a negative externality positive statements—claims that attempt to describe the world as it is poverty line—an absolute level of income set by the federal government for each family size below which a family is deemed to be in poverty poverty rate—the percentage of the population whose family income G L O S S A RY falls below an absolute level called the poverty line price ceiling—a legal maximum on the price at which a good can be sold price discrimination—the business practice of selling the same good at different prices to different customers price elasticity of demand—a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price price elasticity of supply—a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price price floor—a legal minimum on the price at which a good can be sold prisoners’ dilemma—a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial private goods—goods that are both excludable and rival producer surplus—the amount a seller is paid for a good minus the seller’s cost production function—the relationship between quantity of inputs used to make a good and the quantity of output of that good production possibilities frontier— a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology productivity—the amount of goods and services produced from each hour of a worker’s time profit—total revenue minus total cost progressive tax—a tax for which high-income taxpayers pay a larger fraction of their income than low-income taxpayers proportional tax—a tax for which high-income and low-income taxpayers pay the same fraction of income public goods—goods that are neither excludable nor rival quantity demanded—the amount of a good that buyers are willing and able to purchase quantity supplied—the amount of a good that sellers are willing and able to sell regressive tax—a tax for which highincome taxpayers pay a smaller fraction of their income than low-income taxpayers rivalry—the property of a good whereby one person’s use diminishes other people’s use scarcity—the limited nature of society’s resources shortage—a situation in which quantity demanded is greater than quantity supplied strike—the organized withdrawal of labor from a firm by a union substitutes—two goods for which an increase in the price of one leads to an increase in the demand for the other substitution effect—the change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution sunk cost—a cost that has already been committed and cannot be recovered supply curve—a graph of the relationship between the price of a good and the quantity supplied supply schedule—a table that shows the relationship between the price of a good and the quantity supplied surplus—a situation in which quantity supplied is greater than quantity demanded tariff—a tax on goods produced abroad and sold domestically tax incidence—the study of who bears the burden of taxation total cost—the market value of the inputs a firm uses in production total revenue (for a firm)—the amount a firm receives for the sale of its output total revenue (in a market)—the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold 493 Tragedy of the Commons—a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole transaction costs—the costs that parties incur in the process of agreeing and following through on a bargain union—a worker association that bargains with employers over wages and working conditions utilitarianism—the political philosophy according to which the government should choose policies to maximize the total utility of everyone in society utility—a measure of happiness or satisfaction value of the marginal product—the marginal product of an input times the price of the output variable costs—costs that vary with the quantity of output produced vertical equity—the idea that taxpayers with a greater ability to pay taxes should pay larger amounts welfare—government programs that supplement the incomes of the needy welfare economics—the study of how the allocation of resources affects economic well-being willingness to pay—the maximum amount that a buyer will pay for a good world price—the price of a good that prevails in the world market for that good ... natural sciences such as physics, most people are not accustomed to looking at society through the eyes of a scientist Let? ?s therefore discuss some of the ways in which economists apply the logic of. .. us to express Smith? ?s conclusions more precisely and to analyze fully the strengths and weaknesses of the market? ?s invisible hand this book is to understand how this invisible hand works its... produces only two goods Of course, the real world consists of dozens of countries, each of which produces thousands of different types of goods But by assuming two countries and two goods, we